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Arnold's inheritance
The new California governor has to deal with an economic mess with national ramifications.
October 10, 2003: 8:05 AM EDT
By Mark Gongloff, CNN/Money Staff Writer

NEW YORK (CNN/Money) - Now that Californians have recalled Gov. Gray Davis and replaced him with the Terminator, it might be easy to dismiss the entire process as a political sideshow with few implications for the national economy.

Warren Buffett, for one, would disagree.

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"If California has troubles, the country has troubles," Buffett said in August. "If California prospers, the country prospers." The billionaire investor acted as an economic adviser to the campaign of the winner, Republican candidate Arnold Schwarzenegger.

As of 8:16 a.m. ET, returns showed 54 percent of Californians voted to recall Davis. In the vote for his replacement, Schwarzenegger garnered 48 percent of the vote, with Democratic Lieutenant Governor Cruz Bustamante a distant second at 33 percent. (click here for CNN.com's extensive coverage)

At first blush, Buffett's argument seems to make perfect sense. California, by some measures, has the world's fifth-largest economy and is responsible for more than 10 percent of the U.S. economy. Naturally, it would seem to have an overwhelming advantage over the other 49 states, all of which produce far less.

But the relationship may be more symbiotic than that, according to Sung Won Sohn, chief economist at Wells Fargo & Co., who publishes a report on California's economy.

"This is what economists call a simultaneous process, meaning that it works both ways," Sohn said.

Sohn noted that while California consumes a lot of what the rest of the country produces -- such as automobiles and machinery -- it also produces a lot of the stuff the rest of the country "consumes" -- including fruits and vegetables, computer hardware, movies, and services such as tourism.

In other words, even if Californians lose their appetite for services and consumer and capital goods, they're still going to have to keep producing them for the rest of the country. And with output of about $1.35 trillion in 2001, the latest data available, California's economy is smaller only than those of the United States, Japan, Germany and Britain.

On the other hand, if the rest of the country loses its demand for semiconductors and summer blockbusters such as "Gigli," it still will have to keep making cars to clog the L.A. freeway.

In fact, California's recent financial woes, including an $8 billion budget deficit, look suspiciously like those of a number of other states -- states that got fat on higher tax revenues during the late-'90s boom, spent like crazy, and are now terribly hung over.

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"As the national economy gets better, California will get better, and some of its problems will be less acute," said Joshua Feinman, chief economist at Deutsche Bank Asset Management.

But fixing California's problems will be a daunting task, even with an improving economy. The state spends $100 billion a year and will fall about $8 billion short of funds needed to sustain public services at current levels in 2004, according to a report Wednesday in the LA Times.

That same report cited political strategists from both parties, who say Schwarzenegger is likely to raise taxes, which could alienate conservative Republicans -- who already have problems with Schwarzenegger's stated positions on some social issues.

One wild card in the California deck is housing. The state has some of the hottest -- some would say over-inflated -- markets in the country, including Riverside-San Bernardino, Los Angeles, and Sacramento; in all three areas, home prices jumped more than 20 percent in the second quarter, according to the most recent data from the National Association of Realtors.

It still seems unlikely to most economists that these markets are really in a bubble, which would mean prices there are due for a sudden, drastic falloff that would slam the regional and state economies.

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And those economists had better be right, since severe housing-market pain, in major cities in California or elsewhere, could put the rest of the economy at risk.

"If there were a bubble in California and if it were to burst, that would be a national economic catastrophe," said Wells Fargo's Sohn, who emphasized he didn't think there were any regional real estate bubbles.

But he added: "Clearly, California is very vulnerable on that score, along with some parts of the East Coast, from Boston to Washington, D.C."  Top of page


-- This story is an updated version of one that originally ran on Aug. 21, 2003.




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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.