What's Killing California?

California has a case of the same disease that felled the Rust Belt. Will the patient survive?

California Failin'

The troubles of California, and their causes, are a widely discussed topic these days. America's most populated state by far, its successes and failures always loom large in the national consciousness. In the last year we've seen the state face a massive $42 billion budget deficit and the humiliation of having to issue IOU's as payments. Its pensions are radically underfunded and there are other long term structural budgetary problems. Parts of the state were ground zero for the housing collapse and among the highest foreclosure zones in the country. Unemployment, high everywhere, is particularly so in parts of California. California, the place people once moved to, is now the place the move from, as the state is experiencing net domestic out-migration, leading to the prospect of losing a representative in Congress for the first time in its history. A complicated political system has led to decision making paralysis. Even disasters like wildfires have been played up.

There are no end to explanations for this which, unsurprisingly, tend to follow people's political beliefs. To those on the right, California is the ultimate blue state, with high taxes, an anti-business mindset, and environmental and other regulations designed to send people and businesses fleeing for the exits. To those on the left, California's problems are the comeuppance for decades of unchecked sprawl, the ultimate car culture, and unchecked exploitation of resources. Whatever your particular policy pet peeve, California must be it.

But is this really the case?

The real problem could be much more simple and yet much more terrifying in its implications. California has simply now outgrown its youth and is now well into its middle age. Like the Rust Belt before it, California is now old. As with people as they age, "chronic lifestyle diseases" hit places too. These are: unfunded liabilities, the end of growth economics, and institutional rigidity, each of which builds on the one before it.

Unfunded Liabilities

I've long noted that places have an incredible tendency to accumulate unfunded liabilities, most of them of the "off balance sheet" variety. The temptation to defer problems into the future is simply too great for most governments to resist, hence structural imbalances build up over time. The sources of these liabilities are many, but here are some key ones:

• Deferred Infrastructure Investment. As populations and development grow, infrastructure is built with a lag and generally there is a lack of funds for completion. As a result, cities and states end up with deficient infrastructure for their size, leading to all sorts of problems such as traffic and transit congestion. Clearly, California is suffering here.
  
• Infrastructure Maintenance. Similarly, cities build some infrastructure, then "sweat the assets" as long as possible. Infrastructure is often not well-maintained, and the periodic capital refresh unbudgeted. Condo associations do reserve studies and set aside funds to meet future capital needs such as roof replacements to avoid painfully huge special assessments, but government do not. I have yet to see any city or state that even has a schedule of major assets and infrastructure with needed maintenance and replacement timeframes, much less funding for any it. California's Golden Age infrastructure is now aging, and it is facing repair bills merely to maintain what it has.
  
• Underfunded Pensions. Politicians love to sweeten public sector pensions. This buys both labor peace and a powerful political constituency. These are seldom funded at adequate levels - and with the rapid growth in life extending technology, it's questionable whether any level of funding is sufficient - leading to major problems downstream. California's pensions are unfunded by upwards of $300 billion.
• Other Redevelopment Costs. When ever homes and buildings are shiny and new, things are great. But what happens when your building stock gets old like in Rust Belt inner cities, and often no longer meet the functional and technical demands of the modern day, such as sizes, layouts, energy efficiency, etc.?
  

Add this all up, and it's a huge bill that eventually comes due. The most important thing to understand about this is that the bill attaches to the territory, not to the people. So residents and businesses can avoid paying up simply by leaving for another jurisdiction. It's like being able to run up a huge credit card bill in someone else's name, then skip town.

This ability to run up massive deferred and unfunded liabilities, then leave, sticking other people with the bill, is one of the most powerful forces driving greenfield development. Even if there weren't a drop of subsidies to, say, suburban expansion, the financial incentive to escape the huge liabilities of central cities and older suburbs is a key incentive on its own.

This why I've said it is critical to find ways to prevent governments from accumulating these liabilities in the first place.

The End of Growth Economics

Look at companies and industries. There is a standard growth curve to them. They start out in incubation and infancy, then, if successful, on to growth, then finally to maturity and decline. Why would we think that what is true for firms would be different for places? Why would we think that cities or states are immune from the forces of creative destruction? The answer is, they aren't.

Having done consulting in the retail industry for some years, I often observed the growth curves played out in companies. Category killers came along and grew and grew and grew, seemingly as unstoppable juggernauts. But eventually, they hit the end of their growth phase, and had to endure a period of wandering in the wilderness. The reasons for this are varied - market saturation and consequent over expansion, changes in the marketplace, insufficient infrastructure and operational disciplines, more nimble competitors - but we've seen it played out before our eyes in America. Think McDonald's, Home Depot, and the Gap.

The logic and economics of high growth are fundamentally different from that of operating a more or less steady state or low growth business. In the growth phase, everything is oriented towards expansion, mostly building more infrastructure to keep up with it. Also, scale economics are in your favor. With more people, for example, you are spreading fixed costs across more bodies and more buildings, so you can spend more money and tax less per capita all the same time. Your brand value is expanding with size, etc. That's all great if you can pull it off.

But when something causes growth to take a hit - maybe accumulated liabilities, resource exhaustion, jurisdictional limits, etc - the equation changes radically. You can no longer rely on growth to provide unit cost efficiency. You have to start thinking like an operator. That is an extremely difficult mindset shift and requires a totally different set of skills. From what I've seen, companies have an extremely difficult time doing this. They generally have to struggle for some time, usually bring in new leadership, and undergo painful structuring. Many of them never really recover. But some do. I think of McDonald's, which stopped relying on store growth to fuel its engine, but now relies on product innovation (Angus burgers, coffee, salads, etc) and operational effectiveness.

California, for whatever reason, stopped growing. The trends in domestic out migration make this very clear. The fact that total population has not declined doesn't matter. Most Rust Belt states never actually physically lost population. Their growth simply slowed to a crawl. And it was the most entrepreneurial and high skill classes that fled. In California that his been somewhat masked by outsized productivity in the technology sector and international immigration, but the overall trend is clear. California now has to think like an operator. Welcome to the world of legacy. California is now a gigantic "brownfield".

As California struggles with this transition, the scale economics start to go in reverse. As people and businesses leave, the unit cost of all those unfunded liabilities looms large. Just as growth begets growth, decline begets decline. If you are young and ambitious, why stay in California and pay off all those pensions? All things being equal, it is much better to leave for a more greenfield location, where you can benefit from running up the credit card, not paying off someone else's bill. If not arrested, decline eventually reaches a tipping point, as we've seen in so many Rust Belt cities.

Institutional Rigidity

The third symptom of civic aging is a creeping institutional rigidity that makes change difficult. In established, mature places, there many, many powerful institutions and interest groups. These can often be forces for good, but too often become barriers to change or getting things done. What's more, these institutions were typically created in the past to meet the perceived challenges of that time and age, but survive today in a world that is very different. As most institutions are never sunset, and new ones form over time, there is a gradual accumulation of friction over time. Eventually, the gears and seize up.

These institutions can take many forms. Constitutions and political structures, non-profits, clubs and social networks, various trade-offs and political accommodations and deals from over the years, power structures, corruption, local business practices, unions, recipients of government funding, taxpayer or other advocacy groups, political party organizations, business groups, etc. Much is made of California's many times amended constitution as a barrier to change, but that is only the tip of the iceberg.

As decline sets in, a toxic dynamic takes hold. In a growth mode, it is very easy for everyone to hold hands and sing kum-bah-ya. It's comparatively easy to cut deals to divide the fruits of prosperity. In decline, those deals come back to haunt. The status quo is failing, but people are still profiting from it. Even in Detroit, America's ultimate failed city, so many people and groups benefit from the current system that there is complete paralysis. No one wants to give up an inch of hard won gains, especially since in a dismal region there's little hope of replicating that privileged position or income. Hard times promote solidarity, some say. But the reality is that hard times also often produce selfishness and civic dysfunction as well as people cling desperately to what they have instead of looking boldly forward to the future.

I've seen this shift happen in a few cities. Where once civic boosters dreamed of glory and invested their own money into the city, now they focus on what they can get out of it. So too in California. Everyone knows the Titanic has hit the iceberg, but they are determined to loot as many state rooms as they can before shoving the women and children out of the way and commandeering the life boats.

This institutional rigidity is another force driving people to greenfield locations. It's a global phenomenon. Consider this Newsweek coverage of a study of Chinese industry that notes much lower levels of corruption and better governance in new cities than old.

An intriguing pattern is that governance is best in coastal cities that had very little industry when reform began in 1978. Shenzhen now has the highest per capita GDP in China. The same holds in Jiangmen, Dongguan, Suzhou--all were industrial backwaters in 1978, and responded to China's opening by creating good environments for private investment and learning from outsiders. Cities that already had industry tended to protect what they had and reform less aggressively.

Jim Russell hypothesizes that this effect of frontier geography explains a lot of the success of the Sunbelt, which industrialized late.

Cities such as Austin, TX and Charlotte, NC have offered a frontier opportunity akin to the one observed in the boomtowns of China. On the other hand, Pittsburgh stagnates. Governmental reform is key for attracting investment and stimulating growth. This is unlikely to happen in Western Pennsylvania, leaving this region at the rear of economic globalization.

For Pittsburgh, substitute California and you've got a pretty good picture.

Writers like Joel Kotkin like to reminisce about the Golden Age of California, and the leadership of that age from enlightened members of both parties like Pat Brown and Ronald Reagan. But you can never go home again. That letter jacket from your high school glory days might still fit, but you're never going back to the state finals. Brown and Reagan were products of their era - an era that no longer exists. While they might be better executives than Gray Davis and Arnold Schwarzenegger, even if you assume they could get elected today - unlikely - I doubt they'd prove much more effective.

It's been said that China will get old before it gets rich. Well, California got rich first - but it still got old. Not old demographically, but old civically. The polity of California is now well into middle age. As with people, places that reach that point experience a mid-life crisis as they look back longingly at the optimism, energy, flexibility, dynamism, and endless capacity for reinvention of youth. That's often a bitter pill to swallow.

Can California Recover?

Can California pull out of this? It's hard to point to a lot of examples that offer hope. But California has a lot going for it. It's got the stunning climate and physical geography. Cities like San Francisco and Los Angeles remain powerful. In addition to the technology and film industries, California also has a robust agricultural sector, legal and illegal, an entrepreneurial immigrant base, as well as an American hub for contemporary art and other creative fields besides the movie business. So there's a lot of assets to build on.

The challenge is that these existing strengths are part of the institutional rigidity. Another way to say "build on assets" is "defend the past". Other than the its physical setting, the assets of California only exist because previous generations didn't build on assets. If they did, Silicon Valley would still be orchards, not the powerhouse of the global technology industry. If a city or state is failing to create new industries, it has economically stagnated, no matter how prosperous it might be or appear for a time.

Looking at the Rust Belt, we do see that tier one global cities have managed to renew their cores. Chicago, New York, and Boston have glittering city centers and a migration back to the city of upscale residents. This is a far cry from the sour days of the 70's. But if you look beyond those zones, you see places with surprisingly unimpressive metro area statistics in many regards. And the states they are in look at lot like, well, California. A handful of metro thriving cores can't energize an entire state or even metro area. Places like New York and Illinois have major structural challenges of their own. And California has already followed this program, with booming regions that are among globalization's winners, with many larger areas of losers. Of course the alternative is worse - look at Michigan, with the same failures and no global city to even partially make up for it.

The global city phenomenon perhaps illustrates the way. Cities that have experienced that boom like to pat themselves on the back. Indeed, there has been some good leadership along the way. But when something happens in most similarly situated cities, you have to look first to a common force acting on them. Chicago, New York, London, etc. all had their own Rust Belt eras and suffered in the 70's and 80's. Starting in the 90's a large number of what we now call global cities had urban core booms. As Saskia Sassen noted, the new networked global economy requires new financial and producer services, that tend to be concentrated in global cities. In effect, the global city is an emergent property of the globalized economy, just like the company town was in a previous era. I noted previously with regards to Chicago that it was the artifact, not the architect.

To me that shows that a state like California needs to look at and understand the macrotrends affecting it and the world, and figure out how to position itself to profit from them. One area it is trying to do so is in the "green economy". I've got a few problems with "green jobs". The first is that the entire concept of a green economy is a transitory one. Likely in a decade or so it will be gone. There will no longer be green industry, but only industry - it will all be green. This immediately prompts the question of whether, since we're not going a very good job of competing in traditional industry, we'll do any better in green industry. Indeed, China and others are already making a move here.

The other aspect of this is the huge gamble California is placing on the environmental trend. That is, it has imposed the strictest environmental controls in the world. There is no doubt this is one factor causing a lot of short term pain. But the state hopes that in the long term this will attract talent and, what's more, position it for future success because other states will be forced into the same painful restructuring for environmental issues in the future and California will be ahead of the game. California's ultimate goal here is clearly to push to federalize its policies to prevent any other states from not following its lead and producing a differentiated product. Because international migration is so much more difficult than domestic, this would, in theory, eventually help staunch the flow of people out of the state. Other states no doubt realize this and will resist the push at the federal level. It remains to be seen how this turns out on many fronts.

Other than that, it is difficult to identify a strategy California has other than more of the same. While the green realm might be a good place for California to put some chips, I don't think piling everything on one square is a good idea, so new ideas are clearly needed.

And these economic strategies will only be ultimately a success to the extent that they enable California to reach an equilibrium and either successfully make the transition to an operator, or somehow reignite growth.

I would suggest that California and other maturing jurisdictions should look to partner with academics in our economics departments, and especially our schools of business, who have studied industry growth and maturity curves, and how to manage that transition over time, strategically and operationally.

Has the United States Reached Maturity?

Given the problems of California and the current Great Recession and associated talk of American decline, it's worth asking the question: has the United States matured? That is, are the life cycle forces that are hurting California now affecting America as a whole?

Let's consider our three harbingers: unfunded liabilities, the end of growth, and institutional rigidity. Clearly, we've racked up huge unfunded liabilities, just like every industrialized nation. I believe we are projecting a deficit of $1.8 trillion this year alone and that doesn't even count off balance sheet problems like social security and medicare. So a definite check mark in that box.

As far as institutional rigidity, clearly we observe some. There is no doubt that it has gotten harder to do things in America and that one of the key advantages of China is its greenfield location and lack of this cruft, not just its low labor costs. Regulatory arbitrage, for example, can be a powerful motivator. Still, I haven't observed a ridiculous amount of change here in my lifetime. At the federal level, it has always been hard to do things in America, by design. I do argue that in some areas we've turned the dial too far. In a country that desperately needs to make transportation investments, it shouldn't take a decade to get approval to build a new transit line, for example. But on the whole the United States still feels like a fairly dynamic society to me.

Which brings us to growth. Clearly we have been in a major recession. The question is whether our best days are behind us. I say clearly No here. America is demographically healthy. Compared to Europe we have comparatively high birth rates, more or less replacement rate, in our native born population. This shows a society with confidence in the future. Also, people from around the world are still voting with their feet to come here. And I believe we'll get back on economic track eventually.

But this is where the warnings signs should be looked for. If growth dries up, I believe the institutional rigidity will enter that toxic cycle and we could be in trouble. Keep an eye on immigration. When people stop wanting to come here - because they don't want to pay taxes merely to pay off yesterday's unfunded liabilities, because they think there are better opportunities elsewhere, or whatever - and especially if Americans start leaving in any material numbers, we'll know we have a major problem on our hands.

Obviously no one can predict the future, but I remain bullish on America.