State economist Tom Stinson's forecast of a $935 million state budget deficit set up the drama that played out in the legislative session that adjourned Monday. His calculations are bound to be central to the 2009 session as well. Last week, Stinson discussed Minnesota's economy and state government's financial future with editorial writer Lori Sturdevant. Here are excerpts from their conversation: Q: How would you assess the state's financial condition, coming out of this session?

A: We're in a particularly fragile time right now economically. In a lot of ways, we're in uncharted territory.

Q: Do you think that the state's bottom line today is much different from the one you forecast in February?

A: I don't feel bad about that forecast. At this point, we've got $135 million more in monthlies [collections]. There doesn't appear now to be a big hole in the boat in 2007, judging from filed payments and refunds. That was what we saw in June of 2002 -- we were already $300 million short then.

The concern I have is with the reserve. If you're going to be financially responsible, you've got to leave something available for a potential downside.

Q: Counting the cash-flow account, legislators are leaving about $500 million in state reserves left on the bottom line. Is that enough?

A: It's probably enough. When it's raining, you need to use some of the rainy day fund. There's no sense in having that if you don't ever use it.

That said, it's really important to have a significant reserve left going into the November [2008] and the February [2009] forecast. If we don't have a significant reserve left, we've got no flexibility at all. You can't raise taxes fast enough. You can't even do shifts, because you're almost out of money to shift. [The state Constitution requires that the budget must be in balance by June 30, 2009.]

Q: How would you describe the state's economic outlook?

A: Right now, we're having a short, mild recession. The concern is, will we have a little bit of recovery, then go back down to zero growth? This one, partly because of the [federal] stimulus package, looks like it's going to be a W -- a peak this summer, followed by slow quarters thereafter.

Q: Why the backsliding?

A: It's all the usual things. It's credit, it's housing, it's oil.

We're in kind of a fragile position, if oil prices stay high. Global Insights [the state's national economic consultant] now projects oil prices at $112/barrel in this quarter, and falling to $100/barrel by 2009. [Oil was at $127/barrel on Friday.] Every $10/barrel in oil prices knocks 0.2-0.3 percent off real GDP growth in the U.S. If $120/barrel oil is where we end up, that's going to knock us back to zero in GDP growth later this year.

Every penny per gallon increase in gasoline prices costs consumers about $1 billion. When the stimulus package was passed, gasoline was roughly $3/gallon. Now, it's roughly $3.65. That means higher gas prices have burned up half of the stimulus package.

Q: What's the outlook for housing here?

A: Housing is really important for Minnesota's economy. We haven't, since the Great Depression, gone through a full year when we had housing prices decline nationally. We've just done that, and we're going to do another year of it, and maybe another year after that. We're going to have fewer houses built this year than at any year since World War II. This isn't just your normal slump. This is big time.

Typically, we have a housing slump because the Federal Reserve raises interest rates. Here, the problem is, we built too many houses. Interest rates are low. So how do you work out of this? You're not going to see a big surge, because there is no pent-up demand.

Q: We're also seeing big demographic changes. What do they bode for the economy?

A: This year, we're seeing a 30 percent surge in the number of people who are turning 62. That's a huge change.

Meanwhile, the number of people 18-24 is going to decrease faster in Minnesota than in the rest of the U.S. High school graduation rates are a worry, too. Currently, 91 percent of this state's current workforce has a high school diploma. Is there a 91 percent anywhere on this graph? [See graph at left.] No.

The drop-off is among males, both white and minority. That's a problem. If you don't have a high school diploma, you're doomed to be competing against the lowest of the low-wage people in the world.

Q: What do you think Minnesota should be doing in response?

A: We have to pay attention to the new three Rs: retention, recruitment and retraining.

Retention means not only keeping younger workers, but modifying practices so that people near retirement will still find it attractive to work. That's going to help productivity. Those people have a lot of job-specific human capital that we can't afford to lose.

We have to start thinking about what will position the state well for recruitment. One of the things I think needs some serious thinking is tuition policy. There's an important tie there to business. It's got to be easier for 3M to recruit somebody off the campus of the University of Minnesota than off the campus of, say, University of California-San Diego.

There's a fourth R, too -- research. When you fall from 20th in academic R & D per capita to [a position] in the 40s, that's not a place where we should be. This isn't state funding; it's all funding. You've got to have the ability to attract researchers who can in turn attract a lot of money.

Lori Sturdevant is a Star Tribune editorial writer and columnist. She is at lsturdevant@startribune.com.