Magazine

The Future of California


For decades, California has been one of the great global beacons of opportunity. It is a destination, a place where people from around the world can come to break into Hollywood, to push out the frontiers of technology, to make hay while the sun shines. But these days, the Golden State's prospects seem to be getting dimmer and dimmer. Silicon Valley, the state's technological and economic driving force, is plunging headlong into a devastating tech slump, with one-time juggernaut Cisco Systems Inc. (CSCO) predicting Apr. 16 that its revenue this quarter would fall a shocking 30% from the previous quarter. Says CEO John Chambers: "This may be the fastest any industry our size has ever decelerated." Indeed, a slowdown in capital spending--which is hitting Silicon Valley particularly hard--was the prime factor cited by the Federal Reserve on Apr. 18 when it cut short-term rates by half a percent.

The Valley's slowdown is just one part of California's woes, as a state known for earthquakes, mud slides, and brush fires is getting hit this time by man-made disasters. The state is mired in an electricity crisis that has already toppled its biggest utility. On Apr. 6, Pacific Gas & Electric Co. filed Chapter 11 in federal bankruptcy court, saying it couldn't pay its bills when wholesale electricity prices skyrocketed. Asian economies are slowing, so there's less trade for the state that's the gateway to the Pacific. Possible strikes by Hollywood writers in May and actors in July threaten to undermine California's other signature industry, entertainment.

And festering long-term problems that had been covered over by the economic boom are suddenly being laid bare. The state's once-cherished public education system has been in decline for years. Meanwhile, inadequate water supplies, overcrowded roads, and a shortage of affordable housing threaten to choke off growth. California's government, seen by much of the country as too populist and too avant-garde, seems ineffective in dealing with problems like the energy crisis. The upshot: possibly long-lasting damage to California's economic competitiveness.

When California slumps, the whole nation feels the pain. By itself, California accounts for 14% of the U.S. economy, as big as the 22 smallest states combined. More important, California has been one of the key driving forces for the national economy in recent years. In fact, California generated a full 25% of the entire nation's job growth over the past year. With income growth strong, 34 million Californians have helped prop up the national economy by buying dishwashers from Kentucky, cars from Michigan, and maple syrup from Vermont.

The blow from a steep California downturn would be not only financial but psychological. Silicon Valley's entrepreneurial culture, images of overnight wealth, and free-spending ways have inspired businesspeople from Bombay to Zurich. Now, the latest incarnation of the California dream appears to be evaporating at Internet speed. "In the last half of the 1990s, California--Northern California in particular--was the world's greatest emerging market," says Edward Leamer, director of the University of California at Los Angeles Anderson Graduate School of Management's highly regarded economic forecasting unit, which predicts scant 1% growth for the rest of 2001. "It was the Wild Wild West all over again. Now we are seeing a fundamental change in lifestyle. The gas-guzzling SUVs will be abandoned by the side of the road. Web-site designers will see their families again. There's no longer this mad dash to have first-mover advantage."

And the great California job engine? "It's over," he says.

To be sure, many economists are more optimistic about the Golden State's future. For instance, Economy.com Inc., a West Chester (Pa.)-based forecaster, predicts that the state's growth--nearly zero in the first quarter--will pick up to 2% annually in the second quarter, 3.9% in the third, and a booming 4.9% in the fourth. Steven G. Cochrane, the Economy.com senior economist who follows California, expects Silicon Valley to rebound as soon as excess tech inventories are worked off. And he thinks the state economy will be buoyed by construction of housing to meet years of pent-up demand. Says Cochrane: "Although it's slowing at the high end, demand for moderate-size houses is very, very strong." The state reported Apr. 13 that statewide payrolls hit an all-time high in March. Said Governor Gray Davis in an interview with BusinessWeek on Apr. 10: "Growth is slowing, but we will continue to grow and continue to contribute to America's productivity and growth."

HUNKERING DOWN. Still, consumer demand for housing and other goods could dry up quickly if people start to worry about losing their jobs. Growth in Santa Clara County, the heart of Silicon Valley, has already stopped in its tracks: The San Jose area unemployment rate, while still low, reached 2.2% in March, up from 1.3% in December. Meanwhile, companies across the state are reducing overtime hours and temps--a prelude to cuts in full-time workers.

The roster of California companies that have announced major layoffs in recent weeks reads like a Who's Who of job creators: Cisco Systems, Intel (INTC), Walt Disney (DIS), Hewlett-Packard (HWP), Yahoo! (YHOO), and Oracle (ORCL). Charles Schwab & Co. (SCH), the brokerage firm, rolled back salaries and cut jobs. Last year, California came in fourth among the states in the number of layoffs announced, after Illinois, Michigan, and New York, according to outplacement firm Challenger, Gray & Christmas Inc. This year, it shot up to first place, with more layoffs announced in the first three months than in all of 2000.

Each of those pink slips has a ripple effect. Just a year ago, 39-year-old Todd Sotkiewicz was feeling flush with a pile of potentially valuable stock options in an Internet startup called Bigwords.com that sold college textbooks over the Web. Sotkiewicz worked in a converted warehouse in San Francisco's trendy South of Market area. While his colleagues bounced the company's trademark bright orange balls around the office, Sotkiewicz strategized with Bigwords' 25-year-old founder.

The fun ended when Bigwords went bust in October. Todd's wife, Mary Margaret, got laid off last year, too. Her employer, Rice-A-Roni (the San Francisco treat!), relocated to Chicago in a cost-cutting move. Todd recently found a new job at an Internet marketing firm, Ebates.com, but the family is hunkering down just the same. "We have stopped the home remodeling," he says. "I fired the gardener, closed the lease out on a car, and we are driving to Portland for the next vacation, instead of flying. I think the effects of the dot-com bust are just beginning." Further down the economic ladder, Yeny Saavedra, a 24-year-old Mexican immigrant, has been laid off twice this year from minimum-wage jobs in Los Angeles sewing shops. Says Saavedra: "Every place I go, they tell me it's slow."

And the electricity problem won't be solved anytime soon either. Four blackouts early this year cost the state's businesses more than $1 billion in lost production, according to the Los Angeles County Economic Development Corp. State officials fear 34 days of rolling blackouts this summer if Californians don't cut power consumption. Stanford University economist Frank Wolak says California could spend up to $70 billion for electricity this year, up from $7 billion in 1999. The Federal Reserve Bank of San Francisco estimates that the 40% rate hikes announced in March, combined with higher natural-gas prices, will cost the average family $750 a year. The rate increase was designed to slow consumption and thus prevent blackouts, but those benefits will come at a price.

FREE FLASHLIGHTS. Other states such as Arizona, New Mexico, and Texas are exploiting California's energy woes by stepping up business-recruitment efforts that had slowed during California's go-go years of the late 1990s. Tennessee mailed flashlights to California executives. "If the power crisis lasts much longer than a year, it gets burned into the psyches of corporate executives who are making long-term expansion decisions," says Philip J. Romero, dean of the University of Oregon's Lundquist College of Business and former chief economist to Davis' Republican predecessor as governor, Pete Wilson. Says Romero: "California will live with the consequences for five years or more. That's exactly what we went through in the early 1990s."

More and more companies are contemplating following the lead of such outfits as Grundfos Pumps Corp., the subsidiary of a Danish maker of pumps for the water industry. Fed up with long travel times to visit customers in the Midwest and a shortage of skilled labor, Victor Lukic, the manager of the company's 100-person U.S. headquarters in Fresno, decided he would move the offices to Kansas City, Kan. The only question, he said, was when to leave. Then, last fall, the energy crisis hit. On the day in February when the papers arrived to change his company's state of incorporation, the lights went out in Lukic's California office. "It certainly made me feel better about my decision to move," he says.

Intel Corp. hasn't located a chip plant in California since 1988 and says it doesn't plan to ever again. In January, Gap Inc. announced a 300-person corporate relocation to New Mexico. E*Trade Group Inc. (ET) chose to locate a major technology center in Atlanta instead of California. Says James C. Morgan, chairman and CEO of Applied Materials Inc. (AMAT) of Santa Clara, the world's largest maker of wafer-fabrication machines for chipmakers: "California needs to deal with its infrastructure issues....It's a great place to develop products. You just need to manufacture someplace else."

Before the energy crisis, California lawmakers were dreaming up ways to spend a projected $6 billion state budget surplus. But purchases of power on behalf of the crippled investor-owned utilities has eaten up two-thirds of that surplus in just the first three months of this year. Bond rater Standard & Poor's Corp., like BusinessWeek a division of The McGraw-Hill Companies Inc., has warned the state of a possible downgrade in its credit rating. Surcharges on customers' bills to repay the state, coupled with long-term power-purchasing contracts that the state is entering, could saddle consumers with high electric bills for years to come. Says Wilson, the former governor: "The energy crisis has become a financial crisis."

CLASSROOM RATS. Expenditures on electricity are mounting even as the state's sources of revenue begin to stumble. Over the past few years, state coffers have swelled along with the high-tech stock portfolios of its residents. Taxes paid on capital gains and stock option-related income now make up an incredible 21% of California's general fund revenues, up from less than 5% five years ago. This year, that income has begun to disappoint. In February and March, personal income taxes came in 14% under forecast. Another important source of revenues, sales taxes, came in 6% under plan.

Less money coming in the door means less money for schools, streets, and hospitals. California's public schools have gradually deteriorated since 1978, the year of Proposition 13, which limited the local property taxes that are the primary funding source for schools. Last year, Professor Gary Blasi at UCLA outlined the horrendous nature of the schools in a report that included tales of thousands of "temporary" classrooms besieged by rats, strange toxic spores, and stifling heat. During his campaign, Davis, a Democrat, said education would be his first, second, and third priorities. Last year, flush with cash, he authorized $1.8 billion in additional school funding, on top of the state's $41 billion budget. That may not happen again. "The electricity crisis is just killing us," says Wayne Johnson, president of the California Teachers Assn.

More and more, observers are blaming a lack of leadership. "The governor and legislature look like the gang who can't shoot straight," says Peter Navarro, a professor of economics and public policy at the University of California at Irvine. Republicans point the finger at Davis, a former aide to Governor Jerry Brown who served previously as the state's controller and lieutenant governor. Opponents say he failed to recognize the utility crisis when it first showed its face last May in San Diego. At the time, they say, he turned aside pleas from Republican leaders for a special session on utilities. Then, Davis argued for months that he would not raise rates. When state regulators finally did so, he distanced himself from their decision, only to agree with them a week later. But Davis doesn't accept the criticism--and has raised more than $27 million for a reelection drive. In a rousing speech to the state Democratic convention in Anaheim in March, he put the blame squarely on the Republicans who passed and implemented utility deregulation before he arrived. Says Davis: "The Republicans who were so enamored with deregulation five years ago have become even more enamored with criticizing me as I try to clean up their mess."

As politicians fight, the state's troubles mount. Trade with Asia, one of the unsung heroes of the state's growth in the past decade, is sinking. After years of explosive growth, exports from the ports of Los Angeles and Long Beach slid 1% in the first three months of this year. The technology investment boom had been a key source of growth for Asian "tiger" nations such as Singapore and Malaysia, so the effects of the slowdown will spiral downward on both sides of the Pacific. "Asia is twice as important to California as it is to the rest of the country," notes Ross DeVol, a researcher at the Milken Institute, a Santa Monica think tank. "It's 50% of our exports."

Two sectors of the California economy that were major causes of the 1991-93 recession--real estate and banking--are also showing signs of slowdown. For the first two months of the year, the average home price in the state declined 0.2%, to $245,000. Sales of existing homes slid 13% in February, while the time it would take to sell the number of homes on the market at the current sales rate lengthened from 4.3 months to 5.1 months, according to the California Association of Realtors. The national figure: 3.6 months.

Silicon Valley remains the nation's most expensive housing market, but the average cost of a home in the Valley slid 4% between January and February, to $555,000. Economists say that may be only the beginning. "Five years ago, the average differential between a Northern California home and a Southern California home was $75,000. Today, it's $250,000," notes UCLA's Leamer. He says Northern California home prices have a lot further to fall, and as they do, the evaporation of wealth will take a toll on consumer spending. Says Leamer: "That's a recipe for a long, slow recession."

Across the state, office vacancy rates edged up to 9.8% in the first quarter, from 8.2% in the fourth quarter of last year, according to CoStar Group Inc., a real-estate research firm in Bethesda, Md. San Francisco Treasurer Susan Leal says she is noticing a slowdown across the board in real estate taxes, parking, and hotel fees. Mayor Willie Brown has advised city employees that there will be no budget hikes this year.

Past-due loans at California banks increased only modestly in the fourth quarter of last year, from 1.4% to 1.8%. But bankers aren't congratulating themselves. "Banks will continue to experience credit problems," says Joseph Otting, head of commercial lending at San Francisco's UnionBanCal Corp. "I suspect we are in the bottom of the first inning."

Threatened Hollywood strikes by writers and actors would be a horror show. Writers are demanding an increase in residuals, primarily for television shows on cable and in foreign markets. "We're looking at this whole thing with disgust," says ?ber-talent manager Michael Ovitz.

REVERSE OKIES? According to the Entertainment Industry Development Corp., which issues permits for film, TV, and commercial production in Los Angeles, Hollywood employs (directly or indirectly, as in florists and lumber companies) some 296,000 people and accounted for nearly $34 billion in spending statewide last year. It says a strike would mean the loss of some $50 million a day to the county economy alone. Hollywood has been working overtime to stockpile TV shows and films. If the strike fizzles out, there is likely to be a capacity glut in Hollywood much like the one in Silicon Valley. "From what I hear, it's going to be like The Grapes of Wrath in reverse," says My Dog Skip screenwriter Gail Gilchriest. "The Joads are gonna pile up their stuff on the car and go back to Oklahoma."

To see California's woes in microcosm, visit Conexant Systems Inc. (CNXT) of Newport Beach, in Orange County, south of Los Angeles. For a while after its spin-off from Rockwell International Corp. (TOP) in early 1999, the company's revenues grew at a 30%-plus clip. Employees worked in buildings with names like Everest and K-2, suggesting towering heights to be scaled. Conexant's stock surged from $5 a share to $125 as orders poured in for its high-speed Internet-access chips.

These days, Conexant is seeing revenue declines of as much as 50% in some of its key markets, including Asia. In March, Chief Executive Dwight W. Decker laid off 1,500 of his 8,800 employees. "This isn't like other semiconductor cycles," Decker says. "This is a broad technology downturn. Our customers are seeing equipment they sold last year back on the market. There's 15 pages of Cisco routers selling on eBay for 15 cents on the dollar." Meanwhile, the electricity crisis is forcing Conexant to consider shelling out much-needed cash for backup diesel generators.

California's long-term future may well be bright. But with setbacks like the power crisis, the tech slump, and an Asian downturn, the Golden State is in for a long, hot summer. By Christopher Palmeri, with Ronald Grover in Los Angeles, Douglas Robson in Silicon Valley, and bureau reports


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