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Where the Pinch Isn't As Painful

California's economy may have dodged a bullet. Despite an energy crisis, the collapse of tech jobs in Silicon Valley, and the prospect of a big state budget deficit, many economists now believe the state's economy will outperform the U.S. as a whole this year.

The clearest indicator is the labor market, where California has seen a much smaller percentage drop in jobs than the country overall. Nonfarm employment for the U.S. peaked in March and has since dropped by 0.7%. It is now below its level of a year ago (chart). By contrast, the number of California jobs continued to rise until June, then fell by only 0.3% and is still up from a year ago. "California has been outperforming and will continue to outperform," says Bank of America economist Lynn Reaser.

Ten years ago, California's defense and aerospace industries were devastated. The end of the cold war halved defense employment in California in the early 1990s, costing more than 137,000 jobs. In contrast, only about 5,000 defense and aerospace jobs have been lost this year. In fact, Northrop Grumman Corp. (NOC) plans to add more than 1,000 workers over the next year as it ramps up for the new Joint Strike Fighter.

And despite the technology bust, real estate, another weak spot in the early 1990s, also seems to be holding up. The median home price climbed 10% in California in the third quarter, compared with 6% for the nation as a whole. "We're still housing-short," says Stephen Levy, director of the Center for Continuing Study of the California Economy, a private research group in Palo Alto.

That's not to say the Golden State is worry-free. California also outgrew the rest of the nation in the beginning of the 1990-91 recession but ultimately fell further and stayed down longer than other states. Electricity bills have soared as much as 40% and will stay that way for the foreseeable future. State revenues are shrinking, and the Legislative Analyst's Office estimates that the state could face a budget shortfall of $12 billion in the fiscal year beginning in July. That will likely mean higher taxes and sharply reduced state spending at precisely the time many experts are calling for higher government expenditures to spur growth. Still, California may endure this recession with less pain than it did the last one. Good health is good for an economy. In fact, a one-year improvement in a country's life expectancy contributes to a 4% increase in its economic output, according to a National Bureau of Economic Research working paper by David E. Bloom and Jaypee Sevilla of Harvard University's School of Public Health and David Canning of Queen's University of Belfast.

Other studies have noted the correlation between a country's health and its output. But it was never clear whether good health was a driving force in increasing output or simply a consequence of such factors as higher income and better education. By analyzing data from 104 countries across three decades, the researchers were able to separate out the impact of better health. They don't deny that higher incomes improve health. But they found that the opposite is also true. Especially in poor countries where manual labor is important, robust people can work harder and make more money. Says Bloom: "Healthier means wealthier."

Government spending on health care is usually seen as an act of kindness. But the paper's authors say that by enhancing economic output, good health may benefit all of society, beyond the benefits to healthier individuals. If so, they say, "increased expenditures on improving health might be justified purely on the grounds of their impact on labor productivity." Despite cutting interest rates by half a percent, to 3.25%, on Nov. 8, the European Central Bank is still being criticized for not doing enough to fight Europe's economic slowdown. But for the next couple of months, it's going to be difficult to tell whether more interest-rate cuts are really needed.

Why? The introduction of euro notes and coins for ordinary retail transactions, which starts on Jan. 1, will muddy the waters. More than twice as much currency as usual will have to be in circulation to ensure enough euros to go around at the beginning of the changeover. This switch will temporarily swell money-supply figures, push up prices, and distort the financial data the ECB relies on for interest-rate decisions.

Economists at HSBC Investment Bank in London predict that M1--the narrowest definition of the money supply--will soar by 400 billion euros, or 18%, in January alone, after rising by only 7% or so over the previous 12 months (chart). Meanwhile, the cost of living could temporarily trend upward as retailers use the conversion process as an excuse to round up prices. "There's a risk you could get a multiplier effect that could fuel inflation," says Robert Prior-Wandesforde, an economist at HSBC.

To complicate matters, distrust of the new money could persuade some investors outside the euro zone to switch marks, francs, and other legacy currencies into dollars rather than the euro, which could force down the new currency's value on foreign exchange markets. It all adds up to a lot of uncertainty. "In such an environment, policymakers in Frankfurt might prefer to sit on their hands rather than follow an activist approach to monetary policy," says Prior-Wandesforde.

Things should be back to normal by the end of February, when the changeover is complete. But it could be a bumpy ride until then.

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