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The
Right
Stuff

America’s Move to Mass Customization
FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report

2 1998 Annual Report | THE RIGHT STUFF

CONTENTS

A Letter from the President . . . . . . . . . . 1
The Right Stuff: America’s
Move to Mass Customization . . . . . . . . 3
Bank Executives and
Senior Management . . . . . . . . . . . . . . . 27
Boards of Directors . . . . . . . . . . . . . . . . 28
Officers and Advisory Councils . . . . . . 30
Financial Statements . . . . . . . . . . . . . . 33
Notes to Financial Statements . . . . . . . 37
Volume of Operations . . . . . . . . . . . . . . 48

In July 1947, on potato fields 20 miles from
Manhattan, William Levitt pioneered the
mass production of affordable homes.
Variations in the 17,477 houses were minor;
each had two bedrooms, a bath, living
room and kitchen on a 750-square-foot
concrete slab. By standardizing the units,
Levitt eventually was able to put up more
than two dozen a day, helping fill the enormous postwar demand. Over the years,
innumerable changes to the homes have
transformed the community. But even now,
Levittown remains a kind of shorthand for
the sameness of mass production that’s
starting to give way to mass customization.

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report

A LETTER FROM THE PRESIDENT
When I use my remote key to unlock Big Red, it automatically adjusts the seat and mirrors for me. When
my wife, Suzanne, uses her remote, it does the same
for her. Is this a great country or what?
Somehow we were able to get by before this convenience, but life is surely sweeter now. We may save
only 10 or 15 seconds, but, hey, those seconds add up.
The old way met our needs, but the new way
meets them better. That’s what our annual report
essay is about this year: the power of new technology
to customize our products. Things used to be made to
order and made to fit. But they were labor-intensive
and expensive. Mass production came along and
made things more affordable, but at a cost—the cost
of sameness, the cost of one-size-fits-all.
Technology is beginning to let us have it both
ways. Increasingly, we’re getting more personalization at mass-production prices. We’re moving toward
mass customization. That’s the message of our essay.
I hope you enjoy it.
❧
The economy just finished another remarkable year of rapid growth, falling unemployment and declining inflation. Don’t say I didn’t tell you so. Here’s what I said in this space
last year:
Our optimism about the American economy was well placed last year [1997]. Real GDP
grew almost 4 percent, employment was up 3.2 million, unemployment fell to 4.7 percent and
the Consumer Price Index increased only 1.7 percent. The best performance in years in both
unemployment and inflation left many less optimistic souls scratching their heads. We, however, expect more of the same in 1998.

How close was I to the mark? Well, real GDP grew over 4 percent last year, employment
was up 2.8 million, unemployment fell to 4.3 percent and the Consumer Price Index rose
only 1.6 percent. Once again, a stellar performance. Less optimistic souls are still scratching their heads.
Dare I predict more of the same for 1999? Why not? As Tom Wolfe might have me say,
let’s let the red dog off the leash.
I expect real growth in 1999 to benefit again from technology-driven improvements in
productivity, which rose more than 2 percent last year. I also expect the global deflationary environment to combine with strong growth in productivity and real output to hold
down inflation. I’m not saying that inflation will remain low despite strong real growth; I’m
saying it will remain low in part because of strong real growth. If inflation results from too

2 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

much money chasing too few goods, more goods will help as much
as slower money growth. The bottom line will be real growth in the
3–4 percent range, with inflation remaining below 2 percent.
I don’t believe in speed limits on the economy or a stable NAIRU
(nonaccelerating inflation rate of unemployment). And I’m certainly
not a Phillips curver who believes inflation and unemployment are on a
seesaw where one goes down only when the other goes up. I can’t support my optimism with sophisticated models, but I do offer as evidence
the economy itself. As Yogi Berra has said, “You can observe a lot just by
watching.” I’m also reminded of an old Richard Pryor line: “Who are you
going to believe? Me or your own lying eyes?” For the past three years
the economy I’ve been watching has grown at what most models would
consider unsustainable rates while inflation has declined rather than
increased.
I think a fourth year like the last three is possible, but we do face
some unpleasant employment arithmetic. The past three years have
benefited from growth in both productivity (more output per hour
worked) and the labor supply (more hours worked). Declining unemployment during those years means we were drawing down the available labor pool. With unemployment at 4.3 percent, with labor-force
participation over 67 percent and discouraged workers (people who’d
like a job if they thought it possible) at a record low, we may finally run
out of slack in the labor market. If so, productivity will have to increase
even faster for the recent growth rate to continue. Of course, productivity growth and the number of available workers are related, since
much of the consolidation and downsizing undertaken to make companies more efficient frees up labor for other uses.
Congress could help make my optimistic scenario a reality by taking
two easy steps to bolster our workforce. My first recommendation is to
abolish the earnings test on Social Security benefits to make part-time
work more attractive for experienced retirees. My other suggestion is to
ease limits on immigration of foreign workers with the education and
skills to be productive immediately. We need more good people. While
we’re at full employment is the time to do it.
❧

The U.S. economy performed well last year despite the Asian financial crisis. In fact, until the Russian default in August, large parts of our
economy benefited from the flight of capital to the United States. That
changed after the Russian default, however, and our financial markets
became unsettled in September and early October, prompting the Fed to
ease policy in three small steps. Financial markets returned to near normal, and the overall U.S. economy not only remained robust but picked
up strength in the fourth quarter.
Although the U.S. economy has done well for several years, the
Eleventh District has done even better, as measured by employment
growth. During 1998, however, District employment growth slowed to
the national rate in the face of head winds spawned by low oil prices—
which affected both producers and exports to Mexico—and by
depressed computer chip prices. Agriculture also was hard hit. In
recent years, an influx of workers helped keep regional employment
growth above the national pace, but tight labor markets nationwide
narrowed this advantage during 1998.
Banks in the District remain well capitalized, liquid and profitable.
Loan demand has remained strong. Texas bankers were saddened
at the loss of our friend Bob Harris, president of the Texas Bankers
Association. We miss him very much.
Demand for the Dallas Fed’s financial services continues to be
strong overall. 1998 saw increases in check and cash volume as well
as automated clearinghouse and funds transfer volume. These gains
helped us improve productivity and efficiency. We recovered the cost of
our priced services during 1998.
The Dallas Fed devoted considerable attention to Y2K last year. By
midyear the Fed’s critical systems were Y2K compliant, and banks
began testing their electronic interfaces with us. All milestones are
being met. As testing continues in 1999, we will also finalize our contingency plans. In addition to our own systems and electronic connections to financial institutions, our examiners have been overseeing the
Y2K preparations of the banks and holding companies under our jurisdiction. Virtually all are meeting their milestones and are on track. If
there are significant problems with the century rollover, we don’t
expect them to originate in the banking system.

Robert D. McTeer, Jr.
President and Chief Executive Officer

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 3

The
Right
Stuff

America’s Move to Mass Customization

Henry Ford’s first great contribution to America was
the Model T, which rolled off the assembly lines at
his Highland Park, Michigan, plant at the rate of one
every 24 seconds. At the time, it was an amazing display of industrial efficiency. By streamlining automation in his factories, Ford advanced an era of
mass production that built his fortune and brought
the automobile within reach of an emerging middle
class. But while the miracle of mass production
delivered the goods, it didn’t adapt easily, so all
Model T’s looked alike. Ford’s approach can be
summed up in what he said about the car’s exterior:
“The consumer can have any color he wants so long
as it’s black.”
Ford’s take-it-or-leave-it attitude wouldn’t cut it
in today’s economy. Americans are blessed—some
might say overwhelmed—by an ever-expanding
variety of goods and services. (See Exhibits 1 and 2.)
Just since the early 1970s, there’s been an explosion
of choice in the marketplace —the assortment of
new vehicle models has risen from 140 to 260, soft

drinks from 20 to more than 87, TV channels from
5 to 185, over-the-counter pain relievers from 17 to
141. The U.S. market offers 7,563 prescription drugs,
3,000 beers, 1,174 amusement parks, 340 kinds of
breakfast cereal, 50 brands of bottled water. Whole
milk sits on the supermarket shelf beside skim milk,
half-percent, 1 percent, 2 percent, lactose-reduced,
hormone-free, chocolate, buttermilk and milk with a
shelf life of six months. Today’s consumers have
access to more book titles, more movies and more
magazines. Ford’s company still makes black cars
for buyers who want them, but it also offers a palette
of 46 other colors — toreador red, jalapeño green,
Atlantic blue, mocha frost, autumn orange, teal and
more.
This proliferation of products, models and styles
isn’t capitalism run amok. Variety shouldn’t be dismissed as a trivial extravagance. It’s a wealthy,
sophisticated society’s way of improving the lot of
consumers. The more choices, the better. A wide
selection of goods and services increases the chance

4 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Exhibit 1: MORE CHOICES THAN EVER

Item

Americans’ historical buying patterns show a growing penchant for variety. To market closer and closer to customers’ individual tastes, business has increasingly eschewed the par-

Early 70s

Late 90s

Vehicle models

140

260

Vehicle styles

654

1,212

SUV models

8

38

18

192

Personal computer models

0

400

torical data on product variety are surprisingly hard to find, but what’s there tells an unam-

Software titles

0

250,000

biguous tale: today’s richer consumers seek to express themselves through more choice.

Web sites

0

4,757,394

267

458

11,261

18,292

Magazine titles

339

790

New book titles

40,530

77,446

Community colleges

886

1,742

Amusement parks

362

1,174

TV screen sizes

5

15

Houston TV channels

5

185

Radio broadcast stations

7,038

12,458

McDonald’s menu items

13

43

7

14

10

78

160

340

3

29

National soft drink brands

20

87

Bottled water brands

16

50

Milk types

4

19

Colgate toothpastes

2

17

Mouthwashes

15

66

Dental flosses

12

64

6,131

7,563

adigm of mass production, in some cases virtually flooding the market with a profusion of
choice. Today’s athletes, for example, can choose from more than 285 models of running
shoes (167 men’s and 118 women’s), up from just five (unisex) models in 1970. More than
3,000 assorted beers are available to enjoy while surfing 185 different TV channels. His-

SUV styles

Movie releases
Airports

KFC menu items
Frito-Lay chip varieties
Breakfast cereals
Pop-Tarts

Prescription drugs

Over-the-counter pain relievers

17

141

Levi’s jean styles

41

70

Running shoe styles

5

285

Women’s hosiery styles

5

90

Contact lens types

1

36

Bicycle types

8

31

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 5

Exhibit 2:
VARIETY ON THE RISE

Index, 1970 = 100

Statisticians collect reams of

350

data on the quantity of goods
and services in the economy

Community colleges
Airports
Amusement parks
New book titles
Magazine titles
Movie releases

300

but little on product variety. The
few statistics that can be found

250

generally proclaim a common
theme: America cares about

200

choice. We want—and we’re
getting—more

choices

of

150

movies, amusement parks,
educational institutions, books,
magazines and airports, to
name just a few.

100
50
0
’70

’72

each of us will find, somewhere among all the
shelves and showrooms, products that meet our
requirements. (See Exhibits 3, 4 and 5.)
Over time, the American economy has been giving
us more of what we want. Just look at what’s happened in automobile design since Ford made his
declaration about the color of cars. Until 1914,
Model T’s were available in red, blue, green, gray and
black. The move to all black was a concession to
mass production that made the car a commodity of
sorts, but standardization wasn’t a winning strategy
in the long run. By 1927, competition forced Ford to
rethink variety. The Model A came in several body
styles and an array of colors. With each decade, Ford
gave consumers more choices, so that by 1955 the
company offered five model series: mainline, customline, Fairlane, station wagon and the two-passenger Thunderbird convertible. Buyers could select
upholstery and optional equipment.
The possibilities for doing a better job of meeting
consumers’ wants still weren’t exhausted. Ford and

’74

’76

’78

’80

’82

’84

’86

’88

other automakers started designing products for
market niches. In 1964, Ford introduced the Mustang, an inexpensive, sporty vehicle for young drivers. The 1980s brought the Taurus and Sable, cars
for middle- and upper-middle-income families. As
Ford prepares for the next millennium, it’s introducing custom ordering, which allows buyers to specify
what they want. Ford’s Internet site offers six models of the Explorer—each with choices for power
train, exterior, interior, audio, wheels, tires and other
options. All told, there are more than 2.5 million possible combinations for the vehicle.
The trend toward customization isn’t confined to
the automobile industry. From clothing to computers, businesses are working to become more consumer friendly. They do it to gain new sales and stay
competitive. They do it because pleasing the customer isn’t just about producing more stuff. It’s
about producing the right stuff.
Just what is the right stuff? It’s more of what we do
want and less of what we don’t want. The economy

’90

’92

’94

’96

6 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Exhibit 3: THE MORE THE MERRIER: New product
introductions of consumer packaged goods: 1980 vs. 1998

1998

400

1,001

Laundry soaps, detergents

12

48

Paper towels, napkins

11

126

Deodorizers, air fresheners

53

372

8

18

393

2,944

26

255

118

483

4

70

Household items

The customer is always right, even when he changes his mind. Busi-

Examples

nesses refresh their shelves with thousands of new products annually to
keep pace with consumers’ changing tastes. Whether it’s a bottle of
aspirin or ibuprofen, a six-pack of Pepsi or a 48-ounce bottle, a bag of
barbecue-flavored chips or ruffled ones, retailers code and track them

Glues, adhesives, tapes

as shelf-keeping units (SKUs). And with each new variation, businesses hope to bring products closer to what consumers want. In consumer

1980

Beverages
Examples

packaged goods alone, the number of SKUs introduced in 1998

Milk, nondairy milk, yogurt drinks

reached nearly 25,000, up from just 4,414 in 1980. Many new products
undoubtedly fail, but many remain—as long as consumers want them.

Fruit, fruit-flavored drinks

Paradoxically, the nation’s accounts of economic activity tally only the

Health drinks

quantity of goods produced and give no credit for how adept business

Soft drinks

26

252

is at following America’s shifting tastes.

Bottled waters

12

125

Coffee

11

384

Tea

25

461

Beer, ale

25

187

Wine, wine coolers

22

252

1,294

9,509

1980
Food products

1998

2,112 10,803
Examples
Meals, entrées

159

671

Meat

42

234

Health and beauty aids

Fish

32

118

Examples

Poultry

13

168

Pain relief

29

79

Vegetables, vegetable side dishes

68

329

Cough, congestion relief

35

134

Rice, rice side dishes

17

94

Vitamins, supplements

88

1,289

Pasta, pasta side dishes

79

561

Toothpaste

22

38

Sauces—pizza, pasta

26

156

Other dental care products

20

119

Salads and salad kits

3

124

Mouthwash, breath fresheners

19

55

79

260

Skin care

198

1,202

119

291

Shampoos, conditioners

218

346

Bread products

95

324

Hair colorings, other hair products

36

321

Cereals

34

192

Lipsticks, lip products

68

1,112

Cheese

65

300

Chips

46

166

127

396

57

556

159

1,648

Chewing gum

47

167

Snack bars

41

162

Oil, shortening, cooking sprays

20

161

Spices, extracts, seasonings

61

403

Salad dressings
Soup

Cookies
Ice cream, novelties, frozen yogurt
Candies

Eye makeup, accessories

36

541

Nail products

39

1,063

Fragrances

62

502

Baby products

21

137

138

439

58

180

77

269

Pets
Example
Dog food
Miscellaneous
GRAND TOTAL

4,414 24,965

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 7

Exhibit 4: PRODUCT VARIETY AT U.S. GROCERY STORES

Average number of items (in thousands)
60

50

One of capitalism’s greatest creations is the grocery store. Where else can
you find, within just a few steps, so many products at such affordable

1989
1993
1997

prices? Bananas from Ecuador, kiwi fruit from New Zealand, potatoes from
Idaho, wine from France, paprika from Hungary, coffee from Colombia,
oranges from Florida, film from Japan and much more. It’s not public

40

decree that lets us tap the world’s markets in a single shopping trip. It’s
the profit motive of American business. “You want it. You got it!” is the dic-

30

tate of competition, which has put upwards of 22,000 more items on grocers’ shelves in just the past eight years. The average product selection at
conventional grocery stores (those with a full line of groceries, meat and

20

produce) increased from 14,000 in 1989 to 20,000 in 1997; the selection
at superstores (they add nonfood items and are 40,000 square feet or
10

more) was up from 22,000 to 30,000. At food/drug combos (those with a
pharmacy under the same roof), a staggering 50,000 different items are
now within reach of the discerning shopper.

0
Conventional

Superstore

Food/drug combo

provides more of what we do want by customizing
products to our particular tastes. It eliminates what
we don’t want through preventive products. Vaccines,
childproof caps, safety gear on cars and antipollution
devices are valuable for the misfortunes they avert.
Preventive goods and services are often taken for
granted—until they’re needed. They raise living
standards by replacing treatment with immunity,
repair with safer design, helping protect consumers
from some of life’s tragedies.
The rich have always enjoyed the luxury of custommade products. Now, though, personalized goods and
services are increasingly within the budgets of middle-class consumers. Computers, the Internet, DNA
research and other technologies are forging a whole
new paradigm that makes possible the delivery of
custom-designed products to the masses—at ever
lower prices. The descriptive phrase for the phenomenon is mass customization. “Once you know exactly
what you want, you’ll be able to get it just that way,”
says Bill Gates, founder of software giant Microsoft.

“Computers will enable goods that today are mass
produced to be both mass produced and custommade for particular customers.”
The economy’s progression to customization isn’t a
fad. It arises from the free market’s relentless drive
to bring what we buy closer to what we want. What
we buy yields a lot more utility when it exactly
matches our needs, and Americans are reaping enormous benefits as new tools help business cater to
markets of one. We’re getting more for less, helping
keep inflation in check.
There’s just one glitch in this otherwise serendipitous story: traditional measures of the economy may
not reflect how much our living standards are
improving. Conceived in an era of mass production,
the nation’s GDP and productivity statistics may ably
count more stuff, but they give little credit for right
stuff. Mass customization and prevention—just like
variety— deliver their gains in important but subtle
ways, so gross domestic product and productivity
statistics fail to capture the extent of our progress.

8 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Cuisine

Restaurant

Price

Cuisine

Restaurant

Price

1 American

Dave & Buster’s

$6.75

8 English

The Londoner

$5.95

2 Brazilian

Rodizio Grill

$9.95

9 Ethiopian

Queen of Sheba

$5.99

3 Cajun

Crescent City Cafe

$6.95

10 Filipino

Palayok

$4.95

4 Caribbean

Cafe Gecko

$5.95

11 French

La Madeleine

$7.99

5 Chinese

Dragon Pearl

$5.25

12 German

Kuby’s

$5.95

6 Colombian

Casa Vieja

$5.75

13 Greek

Kostas Cafe

$7.99

7 Egyptian

Mediterranean Oasis

$6.50

14 Hungarian

Franki’s L’il Europe

$7.99

Exhibit 5: FOOD FOR THOUGHT
28 days, 28 burgers with fries: $189.00

FOR THE FUTURE,

28 days, 28 different cuisines: $187.37

THE BEST OF THE PAST

We all must eat to survive. But while a poor nation struggles to find rice, corn or

Just as mass production was the hallmark of yesterday’s Industrial Age, mass customization promises
to dominate the modern stage of America’s economic evolution— the Information Age. New eras, of
course, don’t arrive overnight. They emerge slowly
and incrementally as they overlap with the old, taking years and even decades to transform the economy. Even so, we’re already seeing noteworthy moves
to mass customization.
Computers. Dell Computer of Round Rock, Texas,
has proven that complex manufactured products can
be made to order. Using the telephone or the Internet, customers describe the computer they want, the
shape of the cabinet and size of the monitor screen,
the speed of the microprocessor, the capacity of the

bread, a rich one offers myriad ways to partake in the pleasures of the palate.
When it comes to eating out, variety is enormous, and it spices up our dining experience. Some of us like Thai cuisine. Some of us prefer Italian. A consumer who craves Thai won’t enjoy dining as much if his choice comes down
to pizza or pasta. The Dallas–Fort Worth area’s Yellow Pages lists thousands of
restaurants—a cornucopia of cuisines, ambiences, prices and locations.
Wealthy societies don’t just take progress in the form of more goods and
services. They want quality, convenience and variety. Yet national GDP and
productivity statistics don’t generally recognize the gains. Twenty-eight days
spent eating cuisines from around the world counts the same as 28 days spent
eating just burgers and fries.

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 9

Cuisine

Restaurant

Price

Cuisine

Restaurant

Price

15 Indian

Bombay Cricket Club

$7.50

22 Romanian

Café Athenee

$6.95

16 Iranian

Sahara

$5.99

23 Russian

Liza’s Russian Cuisine

$9.95

17 Italian

Momo’s

$5.75

24 Salvadoran Izalco

$4.50

18 Japanese

Fuji-ya

$5.95

25 Spanish

De Tapas

$4.99

19 Korean

Po Jang Ma Cha

$5.99

26 Thai

Chow Thai

$9.99

20 Lebanese

Al-Amir

$7.95

27 Turkish

Cafe Istanbul

$5.95

21 Mexican

La Valentina de Mexico

$7.50

28 Vietnamese Pho Que Huong

Total bill

hard drive. Other choices involve keyboards, mouses, video cards, modems, speakers, data-storage systems and software. The number of possible combinations is staggering—almost 16 million for desktop
models alone. Dell begins assembling a computer
only after it receives an order and then ships the finished product directly to the customer’s home or
business within a few days. Gateway 2000, Micron
Technology and Compaq Computer also make computers to customers’ exact specifications.
Clothing. Off-the-rack apparel has always come in
many sizes, styles and colors, but mass customization
promises a perfect match for each buyer’s fit and
taste. Connecticut’s InterActive Custom Clothes sells
jeans over the Internet, allowing customers to specify hip size, leg and seat room, fabric, color, thread
accents, leg silhouette, fly design, pocket style, but-

tons, rivets and even label. The pants are produced to
exact specifications at a New York factory. Digitoe, a
Washington company, uses a scanner to measure
every millimeter of customers’ feet for custom-made
shoes. Using his computerized mobile fitting unit,
Alan Zerobnick digitizes each foot’s dimensions—
no matter the size or shape— and builds a threedimensional shoe last around which any style can be
molded for a perfect fit. Orders are shipped in three
to four weeks. Reorders require only a phone call.
Entertainment and information. Music buffs who
wanted to hear their favorite songs once had to buy
dozens of compact discs. Now, CDuctive, a New York
company, maintains an Internet site with sound
bites from about 10,000 titles. Customers select a
dozen cuts to be burned onto a CD and shipped to
their door.

$4.50

$187.37

 0 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Exhibit 6: PROVIDING WHAT
CONSUMERS WANT
The evolution of auto production
illustrates America’s move from the
Agrarian Age to the present. Local
craft shops designed and handcrafted the earliest cars. Vehicles such as
the 1911 Springfield were custommade but exhorbitantly priced. In
mass producing automobiles, Ford
sacrificed individualism but was able

The

Springfield

tical models, but productivity soared.

The “Made-to-Order” Car
for 300 Exacting People

Today’s production methods give

THE SPRINGFIELD MOTOR CAR CO.

to slash prices. Consumers got iden-

buyers the best of both worlds—low
prices and custom design. Customers
choose from numerous options on

Agrarian Age

Ford’s web site, then the automaker’s

Hand Production (artisans)

computer-based technology builds

Low fixed cost, high marginal cost

Industrial Age

➧

Mass Production (assembly line)
High fixed cost, low marginal cost

the vehicle to order at little cost over
standard models.

In the age of mass media, the goal was to create
newspapers and television stations that reached a
broad audience. The Internet changes all that.
NewsEdge Corp. gathers a profile of each customer’s
interests, then scans almost 700 news sources to
deliver regular reports on current events, sports,
weather and finance, all geared to the individual
reader. Broadcast.com, a 5-year-old Dallas company,
operates a web site that transforms computers into
the most powerful radio receivers ever, allowing listeners to pick up stations from Turkey, Argentina,
South Africa, Sweden or anywhere else in the world.
Health care. Advances in biotechnology—most
important, the ongoing process of cracking the DNA
code—now allow doctors to individualize drugs and
other treatments. Affymetrix, a Santa Clara, California, company, has produced the first biochip, a dense
grid of molecular tweezers that extracts individuals’
DNA. The biochip can analyze thousands of genes at
once—in effect, speed-reading the cells’ DNA codes.
Although the Human Genome Project has been

mapping genes since 1990, biochips make the
process personal. They give doctors information on
each patient’s medical condition.
Philadelphia’s Acumin sells capsules customized
with specific vitamins and dosages for each customer, cutting the number of pills some people swallow in a day. Advances in cloning technology are
allowing doctors to take a skin sample and reproduce a patient’s own collagen cells. Injections of the
cells can smooth wrinkles and scars without risk of
allergic reaction.
In one industry after another, companies are customizing for the mass market. They’re doing it
because new technologies make it practical and competition makes it imperative. Futurist Alvin Toffler,
who predicted the coming of mass customization in
the 1970s, recently issued a stern warning to producers who aren’t yet on board: “I’d say if you have a company and you’re not moving toward automation on
demand, you’ll have a competitor one day soon who
will put you out of business.”

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 11

Information Age

➧

Mass Customization (computer, etc.)
Low fixed cost, low marginal cost

Whether companies are seeking to expand sales or
just stay in business, mass customization enables
producers to snare buyers by offering extra value. It’s
no surprise that consumer satisfaction lies at the
core of this phenomenon; what consumers want
always shapes market economies. Econ 101 professors have taught this straightforward notion since
Adam Smith published The Wealth of Nations in 1776.
Markets serve as complex information machines that
collect and communicate buyers’ needs, tastes,
desires and whims. Producers that do the best job of
catering to consumers gain market share and make
greater profits. Burger King got it right in its advertising slogan: Have it your way!
Companies prosper by delivering what customers
want. This conventional view of consumer sovereignty is correct —as far as it goes. What’s missing is
a description of how meeting buyers’ needs and
wants evolves over time. (See Exhibit 6.) Americans
have always preferred customized products, but they
couldn’t always afford them. Now, companies are

finding ways to deliver exactly what we want at
prices competitive with those of mass production.
Until the Industrial Revolution, producers catered
to consumers one at a time. Sophisticated machine
tools hadn’t been invented, so every product had to
be handmade. A tailor, for example, would measure
each customer and ask about style, fabric and fit,
then stitch a suit or dress to the exact pattern. When
shoes, furniture and all other goods were made to
order, customers could always buy just what they
wanted— if they could afford it. The drawback of
production by artisans was high cost. The typical
American was lucky to possess one suit of clothes
and one pair of shoes.
Industrialization changed that. Machines began to
make our clothes, shoes, furniture, kitchen utensils
and an array of new products, sweeping America into
an era of mass production. Producer and consumer
rarely came into contact. Goods were made in factories, shipped over great distances and sold in department stores. Mass production dictated large runs of

12 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Exhibit 7: VEHICLE MODELS,
1980–97

Available models
300
All vehicles

In 1970 U.S. consumers had access
to 140 different models of vehicles—

250

110 cars plus 30 pickups, vans and
sport utility vehicles (SUVs). By 1980
the variety of models had risen to

200

172—135 cars and 37 other vehi-

Cars

cles. Today’s economy offers consumers 260 different vehicle models

150

from which to choose. The most
notable shift in consumer taste has

100
Pickups, vans, SUVs

been toward SUVs, whose models
rose from 8 in 1970 to just 12 in
1980 but to 38 by 1997. Today’s

50

median new car buyer drives away
in a model unique among 104 buyers, compared with 1 in 84 in 1980.

0
’80

’82

identical products. Consumers sacrificed the luxury
of personal attention for affordability. Taking what
came off the shelf, though it might not be a perfect
fit, was the best choice because it was cheap. The
Industrial Age brought lower prices. Just as important, each worker produced more, justifying a bigger
paycheck. Today, just about all U.S. households possess cars, television sets, telephones and plenty of
other everyday conveniences—all made possible by
mass production.
What’s increasingly shaping today’s economy isn’t
the raw power of machines but the subtle power of
knowledge. Information Age technology—primarily
the computer—has erased yesterday’s edict that
customization must carry a high price. Mass customization offers consumers the best of both worlds.
It embodies the good qualities from the era of hand
production—custom design and individualized
service. And it retains the most significant gain from
the era of mass production—low cost.

’84

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’92

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’96

Mass production was about producing more stuff.
Mass customization is about producing the right stuff.
Customization for the mass market isn’t just economists’ jargon for variety. The difference lies in
which side of the market calls the shots. Variety represents producers’ best guess about what consumers
will buy. Companies tweak their designs, hoping
what they offer is close enough. Even when companies rely on market research, they’re still aiming at
broad groups of consumers. Variety has delivered
great benefits in recent decades, but it is mass production’s response to the fact that everybody’s tastes
differ. (See Exhibit 7.) Even at its best, variety is an
imperfect substitute for true customization, which
eliminates the need for guesswork. Companies that
customize don’t make anything until they know precisely what the customer wants.
One size fits all? Not anymore. What served as a
good slogan for mass production doesn’t cut it in
today’s world.

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 13

The reason “you can see the computer age everywhere but in the
productivity statistics” is that today’s
new technologies—the PC, the
Internet, biotech and so on—have as
their main advantage the ability to
serve individual customers. They’re
tools of mass customization, not
mass production.

TECHNOLOGY’S ROLE:
DRIVING DOWN COSTS

Why have Americans had to wait until the tail end
of the 20th century for mass customization? The
simplest answer: until now, the country didn’t have
the know-how to customize at low cost. Today’s technology, though, makes it possible.
If there’s a signature tool of mass customization, it’s
the microprocessor. This tiny device is indispensable
to many of today’s “smart” tools—most notably, powerful computers that process, store and send information. The Internet moves vast amounts of information
at the click of a button—not just words and numbers
but pictures and sound as well. Search engines —
software that brings order to the Internet’s chaos —
are key to customizing because they find and organize
information based on users’ profiles and inquiries.
Lasers are used in bar-code scanners, measurement
devices and fiber-optic cables that can transmit whole
libraries in seconds. Artificial intelligence programs
simplify the design of new products. Computer-

controlled manufacturing makes it faster and cheaper to modify designs and assemble one-of-a-kind
items. Breakthroughs in biotechnology are unlocking
the secrets of individual cells. The leap from analog
to digital greatly expands the capacity of all kinds of
communications technologies to process and deliver
that most precious of commodities—information.
The tools of the Information Age are indeed powerful. These technologies spawn mass customization
by revolutionizing the calculus of production costs.
Nearly all business expenses fall into two broad categories—fixed and marginal. Fixed costs include
conceiving, designing and organizing the operation,
setting up plants, installing equipment, bringing in
utilities, hiring workers and slogging through the
usual morass of red tape. These costs are incurred
before the first sale is made. Marginal costs, on the
other hand, aren’t incurred until an enterprise is up
and running. They cover expenses for producing
additional units of output, including wages, raw
materials, electricity, marketing and distribution.

14 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Exhibit 8: AS YOU LIKE IT
An Internet search for the word customized turns up more than 866,000
web pages. Computer-based technologies like the Internet help producer
and consumer communicate directly so the goods and services offered
more closely match individuals’ unique tastes. In virtually every industry—
housing, transportation, apparel, medicine, entertainment, finance and
so on—modern technologies are shifting the business paradigm from
producer-centered productivity to consumer-centered customization.

COMPANY & WEB SITE PRODUCT & SERVICE
Ford Autos
www2.ford.com equipped to your specifications
CDuctive Music CDs
www.cductive.com custom-mixed to your taste
Dell Computers
www.dell.com configured to your requirements
AFE Cosmetics & Skincare Cosmetics
www.cosmetics.com blended to match your skin tone and type
My Twinn Dolls
www.mytwinn.com designed to look like your child
Paris-Miki Eyewear
www.paris-miki.com.au customized to fit your face and personality
Charles Schwab Financial services
www.schwab.com developed to manage your portfolio
Golf to Fit Golf clubs
www.golftofit.com customized to your body and playing style
American Greetings Greeting cards
www.americangreetings.com personalized with your look and sentiment
Mortgage.com Home loan shopping
www.mortgage.com personalized for you
Mike Keesee Designs Homes
www.mikekeeseedesigns.com designed by you for your lifestyle
Streamline Household service
www.streamline.com needs anticipated and met
Dermatology Assoc. of Dallas Isolagen
www.alkek.com cloned from your cells for skin rejuvenation
InterActive Custom Clothes Jeans
www.ic3d.com tailored to your shape and style
CNN Custom News News lineup
customnews.cnn.com matched to your interests
Footmaxx Orthotics
www.footmaxx.com fitted to your gait and pressure
WedServ Planning software
www.wedserv.com for your ideal wedding
Imagine Radio Radio programming
www.imagineradio.com formatted for your pleasure
ShirtCreations Shirts
www.shirtcreations.com tailored to your build and taste
Digitoe Shoes
www.digitoe.com fitted to a precise 3D model of your foot
McGraw-Hill Textbooks
www.mcgraw-hill.com composed of material you select
Acumin Vitamins
www.acumins.com formulated to your nutritional needs
The Weather Channel Weather forecasts
www.weather.com customized to your locale or trip
Andersen Windows Windows
www.andersenwindows.com designed to your specifications

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 15

Billions of inflation-adjusted dollars

Exhibit 9: MARKET
RESEARCH IN THE
UNITED STATES
Over the past 10 years, U.S.

4
3.75

spending on market research has
grown at an average annual pace

3.5

of over 5.1 percent—much faster
than the roughly 2.6-percent rate

3.25

of the overall economy. The added
spending on consumer research

3

indicates that customer focus, not
sheer productivity, defines today’s

2.75

business environment. Even more
market research takes place be-

2.5

hind the veil of Internet traffic.
2.25
2
’87

’88

The interplay of fixed and marginal costs explains
both mass production and mass customization. In
the Industrial Age, electric motors, engines, winches, conveyor belts, machine tools and other
advances reshaped the economy. They were the
high technology of the times. These innovations
allowed companies to turn out identical products
cheaply. The order of the day was standardization—from nuts and bolts to accounting procedures and time zones. The world of mass production
usually involved high fixed costs and low marginal
costs. Producers made money by cranking out as
many units as possible, driving down the average
production cost by spreading the huge fixed cost
over more and more units. That’s precisely what
Henry Ford and his successors did. Customers paid
lower prices for automobiles, appliances, clothing
and household goods, but companies could only
bring a limited number of standardized models to
the marketplace. With high fixed costs and low marginal costs, it’s cheap to make the same product for

’89

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’95

’96

’97

everybody but expensive to produce a different product for each customer.
Industrial Age technology replaced muscle power
with machine power, which ran the assembly lines.
Information Age technology complements machine
power with brain power, enabling us to recognize each
consumer’s preferences and deliver what they want at
a reasonable price. (See Exhibit 8.) Once again, the
key is costs. Mass customization becomes optimal
when both fixed and marginal costs—particularly
fixed—are low. If producers can change designs
quickly and inexpensively, they’ll win customers by
targeting individual tastes and preferences. Average
costs decline even without long production runs, permitting low prices along with the bonus of getting
exactly what we want.
Mass production was the by-product of Industrial
Age tools. Mass customization is the dividend of
Information Age tools.
Modern technologies slash fixed costs in three
areas: information, production and distribution. By

16 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Exhibit 10: IF THE SHIRT FITS
Today’s fashion-conscious male
can point and click his way to a
custom-made shirt. New Yorkbased ShirtCreations’ web site
gives shoppers their choice of collar, cuffs, pockets, monogram style
and fit. Tomorrow’s shopper may be
able to go one better. [TC]2 is working on a body scanner that replaces
the tape measure with lasers, then
stores the data on a smart card for
future shopping trips.

making it easy to supply information, the Internet
gives consumers a cheap and easy way to find out
what goods and services are on the market. Companies can display immense amounts of product information on their web pages and take orders from anywhere in the world. More important, the Internet
frees producers from the expensive proposition of
paying firms to gather information on what buyers
want. (See Exhibits 9 and 10.) They now find out
electronically, at negligible cost. Both InterActive
Custom Clothes, the jeans maker, and CDuctive,
the producer of custom compact discs, compile
consumers’ preferences through the Internet.
Amazon.com, the Internet bookseller, keeps track of
readers’ purchases, allowing the online vendor to
recommend specific books to individual customers.
By making it cheaper to personalize during production, Information Age tools remove the last barriers to providing goods and services for individual
customers. It’s smart automation that allows CDuctive to personalize compact discs at the click of a

button. Once an order arrives, computers retrieve
the selections from a hard drive and burn them
directly onto blank discs. InterActive Custom
Clothes uses computerized fabric cutters that are
quick, precise and inexpensive. Even assembly lines
are no longer limited to endless iterations of the
same product. Computer-aided designs are replacing
costly prototypes. (See Exhibit 11.) Computer-guided
machinery allows production to shift from one style
to another with a few lines of computer code. At
Motorola’s pager factory in Boynton Beach, Florida,
the specifications for each order arrive in a direct
transmission from sales representatives’ laptop computers. Within minutes, these specs are translated
into bar-code instructions for the assembly process.
In theory, the factory could produce 29 million different pagers on the same line, one right after another, without the time and expense of retooling.
Improvements in distribution, made possible by
such technologies as lasers and computers, reduce
the fixed costs of getting products to consumers.

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 17

Exhibit 11: A STEP IN THE
RIGHT DIRECTION
Footmaxx uses computerized gait
and pressure technologies to
analyze an individual’s unique
walk and build custom orthotics.
A patient’s walk across the Footmaxx forceplate—which contains
960 pressure points—is scanned
30 times per second. This and
other personal data are used to
produce a computer-generated
analysis from which custom
insoles are built to correct each
patient’s abnormal biomechanics.

Bar-code scanners allow Federal Express and other
overnight shippers to improve speed and accuracy
while reducing outlays for a global system to pick up,
sort, track and deliver packages. As the Internet
spreads into more homes and businesses, it makes
the delivery of information products relatively inexpensive. What does it cost NewsEdge Corp. to personalize news reports? Next to nothing. Fidelity
Investments and other brokerages offer web sites
that allow investors to track their portfolios in real
time. DirecTV, capitalizing on the increased capacity of satellite television systems, incurs no added
expense by offering the entire National Football
League schedule every Sunday, so sports fans can
choose which games they want to watch.
Michael Dell started his $16 billion computer
business in a University of Texas dorm room in 1983
on the basis of low fixed cost. Dell’s masterstroke:
build to order and do it quickly. Customization would
lose its value if customers had to wait months for
their computers. The Internet allows Dell to find out

what each customer wants, instantly and cheaply.
Continuous-flow manufacturing cuts the cost of customizing: 35 cargo doors line both ends of Dell’s new
Round Rock manufacturing facility. On one side, suppliers deliver components throughout the day. On the
other, workers load finished products onto trucks.
Actual assembly takes five minutes. Even adding
time for loading software and testing for quality, the
whole process takes just four hours. By economizing
on spare parts, product inventory, delivery and every
other step of the process, the company provides a
customized product at a competitive price. No wonder Michael Dell has been lauded as the Henry Ford
of mass customization. (See Exhibit 12.)
Information Age technology thrusts our economy
toward mass customization, but other factors also
contribute. The globalization of commerce, for
example, makes goods and services more widely
available, especially as cutting-edge electronic
media reduce the time and expense involved in gathering information. Access to products from around

18 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Exhibit 12: HENRY FORD,
MEET MICHAEL DELL

Henry Ford
Born July 30, 1863
Ford built his first car in 1896, 10
years after the auto was invented.
He was 32 years old and chief
engineer at Edison Illuminating
Co. in Detroit. Seven years later
he founded Ford Motor Co.

“The consumer can have
any color he wants
so long as it’s black.”

Ford had to defend the assembled car against claims

“I will build a motorcar for
the great multitude.…It
will be so low in price that
no man…will be unable
to own one.”

each working on just a small part of the auto.

from craft shops that it was an inferior product.
Workers were specialists,

All steps in the manufacturing process—refining the raw materials,
molding engine blocks and body parts in a giant steel mill,
making windshields in a glass factory and assembling the final product—
took place in one 6.9-million-square-foot plant.
Cars were produced before they were sold,
then shipped to dealerships that held huge inventories.
Models changed once a year, at most.
The Model T’s exterior went unaltered for 19 years.

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 19

Michael Dell
Born February 23, 1965
Dell built his first computer in
1983, eight years after the PC was
invented. He was 18 years old
and a freshman at the University
of Texas at Austin. A year later he
founded Dell Computer Corp.

Dell had to convince consumers that a customized yet unseen computer
could be economical and superior to a store-bought model.
Workers are highly trained generalists,
each putting together the whole computer.
Parts are delivered on demand from nearby warehouses,
and the final product is assembled by one worker,
drawing selected components from a kit made up for
the individual customer.
Computers are sold over the Internet, then produced and
shipped directly to the individual customer. No inventories are kept.
Models change continuously
as new technologies become available.

“Companies that are
successful today…are those
that can get closest to their
customers’ needs.”
“Building a business solely
on cost or price…[is] not a
sustainable advantage.”

2 0 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Exhibit 13:
THREE SPOONS AREN’T
A PLACE SETTING
Suppose that a knife, fork and
spoon each cost the same to
produce. All else being equal,
an economy that produced
three spoons would register
the same GDP and productivity
as one that produced a knife,
fork and spoon. Diners, though,
would surely choose the threepiece place setting. This example illustrates why add-’em-up
statistics like GDP and productivity often fall short as business
seeks the grander goal: pleasing customers.

the world also makes us more sophisticated consumers, so that even in the home market we demand
the nuances of Italian suits or German beer.
Just as mass customization couldn’t take root in
an isolated society, it couldn’t emerge in a poor one.
Low-income countries are still dominated by mass
production. That’s to be expected, because producing quantity is the quickest way out of poverty. Once
a nation becomes wealthy, most families’ basic needs
are satisfied. As they move up the economic ladder,
consumers typically move down a list of wants from
food, clothing and shelter to luxuries. All of us desire
the luxury of goods and services that embody our
own tastes and preferences. It’s money in the pocket, though, that makes it possible. We’re becoming a
society of mass customization because we can now
afford it.
First we meet basic needs through mass production. Then we gratify individual wants through mass
customization.

RIGHT STUFF, WRONG STATISTICS

As mass customization becomes part of our everyday
lives, most Americans will intuitively understand how
it represents an improvement over mass production.
Clothes will fit better. Entertainment will be more
enjoyable. Doctors and hospitals will have individualized tools to make us healthier.
Yet it may be hard for many Americans to assess how
much better off we are. The problem lies in how we
measure our economic progress. We tend to rely on a
handful of well-publicized statistics—most notably,
gross domestic product, the Consumer Price Index and
productivity figures. The benefits of mass customization, however, are hard to quantify, especially with the
rudimentary economic yardsticks now available.
GDP is a statistic designed for mass production.
It’s a simple counting— the number of units made. It
falls short in measuring intangible benefits. Economic research demonstrates that GDP often fails to
capture consumers’ gains from better quality and new
products. Mass customization introduces a similar

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 21

VACCINES IN THE WORKS

Asthma
Cancer
Diabetes
Ear infection
Hepatitis C
Herpes simplex I and II
HIV/AIDS
Lyme disease
Malaria
Mononucleosis
Multiple sclerosis
Streptococcus A and B
Streptococcus pneumonia
Tooth decay
Tuberculosis

Exhibit 14: AN OUNCE OF PREVENTION
Roughly $107 billion was spent fighting cancer in

as enjoying more leisure time and greater product

1998. The federal government alone spent nearly

variety—options American households value and have

$3 billion on cancer research. Tallying the bill for all

historically chosen in lieu of just having more GDP.

health costs, the nation spent more than $1 trillion last

Advances in biotechnology and genomics promise

year, the bulk of which went for treatment and cures.

solutions to many public health problems. Numerous

Scientists aren’t just looking for cures—they’re seek-

vaccines targeting a number of humankind’s most

ing to eradicate disease altogether. Clearly their suc-

stubborn diseases and conditions are in the develop-

cess would be a big boon to society, but by and large

ment stage. Estimates are that in just the next two

GDP wouldn’t reflect such progress. In fact, GDP

decades, progress in disease prevention will deliver

might even fall. (See the appendix.) Vaccines and the

as many vaccines as have been found so far in all of

like save countless lives and untold pain and suffering

history.

but shut down whole industries dedicated to research,

What’s more, the gains in preventive output aren’t

treatment, fund-raising and public education—all of

limited to medicine. Much progress in preventing

which add to GDP.

accidents, pollution and crime has been made over

No doubt a big chunk of the economic resources

the past quarter century. Even more gains may be

freed by eliminating diseases is eventually recycled

near. But as with medical advances, Americans will

into producing other output. But society may well

have to get used to not seeing their progress fully

choose to take such progress in other ways, too—such

reflected in our economic statistics.

22 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Exhibit 15: THE PARADOX THAT ISN’T
You can see the computer age everywhere but in the productivity statistics.

not have achieved critical mass in industry. It may take more time to realize

This statement by MIT economist Robert Solow stems from the fact that

the gains from computers, so the productivity surge will come later. And the

standard measures of productivity have been disappointing in recent

most disturbing reason: the computer isn’t that big a deal, at least when

decades, just as huge mainframes, increasingly powerful desktops and

compared with the great inventions of the past.

ever-smaller laptops have penetrated the economy’s every nook and cran-

None of these explanations considers the gains from variety, customiza-

ny. From 1870 to 1973, U.S. productivity increased by an average of 2.3 per-

tion or preventive goods. Yet the benefits from computers, software, the

cent a year. After 1973, the growth rate slowed by a full percentage point.

Internet and other innovations aren’t confined to producing just more stuff.

If computers are making American workers and companies more efficient, why are the nation’s productivity measures so lackluster?
This so-called Solow paradox challenges our notions of what creates

These technologies allow companies to produce the right stuff at reasonable prices—making consumers better off in ways not fully captured by
standard economic statistics.

economic progress. The bellwether inventions of the past fostered great

The mathematical proof in the appendix shows that GDP and productiv-

leaps in productivity, which raised wages and living standards. American per

ity accurately measure the gains in living standards when technological

capita income quadrupled as consumers reaped the benefits of such world-

progress lowers marginal costs. But when the economy develops tools that

shaking innovations as steam engines, electricity, refrigeration, telephones

cut fixed costs, the statistics undercount—in fact, totally ignore—the gains.

and automobiles. If computers aren’t providing a big productivity boost,

The appendix also shows that GDP falls when society develops preventive

there’s reason to doubt Americans’ living standards will rise as quickly as

goods, such as vaccines to eradicate diseases or antilock brakes to avert

they did in the past.

accidents, despite the rise in living standards.

Why haven’t computers brought a surge in productivity?
Economists have offered several explanations for the Solow paradox.
Among them: there may be a glitch in the productivity data. Computers may

In the end, there is no Solow paradox. Computers are doing what inventions have always done: they’re benefiting society, and they’re making our
lives better.

bias, one tied to the fact that we can measure production but not consumers’ satisfaction. They aren’t the
same, even though many commentators casually link
them. (See Exhibit 13.)
Nobody ever said quantity was the spice of life.
GDP statistics tell the same tale whether a business
executive owns 12 identical suits or if he possesses a
dozen in an array of fabrics and styles. Is it really the
same? No individual would think so; that’s why our
closets are filled with a variety of garments. Will 100
copies of The Catcher in the Rye offer as much reading pleasure as one copy of 100 different novels? GDP
says so. Most consumers would say no. And just as
variety has produced gains for America that have
eluded the GDP and productivity statistics, mass
customization will produce even more.
Preventive production proves just as slippery for
GDP accounting. (See Exhibit 14.) If electronic sen-

sors in roads and vehicles can prevent accidents,
Americans will have undamaged cars. Without the
technology, they might be involved in more collisions, spending money on repairs. Either way, they
have the same thing—a car without dents. The first
costs less, so GDP accounting would suggest we’re
worse off, not better off. Similarly, scientists are
developing vaccines that will eliminate tooth decay.
We will benefit from improved dental health, but the
holes not drilled in teeth are net losses to GDP. A
stitch in time may indeed save nine, but it also generates one-ninth the GDP.
Inflation-adjusted GDP puts economic growth at
an annual average of 2.7 percent over the past two
decades. GDP may be entirely accurate as a tally of
how much our farms, factories and offices produce,
but it’s increasingly inadequate as a measure of how
well the economy provides what we want—the sat-

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 23

isfaction produced. As we grow wealthier, Americans
are taking more of our progress in ways that aren’t
readily quantified. We’re refining what we produce—making the right stuff, not just stuff.
If GDP can’t detect the benefits of mass customization, it will also miss the mark on productivity,
a number that derives straight from the GDP calculations. Some economists are disappointed in
America’s productivity performance over the past
quarter century, a time of rapid spread of new technologies—most notably the computer. They see
measured productivity slowing to 1 percent a year
and worry that Information Age advances aren’t
delivering the same economic punch as Industrial
Age inventions. It just isn’t so. Our statistics don’t
recognize how the economy is making us better off
by producing for us individually rather than en
masse. (See Exhibit 15.)
Our statistics are a rearview mirror, looking back
at the past. We need to focus on the economy that’s
emerging rather than the one that has been. Tomorrow’s progress can’t be judged with yesterday’s
gauges. What’s needed are analytical tools that can
capture the benefits of mass customization and preventive products.
After all, output and productivity aren’t the goals
of the economy. Consumer satisfaction is.
Mass customization is already making consumers
better off by providing just what we want. And the best
is yet to come. What’s likely to arrive in coming years
will be truly astounding. InterActive Custom Clothes
produces jeans to order, but even more elaborate systems are reaching the prototype stage. A customer
starts with a stroll through a body scanner, which uses
lasers to take 50 measurements from head to toe, then
saves the data on a wallet-sized smart card handy for
shopping. When ready to buy a new suit, shirt or dress,
the customer mixes and matches from among hundreds of fashion accents. At the touch of a button, the
order will go to a factory, where computerized cutting
and sewing machines will turn out clothing with the
buyer’s own label sewn inside.

In the field of medicine, Affymetrix already makes
devices to decode individuals’ DNA. The ability to
quickly gather heretofore unknown information
about patients is giving birth to a new discipline
called pharmacogenomics. Using this distinct genetic portrait, pharmaceutical companies expect to
offer drugs tailored to individuals’ age, symptoms,
condition and hereditary makeup. Personalized
drugs will not only ensure correct dosage, they’ll also
curtail side effects.
Mass customization promises more marvels like
these. Interactive television will give families the
power, now held by network program directors, to
determine the nightly lineup. Automakers are starting
to design systems that will build cars to order. Textbooks, scents, electronic gadgets and just about everything else will someday bear our personal stamp.
We might not see faster growth rates or surges in
productivity, but mass customization will pay off for
America. Resources are wasted guessing what customers want. When more products are customized,
we won’t squander money on clothing that sits in the
closet because it doesn’t fit or compact discs with
only one or two songs we really like. And goods won’t
languish on dealers’ shelves. Achieving a higher standard of living with fewer demands on natural and
labor resources will help ease price pressures and
continue this decade’s good news on inflation.
Two centuries of American economic progress
have brought us a standard of living that’s the envy
of the world. We wouldn’t have it so good without the
immense variety provided as companies move from
standardization to custom-made. Our economy
offers a veritable feast for consumers. Mass customization will make it even better. An economy that’s
delivering more of what we want and less of what we
don’t is doing its job in raising living standards. As we
enter the 21st century, the United States is moving
into a new economic era, one where consumers will
be better off than ever before—because we’ll live in
a world of our own design.
—W. Michael Cox and Richard Alm

24 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

APPENDIX
In the appendix we model and prove mathematically the results stated in the ducing a few goods and creating variety depends on the fixed and marginal costs
main text.1 Specifically, we show that gross domestic product accurately meas-

of production (α and β , respectively), the total resources available for produc-

ures the gains in society’s living standards when technological progress is of the tion (R), the resource cost of overcoming the subsistence level of good
type that lowers marginal production costs. But GDP undercounts—indeed, H, and θ, which reflects the sharpness of the decline in the marginal utility of
totally ignores—the gains in living standards when new technologies cut fixed consumption of each good.
Examining the effect of technological progress on quantity, variety, GDP and

production costs. Moreover, we show that GDP falls when society develops pre-

ventive goods (such as immunities to diseases or antilock brakes to avert acci- living standards, the equations show that a fall in marginal production costs
(β ) raises x, n, U and GDP; however, a fall in fixed costs (α) lowers x, raises n

dents), even though these goods raise living standards.
Assume that living standards can be measured by the transformed CES utility function2

face of technological progress that reduces β, but progress totally eludes the

1
θ

θ


U =  x1θ + x2θ + K + x H − s + K + xθn  ,



(

)

and U but has no effect on GDP. GDP and living standards rise together in the
GDP statistic when new tools that cut fixed costs are developed (when α falls).
Note further that the GDP statistic gives an erroneous (that is, opposite)

where U represents the utility metric for living standards, xi represents the indication of what happens to living standards when progress is made in requantity of each of the n different products produced, and s represents the ducing subsistence levels. For example, a fall in the indigenous level of sickness
subsistence level x H must reach before deriving any satisfaction from good (a lower s) made possible, say, by finding vaccines, raises n and U with no effect
H—such as the level of sickness that must be overcome to enjoy (good) health. on x, but GDP actually declines. Vaccines reduce the economic activity (GDP)
The economy faces the constraint

previously expended in treatment, and some of the resources saved pay the
n

fixed costs of expanding product variety. Overall GDP falls.

R = α n + β ∑ x i,

These findings imply that aggregate output (and its derivative, productivity)

i =1

which dictates that the total quantity of resources used in the production of may have been an adequate gauge of economic progress when such innovations
all goods cannot exceed R, the economy’s resource endowment. In this equation, as the assembly line, standardized nuts and bolts, electricity and motors lowα represents the fixed resource cost of producing each of the n goods and β repre-

ered mass production costs. But GDP at best understates today’s progress when

sents the marginal resource cost of producing one unit of each of the n goods.

innovations such as the microchip, the personal computer, the Internet and

For simplicity, we assume α i = α and β i = β ∀i. The assumption of sym- fiber optics make possible an era of mass customization. What’s more, technometry allows us to infer that the optimal solution involves x1 = x2 = … = xH – s

logical progress in biotech, genomics and preventive outputs may greatly

= … = xn = x, and thereby allows us to reduce the objective function to the improve society’s living standards yet manifest itself in a recession.
simple form

It is worth remembering that a market economy strives to raise our living
standards—not simply GDP—because that’s where business profits lie. Thus,

1
θ

U = n x.

the real paradox is not why “you can see the computer age everywhere but in

Taking advantage of the second welfare theorem, we solve the social planner’s

the productivity statistics” 5 but why economists who preach that individuals

problem: maximize U subject to R = α n + β (nx + s) by choosing the welfare-

maximize utility and firms maximize profit look for signs of progress exclusively

maximizing quantity of each good to produce (x) and the variety of goods (n) in the productivity data.
to produce overall.3 This yields
1


 1−θ 
α θ
θ
θ 1−θ
β
β
x=
, n=
R
s
and
U
=
R
−
s
−



β 1−θ
β
 α 
 α 

(

(

)

)

1−θ
θ

1
2

as the optimal solutions.4 By definition, GDP is the total quantity of goods pro3

duced in the economy, or
GDP = nx + s =

θ
β

( )

R + 1 − θ s.

Essentially, consumers value variety, but firms must expend resources to set

4
5

up production of the different goods. The optimal trade-off between mass pro-

See Cox and Ruffin (1998).
This formulation assumes homogeneous economic agents, so that the individual’s and
society’s utility functions are the same. Generalizing the setup to heterogeneous
agents would introduce the potential for even further gains in living standards as
product variety increases, but at best would complicate the aggregation of social
welfare and at worst would prove mathematically intractable.
The second welfare theorem states that under certain conditions (satisfied here) the
solution to the central planner’s problem of maximizing social welfare is the same as
that of the private market economy, in which individuals maximize utility and firms
maximize profit.
The solution for xH exceeds the other xi by s.
Solow (1987).

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 25

ACKNOWLEDGMENTS
“The Right Stuff: America’s Move to Mass Customization”
was written by W. Michael Cox and Richard Alm. The
essay is based on research conducted by Cox, senior vice
president and chief economist, Federal Reserve Bank of
Dallas. Meredith Walker provided important research
assistance throughout the course of the project. Thanks
also go to Maria Coello, Gallin Fortunov, Charlene Howell,
Sergei Polevikov and Stephen Stout.
SELECTED REFERENCES
Barry, James P., Henry Ford and Mass Production
(New York: Franklin Watts, 1973).
Burness, Tad, Cars of the Early Twenties (Philadelphia:
Chilton Book Co., 1968).
Cox, W. Michael, and Roy J. Ruffin, “What Should Economists Measure? The Implications of Mass Production vs.
Mass Customization,” Federal Reserve Bank of Dallas,
Working Paper no. 98-03 (July 1998).
Dell, Michael, Direct from Dell (New York: HarperBusiness, 1999).
Ford Motor Co., <http://www2.ford.com>.
Gates, Bill, The Road Ahead (New York: Viking, 1995).
Gilmore, James H., and B. Joseph Pine II, “The Four
Faces of Customization,” Harvard Business Review,
January–February 1997, pp. 91–101.
Gordon, Robert J., “Monetary Policy in the Age of Information Technology: Computers and the Solow Paradox,”
prepared for the conference “Monetary Policy in a World
of Knowledge-Based Growth, Quality Change and Uncertain Measurement,” Bank of Japan, June 18–19, 1998.
Greenspan, Alan, “Is There a New Economy?” remarks at
the Haas Annual Business Faculty Research Dialogue,
University of California at Berkeley, Sept. 4, 1998.
Greenspan, Alan, “Problems of Price Measurement,”
remarks at the Center for Financial Studies, Frankfurt,
Germany, Nov. 7, 1997.
Krugman, Paul, “Scale Economies, Product Differentiation and the Pattern of Trade,” Journal of Political
Economy, December 1980, pp. 950–59.
Lancaster, Kelvin J., Variety, Equity, and Efficiency
(New York: Columbia University Press, 1979).
Peppers and Rogers Group, Marketing 1 to 1,
<http://www.1to1.com>.
Pine, B. Joseph II, Mass Customization: The New
Frontier in Business Competition (Boston: Harvard
Business School Press, 1993).

Schonfeld, Erick, “The Customized, Digitized, Have-ItYour Way Economy,” Fortune, Sept. 28, 1998, pp. 114–21.
Sears, Stephen W., The American Heritage History
of the Automobile in America (New York: American
Heritage Publishing, 1977).
Solow, Robert M., “We’d Better Watch Out,” New York
Times, July 12, 1987, p. 36.
Toffler, Alvin, The Third Wave (New York: Bantam
Books, 1980).
Toffler, Alvin, quoted in “Toffler: Change—or Else,” Inc.,
May 1, 1998, p. 23.
EXHIBIT NOTES AND DATA SOURCES
Page 4, More Choices Than Ever
Data on product variety are scarce. The numbers in this
table represent the authors’ best estimates, using the
sources listed below.
Vehicle models: 1970, NADA Official Used Car Guide,
January 1970; 1998, Ward’s AutoInfoBank.
Vehicle styles: 1970, NADA Official Used Car Guide,
January 1970; 1998, <http://www.dealernet.com>.
SUV models: 1970, NADA Official Used Car Guide,
January 1971; 1998, Ward’s AutoInfoBank.
SUV styles: 1970, NADA Official Used Car Guide,
January 1971; 1998, <http://www.dealernet.com>.
Personal computer models: 1998, computers reviewed
by CNET Computers.com, <http://computers.com>,
as of Jan. 5, 1999.
Software titles: 1998, number of files available in
CNET’s shareware.com software library,
<http://www.shareware.com>, as of Jan. 4, 1999.
Web sites: 1998, NetNames, <www.domainstats.com>,
as of Nov. 29, 1998.
Movie releases, airports, magazine titles, new book
titles, community colleges and amusement parks: see
notes for Variety on the Rise.
TV screen sizes: 1972, Popular Science, August 1972;
1998, number of screen sizes available at Best Buy.
Houston TV channels: 1970, TV Guide, Southeast Texas
Edition, Sept. 12–18, 1970; 1998, DirecTV.
Radio broadcast stations: 1970 and 1998 (as of Nov.
30), Federal Communications Commission.
McDonald’s menu items: 1970 and 1998, McDonald’s
Corp.
KFC menu items: 1970 and 1998, KFC.

26 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Frito-Lay chip varieties: 1970 and 1996, Frito-Lay Inc.
Breakfast cereals: 1980 and mid-1990s, The Economics
of New Goods (Chicago: University of Chicago Press for
NBER, 1996).
Pop-Tarts: 1970 and 1998, Kellogg Co.
National soft drink brands: 1970, The Commercial
and Financial Chronicle, Jan. 7, 1971; mid-1990s,
Beverage World, April 1994; Beverage World, March
1995.
Bottled water brands: 1970 and 1998, numerous industry web sites, including <http://www.bottledwater.org>
and <http://www.bottledwaterweb.com>.
Milk types: 1970 and 1998, numerous industry web
sites, including <http://www.whymilk.com> and
<http://www.milk.co.uk>.

Page 5, Variety on the Rise: amusement parks, U.S.
Bureau of the Census, County Business Patterns, various years; general and farm magazine titles, Magazine
Publishers of America, from Audit Bureau of Circulations; new book titles, U.S. Bureau of the Census, Statistical Abstract of the United States, various years; airports, Federal Aviation Administration, Statistical
Handbook of Aviation, various years; community colleges, National Center for Education Statistics; movies
released, Motion Picture Association of America.
Page 6, The More the Merrier: new product introductions of consumer packaged goods by number of new
SKUs, Marketing Intelligence Service Ltd., New York.
Page 7, Product Variety at U.S. Grocery Stores: average number of SKUs by type of store, Willard Bishop
Consulting, Competitive Edge, May issues, 1990–98.

Colgate toothpastes: 1970 and 1998, Colgate-Palmolive
Co.

Pages 8, 9, Food for Thought: average lunch prices
reported by Dallas-area restaurants, phone survey, week
of Jan. 17, 1999.

Mouthwashes: 1970, numerous newspapers, including
Wall Street Journal, Sept. 16, 1970; 1998, brands available at Dallas-area stores.

Pages 10, 11, Providing What Consumers Want:
Burness (1968).

Dental flosses: 1978, Mediamark Research Inc., product
summary report; 1998, brands available at Dallas-area
stores.
Prescription drugs: 1978 and 1998, Physicians’ Desk
Reference (Montvale, N.J.: Medical Ecomomics Co.,
1978 and 1998).
Over-the-counter pain relievers: 1970 and 1998,
numerous industry sources and Dallas-area stores.
Levi’s jean styles: spring 1972 and 1998, Levi Strauss
& Co.
Running shoe styles: 1970, numerous company
and industry sources, including Runner’s World,
September 1970; 1998, Holabird Sports,
<http://www.holabirdsports.com>.
Women’s hosiery styles: 1970 and 1998, National Association of Hosiery Manufacturers.
Contact lens types: 1970 (note: soft lenses were introduced in 1971), Consumer Reports, May 1972; 1998 total
reflects possible combinations of material, wear schedule, replacement schedule and correction modality,
plus types of tinted lenses; numerous industry web sites
consulted.
Bicycle types: 1970 and 1998, Jay Townley & Associates,
Lyndon Station, Wis.

Page 12, Vehicle Models, 1980–97: Ward’s AutoInfoBank, used by permission of Ward’s Communications,
Southfield, Mich.
Page 15, Market Research in the United States:
research spending in 1997 dollars, Marketing News,
June 8, 1998.
Page 21, An Ounce of Prevention: $107 billion in 1998
is the total of $37 billion in direct costs and
$70 billion in indirect morbidity and mortality costs
associated with cancer. American Cancer Society;
National Cancer Institute; National Academy of
Sciences Institute of Medicine; U.S. News and World
Report, Nov. 23, 1998.
PHOTO CREDITS
Inside covers, Joe Scherschel/Life Magazine©Time Inc.;
Page 4, Roderick F. Kasar, Euless, Texas (airplane);
Contact Lenses Online, Inc., www.contactlenses.com;
Pages 10, 11, 18, Courtesy of Ford Motor Company;
Page 14, My Twinn Doll Company (1-800-469-8946);
Andy Sperry (for Softplan);
Page 16, Courtesy of http://www.shirtcreations.com;
Page 17, Catherine Lash for Footmaxx;
Page 19, Wyatt McSpadden

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 27

BANK EXECUTIVES
Standing (from left):

James A. Martin (Deputy Chairman)
Second General Vice President,
International Association of Bridge, Structural,
Ornamental & Reinforcing Iron Workers
Robert D. McTeer, Jr.
President and CEO, Federal Reserve Bank of Dallas

Roger R. Hemminghaus (Chairman)
Chairman, Ultramar Diamond Shamrock Corp.
Seated:

Helen E. Holcomb
First Vice President and COO, Federal Reserve Bank of Dallas

SENIOR MANAGEMENT
Standing (from left):

Millard E. Sweatt
Legal, Operations Analysis and Purchasing

Robert D. Hankins
Banking Supervision, Discount and Credit,
and Financial Industry Studies

Robert Smith III
Houston Branch

James L. Stull
San Antonio Branch

J. Tyrone Gholson
Cash, Protection, Securities and Services

Larry J. Reck
Information Technology Services and Payments Services
Seated (from left):

Harvey Rosenblum
Research and Statistics

Helen E. Holcomb
First Vice President and COO

Robert D. McTeer, Jr.
President and CEO
Not pictured:

Sam C. Clay
El Paso Branch

28 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

DALLAS BOARD OF DIRECTORS
Standing (from left):

Gayle M. Earls
President and CEO, The Independent BankersBank

Dan Angel
President, Stephen F. Austin State University

James A. Martin (Deputy Chairman)
Second General Vice President, International Association of
Bridge, Structural, Ornamental & Reinforcing Iron Workers
Kirk A. McLaughlin
President and CEO, Security Bank

Robert C. McNair
Chairman and CEO, Cogen Technologies Energy Group

Dudley K. Montgomery
President and CEO, The Security State Bank of Pecos
Seated (from left):

Julie Spicer England
Vice President, Texas Instruments

Roger R. Hemminghaus (Chairman)
Chairman, Ultramar Diamond Shamrock Corp.
Not pictured:

Ray L. Hunt
Chairman, President and CEO, Hunt Consolidated Inc.

EL PASO BRANCH BOARD OF DIRECTORS
Standing (from left):

Lester L. Parker
President and COO, Bank of the West

Gail Darling
CEO, Gail Darling Inc.

Patricia Z. Holland-Branch (Chairman)
President and CEO, HB/PZH Commercial Environments Inc.
James D. Renfrow
President and CEO, The Carlsbad National Bank

Beauregard Brite White (Chairman Pro Tem)
Rancher, J. E. White, Jr. & Sons
Seated (from left):

Melissa W. O’Rourke
President, Charlotte’s Inc.

Cecil E. Nix
Business Manager, International Brotherhood of
Electrical Workers, Local 460

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 29

HOUSTON BRANCH BOARD OF DIRECTORS
Standing (from left):

Alan R. Buckwalter III
Chairman and CEO, Chase Bank of Texas

Judith B. Craven
Physician/Administrator

Edward O. Gaylord (Chairman)
Chairman, Jacintoport Terminal Co.
Seated (from left):

Ray B. Nesbitt
President, Exxon Chemical Co.

Peggy Pearce Caskey (Chairman Pro Tem)
CEO, Laboratories for Genetic Services Inc.
Not pictured:

John L. Adams
Chairman, President and CEO (retired), Chase Bank of Texas

Malcolm Gillis
President, Rice University

J. Michael Solar
Principal Attorney, Solar & Fernandes LLP
Alan Buckwalter is filling the unexpired term of John Adams, who
resigned from the Houston board in August 1998. J. Michael
Solar retired from the Houston board in December 1998.

SAN ANTONIO BRANCH BOARD OF DIRECTORS
Standing (from left):

Juliet V. Garcia
President, University of Texas at Brownsville

Arthur Emerson
Vice President/General Manager, KVDA-TV 60 Telemundo

Patty Puig Mueller
Vice President/Finance, Mueller Energetics Corp.
Seated (from left):

Carol L. Thompson (Chairman Pro Tem)
President, The Thompson Group

Richard W. Evans, Jr.
Chairman and CEO, Frost National Bank

H. B. Zachry, Jr. (Chairman)
Chairman and CEO, H. B. Zachry Co.
Not pictured:

Douglas G. Macdonald
President, South Texas National Bank
Richard Evans and Carol Thompson retired from
the San Antonio board in December 1998.

3 0 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

FEDERAL RESERVE BANK OF DALLAS OFFICERS
DALLAS

EL PASO

SMALL BUSINESS
AND AGRICULTURE
ADVISORY COUNCIL

Robert D. McTeer, Jr.

Joanna O. Kolson

Dean A. Pankonien

Sam C. Clay

Stephen K. Balas

President and CEO

Vice President

Assistant Vice President

Vice President in Charge

Helen E. Holcomb

Joel L. Koonce, Jr.

John R. Phillips

J. Eloise Guinn

First Vice President and COO

Vice President

Assistant Vice President

Assistant Vice President

Owner and Pharmacist,
Eagle Lake Drugstore
and Home Health Care
Owner, Balas Farming Co.,
Eagle Lake, Texas

W. Michael Cox

Kenneth V. McKee

Larry C. Ripley

Javier R. Jimenez

Senior Vice President and
Chief Economist

Vice President and
General Auditor

Assistant Vice President

Assistant Vice President

J. Tyrone Gholson

Larry M. Snell

Senior Vice President

Vice President

Robert D. Hankins

W. Arthur Tribble

Senior Vice President

Vice President

Larry J. Reck

Meredith N. Black

Senior Vice President

Assistant Vice President

Sharon A. Sweeney
Assistant Vice President,
Associate General Counsel
and Associate Secretary

Gayle Teague

HOUSTON

Chairman and CEO,
Gaedcke Equipment Co.,
Houston, Texas

Robert Smith III

Robert D. Josserand

Senior Vice President
in Charge

President, AzTx Cattle Co.,
Hereford, Texas

René G. Gonzales

Paula Lambert

Assistant Vice President

Michael N. Turner

Vice President

Assistant Vice President

Harvey Rosenblum

Stephen P. A. Brown

Senior Vice President and
Director of Research

Senior Economist and
Assistant Vice President

Millard E. Sweatt

Terry B. Campbell

Senior Vice President,
General Counsel, Ethics
Officer and Secretary

Assistant Vice President

Earl Anderson

Luther E. Richards
Nancy Vickrey

Vice President

Assistant Vice President and
Community Affairs Officer

Richard J. Burda
Assistant Vice President

Evelyn LV. Watkins
Assistant Vice President

Robert W. Gilmer

Senior Economist and
Assistant Vice President

Stephen M. Welch

Senior Economist and
Assistant Vice President

KaSandra Goulding

Marion E. White

Assistant Vice President

Assistant Vice President

John V. Duca
Assistant Vice President

Vice President

Gloria V. Brown
Vice President

William C. Gruben

Bob W. Williams

Senior Economist and
Assistant Vice President

Assistant Vice President

Emilie S. Worthy
Lyne H. Carter

Johnny L. Johnson

Vice President

Assistant Vice President

Assistant Vice President

Kathy K. Johnsrud
Billy J. Dusek

Evan F. Koenig

Statistics Officer

Vice President

Senior Economist and
Assistant Vice President

William C. Morse, Jr.

Robert G. Feil
Vice President

Operations Officer

C. LaVor Lym
Assistant Vice President

Kermit S. Harmon, Jr.
Vice President

Founder and President,
Mozzarella Co., Dallas, Texas

Robert W. Latimer
President, Adobe Corporate
Capital LLC, San Antonio,
Texas

Joe D. Mitchell
Shareholder, Director and
President, Mitchell & Jenkins
PC, Attorneys and Counselors
at Law, Dallas, Texas

Daron D. Peschel

Vice President

Basil J. Asaro

Gilbert D. Gaedcke

Mine Yücel
Research Officer

James R. McCullin
Assistant Vice President

Operations Officer

Bookman Peters

Marilyn Snider

Certified Public Accountant
and Financial Consultant,
Bryan, Texas

Operations Officer

SAN ANTONIO

Timothy A. Shell
President, ExecuTrain of
Houston Inc., Houston, Texas

James L. Stull
Senior Vice President
in Charge

FEDERAL ADVISORY
COUNCIL MEMBER

Taylor H. Barbee
Assistant Vice President

Charles T. Doyle

Richard A. Gutierrez

Chairman, Texas Independent
Bancshares Inc., Texas City,
Texas

Assistant Vice President

Assistant Vice President

Charles Doyle retired as
Federal Advisory Council
Member in December 1998.

Effective January 1, 1999

Effective December 31, 1998

Karen Ojeda Salisbury

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 31

February 5, 1999
To the Board of Directors of the
Federal Reserve Bank of Dallas:
The management of the Federal Reserve Bank of Dallas (FRBD) is responsible for
the preparation and fair presentation of the Statement of Condition, Statement of Income,
and Statement of Changes in Capital as of December 31, 1998 (the “Financial Statements”).
The Financial Statements have been prepared in conformity with the accounting principles, policies, and practices established by the Board of Governors of the Federal Reserve
System and as set forth in the Financial Accounting Manual for the Federal Reserve Banks,
and as such, include amounts, some of which are based on judgments and estimates of
management.
The management of the FRBD is responsible for maintaining an effective process of internal controls over financial reporting including the safeguarding of assets as they
relate to the Financial Statements. Such internal controls are designed to provide reasonable assurance to management and to the Board of Directors regarding the preparation of
reliable Financial Statements. This process of internal controls contains self-monitoring
mechanisms, including, but not limited to, divisions of responsibility and a code of conduct.
Once identified, any material deficiencies in the process of internal controls are reported
to management, and appropriate corrective measures are implemented.
Even an effective process of internal controls, no matter how well designed, has inherent
limitations, including the possibility of human error, and therefore can provide only reasonable assurance with respect to the preparation of reliable Financial Statements.
The management of the FRBD assessed its process of internal controls over financial
reporting including the safeguarding of assets reflected in the Financial Statements, based
upon the criteria established in the “Internal Control–Integrated Framework” issued by
the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based
on this assessment, the management of the FRBD believes that the FRBD maintained an
effective process of internal controls over financial reporting including the safeguarding of
assets as they relate to the Financial Statements.

President
Federal Reserve Bank of Dallas

First Vice President
Federal Reserve Bank of Dallas

32 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors of the
Federal Reserve Bank of Dallas:

We have examined management’s assertion that the Federal Reserve Bank of Dallas (“FRB
Dallas”) maintained effective internal control over financial reporting and the safeguarding of assets as they relate to the Financial Statements as of December 31, 1998, included
in the accompanying Management’s Assertion.
Our examination was made in accordance with standards established by the American
Institute of Certified Public Accountants, and accordingly, included obtaining an understanding of the internal control over financial reporting, testing, and evaluating the design
and operating effectiveness of the internal control, and such other procedures as we
considered necessary in the circumstances. We believe that our examination provides a
reasonable basis for our opinion.
Because of inherent limitations in any internal control, misstatements due to error or fraud
may occur and not be detected. Also, projections of any evaluation of the internal control
over financial reporting to future periods are subject to the risk that the internal control
may become inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, management’s assertion that the FRB Dallas maintained effective internal
control over financial reporting and over the safeguarding of assets as they relate to the
Financial Statements as of December 31, 1998, is fairly stated, in all material respects,
based upon criteria described in “Internal Control–Integrated Framework” issued by the
Committee of Sponsoring Organizations of the Treadway Commission.

Dallas, Texas
March 5, 1999

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 33

REPORT OF INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP
To the Board of Governors of the Federal Reserve System
and the Board of Directors of the Federal Reserve Bank of Dallas:

We have audited the accompanying statements of condition of the Federal Reserve Bank
of Dallas (the “Bank”) as of December 31, 1998 and 1997, and the related statements of
income and changes in capital for the years then ended. These financial statements are
the responsibility of the Bank’s management. Our responsibility is to express an opinion
on the Financial Statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 3, the financial statements were prepared in conformity with the
accounting principles, policies, and practices established by the Board of Governors of the
Federal Reserve System. These principles, policies, and practices, which were designed to
meet the specialized accounting and reporting needs of the Federal Reserve System, are set
forth in the “Financial Accounting Manual for Federal Reserve Banks” and constitute a
comprehensive basis of accounting other than generally accepted accounting principles.
In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of the Bank as of December 31, 1998 and 1997, and results
of its operations for the years then ended, on the basis of accounting described in Note 3.

Dallas, Texas
March 5, 1999

34 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

STATEMENTS OF CONDITION (IN MILLIONS)

December 31, 1998

December 31, 1997

ASSETS

Gold certificates
Special drawing rights certificates
Coin
Items in process of collection
U.S. government and federal agency securities, net
Investments denominated in foreign currencies
Accrued interest receivable
Interdistrict settlement account
Bank premises and equipment, net
Other assets
Total assets

$

530
367
40
392
20,764
1,029
196
1,680
182
18
_________
$
25,198
_________
_________

$

459
367
37
359
15,761
951
149
5,259
185
12
_________
$
23,539
_________
_________

$

$

LIABILITIES AND CAPITAL

Liabilities
Federal Reserve notes outstanding, net
Deposits:
Depository institutions
Other deposits
Deferred credit items
Surplus transfer due U.S. Treasury
Accrued benefit cost
Other liabilities
Total liabilities
Capital
Capital paid-in
Surplus
Total capital
Total liabilities and capital

The accompanying notes are an integral part of these financial statements.

23,072

20,007

1,166
9
334
103
49
11
_________
$
24,744
_________

2,480
10
424
12
45
8
_________
$
22,986
_________

227
227
_________
$
454
_________
$
25,198
_________
_________

283
270
_________
$
553
_________
$
23,539
_________
_________

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 35

STATEMENTS OF INCOME (IN MILLIONS)

FOR THE YEARS ENDED

December 31, 1998

December 31, 1997

INTEREST INCOME

Interest on U.S. government securities
Interest on foreign currencies
Total interest income

$

1,136
23
_________

$

910
21
_________

$
1,159
_________

$
931
_________

$

$

OTHER OPERATING INCOME (LOSS)

Income from services
Reimbursable services to government agencies
Foreign currency gains (losses), net
Government securities gains, net
Other income
Total other operating income (loss)

56
11
97
2
1
_________
$
167
_________

53
7
(144)
–
1
_________
($
83)
_________

OPERATING EXPENSES

Salaries and other benefits
Occupancy expense
Equipment expense
Cost of unreimbursed Treasury services
Assessments by Board of Governors
Other expenses
Total operating expenses
Net income prior to distribution

$

81
11
10
–
27
54
_________
$
183
_________

$

78
11
10
2
23
51
_________
$
175
_________

$
1,143
_________
_________

$
673
_________
_________

DISTRIBUTION OF NET INCOME

Dividends paid to member banks
$
14
Transferred to (from) surplus
(43)
Payments to U.S. Treasury as interest on Federal Reserve notes
441
Payments to U.S. Treasury as required by statute
731
_________
Total distribution
$_________
1,143
_________
The accompanying notes are an integral part of these financial statements.

$

16
26
–
631
______
$_________
673
_________

36 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

STATEMENTS OF CHANGES IN CAPITAL
FOR THE YEARS ENDED DECEMBER 31, 1998,
AND DECEMBER 31, 1997 (IN MILLIONS)

Capital
Paid-In
BALANCE AT JANUARY 1, 1997
(5.1 MILLION SHARES)

Surplus

Total
Capital

$ 257

$ 250

$ 507

Net income transferred to surplus

–

26

26

Statutory surplus transfer to the U.S. Treasury

–

( 6)

( 6)

26
______

–
______

26
______

$ 283

$ 270

$ 553

Net change in capital stock issued (0.5 million shares)

BALANCE AT DECEMBER 31, 1997
(5.6 MILLION SHARES)

Net income transferred (from) surplus
Net change in capital stock (redeemed)(1.1 million shares)

BALANCE AT DECEMBER 31, 1998
(4.5 MILLION SHARES)

The accompanying notes are an integral part of these financial statements.

–

(43 )

(43 )

(56 )
______

–
______

(56 )
______

$ 227
______
______

$ 227
______
______

$ 454
______
______

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 37

NOTES TO FINANCIAL STATEMENTS

1. ORGANIZATION
The Federal Reserve Bank of Dallas (“Bank”) is part of the Federal Reserve System (“System”)
created by Congress under the Federal Reserve Act of 1913 (“Federal Reserve Act”), which established the central bank of the United States. The System consists of the Board of Governors of the
Federal Reserve System (“Board of Governors”) and 12 Federal Reserve Banks (“Reserve
Banks”). The Reserve Banks are chartered by the federal government and possess a unique set of
governmental, corporate, and central bank characteristics. Other major elements of the System
are the Federal Open Market Committee (“FOMC”) and the Federal Advisory Council. The FOMC
is composed of members of the Board of Governors, the president of the Federal Reserve Bank of
New York (“FRBNY”), and, on a rotating basis, four other Reserve Bank presidents.
Structure
The Bank and its branches in El Paso, Houston, and San Antonio serve the Eleventh Federal
Reserve District, which includes Texas and portions of Louisiana and New Mexico. In accordance with the Federal Reserve Act, supervision and control of the Bank are exercised by a
board of directors. Banks that are members of the System include all national banks and any
state-chartered bank that applies and is approved for membership in the System.
Board of Directors
The Federal Reserve Act specifies the composition of the board of directors for each of the
Reserve Banks. Each board is composed of nine members serving three-year terms: three directors, including those designated as chairman and deputy chairman, are appointed by the Board of
Governors, and six directors are elected by member banks. Of the six elected by member banks,
three represent the public and three represent member banks. Member banks are divided into
three classes according to size. Member banks in each class elect one director representing member banks and one representing the public. In any election of directors, each member bank
receives one vote, regardless of the number of shares of Reserve Bank stock it holds.
2. OPERATIONS AND SERVICES
The System performs a variety of services and operations. Functions include formulating and
conducting monetary policy; participating actively in the payments mechanism, including largedollar transfers of funds, automated clearinghouse operations, and check processing; distributing
coin and currency; providing fiscal agency functions for the U.S. Treasury and certain federal
agencies; serving as the federal government’s bank; providing short-term loans to depository institutions; serving the consumer and the community by providing educational materials and information regarding consumer laws; supervising bank holding companies and state member banks;
and administering other regulations of the Board of Governors. The Board of Governors’ operating costs are funded through assessments on the Reserve Banks.
The FOMC establishes policy regarding open market operations, oversees these operations, and
issues authorizations and directives to the FRBNY for its execution of transactions. Authorized
transaction types include direct purchase and sale of securities, matched sale–purchase transactions, purchase of securities under agreements to resell, and lending of U.S. government securities. Additionally, the FRBNY is authorized by the FOMC to hold balances of, and to execute
spot and forward foreign exchange and securities contracts in, 14 foreign currencies; maintain
reciprocal currency arrangements (“F/X swaps”) with various central banks; and “warehouse”
foreign currencies for the U.S. Treasury Exchange Stabilization Fund (“ESF”) through the
Reserve Banks.
3. SIGNIFICANT ACCOUNTING POLICIES
Accounting principles for entities with the unique powers and responsibilities of the nation’s central bank have not been formulated by the Financial Accounting Standards Board. The Board of
Governors has developed specialized accounting principles and practices that it believes are
appropriate for the significantly different nature and function of a central bank as compared with

38 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

the private sector. These accounting principles and practices are documented in the “Financial
Accounting Manual for Federal Reserve Banks” (“Financial Accounting Manual”), which is issued
by the Board of Governors. All Reserve Banks are required to adopt and apply accounting policies
and practices that are consistent with the Financial Accounting Manual.
The financial statements have been prepared in accordance with the Financial Accounting Manual. Differences exist between the accounting principles and practices of the System and generally accepted accounting principles (“GAAP”). The primary differences are the presentation of all
security holdings at amortized cost rather than at the fair value presentation requirements of
GAAP, and the accounting for matched sale–purchase transactions as separate sales and purchases rather than secured borrowings with pledged collateral, as is required by GAAP. In addition, the Bank has elected not to include a Statement of Cash Flows or a Statement of Comprehensive Income. The Statement of Cash Flows has not been included, as the liquidity and cash
position of the Bank are not of primary concern to users of these financial statements. The Statement of Comprehensive Income, which comprises net income plus or minus certain adjustments,
such as the fair value adjustment for securities, has not been included because, as stated above,
the securities are recorded at amortized cost and there are no other adjustments in the determination of Comprehensive Income applicable to the Bank. Other information regarding the Bank’s
activities is provided in, or may be derived from, the Statements of Condition, Income, and
Changes in Capital. Therefore, a Statement of Cash Flows or a Statement of Comprehensive
Income would not provide any additional useful information. There are no other significant differences between the policies outlined in the Financial Accounting Manual and GAAP.
The preparation of the financial statements in conformity with the Financial Accounting Manual
requires management to make certain estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of income and expenses during the reporting
period. Actual results could differ from those estimates. Unique accounts and significant accounting policies are explained below.
a. Gold Certificates
The Secretary of the Treasury is authorized to issue gold certificates to the Reserve Banks to monetize gold held by the U.S. Treasury. Payment for the gold certificates by the Reserve Banks is
made by crediting equivalent amounts in dollars into the account established for the U.S. Treasury. These gold certificates held by the Reserve Banks are required to be backed by the gold of the
U.S. Treasury. The U.S. Treasury may reacquire the gold certificates at any time, and the Reserve
Banks must deliver them to the U.S. Treasury. At such time, the U.S. Treasury’s account is charged
and the Reserve Banks’ gold certificate accounts are lowered. The value of gold for purposes of
backing the gold certificates is set by law at $42-2/9 a fine troy ounce. The Board of Governors
allocates the gold certificates among Reserve Banks once a year based upon Federal Reserve
notes outstanding in each District at the end of the preceding year.
b. Special Drawing Rights Certificates
Special drawing rights (“SDRs”) are issued by the International Monetary Fund (“Fund”) to its
members in proportion to each member’s quota in the Fund at the time of issuance. SDRs serve
as a supplement to international monetary reserves and may be transferred from one national
monetary authority to another. Under the law providing for U.S. participation in the SDR system,
the Secretary of the U.S. Treasury is authorized to issue SDR certificates, somewhat like gold certificates, to the Reserve Banks. At such time, equivalent amounts in dollars are credited to the
account established for the U.S. Treasury, and the Reserve Banks’ SDR certificate accounts are
increased. The Reserve Banks are required to purchase SDRs, at the direction of the U.S. Treasury, for the purpose of financing SDR certificate acquisitions or for financing exchange stabilization operations. The Board of Governors allocates each SDR transaction among Reserve Banks
based upon Federal Reserve notes outstanding in each District at the end of the preceding year.

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 39

c. Loans to Depository Institutions
The Depository Institutions Deregulation and Monetary Control Act of 1980 provides that all
depository institutions that maintain reservable transaction accounts or nonpersonal time
deposits, as defined in Regulation D issued by the Board of Governors, have borrowing privileges
at the discretion of the Reserve Banks. Borrowers execute certain lending agreements and
deposit sufficient collateral before credit is extended. Loans are evaluated for collectibility, and
currently all are considered collectible and fully collateralized. If any loans were deemed to be
uncollectible, an appropriate reserve would be established. Interest is recorded on the accrual
basis and is charged at the applicable discount rate established at least every 14 days by the
boards of directors of the Reserve Banks, subject to review by the Board of Governors. However,
Reserve Banks retain the option to impose a surcharge above the basic rate in certain circumstances. There were no outstanding loans to depository institutions at December 31, 1998, and
December 31, 1997, respectively.
d. U.S. Government and Federal Agency Securities
and Investments Denominated in Foreign Currencies
The FOMC has designated the FRBNY to execute open market transactions on its behalf and to
hold the resulting securities in the portfolio known as the System Open Market Account
(“SOMA”). In addition to authorizing and directing operations in the domestic securities market,
the FOMC authorizes and directs the FRBNY to execute operations in foreign markets for major
currencies in order to counter disorderly conditions in exchange markets or to meet other needs
specified by the FOMC in carrying out the System’s central bank responsibilities.
Purchases of securities under agreements to resell and matched sale–purchase transactions are
accounted for as separate sale and purchase transactions. Purchases under agreements to resell
are transactions in which the FRBNY purchases a security and sells it back at the rate specified
at the commencement of the transaction. Matched sale–purchase transactions are transactions
in which the FRBNY sells a security and buys it back at the rate specified at the commencement
of the transaction.
Reserve Banks are authorized by the FOMC to lend U.S. government securities held in the SOMA
to U.S. government securities dealers and to banks participating in U.S. government securities
clearing arrangements, in order to facilitate the effective functioning of the domestic securities
market. These securities-lending transactions are fully collateralized by other U.S. government
securities. FOMC policy requires the lending Reserve Bank to take possession of collateral in
amounts in excess of the market values of the securities loaned. The market values of the collateral and the securities loaned are monitored by the lending Reserve Bank on a daily basis, with
additional collateral obtained as necessary. The securities loaned continue to be accounted for in
the SOMA.
Foreign exchange contracts are contractual agreements between two parties to exchange specified currencies at a specified price on a specified date. Spot foreign contracts normally settle
two days after the trade date, whereas the settlement date on forward contracts is negotiated
between the contracting parties, but will extend beyond two days from the trade date. The
FRBNY generally enters into spot contracts, with any forward contracts generally limited to the
second leg of a swap/warehousing transaction.
The FRBNY, on behalf of the Reserve Banks, maintains renewable, short-term F/X swap
arrangements with authorized foreign central banks. The parties agree to exchange their currencies up to a prearranged maximum amount and for an agreed-upon period of time (up to 12
months) at an agreed-upon interest rate. These arrangements give the FOMC temporary access
to foreign currencies that it may need for intervention operations to support the dollar and give
the partner foreign central bank temporary access to dollars it may need to support its own currency. Drawings under the F/X swap arrangements can be initiated by either the FRBNY or the
partner foreign central bank, and must be agreed to by the drawee. The F/X swaps are struc-

4 0 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

tured so that the party initiating the transaction (the drawer) bears the exchange rate risk
upon maturity. The FRBNY will generally invest the foreign currency received under an F/X swap
in interest-bearing instruments.
Warehousing is an arrangement under which the FOMC agrees to exchange, at the request of
the Treasury, U.S. dollars for foreign currencies held by the Treasury or ESF over a limited
period of time. The purpose of the warehousing facility is to supplement the U.S. dollar
resources of the Treasury and ESF for financing purchases of foreign currencies and related
international operations.
In connection with its foreign currency activities, the FRBNY, on behalf of the Reserve Banks, may
enter into contracts that contain varying degrees of off-balance sheet market risk, because they
represent contractual commitments involving future settlement, and counterparty credit risk.
The FRBNY controls credit risk by obtaining credit approvals, establishing transaction limits, and
performing daily monitoring procedures.
While the application of current market prices to the securities currently held in the SOMA
portfolio and investments denominated in foreign currencies may result in values substantially
above or below their carrying values, these unrealized changes in value would have no direct
effect on the quantity of reserves available to the banking system or on the prospects for future
Reserve Bank earnings or capital. Both the domestic and foreign components of the SOMA portfolio from time to time involve transactions that can result in gains or losses when holdings
are sold prior to maturity. However, decisions regarding the securities and foreign currencies
transactions, including their purchase and sale, are motivated by monetary policy objectives
rather than profit. Accordingly, earnings and any gains or losses resulting from the sale of such
currencies and securities are incidental to the open market operations and do not motivate its
activities or policy decisions.
U.S. government and federal agency securities and investments denominated in foreign currencies comprising the SOMA are recorded at cost, on a settlement-date basis, and adjusted for
amortization of premiums or accretion of discounts on a straight-line basis. Interest income is
accrued on a straight-line basis and is reported as “Interest on U.S. government securities” or
“Interest on foreign currencies,” as appropriate. Income earned on securities-lending transactions is reported as a component of “Other income.” Gains and losses resulting from sales of securities are determined by specific issues based on average cost. Gains and losses on the sales of
U.S. government and federal agency securities are reported as “Government securities gains,
net” and “Other income” for the years ended December 31, 1998, and December 31, 1997, respectively. Foreign-currency-denominated assets are revalued monthly at current market exchange
rates in order to report these assets in U.S. dollars. Realized and unrealized gains and losses on
investments denominated in foreign currencies are reported as “Foreign currency gains (losses),
net.” Foreign currencies held through F/X swaps, when initiated by the counterparty, and warehousing arrangements are revalued monthly, with the unrealized gain or loss reported by the
FRBNY as a component of “Other assets” or “Other liabilities,” as appropriate.
Balances of U.S. government and federal agency securities bought outright, investments denominated in foreign currency, interest income, amortization of premiums and discounts on securities bought outright, gains and losses on sales of securities, and realized and unrealized gains
and losses on investments denominated in foreign currencies, excluding those held under an F/X
swap arrangement, are allocated to each Reserve Bank. Securities purchased under agreements
to resell and the related premiums, discounts and income, and unrealized gains and losses on
the revaluation of foreign currency holdings under F/X swaps and warehousing arrangements are
allocated to the FRBNY and not to other Reserve Banks. Income from securities-lending transactions is recognized only by the lending Reserve Bank.

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 41

e. Bank Premises and Equipment
Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is
calculated on a straight-line basis over estimated useful lives of assets ranging from 2 to 50 years.
New assets, major alterations, renovations, and improvements are capitalized at cost as additions
to the asset accounts. Maintenance, repairs, and minor replacements are charged to operations
in the year incurred.
f. Interdistrict Settlement Account
At the close of business each day, all Reserve Banks and branches assemble the payments due to
or from other Reserve Banks and branches as a result of transactions involving accounts residing
in other Districts that occurred during the day’s operations. Such transactions may include funds
settlement, check clearing and automated clearinghouse (“ACH”) operations, and allocations of
shared expenses. The cumulative net amount due to or from other Reserve Banks is reported as
the “Interdistrict settlement account.”
g. Federal Reserve Notes
Federal Reserve notes are the circulating currency of the United States. These notes are issued
through the various Federal Reserve Agents to the Reserve Banks upon deposit with such Agents
of certain classes of collateral security, typically U.S. government securities. These notes are identified as issued to a specific Reserve Bank. The Federal Reserve Act provides that the collateral
security tendered by the Reserve Bank to the Federal Reserve Agent must be equal to the sum of
the notes applied for by such Reserve Bank. In accordance with the Federal Reserve Act, gold certificates, special drawing rights certificates, U.S. government and agency securities, loans allowed
under Section 13, and investments denominated in foreign currencies are pledged as collateral for
net Federal Reserve notes outstanding. The collateral value is equal to the book value of the collateral tendered, with the exception of securities, whose collateral value is equal to the par value
of the securities tendered. The Board of Governors may, at any time, call upon a Reserve Bank for
additional security to adequately collateralize the Federal Reserve notes. To satisfy their obligation
to provide sufficient collateral for their outstanding Federal Reserve notes, the Reserve Banks have
entered into an agreement that provides that certain assets of the Reserve Banks are jointly
pledged as collateral for the Federal Reserve notes of all Reserve Banks. In the event that this collateral is insufficient, the Federal Reserve Act provides that Federal Reserve notes become a first
and paramount lien on all the assets of the Reserve Banks. Finally, as obligations of the United
States, Federal Reserve notes are backed by the full faith and credit of the U.S. government.
The “Federal Reserve notes outstanding, net” account represents Federal Reserve notes reduced
by cash held in the vaults of the Bank of $10,606 million and $6,047 million at December 31, 1998,
and December 31, 1997, respectively.
h. Capital Paid-in
The Federal Reserve Act requires that each member bank subscribe to the capital stock of the
Reserve Bank in an amount equal to 6 percent of the capital and surplus of the member bank. As
a member bank’s capital and surplus change, its holdings of the Reserve Bank’s stock must be
adjusted. Member banks are those state-chartered banks that apply and are approved for membership in the System and all national banks. Currently, only one-half of the subscription is paidin, and the remainder is subject to call. These shares are nonvoting, with a par value of $100. They
may not be transferred or hypothecated. By law, each member bank is entitled to receive an annual dividend of 6 percent on the paid-in capital stock. This cumulative dividend is paid semiannually. A member bank is liable for Reserve Bank liabilities up to twice the par value of stock subscribed by it.
i. Surplus
The Board of Governors requires Reserve Banks to maintain a surplus equal to the amount of capital paid-in as of December 31. This amount is intended to provide additional capital and reduce

42 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

the possibility that the Reserve Banks would be required to call on member banks for additional
capital. Reserve Banks are required by the Board of Governors to transfer to the U.S. Treasury
excess earnings, after providing for the costs of operations, payment of dividends, and reservation
of an amount necessary to equate surplus with capital paid-in. Payments made after September 30,
1998, represent payment of interest on Federal Reserve notes outstanding.
The Omnibus Budget Reconciliation Act of 1993 (Public Law 103-66, Section 3002) codified the
existing Board surplus policies as statutory surplus transfers, rather than as payments of interest
on Federal Reserve notes, for federal government fiscal years 1998 and 1997 (which began on October 1, 1997, and October 1, 1996, respectively). In addition, the legislation directed the Reserve
Banks to transfer to the U.S. Treasury additional surplus funds of $107 million and $106 million during fiscal years 1998 and 1997, respectively. Reserve Banks were not permitted to replenish surplus
for these amounts during this time. The Reserve Banks made these transfers on October 1, 1997,
and October 1, 1996, respectively. The Bank’s share of the 1997 transfer is reported on the Statement of Changes in Capital as “Statutory surplus transfer to the U.S. Treasury.”
In the event of losses, payments to the U.S. Treasury are suspended until such losses are recovered through subsequent earnings. Weekly payments to the U.S. Treasury vary significantly.
j. Cost of Unreimbursed Treasury Services
The Bank is required by the Federal Reserve Act to serve as fiscal agent and depository of the
United States. By statute, the Department of the Treasury is permitted, but not required, to pay
for these services. The costs of providing fiscal agency and depository services to the Treasury
Department that have been billed but will not be paid are reported as the “Cost of unreimbursed
Treasury services.”
k. Taxes
The Reserve Banks are exempt from federal, state, and local taxes, except for taxes on real property, which are reported as a component of “Occupancy expense.”
4. U.S. GOVERNMENT AND FEDERAL AGENCY SECURITIES
Securities bought outright and held under agreements to resell are held in the SOMA at the
FRBNY. An undivided interest in SOMA activity, with the exception of securities held under agreements to resell and the related premiums, discounts, and income, is allocated to each Reserve
Bank on a percentage basis derived from an annual settlement of interdistrict clearings. The settlement, performed in April of each year, equalizes Reserve Bank gold certificate holdings to Federal Reserve notes outstanding. The Bank’s allocated share of SOMA balances was approximately
4.547 percent and 3.632 percent at December 31, 1998, and December 31, 1997, respectively.
The Bank’s allocated share of securities held in the SOMA at December 31, 1998, and December
31, 1997, that were bought outright, were as follows (in millions):
1998
Par value:
Federal agency
U.S. government
Bills
Notes
Bonds
Total par value
Unamortized premiums
Unaccreted discounts
Total allocated to Bank

$

15

1997
$

25

8,856
8,543
3,159
$ 20,573

7,159
6,326
2,157
$ 15,667

336
(145)
$ 20,764

225
(131)
$ 15,761

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 43

Total SOMA securities bought outright were $456,667 million and $434,001 million at December
31, 1998, and December 31, 1997, respectively.
The maturities of U.S. government and federal agency securities bought outright, which were allocated to the Bank at December 31, 1998, were as follows (in millions):
Par value

Maturities of Securities Held
Within 15 days
16 days to 90 days
91 days to 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years
Total

U.S.
Government
Securities
$

Federal
Agency
Obligations

53
4,507
6,531
4,898
2,038
2,531

$

–
1
3
3
8
–

$ 20,558

$

15

Total
$

53
4,508
6,534
4,901
2,046
2,531

$ 20,573

At December 31, 1998, and December 31, 1997, matched sale–purchase transactions involving
U.S. government securities with par values of $20,927 million and $17,027 million, respectively,
were outstanding, of which $952 million and $618 million were allocated to the Bank. Matched
sale–purchase transactions are generally overnight arrangements.
5. INVESTMENTS DENOMINATED IN FOREIGN CURRENCIES
The FRBNY, on behalf of the Reserve Banks, holds foreign currency deposits with foreign central
banks and the Bank for International Settlements and invests in foreign government debt instruments. Foreign government debt instruments held include both securities bought outright and
securities held under agreements to resell. These investments are guaranteed as to principal and
interest by the foreign governments.
Each Reserve Bank is allocated a share of foreign-currency-denominated assets, the related interest income, and realized and unrealized foreign currency gains and losses, with the exception of
unrealized gains and losses on F/X swaps and warehousing transactions. This allocation is based
on the ratio of each Reserve Bank’s capital and surplus to aggregate capital and surplus at the
preceding December 31. The Bank’s allocated share of investments denominated in foreign currencies was approximately 5.203 percent and 5.577 percent at December 31, 1998, and December
31, 1997, respectively.
The Bank’s allocated share of investments denominated in foreign currencies, valued at current
exchange rates at December 31, 1998, and December 31, 1997, were as follows (in millions):
1998
German marks:
Foreign currency deposits
Government debt instruments
including agreements to resell
Japanese yen:
Foreign currency deposits
Government debt instruments
including agreements to resell
Accrued interest
Total

$

544

1997
$

461

123

179

35

32

322
5

274
5

$ 1,029

$

951

44 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

Total investments denominated in foreign currencies were $19,769 million and $17,046 million at
December 31, 1998, and December 31, 1997, respectively, which include $15 million and $3 million in unearned interest for 1998 and 1997, respectively, collected on certain foreign currency
holdings that is allocated solely to the FRBNY.
The maturities of investments denominated in foreign currencies that were allocated to the Bank
at December 31, 1998, were as follows (in millions):
Maturities of Investments Denominated
in Foreign Currencies
Within 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years
Total

$

979
26
24
–

$ 1,029

At December 31, 1998, and December 31, 1997, there were no open foreign exchange contracts or
outstanding F/X swaps.
At December 31, 1998, the warehousing facility was $5,000 million, with zero outstanding.
6. BANK PREMISES AND EQUIPMENT
A summary of bank premises and equipment at December 31, 1998, and December 31, 1997, is as
follows (in millions):
1998
Bank premises and equipment:
Land
Buildings
Building machinery and equipment
Construction in progress
Furniture and equipment
Accumulated depreciation
Bank premises and equipment, net

$

$

32
115
24
2
77
250
(68)
182

1997
$

$

31
115
24
1
77
248
(63)
185

Depreciation expense was $11 million for both the years ended December 31, 1998, and December 31, 1997, respectively.
The Bank leases unused space to outside tenants. These leases expired in 1998. Rental income
from such leases was $30,000 and $49,000 for the years ended December 31, 1998, and December
31, 1997, respectively.

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 45

7. COMMITMENTS AND CONTINGENCIES
At December 31, 1998, the Bank was obligated under noncancelable leases for premises and equipment with terms ranging from one to approximately five years. These leases provide for increased
rentals based upon increases in real estate taxes, operating costs, or selected price indices.
Rental expense under operating leases for certain operating facilities, warehouses, and data processing and office equipment (including taxes, insurance and maintenance when included in
rent), net of sublease rentals, was $399,000 and $382,000 for the years ended December 31, 1998,
and December 31, 1997, respectively. Certain of the Bank’s leases have options to renew.
Future minimum rental payments under noncancelable operating leases, net of sublease rentals,
with terms of one year or more, at December 31, 1998, were as follows (in thousands):
1999
2000
2001
2002
2003
Total

$

363
342
333
333
55

$ 1,426

There were no capital leases at December 31, 1998.
There were no other commitments and long-term obligations in excess of one year at December
31, 1998.
Under the Insurance Agreement of the Federal Reserve Banks dated June 7, 1994, each of the
Reserve Banks has agreed to bear, on a per-incident basis, a pro rata share of losses in excess of 1
percent of the capital of the claiming Reserve Bank, up to 50 percent of the total capital and surplus of all Reserve Banks. Losses are borne in the ratio that a Reserve Bank’s capital bears to the
total capital of all Reserve Banks at the beginning of the calendar year in which the loss is shared.
No claims were outstanding under such agreement at December 31, 1998, or December 31, 1997.
The Bank is involved in certain legal actions and claims arising in the ordinary course of business.
Although it is difficult to predict the ultimate outcome of these actions, in management’s opinion,
based on discussions with counsel, the aforementioned litigation and claims will be resolved without material adverse effect on the financial position or results of operations of the Bank.
8. RETIREMENT AND THRIFT PLANS
Retirement Plans
The Bank currently offers two defined benefit retirement plans to its employees, based on length
of service and level of compensation. Substantially all of the Bank’s employees participate in the
Retirement Plan for Employees of the Federal Reserve System (“System Plan”) and the Benefit
Equalization Retirement Plan (“BEP”). The System Plan is a multi-employer plan with contributions fully funded by participating employers. No separate accounting is maintained of assets contributed by the participating employers. The Bank’s projected benefit obligation and net pension
costs for the BEP at December 31, 1998, and December 31, 1997, and for the years then ended,
are not material.
Thrift Plan
Employees of the Bank may also participate in the defined contribution Thrift Plan for Employees of the Federal Reserve System (“Thrift Plan”). The Bank’s Thrift Plan contributions totaled
$3 million and $2 million for the years ended December 31, 1998, and December 31, 1997, respectively, and are reported as a component of “Salaries and other benefits.”

46 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

9. POSTRETIREMENT BENEFITS
OTHER THAN PENSIONS AND POSTEMPLOYMENT BENEFITS
Postretirement Benefits Other Than Pensions
In addition to the Bank’s retirement plans, employees who have met certain age and length-ofservice requirements are eligible for both medical benefits and life insurance coverage during
retirement.
The Bank funds benefits payable under the medical and life insurance plans as due and, accordingly, there are no plan assets. Net postretirement benefit cost is actuarially determined, using a
January 1 measurement date.
Following is a reconciliation of beginning and ending balances of the benefit obligations as of
December 31, 1998, and December 31, 1997 (in millions):

Accumulated postretirement benefit obligation at January 1
Service cost—benefits earned during the period
Interest cost of accumulated benefit obligation
Actuarial loss (gain)
Contributions by plan participants
Benefits paid
Plan amendments, acquisitions,
foreign currency exchange rate changes,
business combinations, divestitures, curtailments,
settlements, special termination benefits
Accumulated postretirement benefit obligation
at December 31

1998

1997

$ 40.2
1.4
2.7
2.9
0.3
(1.2)

$ 38.7
1.4
2.7
(1.5)
0.3
(1.4)

(9.6)
$ 36.7

–
$ 40.2

Following is a reconciliation of the beginning and ending balance of the plan assets, the unfunded
postretirement benefit obligation, and the accrued postretirement benefit cost as of December 31,
1998, and December 31, 1997 (in millions):
1998

1997

Fair value of plan assets at January 1
Actual return on plan assets
Contributions by the employer
Contributions by plan participants
Benefits paid
Fair value of plan assets at December 31

$

–
–
0.9
0.3
(1.2)
$ –

$

–
–
1.1
0.3
(1.4)
$ –

Unfunded postretirement benefit obligation
Unrecognized initial net transition asset (obligation)
Unrecognized prior service cost
Unrecognized net actuarial (loss)
Accrued postretirement benefit cost

$ 36.7
–
16.4
(9.9)
$ 43.2

$ 40.2
–
7.4
(7.2)
$ 40.4

Accrued postretirement benefit cost is reported as a component of “Accrued benefit cost.”

FEDERAL RESERVE BANK OF DALLAS | 1998 Annual Report 47

The weighted-average assumption used in developing the postretirement benefit obligation as of
December 31, 1998, and December 31, 1997, is as follows:

Discount rate

1998

1997

6.25%

7.00%

For measurement purposes, an 8.5 percent annual rate of increase in the cost of covered health
care benefits was assumed for 1999. Ultimately, the health care cost trend rate is expected to
decrease gradually to 4.75 percent by 2006, and remain at that level thereafter.
Assumed health care cost trend rates have a significant effect on the amounts reported for health
care plans. A 1 percentage point change in assumed health care cost trend rates would have the
following effects for the year ended December 31, 1998 (in millions):
1 Percentage
Point
Increase
Effect on aggregate of service and interest cost
components of net periodic postretirement benefit cost
Effect on accumulated postretirement benefit obligation

$

1.0
7.5

1 Percentage
Point
Decrease
$ (0.8)
(6.9)

The following is a summary of the components of net periodic postretirement benefit cost for the
years ended December 31, 1998, and December 31, 1997 (in millions):
1998
Service cost—benefits earned during the period
Interest cost of accumulated benefit obligation
Amortization of prior service cost
Recognized net actuarial loss
Net periodic postretirement benefit cost

$

1.4
2.7
(0.5)
0.1
$ 3.7

1997
$

1.3
2.7
(0.5)
0.2
$ 3.7

Net periodic postretirement benefit cost is reported as a component of “Salaries and other benefits.”
Postemployment Benefits
The Bank offers benefits to former or inactive employees. Postemployment benefit costs are actuarially determined and include the cost of medical and dental insurance, survivor income, and disability benefits. Costs were projected using the same discount rate and health care trend rates as
were used for projecting postretirement costs. The accrued postemployment benefit costs recognized by the Bank at December 31, 1998, and December 31, 1997, were $6 million and $5 million,
respectively. This cost is included as a component of “Accrued benefit cost.” Net periodic postemployment benefit costs included in 1998 and 1997 operating expenses were $1 million each year.

48 1998 Annual Report | FEDERAL RESERVE BANK OF DALLAS

VOLUME OF OPERATIONS
(UNAUDITED)

Number of Items Handled
(Thousands)

Dollar Amount
(Millions)

1998

1997

1998

1997

Currency received from circulation

1,789,661

1,582,135

27,779

24,582

Coin received from circulation

1,512,784

827,340

139

112

1,204,449

1,121,958

705,416

651,531

Commercial–fine sorted

193,347

240,946

72,545

88,709

U.S. government checks

26,236

26,736

24,893

26,636

210,360

187,438

639,038

586,317

11,686

8,811

16,097,218

13,207,835

155

291

2,452,537

3,437,462

SERVICES TO DEPOSITORY INSTITUTIONS
CASH SERVICES

CHECK PROCESSING

Commercial–processed

ELECTRONIC PAYMENTS

Automated Clearinghouse items originated
Funds transfers processed
Book-entry security transfers processed

LOANS

Advances made

59*

158*

327

176

14

20

892

932

739

787

3

4

SERVICES TO THE U.S. TREASURY
AND GOVERNMENT AGENCIES

Issues and reinvestments of Treasury securities
Food coupons destroyed

*Individual loans, not in thousands.

Kay Champagne, Publications Director
Monica Reeves, Editor
Patti Holland, Art Director
Laura J. Bell, Chart Designer
Gene Autry, Photographer

About the Dallas Fed
The Federal Reserve Bank of Dallas is one of 12 regional
Federal Reserve Banks in the United States. Together with
the Board of Governors in Washington, D.C., these organizations form the Federal Reserve System and function as
the nation’s central bank. The System’s basic purpose is to
provide a flow of money and credit that will foster orderly
economic growth and a stable dollar. In addition, Federal
Reserve Banks supervise banks and bank holding companies and provide certain financial services to the banking
industry, the federal government and the public.
The Federal Reserve Bank of Dallas has served the financial institutions in the Eleventh District since 1914. The
District encompasses 350,000 square miles and comprises
the state of Texas, northern Louisiana and southern New
Mexico. The three branch offices of the Federal Reserve
Bank of Dallas are in El Paso, Houston and San Antonio.

Federal Reserve
Bank of Dallas
2200 North Pearl Street
Dallas, Texas 75201
(214) 922-6000
El Paso Branch
301 East Main Street
El Paso, Texas 79901
(915) 544-4730
Houston Branch
1701 San Jacinto Street
Houston, Texas 77002
(713) 659-4433
San Antonio Branch
126 East Nueva Street
San Antonio, Texas 78204
(210) 978-1200
www.dallasfed.org