Recession could wreck California’s spending plans

The 2022-23 fiscal year will begin in less than a week and Gov. Gavin Newsom and legislative leaders are still negotiating — or arguing — over how to divvy up a nearly $100 billion projected budget surplus.

Roughly half of the money would automatically go to public schools and community colleges under state law but the other half is up for grabs. The biggest unresolved issue is how much of the budget will return to Californians as an election year offset to higher prices for gasoline and other living costs, and how the money will be distributed.

However, even as the talks continue behind closed doors, a new factor has crept into the picture — the growing possibility that recession will strike the national economy due to soaring inflation and interruptions in international trade following the Russian invasion of Ukraine.

Increasingly, private and public sector economists are warning that a recession looms on the horizon. Just last week, for example, Goldman Sachs, one of the largest banking firms in the world, issued a revised economic forecast, increasing the chances of recession in the next year.

“We now see recession risk as higher and more front-loaded,” wrote a team of Goldman Sachs economists led by Jan Hatzius in a research report.

Were recession to hit, California’s revenue system, which is extremely dependent on taxing the investment earnings of the state’s highest income residents, would be clobbered, as it has been repeatedly in past recessions. In fact, the state’s surplus forecasts are largely due to an assumption that the economy will continue to grow and that the wealthy will continue to reap billions in taxable investment gains.

A bit of nervousness is seeping into the budget negotiations. When legislative leaders released their version of the budget, Newsom spokesman Anthony York took a swipe at its spending plans, saying, “The governor remains opposed to massive ongoing spending and wants a budget that pays down more of the state’s long-term debts and puts more money into state reserves.”

The Legislature’s own budget advisor, Gabe Petek, also has issued a warning: “Although predicting the next recession is impossible, economic indicators currently suggest a heightened risk of recession within two years. Past recessions — with the exception of the one induced by the pandemic — have resulted in cumulative revenue losses of tens of billions of dollars. In two recent recessions, in fact, total revenue losses were around $100 billion.”

The sharpest critique of enacting a $300-plus billion budget, however, comes from Christopher Thornberg, director of UC-Rverside’s Center for Economic Forecasting and a veteran student of California’s economy and its fiscal policies.

Writing in CalMatters, Thornberg criticized the Newsom administration’s projection of continued economic expansion, noted that “overstimulated economies begin with a bang, but fizzle in the face of inflation and rising interest rates” and warned “All those tax revenues built on capital gains will start falling or, more likely, dry up.”

“While we can debate how far and how rapidly state tax revenues will fall, the idea that they will plateau is nonsensical. The debate over how much of the surplus to spend on ongoing versus one-time expenditures is a dangerous red herring. California should be preparing instead for the $40 billion budget deficit coming at us.”

The competing budgets do have “rainy day” reserves and would add to them, but a truly serious recession of the kind we saw 20 years ago and then 15 years ago would quickly drain those reserves. Given the uncertain future, foregoing massive new spending and building more reserves would be the responsible thing — the adult thing — to do.