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.

I was shocked that almost everyone complained about increased bureaucracy and regulation.  For example, the farmer’s complaints included a “social responsibility” audit.  Even people who worked for quasi-government or government funded enterprises complained about new requirements.  Only the accountant was happy; regulation increases his business.

Complaints about regulation and bureaucracy are common.  I hear them all the time.  However, I’ve never seen such widespread complaints.  In a group of this size, I would expect maybe three people to complain about regulation, but at this meeting, it was practically universal.

This doesn’t bode well for the recovery.  However well intentioned, new broad-based regulatory requirements will serve as sand scattered throughout the gears of economic activity.  It creates additional costs–costs that are likely to exceed the benefits–and uncertainty.  This is exactly the opposite of what we need for robust growth.

It also doesn’t bode well for our forecast.  We have a very difficult time bringing this type of thing into our models.  It probably means that our models are a bit optimistic, and that is a bit scary.

Fixing the underlying problem is beyond most politicians’ planning horizon, and thus of little interest to them.  Wealth transfers have well-known incentive problems, and they eventually result in high government debt.  Still, this path is popular in some countries, Greece for example.  It is, however, not sustainable in the long run.

In the United States, we choose to increase credit availability, in large part through housing markets.  Ultimately, though, this process is also self limiting.  The debt buildup eventually results in a crisis, one with huge social costs.  As Rajan notes, the current crisis is not the first where the United States tried to lend its way out of an inequality problem.

California has a huge and growing inequality problem, one that I’ve been talking about for years.  Santa Barbara and Monterey are extreme examples of what we see statewide. These are communities of the wealthy, most of whom made their fortunes elsewhere, and the mostly low-wage workers who provide services to the wealthy.

The middle class has mostly left Monterey and Santa Barbara, and they are leaving California.  California’s domestic migration has been negative for years now.  At the same time, the low-wage population is growing.  International migration contributes to the problem, but it is by no means the sole source of the problem.

California must implement two sets of reform to address the growing inequality problem.  It must stem domestic migration tide by increasing opportunity for the middle class.  This would involve several policies that would make California more profitable for business and manufacturing: increased infrastructure investment, tax reform, and regulatory reform.  The benefits of a pro-business regime would be felt most by low-wage and middle-wage workers.

Stemming domestic migration is only part of the problem.  At present, California completely fails its lower class population.  It begins with an educational system that many don’t complete, while many of those who do are often unprepared to participate in a 21st century economy.  It ends with a lack of opportunity and upward mobility.

California’s K-12 program is a failure.  Dropout rates are extraordinary, and those who finish are often unprepared for employment or college.  The failure continues when the few who do manage to prepare for college find that the price has gone up and is now unaffordable for many.  Just as bad, classes are often not offered at times that are convenient for working students.

California needs to renew its commitment to education, at all levels.  In particular, it needs to make education more effective and available to disadvantaged students.  In the end, Education and opportunity, and you need both, are the only long-term solution to inequality.  In the end, we can’t afford not to address the problem.

The great French economist Leon Walras (1834-1910) showed that perfect markets result in an allocation of goods and services that can’t be improved on, in the sense that no one could be made better off without someone else being made worse off.

Of course, we don’t have completely unfettered markets. In fact, they have never existed. They will never exist. In particular, we economists like to talk about what we call negative externalities. These occur when I do something, but an unintended consequence is that it hurts you, and you have no recourse.

An example may make things clearer. Suppose I have a factory that spews out a deadly chemical, one that destroys all life downwind for ten miles. Obviously I’ve reduced the property values for the downwind property owners. (We’re simplifying here. There are many other issues.) There is no market for the damage I’ve done, and downwind landowners may not be able to afford to sue me, and there was a time when they would have likely lost such a case.

Society’s solution to the problem of negative externalities has been regulation. Until recently, the concept of negative externalities has been the rationale for most environmental regulation. Negative externalities’ victims have also been extended to include non-humans: flora, fauna, and “mother earth.”

Climate change regulation, though, is a bit different. In the first place, we don’t know how much of its justification, the claim of manmade global warming with long-term negative economic impacts, is accurate. Some, the “non-believers” completely deny the possibility of man-caused global warming. Others, “the believers” believe in man-caused global warming with a fervor that matches that of any religious zealot. Another group, me included, believes that manmade global warming is a possibility that should be considered as a factor in making long-term economic policy.

If manmade global warming was a certainty, you could reasonably argue that negative externalities justify regulation, the parties being hurt are just not yet born. That’s essentially what the believers are trying to say when they point to the imminent destruction of all life on earth.

However, once the existence of manmade global warming becomes a probability, it becomes an insurance question. This dramatically increases the level of complexity of the problem, and it dramatically complicates the political problem of reaching consensus about what to do.

So, proponents of climate-change regulation have tried to simplify the issue. One approach has been to turn everyone into believers, either by attempting to convince the skeptical—as it turns out by using gross exaggeration if necessary—or, failing conversion, excommunicating even the mildest skeptics from civil society.

Climate-change regulation proponents have also tried, with success, to use the novel argument that climate-change regulation is not only costless but will generate economic growth. The most enthusiastic proponents of this argument, California’s Governor Schwarzenegger among them, describe a utopian future of happy people enjoying previously-unknown prosperity in a pristine earthly heaven.

Sadly, this better-than-a-free-lunch deal is not likely to materialize. It is true that clever economists have constructed models where such an outcome is possible—models having to do with large-scale inefficiencies existing because of historical accident—but large-scale unrecognized opportunities are unlikely in today’s economy.

It is also true that some economists have found some evidence of small un-captured gains. I’ve participated in this literature. However, those gains are also unlikely to be of the scale necessary to achieve the promised new economic age. Indeed, most economists doubt their existence, arguing, reasonably, that the researchers failed to measure all of the relevant costs. Economists have a hard time believing that markets are so bad that unrecognized profitable opportunities exist in abundance.

Today, California is considering the repeal or postponement of its landmark global-warming regulation, AB32. Oddly, both sides are using the same argument. The forces arguing against the repeal of AB32 argue that the repeal will cost jobs. Those arguing for the repeal argue that failure to repeal will cost jobs.

They are both correct, and they can both prove it with their warring models, which brings us to our second great dead French economist.

Frederick Bastiat (1801-1850), not long before his death, wrote a piece What is Seen and What is Not Seen. In the essay, Bastiat gives the example of jobs created by breaking windows. The broken window creates work for the glazier, a multiplier is attached to that work, and it looks as if economic activity has increased. However, society is not better off. The problem is that we see, and account for, the work, but we do not see or count the costs associated with the initial destruction of capital.

So it is with California’s regulation. Proponents of the regulation have research to support their claim of job creation. The “green jobs” created by the regulation are seen and counted. The jobs lost to the regulation are not seen and are not counted.

The opponents of California’s regulation have estimated the jobs lost to the regulation, mostly a consequence of higher energy costs, but that research—the portion I’m aware of at least—has been criticized for ignoring the jobs created by the regulation. More importantly, they do not see the jobs that might be lost if global warming kills jobs. They only see, and show, the jobs lost to failure to repeal the regulation.

Creating jobs is easy; creating real economic growth is harder. Banning the use of any productivity-enhancing technology will create jobs, but this could occur at the cost of societal well being. We could achieve full employment by banning all agricultural technology created after the 17th century. There is no unemployment in a Malthusian economy. We’d all have “idyllic” jobs on the farm, yet this would in reality be back-breaking work. Many people would live on the edge of starvation. I don’t think anyone really wants that outcome. It is also easy to create subsidized jobs, even if those jobs add nothing to, or worse detract from, society’s well being.

Instead of jobs, the argument should focus on such things well being, consumption, income, probabilities, and the like. It is complicated by the uncertainty surrounding the theory of manmade global warming, and the uncertainty surrounding the economic impacts of any warming. But, the stakes are high. People’s lives will be changed. The debate deserves a higher-level of discourse than we’ve seen. Frenetic predictions of job losses or overly optimistic projections of employment created by a green economy will not do. Instead, let’s recognize the complexity of the issue and have a reasoned discussion.

This previously appeared at newgeography.com

• Keep it simple. Simple regulation is cost-effective regulation. Simple regulation minimizes both regulatory costs to the government and compliance costs to the regulated firms, costs eventually borne by consumers or taxpayers. Complicated regulation invites lawsuits and encourages efforts to avoid the regulation.

• Regulate the smallest possible number of firms. Regulation is a market distortion and tends to limit innovation. Because of the September 2008 collapse, some people are not convinced of the benefits of financial innovation. This is unfortunate. Financial innovation is, on net, positive. Consider the Farmer who hedges against bad weather by using futures or the airlines that hedge against higher gasoline costs. We need to encourage financial innovation.

• Preserve incentives. We’ve all encountered either government monopolies or government regulated monopolies. The DMV, the Post Office, and utilities come to mind. We’ve also seen the innovation that followed the elimination of the phone monopoly. Bad regulation provides perverse incentives. Good regulation maintains incentives for quality, service, and innovation.

• Maximize market feedback. Markets have built in incentives that are beneficial to society. Where possible, we should allow that feedback to do its magic. It is the cost-effective way to preserve incentives.

• Minimize moral-hazard problems. Moral-hazard issues result from free or under-priced insurance. It is currently pervasive, and it is our single largest source of unnecessary systematic risk. The too-big-too-fail concept in particular has resulted in excessive risk taking, with disastrous results. Similarly, FDIC insurance was under-priced, as evidenced by the FDIC accelerating the collection of future premiums, and the results are self-evident.

• Minimize political influence. Political influence in economic matters is counterproductive. It is clear to me that the vast majority of political types are trying to optimize something other than economic activity or efficiency. Whether the political objective is maximizing the likelihood of reelection, rewarding supporters, or simply greedy corruption, we need to avoid the results.

• Regulation is not protection. Regulators often become partners with the regulated. Sometimes this is because the regulator expects to be eventually employed by the regulated. The regulator may have been employed by the regulated, or may become friends with the regulated, or may be corrupt and accept bribes. In all cases, we are ill served when the regulator is protecting the regulated.

• Regulation should not be adversarial. The purpose of regulation is not to punish the regulated. We have a legal system to provide punishment when it is needed. Adversarial regulation will encourage evasion. The best approach is arms-length, fair, and firm.

The problem with regulating capital ratios is that the capital ratio is not a sufficient measure of the firm’s risk. The firm’s risk is a function of both the capital ratio and the riskiness of the assets it holds, and that poses serious regulatory challenges.

A firm has a preferred risk profile. If you limit the capital ratio, the firm can achieve its target risk profile by increasing the riskiness of its assets. This means that if you want to regulate the riskiness of a firm using a capital ratio, you must also control the riskiness of its assets. No problem there.

Well, actually, there is a problem. Controlling the riskiness of a firm’s assets is impossible.

If regulation is to have any impact, the firm has a big financial interest in having riskier assets than the regulators would prefer—an interest that is only made larger by free (too-big-to-fail) or under-priced (FDIC) insurance—and the regulators have only a limited interest. Therefore, the firm will succeed in working around any constraints, and they will always be at least a step ahead of the regulators. The regulators are just no match for a determined firm with a big financial incentive.

Even if regulators could control the risk of firms’ assets, they still could not control the risk of the firm, because risk is dynamic, changing over time. In my banking days, we had a saying: In good times you don’t need capital; in bad times you will not have enough capital.

The problem is that in bad times, everything goes bad. We say the covariance goes to one. It may seem farfetched that a New York grocer, a Los Angeles realtor, and a Chicago lawyer would have economic prospects that were related, and that is true in most states of the world. This is the argument for geographic diversification. However, in a big event like we saw in September 2008 the grocer, the realtor, and the lawyer were all in the same boat. The probability of each of them failing to meet obligations has gone up, but more importantly, the probability of all of them defaulting has gone way up.

There must be a better way to regulate financial companies.

• Keep it simple
• Preserve correct incentives
• Minimize political influence
• Maximize market feedback
• Minimize moral hazard issues
• Regulation is not protection

Our friends at KERN Economics have come up with a plan that meets all of my criteria. It also has the desirable characteristic of having successful working examples, examples that were unfazed by 2008’s meltdown. Good original thinking. Read it here.

Scheer doesn’t give his reasons for supporting a new Glass Steagall, but he quotes McCain extensively. McCain’s comments are essentially a populist rant against “fat cat bankers on Wall Street.”

That’s a problem. I’m all for a new Glass Steagall, but let’s get the reasons right. Populist rants only confuse things.

The Glass-Steagall Act, passed in 1933, was part of the response to the Great Depression. The component relevant to today’s debate was the restrictions on the breadth of financial institutions’ operations. Investment banks were restricted from commercial banking, and commercial banks were similarly restricted from investment banking. An investment bank engages in transactions involving capital, securities, mergers and the like. Commercial banks take deposits and make loans.

The repeal of Glass-Steagall, in November 1999, was supported by both political parties. The arguments for repeal were that it would reduce risk by diversification and that advances in financial technology meant that risk was low.

Right.

The diversification argument sounds reasonable: Banks could diversify, and if one business was in trouble, the other probably won’t be in trouble. But, there is a problem with that argument. Financial theory and experience is clear. Stockholders can diversify for themselves. Businesses should concentrate on their core competency, the one where they maintain a comparative advantage.

The diversification argument also implicitly assumes a relatively low correlation between the returns from the various businesses. Financial panics throughout history have demonstrated that when things go bad, the correlation goes to one. When things go wrong, they go wrong everywhere.

The argument that financial technology has improved, and we now know how to do things with low risk is an old one. I refer readers to Reinhart and Rogoff’s book This Time is Different: Eight Centuries of Financial Foll. In it, these respected economists document the plethora of financial panics this type of thinking has created.

We do need to reinstate the separation of bank business. Let’s do it for sound reasons. While we’re at it, let’s limit the maximum size of any corporation. We also need to get rid of the Too Big To Fail concept.

Of course, the problem is that the Too-Big-To-Fail concept, regulators, and Fed policy are the reason banks are taking excessive risk in the first place. What happened was that there were perceived problems with the market. So, there was regulation. Then, we had the Greenspan market interventions. The regulations and the market interventions encouraged excessive risk taking. Now, they want to limit salaries.

Of course, limiting bank executives’ salaries will lead to other problems. To have any impact, the salary caps will have to be below market. That means high-quality executives outside the industry will not consider entering the industry. Talented young people will not enter the industry. Over time, the best banking executives will leave the industry.

What regulations will be proposed when banking is dominated by mediocre executives who selected the industry because of a lack of competent competitors?