An Economic Reprieve for Gray Davis?


By Christopher Farrell The pundits have spoken: Gray Davis, California's highly unpopular governor, will be gone when Golden State voters go to the polls in October for a special recall election. But no one is quite sure who among the circus of professional politicians, movie stars, pornographers, college students, bounty hunters, centenarians, and others on the crowded ballot will replace the incumbent.

Yet the surprise, in my view, could be how fast the Dump Davis movement fizzles if the economy really is on the mend. Indeed, California municipal bonds have rallied modestly ever since the legislature and the governor agreed on a $99 billion budget, never mind Sacramento's reliance on smoke and mirrors in making its fiscal calculations.

STILL WEIGHED DOWN. Much depends on how the national economy does over the next several weeks. Management professor Edward Leamer, who also heads the UCLA Anderson Forecast Center, counts himself among the skeptics.

He notes that because of state spending cuts in California and elsewhere, teachers, police officers, firefighters, and other public-sector employees are losing their jobs. The recent rise in interest rates undermines the housing market. And business' animal spirits aren't going to stir without strong consumer demand for homes, cars, and other big-ticket items. The bursting of the dot-com bubble still weighs heavily on the national economy, which has too much capacity.

It seems to add up to a scenario of sluggish growth nationally and in California. "You can't have a vigorous recovery this time," says Leamer.

SPENDING PICKUP. Well, call me a crazy optimist. The impressive signs of an improving economy suggest that the turnaround is for real this time. Witness the bigger-than-expected jump in retail sales in July. Perhaps the Bush Administration's fiscal-stimulus program is finally paying off. For instance, Wal-Mart (WMT) reports that consumers who cashed in their $400 per child tax-credit checks at its stores spent about 15% of that money there.

Business investment on high-tech gear is up at a double-digit pace over the past two quarters. Most important for future capital-spending plans, corporate profits have been up five out of the last six quarters. Investment in equipment and software gained at a 7.5% annual rate in the second quarter, the best performance in three years.

True, much of that spending went into replacing aging but essential equipment, rather than into expansion (see BW Online, 8/14/03, "Behind the Surge of Capital Spending"). But the economic life of computer hardware is less than two-and-a-half years, and managers know that if they want to maintain their competitiveness, they'll have to keep investing in new technology -- capacity glut or not.

OVERREACTION IN BONDS? One sign of the times: Business magazines and trade publications have stopped publishing post-mortems on the turn-of-the-millennium telecommunications bust and started emphasizing the economic benefits from promising new technologies again.

The stock and commodity markets have rallied. And fear over bond yields' recent jump may be overdone. James W. Paulson, chief investment officer at Wells Capital Management, argues that bond yields took an unexpected nosedive after the Federal Reserve Board set off alarms about the risk of a deflationary spiral.

Yet that cloud seems to be lifting as the economy picks up. The 10-year Treasury bond yield has moved back to the 4.25% trading range that has held for much of the year. The violence of the upward move in rates was exacerbated by hedge funds unwinding some positions in the mortgage market.

INCUMBENT BOOSTER. Sure, Davis doesn't have much time. The recall is only a few weeks off. Nevertheless, the governor's best ally right now may be President George W. Bush.

The Republican Chief Exec needs a sustained economic rebound to bolster his chances for reelection next year. The political status quo starts to look pretty good when incumbents preside over an investment-led economic recovery, especially if it gives hope to Northern California's battered high-tech industries. Voters could then decide the recall circus is no way to run a modern state.

As Davis adviser Bill Clinton is fond of saying, "It's the economy, stupid." So governor, it's not too late to think about tomorrow. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online


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