Economic Outlook

The Twentieth Century ended on a high note for both the U.S. and California economies. Nationally, economic growth, as measured by real (inflation-adjusted) gross domestic product (GDP) exceeded 5 percent, the largest gain in 16 years. The strong performance was all the more remarkable for having occurred in the record-breaking ninth year of sustained economic growth.

California’s economy significantly outpaced the strong national performance. Personal income rose more than 11 percent, also the largest gain in 16 years, and far above the nation’s 6.5 percent increase. Nonfarm employment increased 3.6 percent, the largest gain since 1985 and nearly double the nation’s 2 percent rise.

The Nation—Gathering Clouds? Despite the robust full year figures, the final weeks of 2000 brought unsettling news on several fronts, most notably from the consumer sector. November retail sales declined unexpectedly, following a flat October report; consumer confidence dropped sharply in November and early December on both the Conference Board and University of Michigan surveys; and several personal computer makers reported disappointing holiday season sales.

Accompanying these reports has been a steady rise in initial unemployment claims from the near-record low levels of last spring, a sharp drop in factory orders, and announcements of production cutbacks from major U.S. automakers who seem to be bearing the brunt of the sudden pullback in household spending. The strong upward surge in the stock market, which helped fuel household spending in 1999 and the early part of 2000, has clearly ended, and in particular, the technology-heavy NASDAQ market lost nearly half its value from early March through early December.

The sudden reversal in these key economic indicators has raised concerns—thus far largely confined to the mainstream media—that this record-long economic expansion may be nearing an end. In contrast, most economic observers have concluded that the recent statistics signal the long-awaited and even welcome moderation of growth that will allow the upswing to continue in 2001 and possibly beyond. In its December 10, 2000 release, only one (UCLA-Anderson) of the 50 forecasters surveyed by Blue Chip Economic Indicators believed a recession to be the most likely outcome for 2001.

It is often difficult to differentiate between a slowing of growth and the beginnings of an economic reversal. But the recent statistics need to be placed in some perspective. As noted, the automobile industry is the source of much of the apparent weakness in consumer spending. Excluding autos, sales rose during both October and November, albeit at a more moderate pace than in previous months.

Retailers commonly gauge sales results on a year-to-year basis, and in November, retail sales excluding autos were up more than 7 percent from the 1999 month, after taking into account the effects of 2000’s early Thanksgiving weekend. (Without the holiday adjustment, sales were up almost 9 percent.) The key general merchandise, apparel, and home furnishings sector (GAF), where most holiday purchases are concentrated, also posted a solid 7 percent increase. Since there is virtually no inflation in GAF goods—apparel prices, for example, were down 1.3 percent over the year, while November apparel store sales were up 8.6 percent, implying a 10 percent increase in physical volume—these gains hardly portray a weak or faltering consumer.

Moreover, the recent evidence of slower growth has also come to the attention of the Federal Reserve. In early December, Fed Chairman Alan Greenspan made it clear that the central bank is fully prepared to relax monetary policy in response to the shift in economic momentum. Of course, a slowdown to a more sustainable rate of growth—a so-called "soft landing"—has been the Fed’s goal since it began raising interest rates in June 1999. Largely in anticipation of future Fed rate cuts, longer-term interest rates have fallen sharply in recent months. Fixed-rate home mortgages, for example, are now widely available at a 7 percent rate, down from more than 8-1/2 percent last spring.

The stock market’s performance also needs to be seen in perspective. The broader measures such as the Dow Industrials and the Standard and Poor’s 500 were down little more than 6 percent from the end of 1999 to mid-December 2000. The New York Stock Exchange Index was virtually flat during that period. As noted, the NASDAQ was off considerably more—nearly 30 percent from December 31, 1999, and over 40 percent from the March peak—but that market clearly experienced a very short-lived "bubble" that lasted no more than four and one-half months, from mid-October 1999 through early March 2000. Even after reversing the bubble, the NASDAQ at mid-December 2000 remained several hundred points above the mid-October 1999 takeoff point.

Certainly, there is a "wealth effect" in which high and rising asset values embolden households to spend more and save less. To a considerable degree, stock market appreciation replaced household savings in 1999 and early 2000. Thus, to the extent that households must now reevaluate the need to save, some slowing of consumer spending is to be expected.

Nonetheless, the fundamental forces of rising productivity that helped power the U.S. economy over the past four years of extraordinary growth have not suddenly vanished (Figure ECON-1). Rising energy prices, which is one factor holding back growth at present, should slowly reverse in the year ahead. Petroleum prices, for example, have come off their early fall peaks, and the sharp run-up in natural gas prices is already encouraging increased production. Falling interest rates will help boost housing and other credit-sensitive segments of the economy. A somewhat weaker U.S. dollar should help boost exports, while the slowdown in consumer demand will serve to contain the growth of imports, both of which should help cushion the effects of moderating domestic activity.

Thus, although a mild recession poses a risk, the most likely outcome remains the "soft landing," with growth moderating to a more sustainable pace. In 2001, this Budget forecast expects real GDP growth of 3 percent, down from over 5 percent last year and 4 percent in each of the three previous years. A return to 4 percent growth is quite possible in 2002. This implies a modest rise in the unemployment rate from 4 percent in late 2000 to a little over 4 1/2 percent by late next year, thus relieving pressures on the labor markets. Inflation, which averaged nearly 3 1/2 percent last year, should moderate to about 2 1/2 percent in 2001. The national forecast is summarized in Figure ECON-5 at the end of this section.

California—Cooling Off? Available economic and financial statistics for California have yet to reflect the slowing evident in the national figures. In particular, job growth in California actually strengthened over the late summer and fall of 2000, while nationwide data reveal a marked slowing in new hiring and a rise in jobless indicators. Likewise, sales tax receipts remain strong, suggesting that the pullback in household spending nationwide has not yet spread to California.

Indeed, when compared to the nationwide figures, California’s labor market is exceptionally strong. The working age population is growing at twice the national pace, the labor force and civilian employment three times faster, and nonfarm employment at more than double the national rate (see Figure ECON-2.)

The state continues to benefit from strong economic growth in much of Asia and Mexico and solid gains in Europe as well. Through the first nine months of 2000, California-made exports increased more than 21 percent over comparable 1999 shipments. In essence, it appears that still-rising foreign demand is serving to cushion the effects of the U.S. slowdown. (See Figures ECON-3 and Econ 4.)

Even so, much attention has been focused on the shakeout among the so-called "dot.coms," firms doing business on the Internet. However, many of these firms have received attention far beyond their economic importance. While California and the San Francisco Bay Area are justifiably proud of the entrepreneurial spirit reflected in these young companies, California’s high-technology economy is in fact dominated by a relative handful of large, well-established firms. The employment effects of the dot-com shakeout are relatively small, although there are clearly ripple effects in segments of the economy serving these companies.

Nonetheless, in spite of the cushioning effect of continued export demand, California should expect a slowing of job growth in the year ahead. On an annual average basis, job growth is forecast at 2.8 percent, although gains on a year-end 2000-2001 comparison may be closer to 2 percent.

If California’s labor market has been exceptionally strong, income gains have been nothing short of spectacular, fueled by massive increases in wages and salaries—the largest single source of income. With employment growing by 3.6 percent, wages last year shot up by 14.5 percent, implying average per worker wage gains of 11 percent. Since most surveys indicate that employee raises are averaging in the neighborhood of 4 percent, much of the extra income has apparently come from nontraditional sources, mainly stock options and bonuses.

As the accompanying section on stock options indicates, option incomes are highly concentrated among a relatively few large firms, whose share prices have generally fared better than many of the newer, less established companies. Moreover, because options are exercised three to ten years after they are granted, stock prices would have to collapse by 50 to 90 percent before most options fall "out of the money."

At the same time, the average striking price (the price at which the option was granted) of options that will be exercised in 2001 will be higher and—assuming recent market conditions do not improve markedly—most stock prices will be lower than during much of 2000. Thus, it seems reasonable to expect some reduction in option incomes in the year ahead. For the most part, the slowing of wage growth from 14.5 percent in 2000 to 5.5 percent in 2001 rests on the assumption that the dollar value of stock options will decline by 10 percent this year (to about $75 billion), following 2000’s extraordinary 68 percent leap. Overall, personal income growth is expected to slow from 11.7 percent in 2000 to 5.7 percent in 2001.

Apart from the possibility of a national downturn, a significant risk to the California outlook comes from the energy sector. The current electric power situation results from a complex set of circumstances arising from a steep rise in demand throughout the Western United States, sharply higher natural gas prices exacerbated in California by the break in a key pipeline last summer, and a dysfunctional wholesale electricity market in which prices have soared to levels several times the actual cost of the least efficient, most expensive production in the region.

The fundamental solution lies in increased generating capacity and more secure fuel supplies, both of which are likely to occur over the next two to three years, as new capacity—now receiving regulatory approval on an accelerated timetable—comes on-line. In the meantime, measures must be taken—at both the State and federal levels—to correct major defects in the region’s wholesale electricity markets that will ensure reliable supplies at prices that reflect the true cost of production.

The California forecast is summarized in Figure ECON-5.

A significant portion of recent extraordinary growth in California personal income has been derived from the exercise of stock options. In 2000, stock options may have accounted for as much as 13 percent of California wages and salaries, up from less than 2 percent in 1995. Option income is in addition to capital gains on the sale of stock and other asset holdings, which although taxable, are by definition not included in personal income.

As explained in the following section on revenues, these two income sources—options and capital gains—together account for more than one-fifth of General Fund revenues in the current fiscal year. Because stock options are generally paid to employees with the highest marginal income tax rates, they have important implications for the State’s General Fund revenues. The stock market has a very direct and dramatic impact on stock option income, and an increased reliance on this form of income heightens the sensitivity of the General Fund to the stock market.

Stock options are agreements to sell a certain number of shares of a given stock at a stated price—the exercise or striking price—during a specific period in the future. Income is generated when an option is exercised (i.e., when the holder buys the security, the difference between the market price and the exercise price is considered income, whether or not the option holder chooses to sell or hold the stock). Options are "in the money" whenever the market price of the security exceeds the exercise price. An option is "out of the money" if the stock’s price falls below the exercise price.

Stock options are attractive for several reasons. They give the recipient an ability to share in the fortunes of a successful company. Since options normally cannot be exercised immediately, they enhance employee loyalty. Options can also improve a company’s profitability in the short run by substituting for cash wage payments. (Companies also receive a tax benefit when options are exercised, because the value of the option is considered a deductible employee compensation expense. However, because options can also dilute share values, this benefit is usually credited directly to shareholders’ equity, without being run through published profit and loss statements.)

Stock options usually have a stated life-span. Typically, stock options issued in lieu of wages cannot be exercised until three years after their issuance and expire after ten years. Normally, a stock option’s exercise price is set at the stock’s market price when the option is granted. Thus, throughout its life, an option’s value varies with the market price of the stock. In some cases when the market price has fallen below the exercise price, companies have reset the exercise price to the new market price.

Potential stock option income is directly related to movements in stock prices over time. Companies that use stock options typically issue them on a regular basis and only a fraction are exercised in any year. Thus at any one point in time, there exists a pool of exercisable options issued during various years at different exercise prices. As time goes by, the average exercise price of a pool of options will move with the stock’s market price. Since there is a 3 to 10 year lag between current and exercise prices, total potential income is determined by the movement of stock prices over the past 10 years.

While stock options are used in a wide variety of companies, they are particularly popular in the high technology, durable-goods manufacturing, and wholesale and retail trade industries. Nationally, about one in five executives in these industries was a recipient of stock options in 1999. Their use in the high technology sector is particularly important to California. Options are attractive to many cash-starved high technology start-up companies. Stiff competition for top employees coupled with rapidly appreciating technology stock prices makes stock options well suited to this industry’s business environment.

The unprecedented appreciation of high technology stocks over the past decade is clearly responsible for the growth of stock option income. As an indication, the technology-dominated NASDAQ index has risen over 670 percent over the past ten years and 84 percent over the past three. In spite of the NASDAQ’s sharp retraction since the first quarter of 2000, the average technology stock would need to lose nearly half of its value in order to put the newest exercisable options out of the money and would have to fall nearly 90 percent to nullify the oldest options. Thus, barring a catastrophic collapse, stock options will continue to generate significant income for some time to come.

Based on financial reports submitted to the U. S. Securities and Exchange Commission (SEC), it is estimated that over $25 billion of stock option income was generated in California in 1998, followed by $50 billion in 1999, and $84 billion in 2000. Over this three-year span, option income accounted for between one-quarter and one-half of annual wage growth.

Moreover, option income is highly concentrated. SEC reports suggest that just seven high technology corporations generated nearly half of this income. The largest 100 California corporations accounted for over 80 percent of the total. While this significant concentration is associated with a degree of risk, it also underscores the fact that option income comes mainly from larger, well-established firms, rather than the newer, smaller companies that have been the source of much recent attention.

Figure ECON-6