California remains mired in something like a zombie state, not quite dead, but certainly not vigorous, moving but with no clear direction. Perhaps, jobs and migration data best show California listless nature.

Jobs have been increasing in almost every sector, but that job growth has been anemic. We saw only 0.6 percent job growth in the past year, leaving us still down over 1.2 million jobs since the recession started. Consequently, the State’s unemployment rate remains over 30 percent above the national rate, and difference has been growing.

Similarly, California’s population has been growing, but extremely slowly compared to California’s golden past. Net domestic migration remains negative, as it has for most of a couple of decades now. Even net international migration has fallen, to less than 170,000 in 2009, the most recent year for which we have data.

Some parts of California are worse than others. California’s great Central valley is in terrible economic shape, by every measure, and unemployment rates in excess of 20 percent are not uncommon. Southern California’s once-thriving Inland Empire, Riverside and San Bernardino Counties, languishes with unemployment rates over 14 percent and decimated housing markets.

Some regions are doing better, most only modestly. San Diego, Orange County, and San Francisco are examples. Only one region the Silicon Valley is doing well enough to generate real enthusiasm. This strength is due to its famous tech sector and to the region’s high density of venture capital firms.

Sectorally, healthcare continues to lead in job creation, recently followed closely by wholesale trade. Natural resources and mining is a small sector that has recently shown strong gains, driven mostly by rising oil prices.

Local government has been California’s weakest sector, which is contrasted by the State government’s continuing job increases. Invariably, in downturns, Sacramento is able to pass most of the pain down to local governments.

California ports have been another bright spot, benefiting from California’s location on the Pacific Rim and serving as a gateway to the vast United States markets.

Of course, the logical question is: why is California’s economy doing so much worse than is the United States economy? Some will answer that California’ has had another idiosyncratic shock. This time, California was ground zero for the collapse of the housing bubble. At the previous recession, California was ground zero for the collapse of the dot-com bubble. In the 1990’s California was ground zero for the downsizing of the United States defense industry.

California has been hit with some shocks. No doubt about it. Between the shocks, however, California has also shown weaker growth, particularly outside of the Silicon Valley. This is an indication that something else is at play, something is wrong, and it has costs.

California is an expensive place to do business, but it not just taxes. The cost of operating in a state is what I call the cost of DURT: Delay, Uncertainty, Regulation, and Taxes. It is the sum of these that helps to determine a state’s job-creating competitiveness, and economic vigor. California DURT is expensive, and it is hurting the State’s economic performance. As long as DURT remains a force of reckoning in California, I expect that the state’s long-term economic structure will continue to slip away from vitality and growth.

True enough, the unemployment claims are down a bit from the previous week, but last weeks numbers were also revised up.  The fact is initial unemployment claims of 453,000 is a big number.  It is not good news.  Similarly, 1.7 percent GDP growth is is a slight revision upward from the initial estimate, but it is still extraordinarily weak.

It is not time to celebrate yet.

Here are a few key findings:

• 2010 Q2 commitments only $1.9 billion, down 49 percent from 2010 Q1 and the lowest since 2003 Q3.
• 20101 first half commitments only $5.6 billion, down from $9.5 billion in the first half of 2009.
• 90 percent of United States survey respondents expect to see a decline in the number of venture capital firms in their country.
• A majority of respondents in China, India, and Brazil expect to see an increase in the number of venture capital firms in their country.

The pessimists cited unfavorable investment environments caused by economic uncertainty, increased regulatory uncertainty, increased taxes, decreased research spending, and problems in the exit markets.

This is a problem for the United States, and California in particular.  Our high-tech sector, supported by massive amounts of venture capital, has been one of our few relative strengths over the past decade, omitting real estate and finance for obvious reasons.  Given the continuing decline in manufacturing jobs, and the ongoing weaknesses in the real estate and finance sectors, it is hard to see the impetus for a strong rebound without vigorous venture capital activity.

The Office of Economic Analysis blog has a nice picture that does a good job describing the torpedo the good ship Oregon took to her hull.

This is net receipts from February though April for the last 14 years. Note how Oregon is $400,000 in the red in 2010, meaning we refunded $400,000 more than we took in during that period, and this is with 66 and 67.

What is going on?

…preliminary numbers show that the biggest culprit was capital gains. Following a 60 percent decline in capital gains income from the 2007 tax year to the 2008 tax year, we were expecting an additional 10 percent decline for the 2009 tax year. This was in line with what many other states were projecting (5 percent to -20 percent) based on an informal survey conducted early last winter. Unfortunately, preliminary estimates show that capital gains income likely dropped at least another 50 percent for the 2009 tax year. Going forward we believe that we will see an uptick in capital gains income, but carry forward losses and low levels of business transactions will limit growth.

Sigh.

The tax increase was supposed to solve Oregon’s problem.  It did not.  Proponents will blame the economy, but people respond to incentives.  These results were predictable.  In fact, we warned Oregonians about this in January.

You can’t tax yourself to prosperity.

How will the Fed raise the short-term market interest rate? The old-fashioned way of tightening monetary policy is to shrink the amount of reserves outstanding by selling assets. Over the past one and a half years, the Fed has piled on securities with long maturities and exposed itself to credit risk. If it sold those assets, it would post considerable losses, deadly to the institution’s already fragile reputation in the current political climate. Instead, the Fed will raise the rate it pays on excess reserves (or deposits of banks at the Fed). Banks will pull up interest rates in the money market as the alternative use of reserves—parking them at the Fed—becomes more remunerative.

Who at the Fed will raise the short-term market interest rate? Congress explicitly gave the authority to raise the interest rate on excess reserves to the Board of Governors (or the seven appointed officials who work in Washington), not the Federal Open Market Committee (FOMC, or the board governors and a subset of reserve bank presidents who normally vote on reserve conditions). Thus, the balance of power within the Fed will shift toward the governors when the instrument of policy becomes the interest rate on reserves. (Bernanke elided this issue in his recent testimony when he left the impression that the FOMC will still set policy in conjunction with the board. In fact, the Federal Reserve Act prohibits the board from delegating monetary policy to others.) This matters because two slots on the board are currently open, giving the White House an important opportunity to shape monetary policy through future nominations. Indeed, given natural turnover among governors, President Obama will probably be able to appoint a majority of the board in a single term of office.

In the first paragraph, Vince highlights the flipside of quantitative easing. The Fed bought a bunch of long-term financial assets, the value of which will go down when interest rates go up. Now, owning these assets is a constraint on Fed actions. There is already plenty of pressure to reduce the already-compromised “Fed independence.” Selling those assets at a loss will further increase pressure for more congressional oversight.

This means the Fed will control inflationary pressure by increasing the rate they pay on excess bank deposits at the Fed. That will work, but it will likely have a more negative impact on economic activity than traditional methods. With high risk-free yields at the Fed, banks, already under regulatory pressure, undercapitalized, and risk averse after the 2008 meltdown, will have no incentive to lend. Small business, which traditionally funded growth with bank loans, will have difficulty obtaining capital. Big business, with direct access to debt and equity markets, will have easier access.

Economic growth, therefore, will probably be slower than under traditional Fed tightening, and it will be biased toward big business. Small business, handicapped by an uneven playing field, will almost surely decline as a percentage of business activity.

The second paragraph is important, because it implies that Fed policy will become more political. Given current and projected United States debts levels, political pressure to monetarize the debt will be strong. As debt levels and interest rates increase, interest costs will soar, as will the pressure to inflate. Will a more politicized Fed resist that pressure? I wouldn’t bet on it.

Jeff isn’t buying any of this. He says:

It seems peculiar to me that the Fed would conduct its monetary policy with a major constraint being the effect on its own profitability. While it might be embarrassing to sell some securities at a loss, it would be even more embarrassing to have a portfolio like the thrifts in the 1980s: long-term fixed rate assets funded with short-term liabilities in a rising rate environment. That would look really stupid.

Good point. We’ll see.

Why did the GDP estimate come in so strong?

Mostly, it was investment. Fourth quarter 2009 private investment activity and consumption grew with such strength from third quarter that resulting fourth quarter GDP growth was a resounding 5.7 percent (annualized). The bulk of this growth, two-thirds of it, came from private sector investment activity. About ninety-percent of the private sector investment activity was driven by inventory spending.

Inventory changes have been negative since the second quarter of 2008, and it was massively negative during the first three quarters of 2009, as establishments corrected their stockpiles in light of the recession. Inventory change was still negative in fourth quarter, but was much less negative than in the third quarter, indicating increased spending to slow the inventory decline. See chart below.

The foreign trade sector and the government sector played little roles in driving fourth quarter economic growth. Trade contributed half a percent to overall GDP growth as export growth rose and import growth fell. Government sector expenditures actually contracted slightly during the fourth quarter of 2009.

These GDP growth results will improve people’s perceptions about the economy. Households, many of whom have volunteered to sit on the sidelines rather than make purchases, may now begin to move back into the arena of making purchases and investing in the future.

The future path of business inventories is very uncertain. We could see inventory changes increase again during 2010, providing further stimulus to GDP growth. Then again, the relatively weak 4th quarter retail sales may cause businesses to decrease target inventories. While we remained concerned about many weaknesses that remain in this economy, including residential real estate, commercial real estate, banking, and household balance sheets, our next United States forecast will likely be more optimistic.