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Irrepressible California

Despite near blackouts, the tech wreck and high job losses, the California dream endures. Lucky for the rest of us.

Despite near blackouts, the tech wreck and high job losses, the California dream endures. Lucky for the rest of us.

By Steven Brull
November 2001
Institutional Investor Magazine

"Satan, from one of his elevations, showed mankind the kingdom of California, and they entered into a compact with him at once." , Henry David Thoreau, 1852

The naturalist and moralist from Walden Pond, in decrying this hasty, Faustian bargain, was referring specifically to the gold rush of 1849. But in a sense, California has always had a gold rush (and, often enough, a pact with the devil). Brash men and women have gone there to make their fortunes rather than scratch out a hardscrabble living in Iowa or Kansas or New York. California was the glorious Golconda where you could take great risks for huge rewards and break free of the starched-collar strictures of life in the East.

The migration of animal spirits westward has meant that California has seen more than its share of booms and busts , in agriculture, real estate, entertainment, defense and technology. But this extraordinarily resilient state, a bellwether for the U.S. economy, has always bounced back , and found a way to bounce higher each time.

It's happening again.

Even before terrorists rammed jets into New York,s Twin Towers and the Pentagon on September 11, pundits were proclaiming the end of the California dream. "The Golden State's prospects seem to be getting dimmer and dimmer," intoned an April BusinessWeek cover story pegged to fears that blackouts over the summer would cripple the state's economy. The lights, however, have stayed defiantly lit. "California is not declining the way the East Coast would like it to," quips Joel Kotkin, a senior research fellow at the Institute for Public Policy at Pepperdine University in Malibu.

Nevertheless, the state's economic growth of 9.4 percent in 2000 had slowed to near zero by midyear, the victim not only of the national downturn but also, closer to home, of the implosion of the tech bubble, the drop in exports to Asia and a spike in energy costs. Now the nation's largest state is sustaining blows to tourism and air travel, key components of a $75 billion travel industry that employs 1.1 million people and constitutes 5.5 percent of California,s economy.

The long-term impact of September 11 and its aftermath is impossible to predict. But a sharp downturn that had been expected to be limited to Silicon Valley is spreading throughout the Bay Area and is likely to hurt the entire state. "If the [war against terrorism] is a longer-term conflict, then the state will fall into a lengthy recession," cautions Steven Cochrane, a senior economist and director of regional services at Economy.com, a think tank based in West Chester, Pennsylvania. His thesis: A prolonged decline in travel and tourism could sink United Air Lines, the Bay Area's largest employer, and further damage trade with Asia.

"There is no part of the [California] earth to be taken up, wherein there is not some special likelihood of gold or silver." , Richard Haklyut, The Famous Voyages of Sir Francis Drake, 1589

So is the vaunted California dream in danger of becoming a B-movie nightmare? Is there no bounce left?

Hardly. California's problems, though real, appear to be relatively short term, assuming the U.S. itself does not spiral into a protracted recession. In any event, the difficulties should be partially offset by increased demand for the new technology to combat terrorist threats, much of it invented and manufactured in California. Over the long term the state's economic fundamentals remain intact. The outlook, in fact, is as sunny as the legendary climate.

"California is rich in human skills and resources, has a diverse population and great weather and is on the Pacific Rim," says Richard Kovacevich, CEO of Wells Fargo & Co. "The state will outperform the national economy over the next decade," he maintains, adding that small entrepreneurial companies will be the primary drivers of growth.

This would be good news for the country, because California's economic prospects have significance far beyond Silicon Valley or Hollywood. The state represents one eighth of the U.S. economy (see graph below) and in the late 1990s generated one fifth of the nation's new jobs. Moreover, notes Stephen Levy, director of the Center for Continuing Study of the California Economy, a private think tank in San Francisco, California's current challenges are those the rest of the nation will eventually face: the need to compete in a high-tech, "information" economy, capitalize on ethnic diversity, make inroads into Asian markets and combine environmental protection with economic growth.

The numbers rolled out by the CCSCE inspire awe: By 2010 California's economy is expected to add some 4 million jobs, bringing its total to 20.3 million, or 12.5 percent of the nation's projected workforce (up from 11.3 percent in 2000). That's an annual growth rate of 2.2 percent, double the rate of the nation as a whole. The biggest gains will be in professional services, such as computer, engineering, management and legal work; tourism and entertainment; diversified manufacturing; and high tech, according to the CCSCE. Employment growth will be driven in part by population growth: The CCSCE predicts that the nation's most populous state will swell by some 5 million, to nearly 40 million, by 2010. The state's output of goods and services, which in 2000 totaled about $1.3 trillion (making California the world's fifth-biggest economy, ahead of France) is expected to grow to $2.3 trillion, by 2010, according to the September 2001 UCLA Anderson Forecast, published by the University of California, Los Angeles.

Whenever California suffers a downturn, doomsayers emerge. A decade ago, when defense cutbacks threw the state's economy into a sharp recession and thousands of engineers were laid off, a Time magazine cover declared that the California "dream" was "endangered." But most of those engineers found other jobs.

Similarly, The Economist, lamenting a downturn in venture capital in 1991, headed an article: "Silicon Valley, the Grandfather of All High-Tech Families, Is Growing Old." But it turned out there was some life in the old fellow yet.

Today's ominous auguries , that California will be overwhelmed by immigrants or run out of water or become unbearably congested or grow so costly to live in that only the rich can afford to be middle class or lose its entrepreneurial verve to a sybaritic lifestyle , will in time be proved equally groundless.

California-bashing, of course, is a well-established form of Schadenfreude, prompted by a complex mix of envy and antipathy. In many ways, the West Coast has usurped the East Coast's longtime primacy as the nation's leading business hub and even (briefly) New York's hegemony as a financial center, with the development of California's venture capital industry. "When California's economy has glitches, there's a natural sense of relief, because California represents such an oppressive presence to many other parts of the country that are struggling," says Kevin Starr, the state librarian and the nation's foremost scholar on California. "There's always a temptation for other parts of the nation to say, ,It's over; the trapeze artist finally fell.,"

Others are only too eager to pick up the pieces. Economic development officials from more than a dozen states have been fanning out across California, trying to lure companies away from the Golden State. So far with little success. Officials from Tennessee spoofingly proffered flashlights to California high-tech execs. But where did they invite them to dine? At Spago in Beverly Hills. That's a long way from a barbecue pit in Nashville.

"A lot of CEOs are looking for areas where their workforce doesn,t have to contend with congestion, long commute times and high housing prices," says Tony Grande, deputy commissioner of the Tennessee Department of Economic and Community Development. "Here, half a million dollars will buy a 5,000-square-foot home on five acres, not 1,500 square feet." Because of the outreach, he says, two California companies will soon invest a total of more than $25 million in Tennessee. But the companies are not relocating; they are expanding their base of operations from California to better reach markets east of the Mississippi.

"It's a scientific fact that for every year you live in California, you lose two points off your IQ. It,s redundant to die in LA." , Truman Capote, 1975

California critics have had plenty to gloat about lately. Just as the state is prone to periodic mud slides and forest fires, so is its economy seemingly disaster-prone. There's no denying that California is going through its roughest patch in a decade, and Silicon Valley is the epicenter of the tech earthquake. No region of the country benefited more from the tech boom. No region is suffering more from its bust.

"The Internet bubble and its effects were so highly concentrated in California and leveraged so much of what's going on in California that we felt the bubble much more, and we feel the collapse much more," says Eric Schmidt, CEO of Google, the Web's leading search engine. Nevertheless, he quickly adds that "California has the most robust and resilient economy in the country."

The downturn in demand for high-tech goods threw the job-creation engine into reverse, with Hewlett-Packard Co., Cisco Systems, JDS Uniphase Corp. and others shedding tens of thousands of workers. In San Jose County, which encompasses Silicon Valley, employment was burgeoning at an annualized 7.5 percent during the first quarter of 2000. By the second quarter of this year, jobs were declining at a 4.9 percent rate. In September the statewide unemployment rate was 5.4 percent, significantly higher than the national rate.

Wealth appears to be evaporating almost as fast as it was created. According to the Federal Reserve Bank of San Francisco, the market value of all high-tech companies in the Bay Area peaked in March 2000 at close to $3 trillion; of this, $670 billion came from companies that went public after 1996. Through June 2001 the total loss of market capitalization was some $1.8 trillion; those newly public companies lost $450 billion, or 67 percent, of their value.

Not surprisingly, the Bay Area's real estate bubble has been leaking air: Prices for residential properties, especially those valued at more than $1 million, are slipping; vacancy rates for commercial properties are on the rise. The joke now is that even doctors and lawyers can afford to buy a house.

A global recession would hit California above and below the Sun Belt, reducing the numbers of tourists visiting Disneyland, Hollywood, San Francisco, the wine country and other attractions as well as cutting demand for computers, software and other information technology products. Cutbacks by airlines will be felt in the Bay Area especially: United has a major hub in San Francisco and a maintenance facility in Oakland, and American Airlines has major operations in San Jose.

The state's budget, meanwhile, is slipping from surplus to deficit. Sacramento borrowed $12.5 billion from its general fund earlier this year to buy power for its insolvent utilities, Pacific Gas & Electric Co. and Southern California Edison Co. But the state has postponed until next year issuing $12.5 billion of revenue bonds that were meant to repay the general fund; regulators have been unable to agree on how to use utility revenues to repay bondholders. If the general fund isn,t repaid by next June, the end of fiscal 2002, the state's budget the following year will face a $9.3 billion deficit, jeopardizing education, health care and law enforcement programs, according to State Treasurer Philip Angelides.

Still, it's easy to exaggerate the state's economic problems. Unusually cool weather and aggressive conservation allowed California to get through this summer without any blackouts. Despite the tech wreck, the valuation of publicly traded tech companies in the Bay Area remains about double what it was at the end of 1997. In 2000 residents of California claimed $84 billion in income from exercising options. "A great deal has been lost, but on net there has still been a great deal of wealth created over the past few years," says Frederick Furlong, an economist with the San Francisco Fed.

The financial meltdown actually has positive elements. "It's good news," says David Teece, a professor of business administration at the Haas School of Business at the University of California, Berkeley. "The market had a significant speculative element, and the pricing of these dot-coms was not anchored in economic fundamentals. Although venture capital amounts have been cut dramatically year-over-year, the amounts are still very significant and not too much off the long-term trend." According to VentureOne, a company that tracks venture capital spending, equity financings for venture-backed companies totaled $25.4 billion in the first three quarters of 2001. That's about a third of the $72.7 billion invested in the first three quarters of 2000, but it far exceeds 1998's full-year total of $17.5 billion.

The pace of innovation, Teece and others say, may not be seriously affected by recession. "Innovation is a disease in California," says Jehoshua (Shuki) Bruck, a professor of computing and neural systems and of electrical engineering at the California Institute of Technology and co-founder of Rainfinity, a company that provides software for Internet commerce. He acknowledges that it will take longer for innovation to reach the marketplace with less funding available but adds: "Innovation results from very strong creative needs of people to express themselves. It's not something that is affected by funding."

Indeed, technological innovation of one sort or another has powered California's economy for more than a century. The early gold miners developed sophisticated hydraulic drilling equipment that was later used to irrigate arid terrain, transforming California into the nation's biggest agricultural state. Imaginatively conceived reservoirs permitted big cities to form. The sunny climate attracted pioneers in filmmaking but also in aviation, men like Donald Wills Douglas, Glenn Martin, Allan and Malcolm Loughhead and John Knudsen Northrop. Xerox Corp. chose California, not New York or Connecticut, as the site for its now-famous Palo Alto Research Center, attracting freethinking scientists who conceived the inconceivable. Xerox PARC, as it was known, spawned Ethernet, the graphical interface, the mouse and the personal computer.

Now the marriage of high-speed computers and silicon technology is rapidly giving bioscientists a new understanding of genomics and genetics, opening the door to faster, more efficient development of diagnostic equipment and tailor-made drugs. "California's culture embraced technology as part of its founding DNA," says state librarian Starr.

Just as California was hurt by post-cold-war defense cutbacks, its firms will benefit from post,September 11 defense spending, which will increasingly rely on sophisticated systems that can instantly analyze reconnaissance from satellites as well as airborne and ground-based sources. Traditional California defense companies are well placed for the new era of high-tech warfare. Raytheon Co., a specialist in missile systems and reconnaissance networks and communications, has huge operations in Southern California. Northrop Grumman Corp. is building its Global Hawk drone plane in Palmdale; the Pentagon has already ordered 60. Kent Kresa, chairman and CEO of Northrop Grumman, says: "My sense is that the incremental dollars will go to information technology, surveillance and reconnaissance and cyberwar. The bioengineering business should benefit on many fronts , from understanding the fundamental characteristics [of biological warfare] to protection with sensors that determine what's going on. All these things play well to the California economy."

The Bay Area is home to companies making the technology to protect computer data and guard against bioterrorism. Mountain View,based Veritas Software Corp. specializes in data storage and availability. Scientists at the Lawrence Livermore Labs and SRI International are developing handheld devices that can detect lethal microbes. Los Gatos,based Identix is a leading provider of fingerprint recognition technology. "The phone started ringing on 9/11 and hasn,t stopped ringing since," says Identix CEO Robert McCashin.

Which industries will be the next to take off , providing the bounce that makes California's economy so buoyant? There is no shortage of good bets.

Information technology is one. "Even though we,re 20 years into a shift from mass production to a technology economy, Moore's law has at least another ten years to run, and probably 20," says Michael Murphy, chief investment officer of Murphy New World Mutual Funds. Moore's law, named for Intel Corp. co-founder Gordon Moore, holds that the capacity of integrated circuits will double every 18 months. And as the geometry of semiconductors gets too dense for silicon devices, optical switches and computers will emerge, Murphy predicts.

"I think we,re on the cusp of the next big transformative technology, which will be based around global broadband interconnectivity," says Google,s Schmidt. "The prices for bandwidth around the world are extraordinarily cheap, and they,re collapsing. This will change the way people think about communications and how they want to spend their time."

Biotechnology will be huge in California. Most of the industry's science emerged from Stanford University and UC campuses in San Francisco, Berkeley and Davis. California has about one third of the world's 500 biotech companies, including Amgen and Genentech, but accounts for a much higher proportion of the value of biotech companies, reckons G. Steven Burrill, who runs a biotech-focused venture capital fund in San Francisco. "The enormous history of innovation is beginning to yield substantial products and profits," says Burrill, who manages about $350 million. "We,re at the point of the hockey stick where the value goes up pretty rapidly."

What about software? Chip-making equipment? Wireless? Nanotechnology? Multimedia? All are possibilities. But "nobody would have predicted the boom we had in Silicon Valley , nobody can predict winners," says Tom Lieser, a senior economist at UCLA Anderson Forecast.

What is certain, though, is that California,s competency lies not just in manufacturing and services but also in its unique nexus of supporting institutions , from national labs to universities to venture capitalists , that, along with cultural tolerance and a mild climate, have lured ambitious people and amplified the emphasis on entrepreneurship and new business formation. California companies have received nearly half of all U.S. venture funding over the past decade and have figured in nearly half of venture capital deals. The state is an entrepreneurial engine that has created more than two thirds of the major high-tech start-ups in the nation since 1995, according to Ross DeVol, director of regional studies at the Milken Institute in Santa Monica. "Everybody looks with envy at Silicon Valley," says Northrop Grumman's Kresa. "Everyone knows it's coming back, and it's going to be just as strong in a decade as it ever has been."

"This valley [San Joaquin] is a paradise. Grass, flowers, trees, beautiful clear rivers, thousands of deer elk, wild horses, wonderful salmon . . ." , Charles Preuss, cartographer on the Frémont expedition to California, 1844

California's biggest challenge is not spurring growth but managing it: preventing congestion, pollution and exorbitant living costs from undermining the easygoing, live-well-and-let-live-well lifestyle that has attracted so many talented people. Continued growth will attract more immigrants, boosting the population to as many as 50 million by 2025. Infrastructure challenges will become increasingly multidimensional, no longer solved simply by spending more money.

In fact, the biggest risk to California's future growth is not an economic downturn but its antibusiness climate. Resistance to building new power plants helped create the state's energy shortages; the development of housing, roads and water supplies has been similarly impeded.

The state's residents have been ambivalent about growth since statehood in 1850. In the 1920s San Diego residents sent postcards to newspapers around the country, warning people to stay away from a town crawling with rattlesnakes. The last major investments in infrastructure were during the 1960s, when the population was half of what it is today. "The only thing that could kill the golden goose is a very unfriendly business climate," says Wells Fargo,s Kovacevich.

Expensive housing is the most toxic problem. As teachers, policemen and other middle-income workers are forced to move to distant bedroom communities, sprawl, commute times and air pollution all worsen. The problem is most severe in the Bay Area. Despite recent softening in prices for luxury homes, the median price of a single-family home in the Bay Area in September was $463,440 , a 4.6 percent increase from a year earlier. Statewide, the median-priced home sold for $276,960 in September, a sum that only a third of Californians could afford. Nationally, 55 percent of households could afford the median-priced home in their communities, according to the California Association of Realtors.

A solution to the housing problem is nowhere in sight. Because of a lack of developable land, coupled with aggressive environmental and construction-defect litigation, only about 150,000 new housing units were built in the 12 months through last January. That was just 60 percent of the number needed to house the state's 600,000 new residents, says Jack Kyser, chief economist with the Los Angeles Economic Development Corp.

Rectifying California's infrastructure deficits will require an abundance of political leadership and creative ideas. "California must in the immediate future confront the ,no growth, lobby," says former governor Pete Wilson. Communities will have to accept more housing and alter tax policies that favor retail developments; population density must rise, although in the post,September 11 world, it may occur in more-dispersed business centers.

A state that toots its own horn about having more cars than registered drivers will have to adopt peak-hour tolls on freeways, late-night cargo delivery and high-speed railways. School buildings will have to be used year-round; alternatives to failed bilingual education programs will have to be found. James Albaugh, president of Boeing's Space and Communications Group, complained recently to a group of Orange County business leaders that "the high cost of doing business here affects our ability to compete."

Lowering the cost of doing business in California won,t be easy, but then, as O. Henry said, Californians are not merely "inhabitants of a state" but "a race of people." History suggests they,ll be up to the challenge.