Economics
California is gripped by economic problems, with no easy fix
HOME TO MANY of America’s most progressive policies, from criminal justice to vehicle emissions, California serves a unique role as a punchbag for right-wing politicians. Every few years it becomes fashionable to declare that it is a failed state, or that the California dream is turning into a nightmare. This rhetoric is often overblown: in terms of pure economic heft California remains the most powerful American state. But for all its continuing prowess in innovation (not least in artificial intelligence), California again appears to be entering one of its periodic rough patches.
The state faces three overlapping challenges: rising unemployment, growing fiscal strains and population outflows. All of these should abate over time, but for now they mark out California as a pocket of relative weakness in an otherwise robust American economy.
When the Federal Reserve jacked up interest rates in 2022 in order to tame inflation, many analysts and investors fretted that this monetary tightening would lead to a recession. Instead, the broader economy has been surprisingly resilient. The national unemployment rate remains less than 4%, within spitting distance of a six-decade low. In California, by contrast, the unemployment rate has shot up to 5.3%, the highest of any state (see chart 1).
On its surface the reason for the rise in joblessness in California is no bad thing: as the aftershocks of the covid pandemic fade away, more people are actively seeking jobs. Until they find work, they show up in official data as unemployed. The deeper problem is that the state does not have enough work for them. In California there are roughly 0.8 job openings per unemployed person—the lowest in the country—whereas in America’s other 49 states the overall ratio is 1.6. On Indeed, a recruitment website, California is one of only a handful of states to have suffered a decline in job postings since the eve of the pandemic. Tech firms, which had hired aggressively during the long period of low interest rates, are now retrenching. Silicon Valley’s downsizing has seeped into other parts of the Californian economy, with transport, financial and manufacturing companies all shedding workers.
The Legislative Analyst’s Office (LAO), a nonpartisan fiscal adviser for California’s legislature, last autumn pointed to the rise in unemployment as a potential signal of a recession in the state. The LAO’s judgment matters because it focuses on the state’s fiscal picture, which appears to be badly frayed. Last year California’s income-tax collection tumbled by 25%, similar to falls during the global financial crisis of 2007-09 and the dotcom bust of the early 2000s.
Weakness has persisted. In his budget for the new fiscal year, which begins on July 1st, Gavin Newsom, California’s governor, projected that the state’s deficit would hit $38bn. But the LAO estimates that it is instead on track to hit $73bn. A slightly different methodology accounts for roughly half of that discrepancy, but however the numbers are sliced, California’s constitution requires a balanced budget and it must find a way to close its fiscal hole.
The state has built up a rainy-day fund over the past decade, but Mr Newsom’s proposed budget will draw down roughly half of it. Other solutions have involved deferring promised funding—for universities, the homeless and the disabled. That, however, will only add to shortfalls in the near future, when the LAO projects continued deficits. “It might be easier to tell various stakeholders that the money has just been delayed, but the reality is much of it needs to be eliminated,” says Gabriel Petek, head of the LAO.
As for the outflow of Californians—the third worry—it is not new. Since the early 1990s Californians moving out have usually outnumbered other Americans moving in. But the impact of this out-migration has become more serious. In the past immigrants from abroad more than made up for the domestic outflows, such that California’s population continued to grow. The slowdown in international arrivals during the covid pandemic changed that dynamic. California has recorded an outright decline in its population for three straight years, the first sustained drop since 1850, the year it became a state.
From a fiscal standpoint, the damage has been compounded by the wealth of those leaving. California has lost a steadily growing number of high-earning residents, with the trend accelerating at the height of covid. In 2021 California lost nearly $30bn in net taxpayer income to other states, amounting to about 2% of its tax base. And given its reliance on capital-gains taxes as a big, if volatile, source of revenue, departures of the wealthy may hurt its future fiscal position. Taken together these outflows limit the state’s flexibility in fixing its budget mess. Raising taxes would be one possible solution but doing so may just drive more rich Californians to leave.
As it stands, the overall tax burden on Californians is the fifth-highest in the country, according to the Tax Foundation, a think-tank. The one area where the state’s tax revenues are low—absurdly so—is on property because of a law, passed by popular vote in 1978, which has led to homes being assessed well below their market value. That in turn contributes to inflated housing prices in California, pushing yet more people away from the state.
Golden handcuffs
It is salutary to remember that California has experienced worse. In the early 1990s, reeling from a deep recession, more than 1m Californians left for other states. In 2000-01 a grossly mismanaged electricity market (plus Enron’s corruption) led to blackouts. In 2009 California began paying IOUs to businesses, students and taxpayers to whom it owed money. California’s unemployment rate tends to run a little higher than the rest of America’s. This partly reflects the churn of its tech sector, with firms expanding rapidly but also, when times are tough, pulling back sharply. Throughout California’s many brushes with economic trouble, its innovation-led growth model has been remarkably resilient. The state accounted for about 14% of America’s total output last year, up from 12.5% in the late 1990s (see chart 2).
“People are always judging us on past metrics. So they’re looking at what’s receding, and not enough at what is emerging,” says Dee Dee Myers, a senior adviser to the governor. She points to rising stars across different parts of the state: AI, quantum computing, space tech, immunotherapy, electric vehicles and more. California’s entrenched strengths include the largest higher-education system in the country, more national laboratories than any other state, a location that makes it the gateway for a third of America’s foreign trade and—rumour has it—some pretty nice beaches and mountains. “I also think it’s the culture of California, which often gets maligned. It’s not an accident that all these new ideas are happening here,” says Ms Myers.
Another transition is under way, with more of California’s population and, by extension, economy shifting inland. Among people who left the two biggest Bay Area cities (San Jose and San Francisco) between 2016 and 2020, five of their six most popular destinations were within California, not to other states, according to Oxford Economics, a research firm. Two of the winners were Sacramento and Stockton in the Central Valley, both less than three hours by car from San Francisco. That is spreading tech expertise more widely. “If you’ve got the talent elsewhere and you don’t need to be in San Francisco, why would you build a factory there? You can build in the greater San Francisco area, where land is much cheaper,” says Jerry Nickelsburg of UCLA.
Yet the inland migration by itself is not enough to solve California’s problems. A recent research paper by the Hoover Institution, a conservative think-tank, counted 352 firms that had moved their headquarters to other states in the four years to the end of 2021. A bevy of cost factors were, it argued, pushing them out: high taxes, high energy prices and high wages. Lee Ohanian, one of the report’s authors, thinks more of the same—a steady decay, not a crash—is in store for California’s economy. “The more you have this insidious drop, the tougher it becomes for the state government,” he says. “We have hit the wall where we really can’t get any more tax revenue without significantly damaging the economy.”
One fulcrum that could dramatically alter California’s fortunes is the property market. Housing has become more unaffordable throughout America over the past decade but California continues to claim the dubious crown as the least affordable big state. The price-to-income ratio for buying homes is 12 in San Jose and 11.3 in San Francisco, double the national median, according to researchers at Harvard University. The root cause is a lack of new housing. Mr Newsom is well aware of this and has sought to kick-start construction. Since 2017 lawmakers have passed more than 100 separate pieces of legislation to make it easier to build homes. But the results have been dismal so far. Construction permits have plateaued at about 110,000 housing units per year, far short of what California needs.
Instead, the property sector stands as an example of how California often ties itself in regulatory knots. The state has sped up its notoriously cumbersome environmental reviews for housing, especially for affordable projects. Yet to benefit from this provision, companies must demonstrate that they are using highly skilled workers at prevailing wages—a requirement that in practice compels them to hire union contractors. Alexis Gevorgian, a developer, calculates that this can increase costs by as much as 40%, turning affordable housing into a guaranteed loss-making venture. “The expedited reviews themselves are useless unless you get a subsidy from the government,” Mr Gevorgian says. One of the things on the chopping block as California looks to close its budget deficit? About $1bn of funding for affordable housing, including subsidies for developers. California is no failed state. But it certainly is a struggling one. ■
U.S. President Donald Trump speaks alongside entertainer Kid Rock before signing an executive order in the Oval Office of the White House on March 31, 2025 in Washington, DC.
Andrew Harnik | Getty Images
President Donald Trump is set Wednesday to begin the biggest gamble of his nascent second term, wagering that broad-based tariffs on imports will jumpstart a new era for the U.S. economy.
The stakes couldn’t be higher.
As the president prepares his “liberation day” announcement, household sentiment is at multi-year lows. Consumers worry that the duties will spark another round of painful inflation, and investors are fretting that higher prices will mean lower profits and a tougher slog for the battered stock market.
What Trump is promising is a new economy not dependent on deficit spending, where Canada, Mexico, China and Europe no longer take advantage of the U.S. consumer’s desire for ever-cheaper products.
The big problem right now is no one outside the administration knows quite how those goals will be achieved, and what will be the price to pay.
“People always want everything to be done immediately and have to know exactly what’s going on,” said Joseph LaVorgna, who served as a senior economic advisor during Trump’s first term in office. “Negotiations themselves don’t work that way. Good things take time.”
For his part, LaVorgna, who is now chief economist at SMBC Nikko Securities, is optimistic Trump can pull it off, but understands why markets are rattled by the uncertainty of it all.
“This is a negotiation, and it needs to be judged in the fullness of time,” he said. “Eventually we’re going to get some details and some clarity, and to me, everything will fit together. But right now, we’re at that point where it’s just too soon to know exactly what the implementation is likely to look like.”
Here’s what we do know: The White House intends to implement “reciprocal” tariffs against its trading partners. In other words, the U.S. is going to match what other countries charge to import American goods into their countries. Most recently, a figure of 20% blanket tariffs has been bandied around, though LaVorgna said he expects the number to be around 10%, but something like 60% for China.
What is likely to emerge, though, will be far more nuanced as Trump seeks to reduce a record $131.4 billion U.S. trade deficit. Trump professes his ability to make deals, and the saber-rattling of draconian levies on other countries is all part of the strategy to get the best arrangement possible where more goods are manufactured domestically, boosting American jobs and providing a fairer landscape for trade.
The consequences, though, could be rough in the near term.
Potential inflation impact
On their surface, tariffs are a tax on imports and, theoretically, are inflationary. In practice, though, it doesn’t always work that way.
During his first term, Trump imposed heavy tariffs with nary a sign of longer-term inflation outside of isolated price increases. That’s how Federal Reserve economists generally view tariffs — a one-time “transitory” blip but rarely a generator of fundamental inflation.
This time, though, could be different as Trump attempts something on a scale not seen since the disastrous Smoot-Hawley tariffs in 1930 that kicked off a global trade war and would be the worst-case scenario of the president’s ambitions.
“This could be a major rewiring of the domestic economy and of the global economy, a la Thatcher, a la Reagan, where you get a more enabled private sector, streamlined government, a fair trading system,” Mohamed El-Erian, the Allianz chief economic advisor, said Tuesday on CNBC. “Alternatively, if we get tit-for-tat tariffs, we slip into stagflation, and that stagflation becomes well anchored, and that becomes problematic.”
The U.S. economy already is showing signs of a stagflationary impulse, perhaps not along the lines of the 1970s and early ’80s but nevertheless one where growth is slowing and inflation is proving stickier than expected.
Goldman Sachs has lowered its projection for economic growth this year to barely positive. The firm is citing the “the sharp recent deterioration in household and business confidence” and second-order impacts of tariffs as administration officials are willing to trade lower growth in the near term for their longer-term trade goals.
Federal Reserve officials last month indicated an expectation of 1.7% gross domestic product growth this year; using the same metric, Goldman projects GDP to rise at just a 1% rate.
In addition, Goldman raised its recession risk to 35% this year, though it sees growth holding positive in the most-likely scenario.
Broader economic questions
However, Luke Tilley, chief economist at Wilmington Trust, thinks the recession risk is even higher at 40%, and not just because of tariff impacts.
“We were already on the pessimistic side of the spectrum,” he said. “A lot of that is coming from the fact that we didn’t think the consumer was strong enough heading into the year, and we see growth slowing because of the tariffs.”
Tilley also sees the labor market weakening as companies hold off on hiring as well as other decisions such as capital expenditure-type investments in their businesses.
That view on business hesitation was backed up Tuesday in an Institute for Supply Management survey in which respondents cited the uncertain climate as an obstacle to growth.
“Customers are pausing on new orders as a result of uncertainty regarding tariffs,” said a manager in the transportation equipment industry. “There is no clear direction from the administration on how they will be implemented, so it’s harder to project how they will affect business.”
While Tilley thinks the concern over tariffs causing long-term inflation is misplaced — Smoot-Hawley, for instance, actually ended up being deflationary — he does see them as a danger to an already-fragile consumer and economy as they could tend to weaken activity further.
“We think of the tariffs as just being such a weight on growth. It would drive up prices in the initial couple [inflation] readings, but it would create so much economic weakness that they would end up being net deflationary,” he said. “They’re a tax hike, they’re contractionary, they’re going to weigh on the economy.”
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