Fiscal Perspectives

Taking Stock of California’s Recession Readiness

February 12, 2020

Gabe Gabriel Petek
Legislative Analyst

California’s capacity to absorb adverse fiscal shocks, including those from a recession, is critical to how well it can sustain the Legislature’s program commitments through various phases of the business cycle. Building and maintaining a prudent budget reserve is arguably the most effective way the state can strengthen its fiscal resilience prior to a downturn. After several substantial increases in recent years, the Governor’s budget proposal includes $20.5 billion in total reserves for 2020‑21. The historic nature of the state’s budget reserves has given rise to questions about whether policymakers have done enough to prepare for a recession or other noneconomic sources of budgetary imbalance. Our office is on record that while the state has made significant progress, considerable uncertainty remains. Not least are signs of slowing economic growth and risk from draft federal regulations regarding the types of fees and taxes the state can levy on healthcare providers. Therefore, in addition to reserves, the Legislature may want to consider the role of planned operating surpluses as a preemptive fiscal defense against a recession. The argument for maintaining an operating surplus in the state’s multiyear budget plan is stronger in the context of a mature economic expansion. We describe and make the case for operating surpluses as an instrument of fiscal resilience in our recent report, The 2020‑21 Budget: Structuring the Budget.

Scenario Analyses Are Valuable for Fiscal Planning

Accurately predicting recessions in a reliable fashion remains elusive within economics. A next best option for policymakers as they assess the adequacy of California’s fiscal resilience is to develop fiscal estimates under conditions of a hypothetical recession. In recent years, our office has conducted such “stress-tests” of the state’s finances by including recession and other stress scenarios in our annual November Fiscal Outlook and other budget reports. While these scenario analyses aim to provide the Legislature with rough measures of the state’s recession preparedness, some ground rules are useful for appropriately interpreting their findings.

First, the adequacy of the state’s fiscal resilience is revealed only to the extent it is tested. To no one’s surprise, a severe recession generally will inflict greater fiscal stress on the state than a milder downturn. This aligns with what our office found in its March 2018 report, Building Reserves to Prepare for a Recession. In that report, we illustrated how the state’s budget reserves—as proposed by then-Governor Brown—were approaching a level that could cover the budget problems of a “mild” downturn. Yet even with the large $3.5 billion optional reserve deposit the Governor had proposed that year, the report also found that the state’s reserves would remain insufficient to cover a “moderate” stress scenario. This analysis illustrated how evaluating the state’s fiscal structure under a range of stress scenarios can serve as a useful gauge of its progress toward recession preparedness. The findings should also send a cautionary message, however, against declaring mission accomplished based on a fiscal modeling exercise showing that the state can withstand a relatively mild downturn. Doing so risks inviting unwarranted complacency. Unlike a discrete task, preparing for a recession is akin to saving for retirement or an exercise regimen—plagued by uncertainty over how much is enough and rarely ever finished.

Second, while building reserves may be the most important form of budget resilience, it is not the only one. The state’s operating position, which refers to its annual revenues relative to expenditures, also influences its fiscal resilience. When multiyear estimates show that revenues will exceed expenditures on a recurring basis, there is an operating surplus (when annual expenditures exceed ongoing revenues, there is an operating deficit). Our November 2019 Fiscal Outlook found the state was in good shape to weather a recession typical in severity to those of the post-World War II era. The state’s large budget reserves were important to our finding, but so too were its operating surpluses. A notable property of projected operating surpluses, however, is that they exist only in the state’s multiyear plan.

Planning for an Operating Surplus Bolsters Resilience

Each year, our office constructs a fiscal outlook that estimates state budget performance several years into the future based on the consensus economic forecast reported by Moody’s Analytics. These estimates—which typically assume a continuation of recent economic trends—serve as a baseline. As noted, in recent years we have also generated estimates of state revenues and expenditures under one or more recession scenarios. In the recession scenarios, revenue estimates are lowered from the (baseline) growth scenario. (Lower revenues also cause the state’s formula-driven spending requirements to decline, though not so much as to offset the revenue shortfalls.) Potential for a budget problem occurs when revenue estimates fall below estimated expenditures. We assess the state’s recession preparedness by comparing the estimated combined budget problem across several years to the state’s budget reserves. If reserves exceed the estimated cumulative budget problem of our recession scenario, we describe the state as being in good shape to withstand our recession scenario (although we caution that our assessment may not hold in a more severe downturn than what we considered). Conversely, if the estimated budget problem exceeds reserves, then other actions, such as spending cuts or revenue increases, would become necessary in the event of a recession.

Whether the state’s multiyear fiscal outlook shows operating surpluses or deficits when a recession begins can have a significant effect on how resilient it is through the downturn. If the state enters the recession with an operating deficit, the decline in revenues caused by the recession will only worsen the state’s budget problem. But if the state enters a recession with an operating surplus, the budget problem itself will be smaller, allowing reserves to go further. This was the situation in our November 2019 Fiscal Outlook in which we estimated an average annual operating surplus of $3 billion through 2023‑24. The budget problem created by the reduced revenues of our recession scenario was significantly mitigated by the presence of the operating surpluses.

Key Spending Assumption May Not Align With Legislative Priorities

When conducting scenario analyses, our practice has been to assume the Legislature authorizes only the funding level necessary to comply with constitutional requirements and to maintain existing program commitments. We make no presumption about additional spending choices in deference to the Legislature’s appropriation authority. Stripping expenditure estimates down to what is constitutionally required and necessary to sustain existing programs is also a way we can provide the Legislature with our estimate of the state’s fundamental fiscal capacity. One notable implication of this assumption, however, is that in a declining General Fund revenue scenario, estimated spending on K-14 education is reduced, consistent with the Proposition 98 (1988) formulas. Proposition 2 (2014) would similarly allow for reduced spending on certain debt repayments while temporarily halting deposits into the Budget Stabilization Account—the state’s main budget reserve. Viewed solely from the perspective of the state’s fiscal condition, these features of Proposition 98 and Proposition 2 can act as automatic stabilizers by helping shrink the potential budget problem. However, to the extent the Legislature instead preferred not to reduce funding levels—particularly for schools—in response to a revenue decline, larger reserves (or entering operating surpluses) are needed.

Legislature’s Risk Tolerance Is Ultimate Guide When Setting Operating Surplus Target

What lessons are there to take away from our various scenario analyses? One is that there is a dynamic quality to the state’s fiscal resilience. A scenario analysis from one year may not be directly comparable to that of another. A major source of this variation is the severity of the recession scenario considered in the analysis. Therefore, rather than attempting to simulate a possible recession, one alternative is to estimate how much revenue shortfall the state’s fiscal structure can withstand. The Legislature can then decide whether its existing or contemplated level of ongoing spending commitments align with its risk tolerance. If not, the Legislature should consider adding to its budget reserves.

Besides recession, another reason our findings vary is that important circumstantial assumptions—including those that lie outside of the Legislature’s control—inevitably will differ from one year to the next. Such changes can materially affect estimates of the state’s budget condition across the multiyear outlook period. In our 2019 Fiscal Outlook, for example, we included an alternative (economic growth) scenario that estimated the effects of adverse decisions by federal regulators combined with a major natural disaster. We found that developments such as these could shrink the state’s annual operating surpluses by two-thirds, from around $3 billion to $1 billion.

A second lesson—related to the first—is that building an operating surplus into the state’s multiyear fiscal plan is a powerful way to enhance its fiscal resilience. Our scenario analyses demonstrate that a prudent operating surplus can buffer the state’s budget and multiyear fiscal condition against recessions and other unexpected developments that push costs higher than anticipated.

While California’s budget reserve balances are at all-time highs, the Governor’s 2020‑21 budget proposal would leave minimal operating surpluses in later years. Given the prolonged nature of the current economic expansion and that the economy is showing signs of slowing growth, there is risk to this approach. Therefore, the Legislature may wish to consider supplementing the state’s fiscal resilience with a discretionary reserve deposit or by retaining larger operating surpluses in its multiyear plan.