California’s $125 Billion Death Spiral

Newsom is betting his last budget on AI stocks his own analysts call overheated. Four straight deficit years. A $35 billion structural gap incoming. And a pension system that makes all of it worse. We’ve seen this movie. It ended badly.

In the spring of 2000, California’s budget office projected a $12 billion surplus. By 2002, the state faced a $35 billion deficit. The dot-com bubble had popped, the concentrated revenue base built on stock options and capital gains had evaporated, and Sacramento was left holding the tab for a decade of spending commitments built on the assumption that NASDAQ would go up forever.

Gavin Newsom is writing the sequel.

California’s nonpartisan Legislative Analyst’s Office, the state’s equivalent of the Congressional Budget Office, released its November 2025 Fiscal Outlook with language that should have made front pages from Sacramento to Wall Street. Current revenue growth, the LAO wrote, is “being driven by enthusiasm around AI, which has pushed the stock market to record highs and boosted compensation among the state’s tech workers.” The S&P 500 had risen 50 percent in two years. Most of the gains were concentrated in “a handful of tech companies that investors believe will be major beneficiaries” of AI. The LAO used one word to describe this environment: “overheated.”

Newsom’s January 2026 budget proposal ignored the warning entirely. The LAO called him out for it in print, writing that “these risks are severe enough that not incorporating them into this year’s budget, as the Governor proposes, would put the state on precarious footing.” That is budget-analyst language for: we told you so, and we want it on record.

California has now run deficits for four consecutive fiscal years – during a period of genuine revenue growth. That is not a cyclical problem. That is a structural one. The LAO’s own language confirms it: “Deficits have persisted even as the state’s economy and revenues have grown, underscoring that the problem is structural rather than cyclical.”

The 2026-27 budget deficit is projected at $18 billion – $5 billion larger than the administration anticipated just months earlier. By 2027-28, the structural gap reaches $35 billion annually. To close that gap through revenue alone, California would need $60 billion above forecast, a threshold the LAO’s chief deputy analyst Carolyn Chu called “highly unlikely.” The state has already burned through its least painful tools: one-time spending reductions, reserve drawdowns, internal borrowing, and Medi-Cal enrollment freezes for undocumented immigrants. The easy levers are gone.

Spending is growing at roughly 6 percent annually. Revenue is growing at just above 4 percent. The gap between those two lines is not an accident and it is not a tariff. It is a compounding arithmetic problem that Sacramento has been declining to solve for the better part of a decade by funding recurring obligations with one-time maneuvers that kick the tab to the next Legislature, the next governor, or the next generation.

The operating deficit is the visible problem. The pension liability is the structural one that makes everything else worse.

CalPERS, the nation’s largest public pension system, carries $180 billion in unfunded liabilities as of its most recent actuarial report. Its 23-year average investment return is 5.6 percent. Its assumed discount rate, the return it needs to meet obligations without additional taxpayer funding, is 6.8 percent. That gap between assumption and reality is the mechanism by which unfunded liability is manufactured year after year. When CalPERS misses its target, the shortfall lands on state and local governments. Public pension liabilities are legally binding. There is no restructuring, no negotiation, no Chapter 9 for the state of California.

Since 2014, the state employer contribution rate has risen from 19.5 percent of payroll to 32.4 percent. In plain English: for every dollar a state employee earns today, Sacramento is contributing an additional 32 cents just to stay current on pension obligations, up from 19 cents a decade ago. CalSTRS adds another $107 billion in unfunded teacher pension obligations. The state’s unfunded retiree healthcare liability adds $91.5 billion more. Total structural pension and retiree benefit overhang: north of $378 billion, against a General Fund that collects approximately $225 billion in a strong year.

CalPERS’ response to chronic underperformance has been to double down on risk. The board recently approved a plan to increase private equity and private credit exposure to 40 percent of the portfolio — doubling private market allocations in a system that, over the past 20 years, has underperformed a simple passive 60/40 index by a full percentage point annually. More risk, higher fees, lower returns. The Reason Foundation’s Pension Integrity Project has documented the pattern in exhaustive detail. Sacramento’s response has been to look away.

The LAO has, with admirable clarity, told the Legislature what structural balance requires: ongoing revenue increases, genuine spending cuts, or both. The political class has responded with the California equivalent of thoughts and prayers: federal blame, one-time maneuvers, and the implicit assumption that the AI bull market will continue indefinitely.

Three things need to happen, and the current governor has shown no appetite for any of them.

First, honest revenue forecasting. Newsom’s budget should incorporate the downside scenario his own analysts demanded. Build the budget on median projections, not AI-cycle peak assumptions. If the market corrects, Sacramento needs a plan that doesn’t require the Legislature to reconvene in emergency session.

Second, a serious CalPERS reform conversation. Move new state hires to a defined-contribution system. Freeze the defined-benefit accrual for existing employees on a prospective basis. Adopt index-fund investment strategies that have outperformed the current approach by documented margins at lower cost. These are not radical proposals — they are standard practice in the private sector and in better-managed states.

Third, structural spending discipline. The LAO’s spending growth projection of 6 percent annually is not a law of physics. It is the cumulative output of years of program expansions, union contracts, and entitlement commitments made during boom years and never revisited. Some of them are good programs. All of them need to be paid for, and the math currently doesn’t work.

In 2000, California’s budget office was projecting surpluses. Within 24 months the state was running the largest deficit in its history. The dot-com bubble didn’t announce itself. Overheated markets rarely do. But the state’s own analysts used the word “overheated” in their official forecast, and the governor chose to build his last budget anyway.

When Gavin Newsom’s successor inherits this balance sheet in 2027, they will not be able to say no one warned them. The LAO warned them. In writing. In November. The governor just didn’t want to hear it.