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IS S N 0007-7011 Federal Reserve Bank of Philadelphia SEPTEMBER • OCTOBER 1985 Working Paper Summary: Tax Reform & Housing, Theodore Crone IBS' Federal Reserve Bank of Philadelphia Ten Independence Mall Philadelphia, Pennsylvania 19106 REGIONAL REPORTS A s w e m o v e in to th e s e c o n d h alf of th e 1 9 8 0 s , th e re g io n 's e c o n o m y se e m s to be in m u ch b e tte r sh ap e th an m a n y p e o p le w ou ld h a v e e x p e c te d a few y e a rs ag o . T h is is p articu larly g o o d n ew s co n sid e rin g b oth th e se rio u s e m p lo y m e n t d e clin e s th e re g io n e x p e rie n ce d in th e 1 9 7 0 s , an d so m e alarm in g fin ancial d e v e lo p m e n ts in th e n atio n re ce n tly . T h is issu e of th e Business Review su rv e y s th e re g io n a l e c o n o m ic sce n e in this light. In th e first article, T h o m a s K. D esch an d R ich ard W . L an g b riefly an a ly z e so m e o f th e ca u se s of th e re c e n t su rg e in th e n u m b e r o f failed b anks n ation ally, an d assess th e h ealth o f bank s in th e T h ird D istrict. W ith o n ly o n e b ank failure in this D istrict in th e 1 9 8 0 s , an d g o o d s c o r e s fo r D istrict b anks o n v a rio u s m e a s u re s of b an k s' h ealth , th e co n d itio n o f th e re g io n 's b anks a p p e a rs to b e q u ite g o o d . In th e se co n d article , Jo h n M. L. G ru e n ste in co n tra sts se v e ra l m e a s u re s o f th e re g io n 's p e rfo rm a n c e relativ e to th e n atio n in th e 1 9 7 0 s w ith th e 1 9 8 0 s . W h ile th e re g io n 's p e rfo rm a n ce in th e 1 9 7 0 s se e m e d to signal co n tin u in g d e clin e , so far in th e 1 9 8 0 s it h as p e rfo rm e d m u ch clo se r to th e n atio n al a v e ra g e . T h e an aly sis su g g e sts b oth th at th e re g io n n o w sh a re s m o re fully in n atio n al e x p a n sio n s an d c o n tra cts less in n atio n al re c e ssio n s, a n d th at reg io n al g ro w th is n o t lim ited to o n e se cto r, su ch as se rv ice s, b ut is b ro a d b ased. SEPTEMBER/OCTOBER 1985 THE HEALTH OF BANKING IN THE THIRD D IS T R IC T ..........................................................3 Thomas K. Desch and Richard W. Lang WORKING PAPER SUMMARY: “ The Effect of Recent Tax Reform Proposals on the Return to Owner-Occupied H ou sing".................................................................................12 Theodore Crone THE PHILADELPHIA AREA ECONOMY: Faster Growth in the 198 0 s?...................................... 13 John M. L. Gruenstein by th e tw elve regional banks located a ro u n d th e nation as well D epartm ent of R esearch ev ery o th er m on th . It is edited as the B oard of G o v ern o rs in W ashington. T h e Federal by Ju d ith F a rn b a ch . A rtw o rk is d ire cte d b y R on ald B. R e se rv e S y stem w as estab lish ed b y C o n g re s s in 1 9 1 3 W illiam s, w ith th e a ssista n ce o f D ian n e H allow ell. p rim arily to m a n a g e th e n atio n 's m o n e ta ry affairs. T h e B U S IN E S S R E V IE W is p u b lish ed T h e v iew s e x p re s s e d h e re in a re n o t n e ce ssa rily th o se Supporting functions include clearing checks, providing of this Ban k o r o f th e F e d e ra l R e se rv e S y stem . T h e co in an d c u rre n c y to th e b an k in g sy ste m , actin g as R ev iew is availab le w ith o u t ch a rg e . b an k er fo r th e F e d e ra l g o v e rn m e n t, su p erv isin g co m m e rc ia l banks, an d e n fo rcin g c o n s u m e r cre d it P le a se se n d su b scrip tio n o rd e rs an d ch a n g e s of a d d re ss to th e D e p a rtm e n t o f R e se a rch at th e a b o v e p ro te c tio n law s. In k eep in g w ith th e F e d e ra l R e se rv e a d d re ss A ct, th e S y s te m is an a g e n c y o f th e C o n g re s s , in or te le p h o n e (2 1 5 ) 5 7 4 -6 4 2 8 . E ditorial co m m u n icatio n s also sh ould b e sen t to the D epartm ent d e p e n d e n t a d m in istrativ ely o f th e E x e cu tiv e B ran ch , of R esearch o r telep h o n e (2 1 5 ) 5 7 4 -3 8 0 5 . R equests for an d in su lated fro m p artisan p o litical p re ssu re s. T h e ad d itio n al co p ie s sh o u ld be se n t to th e D e p a rtm e n t of F ed eral R eserv e is self-su p p o rtin g an d reg u larly P u b lic S e rv ice s. m ak es p a y m e n ts to th e U n ited S tates T reasu ry fro m T h e F e d e ra l R e se rv e B an k of P h ilad elp h ia is p art of the Federal R eserv e S y stem — a S ystem w hich includes its o p eratin g su rp lu ses. The Health of Banking in the Third District Thomas K. Desch and Richard W. Lang* INTRODUCTION The rising number of bank failures since 1981 has fueled concern about the health of the bank ing industry. Between 1981 and 1984, more than 150 FDIC-insured banks failed. In 1984 alone, 79 banks failed—a level not approached since 1938 (Figure 1, p. 4 ).1 News reports have been *Thomas K. Desch is the Senior Vice President of the Super vision and Regulation Department and Richard W. Lang is the Senior Vice President and Director of the Economic Research Department at the Federal Reserve Bank of Philadelphia. The authors wish to thank Mark Denesevich, Diane Mayer, and Eric Sonnheim for their able research assistance on this paper. ^Bank failure data used in this article are failures of FDICinsured banks, which include some savings banks as well as widespread that banks are troubled with loan losses and a general deterioration in their condi tion. One of the explanations for this state of affairs revolves around changes in the economic environment. Declining prices in the energy industry, problems in the agricultural sector, and poor economic performance by foreign commercial banks. These data include both payoffs and purchase and assumptions. The data do not include failures of savings and loans or credit unions. It should be noted that the high number of bank failures over the past few years cannot be attributed to the general econom ic and deregulatory environment alone. According to Attorney General Edwin M eese 3rd, bank fraud was a factor in more than half of the bank failures in recent years. See Leslie Maitland Werner, "U.S. Drive on Bank Fraud Set," Wall Street Journal (April 3 ,1 9 8 5 ), p. D-6. 3 SEPTEMBER/OCTOBER 1985 BUSINESS REVIEW FIGURE 1 INSURED BANK FAILURES NOTE: Failures of FDIC-insured commercial banks and savings banks. These data do not include failures of savings and loans or credit unions. SOURCE: Annual Report of the FDIC, 1984. debtors have translated into substantial losses for banks on energy loans, agricultural loans, and international loans. A nother prominent ex planation in news reports involves the trend toward financial deregulation, which has ex posed banks to stiffer competition for both de positors and loan customers. Despite these widespread reports of problems in the banking industry, only one FDIC-insured bank failed in the Third Federal Reserve District during 1981-84 when bank failures were rising rapidly for the nation as a whole.2 Indeed, a look 2The Third Federal Reserve District includes the eastern two-thirds of Pennsylvania, the southern half of New Jersey, and the state of Delaware. 4 at several measures of bank soundness and per formance reveals that the health of banks in the Third District has not deteriorated during the past few years and compares favorably with banks nationally. These measures help explain the success of Third District banks in adjusting to recent changes in the economic and regulatory environments. BANKS' HEALTH IN A CHANGING ENVIRONMENT The health of the banking system certainly depends in part on the health of the national economy, just as the health of individual banks is tied to the health of the region's economy in which the bank does most of its business. Banks' FEDERAL RESERVE BANK OF PHILADELPHIA Thomas K. Desch & Richard W. Lang Health of Banking problems with deteriorating loan quality can be traced in part to the rising number of business bankruptcies resulting from the recessions of 1980 and 1982 (Figure 2). A rise in bankruptcies in the early stages of a recovery from a recession is typical in business cycles. As a result of this increase in bankruptcies, banks faced a rise in nonperforming loans—loans to businesses that are not being repaid on schedule—as well as outright losses on some business loans—called loan chargeoffs. Banks that have many of their loans turn sour find that their own health can deteriorate quite quickly.3 In the early 1980s, business bankruptcies increased even more sharply than usual in an economic recovery for several reasons. In addi tion to back-to-back recessions in 1980 and 1982—the latter of which was one of the most severe recessions in the post-World War II period—the economy in the 1980s has been experiencing a prolonged period of historically high real interest rates (that is, interest rates adjusted for expected inflation). Furthermore, some sectors of the economy suffered special problems and did not share equally in the eco nomic recovery that began at the end of 1982. Energy conservation measures that reduced energy demand and declining energy prices resulted in cash-flow problems for businesses in the energy sector. Falling agricultural prices reduced farm income and land values. In many other industries, the rise in the value of the dollar on foreign exchange markets after 1980 increased foreign competition with U.S. pro ducers and led to a rising trade deficit. Despite an increase in consumer and business spending between late 1982 and m id-1984 that was the strongest during the first 18 months of an eco nomic recovery since 1949-50, foreign compe tition took away sales from U.S. manufacturers in domestic markets, reduced their exports, helped to hold down their prices, and thereby narrowed their profit margins. All of these factors help to explain why some sectors of the economy found it more difficult to recover from the reces sions of the early 1980s, and why banks that lent to firms in these sectors found the quality of their loans deteriorating despite the economic recovery that began in late 1982. Banks in 1982 also found that changing eco nomic conditions in other countries affected the quality of their loan portfolios. The international debt problems of several Latin American, East European, and Southeast Asian nations came to a head in 1982 and 1983, contributing to the overall deterioration in the condition of some U.S. banks by increasing their nonperforming loans. In addition to the problems tied to general economic conditions in the early 1980s, the bank ing industry also faced an increasingly competi tive environment that was spurred by deregu lation. Since 1980, deposit interest rates have FIGURE 2 BUSINESS FAILURES U. S. TOTAL 30.000 25.000 20.000 15.000 10.000 5,000 0 3Gary Gorton has shown that, historically, business bank ruptcies have been good indicators for predicting bank fail ures. See Gary Gorton, "Bank Suspension of Convertibility," Journal of Monetary Economics (March 1985), and "Banking Panics and Business Cycles," Federal Reserve Bank of Phila delphia Working Paper, forthcoming. 1978 1979 1980 1981 1982 1983 SOURCE: Dun and Bradstreet. (1984 data are not comparable to earlier data and are not available.) 5 BUSINESS REVIEW SEPTEMBER/OCTOBER 1985 been progressively deregulated and barriers to more difficult for weaker financial institutions to competition among financial institutions for both survive because of increased competition. Despite the problems facing the banking assets and liabilities have been reduced.4 Banks and other depository financial institutions found industry during the past three years, not all parts in the late 1970s that money market mutual of the U.S. suffered them to the same degree. funds were competing vigorously for depositors' Although the geographic distribution of bank funds. This was primarily because banks faced failures is fairly widespread (Figure 3), there are regulated ceilings on the interest rates they could some areas of the U.S. that have had fewer than pay depositors, whereas the interest rates that their share of failures given the number of banks could be paid on money market mutual funds in those regions. This has been the case in the were unregulated. To free banks and other de Third Federal Reserve District. pository institutions from this competitive dis advantage, Congress deregulated deposit interest COMPARING HEALTH OF THIRD DISTRICT BANKS rates in several steps, which resulted in the nation TO THE NATION wide introduction of NOW accounts in 1980, Banks in the Third District have not experi and of MMDAs in late 1982 and Super-NOW s in enced the rising number of failures that banks early 1983. At the same time that Congress pro have nationally. In fact, an examination of some vided for the deregulation of deposit interest of the measures used to profile banks' health rates, it also permitted other depository insti shows that, on average, the condition of Third tutions, such as savings and loan associations District banks in the early 1980s did not dete and credit unions, to offer transaction accounts riorate significantly and that Third District banks in competition with banks and to make a wider generally were healthier than the national range of consumer and commercial loans. In average. These measures include asset quality, creased competition for both deposits and loans has meant that banks have had FIGURE 3 to run harder just to stay in place in terms of their market BANK FAILURES BY STATE THREE YEAR TOTAL 1 9 8 2 -1 9 8 4 shares and profit margins. So although deregulation brought opportunities, it also made it 4 For a discussion of interest rate de regulation, see Herb Taylor "The Return Banks Have Paid on NOW Accounts," this Business Review (July/August 1984). For a discussion of deregulation of barri ers to competition for assets and liabili ties, see Janice Moulton, "Delaware Moves Toward Interstate Banking: A Look at the FCDA," this Business Review (July/August 1983), Jan Loeys, "Deregu lation: A New Future for Thrifts," this Business Review (January/February 1983), and Janice Moulton, "Antitrust Implications of Thrifts' Expanded Com mercial Loan Pow ers," this Business Review (Septem ber/O ctober 1984). 6 NOTE: The 3 failures in New Jersey were not in the Third District. FEDERAL RESERVE BANK OF PHILADELPHIA Health of Banking Thomas K. Desch & Richard W. Lang earnings, capital adequacy, and liquidity.5 to absorb such loan losses when they do occur. Asset Quality. Third District banks managed The ability to absorb such losses depends both on to avoid the severe deterioration in loan quality banks' earnings performance—that is, whether observed nationally. As a percent of total loans, current earnings can cover such losses—and on net loan losses (chargeoffs less recoveries) for their capital position—that is, whether the bank has sufficient capital to cover such losses. the nation roughly doubled between 1981 and Earnings. Although the deregulation of de 1984 (Figure 4). Although this loan-loss ratio for posit interest rates and heavier competition for Third District banks began the decade at a level loans and deposits in the early 1980s helped to above the national average, the District banks' increase banks' interest expense, banks' interest ratio has not been rising during the past few income was increasing at the same time. In fact, years. Consequently, this ratio has remained for the nation as a whole during this period, net below the national average since 1982, and at interest margins (that is, net interest income as a the end of 1984 was only about half that of the percent of average assets) were quite stable national average. (Figure 5, p. 8). But even though banks in the A major reason for a better loan-loss experi Third District have maintained higher net interest ence in the Third District is that the region's margins than the national average in the early economy has a diversified base of manufactur 1980s, their margins have declined because ining, service, and agricultural firms. Consequently, banks in this region generally have been able to avoid concen FIGURE 4 trating their loan portfolios in NET LOAN LOSSES AS A PERCENT one sector or industry. Diver sification of banks' loan port OF NET LOANS AND LEASES folios helps to cushion shocks coming from any one sector or Third District U.S. industry, such as from energy loans, agricultural loans, or in Percent ternational loans. Although Third District banks 0.60 have avoided an increasing loan-loss ratio over the past sev eral years, another aspect of banks' health to consider is whether they are in a position 5Bank regulators construct a detailed profile of a bank's health based on what is called the CAMEL rating system. The CAMEL acronym stands for Capital adequacy, Asset quality, Management, Earnings, and Liquidity. For a discus sion of the CAMEL rating system, see "Warning Lights for Bank Soundness: Special Issue on Commercial Bank Sur veillance," Federal Reserve Bank of Atlanta Economic Review (November 1983). 1980 1981 1982 1983 1984 Loan chargeoffs less loan recoveries expressed as a percent of net loans and leases. SOURCE: Federal Financial Institutions Examination Council Quarterly Reports of Condition and Income for Insured Commercial Banks. 7 SEPTEM BER/OCTOBER 1985 BUSINESS REVIEW FIGURE 5 NET INTEREST MARGIN H i Third District U.S. Percent of Assets 4.50 4.00 3.50 3.00 1980 1981 1982 1983 1984 NOTE: Net interest margin is calculated as the difference between interest income (adjusted for taxable equivalence on tax-exempt state and local securities) and interest expense, expressed as a percent of the beginningand end-of-year assets. SOURCE: See Figure 4. FIGURE 6 RETURN ON ASSETS Percent 0.80 0.60 0.40 0.20 0.00 1980 1981 1982 1983 1984 NOTE: Return on Assets is calculated as net income as a percent of the average of the beginning- and end-of-year assets. SOURCE: See Figure 4. 8 terest income in the Third Dis trict did not increase as much as interest expense. This nar rowing of the net interest mar gin for Third District banks has been more than offset, however, by an improvement in the dif ference between noninterest in come and expenses less taxes and extraordinary items. Conse quently, earnings at Third Dis trict banks were somewhat stronger in the early 1980s than were banks' earnings in other parts of the nation. In fact, the return on average assets for Third District banks has been increasing since 1981, whereas it has been declining for banks nationally (Figure 6). The de cline in return on average assets (ROA) in the national figures cannot be explained by the change in net interest margins. Instead, the decline in ROA na tionally is primarily the result of mounting loan losses—both increased loan chargeoffs and additions to loan loss reserves in the expectation of future chargeoffs. Excluding such loan loss figures, banks' earnings na tionally improved slightly be tween 1981 and 1984, although they improved even more in the Third District. So Third Dis trict banks have been better positioned to absorb additional loan losses than have banks in other parts of the nation.6 Capital Adequacy. Banks' pri- 6From these data, it appears that the claim that deregulation of deposit rates would result in a large drop in banks' FEDERAL RESERVE BANK OF PHILADELPHIA Health of Banking Thomas K. Desch & Richard W. Lang mary capital represents funds put up by stock holders of the bank (equity capital), as well as funds set aside in a reserve to cover loan losses (loan loss reserves).7 Because of poorer loan quality the past several years, banks nationally and in the Third District have increased their loan-loss reserves as a share of their total capital position in order to be in a better position to earnings has not been supported by actual declines in net interest margins nationally. One explanation for this is that increased interest expenses stemming from deregulation were offset by the acquisition of higher yielding, riskier assets which later contributed to the rise in loan losses and the decline in profits. Net interest margins did decline in the Third District, however, and loan losses have not been rising in step with the national figures, suggesting that Third District banks followed a m ore conservative strategy in acquiring assets in response to rising interest expenses during the early 1980s. For more discussion of the effects of deregulation on banks' profitability, see Michael C. Keeley and Gary C. Zimmerman, "Deregulation and Bank Profitability," Federal Reserve Bank of San Francisco Weekly Letter, July 13, 1984, and Mark J. Flannery, "Removing Deposit Rate Ceilings: How Will Bank Profits Fare?" this Business Review (M arch/ April 1983), pp. 13-21. 7For regulatory purposes, primary capital also includes mandatory convertible debt outstanding and the bank's minority interests in consolidated subsidiaries. absorb loan losses. As a percent of total assets, Third District banks' average loan-loss reserves increased from 0.62 percent in 1980 to 0.74 per cent in 1984, while nationally this average rose from 0.54 percent to 0.74 percent (Table 1). In addition, banks nationally have been increasing their equity capital as a percent of total assets. Partly this has occurred in response to the urgings of the various bank regulators. In fact, all of the federal bank regulators have recently announced higher minimum standards for banks' capitalasset ratios.8 The ratios of primary capital to assets have been on an upward trend in the early 1980s for both the District and the nation, with the excep tion of one year, 1984, in which Third District banks' average capital-asset ratio declined (Table 1). This decline in 1984 was due largely to the early retirement of a special assistance package to one large bank, rather than to a general decline 8The new capital-asset ratio set by the Comptroller of the Currency and the FDIC is 6 percent, up from 5ty2 percent. The Federal Reserve has adopted similar guidelines, although the exact definition of what can be counted to meet die capital guidelines is somewhat different. TABLE 1 PRIMARY CAPITAL RATIOS (As Percent of Total Assets) 1980 Loan-Loss Reserves Equity Capital Primary Capital 1981 1982 1983 1984 0.54 0.62 0.56 0.63 0.60 0.62 0.66 0.67 0.74 0.74 |Third District 5.79 6.37 5.81 6.65 5.85 6.72 6.00 6.91 6.15 6.72 U.S. Third District 6.33 6.99 6.37 7.28 6.46 7.34 6.65 7.59 6.89 7.46 | U.S. j Third District lu.s. NOTE: The primary capital ratio is the sum of the loan-loss reserve ratio and the equity capital ratio. SOURCE: See Figure 4. 9 BUSINESS REVIEW in the capital-asset ratios at many of the region's banks. Despite this decline, Third District banks' capital-asset ratios have been higher than the national average throughout the 1980s. On the whole, then, Third District banks' capital has been in a good position, relative to the national average, to cover unexpected loan chargeoffs. Liquidity. Another yardstick by which to assess a bank's ability to withstand a sudden deteriora tion in loan quality or a sudden loss of its deposi tors' confidence is generally referred to as a bank's liquidity—that is, its ability either to con vert quickly some of its assets into cash or to maintain a stable source of funding its assets. Since a bank's loans are generally less easily converted into cash (that is, less liquid) than its securities holdings (particularly short-term securities), one measure of liquidity is the ratio of loans and leases to total assets. The higher this ratio, the less liquid the bank's assets. Between 1980 and 1983, the loans-to-totalassets ratio decreased slightly for Third District banks while rising slightly for the nation (Figure 7a). Although the changes were not very large, this measure suggests that Third District banks' liquidity increased slightly over the 1980-83 period compared to the national average. The reversal of this situation in 1984 was primarily the result of the increasing numbers of new, rapidly growing banks in Delaware. These insti tutions are limited purpose banks that specialize in credit card or commercial lending, and conse quently they maintain higher loans-to-assets ratios than full service banks.9 As these institu tions expanded in 1984, they pulled up the over all loan-to-asset ratio for the District. Another aspect of liquidity can be assessed by looking also at the banks' liability structure. Banks that have raised most of their funds from stable sources of deposits, such as savings and small time deposits, have a stronger base on which to 9For more information about these limited purpose banks in Delaware, see Moulton, "Delaware Moves Toward Inter state Banking: A Look at the FCD A," this Business Review (July/August 1983). 10 SEPTEMBER/OCTOBER 1985 increase their assets than those banks whose major sources of funds are more volatile liabili ties, such as short-term certificates of deposit sold overseas or overnight federal funds pur chases. Such liabilities are called "volatile" because they tend to be sensitive to interest rate fluctuations and to swings in their holders' confi dence about the bank since they are uninsured. Therefore, banks with a higher ratio of what are called core deposits to their total assets would be less subject to sudden shifts of depositors' con fidence or to interest rates than banks with lower core-deposit-to-total-asset ratios.10 This core deposit ratio has been higher for Third District banks than the national average during the early 1980s (Figure 7b). In fact, the core deposit ratios for the nation and the District declined somewhat between 1979 and 1982 when market interest rates were substantially above the ceiling interest rates on core deposits. This decline was not reversed until money market deposit accounts were introduced at the end of 1982. The District's higher core-deposit ratio suggests that Third District banks had a more stable source of funding their asset growth, and in particular their loan growth, in the early 1980s than did banks in other parts of the nation.11 This point is made clearer by examining the ratio of loans to banks' total sources of funds (Figure 7c) along with the first two ratios. Banks' total sources of funds is simply the sum of their core deposits and volatile liabilities. Although the mix of funding for banks nationally between ^ C o r e deposits include all demand and savings deposits, money market deposit accounts, NOW and Super-NOW accounts, and time deposits in amounts less than $100,000; volatile liabilities include all time deposits in amounts of $100,000 or more, deposits of foreign offices, federal funds purchased, securities sold under agreements to repurchase, interest-bearing demand notes issued to the U.S. Treasury, and other liabilities for borrowed money. n The same conclusion emerges from comparing the ratios of volatile liabilities to total assets for the Third District and the nation. It should be noted that the increasing num bers of new, rapidly growing limited purpose banks in Dela ware pulls down the core-deposit-to-assets ratio for the Third District banks in 1984. FEDERAL RESERVE BANK OF PHILADELPHIA Health of Banking Thomas K. Desch & Richard W. Lang FIGURE 7a NET LOANS AND LEASES TO TOTAL ASSETS Third District U.S. Percent 60 1980 1981 1982 1983 1984 Total loans and leases less reserves for loan losses expressed as a percent of total assets. FIGURE 7b CORE DEPOSITS TO TOTAL ASSETS Percent 70 65 60 55 Total domestic deposits less large CDs (over $100,000) as a percent of total assets. FIGURE 7c LOANS AND LEASES TO TOTAL SOURCES OF FUNDS Percent 70 65 60 j ■ 55 50 1980 1981 1982 1983 1984 1980 and 1983 was shifting away from core de posits toward more volatile liabilities, their loansto-total-sources-of-funds ratio changed little, while this ratio declined for Third District banks between 1980 and 1982. Combining this with the changes in the core deposit and loan-toasset ratios shows that banks nationally were funding their less-liquid assets (loans) with more volatile sources of funds. Third District banks between 1980 and 1982 were decreasing the share of loans in their total asset structure, were decreasing loans relative to their total sources of funds, and were not increasing their funding of their loans through the use of more volatile sources of funds. In sum, Third District banks maintained a better liquidity position than the national average in the early 1980s. SUMMARY Despite widespread problems in the banking industry due to the changing economic and deregulatory environments in the early 1980s, the condition of Third District banks did not deterio rate substantially over the past several years. Indeed, a comparison of measures used to profile banks' health reveals that Third District banks generally have been in good condition and com pare favorably to banks nationally. This better health in the early 1980s was reflected in better loan quality, solid earnings performance, higher capital ratios, and a better overall liquidity posi tion. As a result, Third District banks have been better able to adjust to recent changes in the economic and regulatory environments than have banks in other parts of the nation. This undoubtedly has helped banks in this region to avoid the financial difficulties that have plagued banks in other parts of the country during the past several years. Net loans and leases as a percent of the sum of: domestic and foreign deposits, federal funds purchased, securities sold under agreement to repurchase, U.S. notes and other borrowings, less cash items in the process of collection. SOURCE: See Figure 4. 11 Philadelphia/RESEARCH — BM— Working Paper No. 85- Summary The Research Department of the Federal Reserve Bank of Philadelphia occasionally publishes working papers based on the current research of staff economists. These papers deal with virtually all areas within economics and finance. From time to time, the results of studies that are of general interest are summarized in the Business Review. The analyses and conclusions expressed are solely those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or of the Federal Reserve System. A list of all available papers may be ordered from WORKING PAPERS, Department of Research, Federal Reserve Bank of Philadelphia, 10 Independence Mall, Philadelphia, Pennsylvania, 19106. Single copies of papers may be ordered from the same address. For overseas airmail requests only, a $2.00 per copy prepayment is required. The Effect of Recent Tax Reform Proposals on the Return to Owner-Occupied Housing Theodore Crone Three major tax reform proposals have recently been pre sented to the Congress: Bradley-Gephardt (S.409); KempKasten (H.R.777); and an Administration proposal. This work ing paper examines the effect of these three proposals on the homeownership decision. By altering the tax advantages to homeownership, all three proposals would increase the user cost of owner-occupied housing. This has raised concerns that the reforms would also lower the homeownership rate in the U.S., that is, the proportion of households who own their principal place of residence rather than rent. In this paper, the homeownership decision is analyzed as an investment decision in which a household invests its accumulated wealth in that asset which promises the highest after-tax rate of return. This return will be dependent upon the tax advantages of homeowners as well as on the implicit rent they receive from their property. A number of provisions in the three proposals would lower the value of the current tax advantages enjoyed by homeowners, thus raising the cost of owning a home. These include a reduction in marginal tax rates, an increase in the standard deduction, the elimination of some non-housing deductions, and, in the Administration proposal, the elimination of the deduction for state and local property taxes. The yearly economic cost of owning a home is the sum of mortgage pay ments, maintenance costs, property taxes, and forgone in terest on equity minus capital gains. Let us consider a threeperson household with one wage earner and an annual income of $40,000 who buys an $80,000 house with a 20 percent down payment. With the interest rates that prevailed in January 1985 and under the assumption of a 5 percent inflation rate, the after-tax economic cost of living in this home for the first year would be $7,391 under the current tax law. This cost would rise by 23 percent under BradleyGephardt, by 8 percent under Kemp-Kasten, and by 20 percent under the Administration proposal. These estimated increases presume no change in interest rates or rents as a result of changes in the tax law. However, both interest rates and rents can be expected to change if any of the tax reform proposals becomes law. A reduction in marginal tax rates is likely to reduce the equilibrium interest rate by the amount that would keep the after-tax rate for the marginal borrower unchanged. This would imply a 7 percent reduction in the rates which prevailed in January 1985. 12 There are also provisions in each of the tax reform pro posals which would increase rents. These provisions include lower marginal tax rates for landlords, an increase in the capital gains tax rate, and, in the Administration proposal, a longer depreciation period. Others have estimated that rents would rise by 6 percent under Kemp-Kasten and by 10 percent under Bradley-Gephardt or the Administration pro posal. While rent increases do not affect the cost of homeownership, they will influence the homeownership decision since the untaxed imputed rent which the homeowner enjoys represents a major portion of the return on his investment. The homeownership decision in this study is viewed as a choice between alternative investments, in this case between owner-occupied housing and government securities. Based on a ten-year expected length of residence, the critical income level above which a three-person household would fare better by investing in an owner-occupied house under current law is $30,000. With no changes in interest rates or rents this critical income level would rise to $68,000 under Kemp-Kasten or the Administration proposals. Under Bradley-Gephardt this household would fare better by investing in a home only if its expected length of stay were 17 years and its income $71,000 or more. The longer length of stay required under Bradley-Gephardt is due to the fact that the major tax advan tages come later in the period of residence because the repeal of indexation increases real marginal tax rates over time. If we assume that market interest rates fall by 7 percent because of the adoption of any of the reform proposals and that rents rise by 6 percent under Kemp-Kasten and by 10 percent under the other two proposals, the critical income level for our hypothetical three-person household falls dramatically. For Kemp-Kasten it is $24,000, for BradleyGephardt it is $30,000, and for the Administration proposal it is $33,000. Even though the after-tax cost of homeownership would rise under any of the proposed tax reforms, the results of this study suggest that because of offsetting effects from lower interest rates and higher rents the homeownership rate may actually increase under Kemp-Kasten or BradleyGephardt and decline only slightly under the Administration proposal. FEDERAL RESERVE BANK OF PHILADELPHIA The Philadelphia Area Economy: Faster Growth in the 1980s? John M. L. Gruenstein* In the 1970s, economic growth in the Phila delphia area was slow, both absolutely and rela tive to the nation as a whole. Payroll employment growth, a commonly used measure of regional economic activity, lagged far behind the rest of the country. This, in turn, helped push the unemployment rate in the region significantly above the national average. By the end of the decade there were worries that the region was *John M. L. Gruenstein is a Vice President and Economist in the Research Department at the Federal Reserve Bank of Philadelphia. locked into a downward spiral of self-reinforcing slow growth, destined to be outperformed by booming areas elsewhere, especially in the South and West. So far in the 1980s, the region's economy has shown a fairly small increase in absolute growth rates, but a very large increase relative to the nation. The large gap between annual average employment growth in the nation and in the region that characterized the 1970s has been greatly reduced. The region's unemployment rate has dipped below the U.S. average, and income is growing faster regionally than nation ally. 13 BUSINESS REVIEW SEPTEM BER/OCTOBER 1985 Whether the upturn in absolute and relative the Philadelphia metropolitan area's economic growth rates of regional economic indicators performance in the 1980s is its sharp improve will persist is of concern to a variety of groups ment relative to the nation since the 1970s. While with interests in the region. Local bankers, for the change in the absolute performance of the instance, want to keep an eye on potential future region between the two periods included some growth in loans and deposits, and on how this gains, a variety of commonly used economic indi market will compare to others around the country. cators all showed much smaller gaps between Real estate investors want to judge the level of the region and the nation in the 1980s. Absolute Performance Mixed. Measures of new office and industrial development that is sustainable here, again in both absolute terms both employment and income for the Phila and relative to the rest of the nation. Policy delphia Primary Metropolitan Statistical Area makers want to be able to plan for changes in (PMSA) indicate that there was faster growth in services and in the tax base, and to assess the the 1980s than in the 1970s, although in some effect of local economic development initiatives cases the change was not very large (Table l ) . 1 on local employment growth and unemploy ment rates. Future rates of growth in bank loans, ^The PhUadelphia PMSA includes Philadelphia, Bucks, deposits, office and industrial space, taxes, and Chester, Delaware, and Montgomery counties in Pennsyl public services are all related to future rates of vania and Burlington, Camden, and Gloucester counties in growth of general regional economic indicators, New Jersey. such as employment. Different explanations about TABLE 1 what underlies the upturn lead GROWTH IN THE PHILADELPHIA PMSA to different expectations about THE 1970s VERSUS THE 1980s its continuation. One possible Percentage Growth explanation for the upturn in (Average Annual Rate) Difference relative performance is the re gion's reaction to the longer 1970s 1980s period of recessions in the 1980s +0.7 +0.8 Payroll Employment +0.1 than in the 1970s. A second Residential Employment +0.9 + 1.2 +0.3 explanation often mentioned is the shift of employment from + 1.0 Real Personal Income +2.0 + 1.0 the slow-growing manufactur + 1.7 +0.5 + 1.2 Real Income Per Capita ing sector to the fast-growing Unemployment Rate (level) 6.8 8.6 + 1.8 service sector in the region and the nation. Trying to assess the -0.2 Population3 +0.3 +0.5 relative importance of these two factors gives some insight into the likely persistence of the NOTE: For employment and unemployment, the 1980s include Jan. 1980 to turnaround in the region's rela Feb. 1985. Data are seasonally adjusted. For income, income per capita, and tive economic performance. population, data are annual averages, and the 1980s include 1980 to 1983. REGIONAL ECONOMIC PERFORMANCE: THE 1970s VERSUS THE 1980s The most striking aspect of 14 The deflator for both Philadelphia income and U.S. income is the U.S. Consumer Price Index for all urban workers, which is not available separately for Philadelphia for 1970. P op u latio n is included in order to give information about the differences between income and income per capita, and employment and unemploy ment. FEDERAL RESERVE BANK OF PHILADELPHIA Philadelphia Economy in the 1980s Two measures of regional employment flashed mildly positive signs in the first half of the 1980s: both payroll employment and residential employ ment recorded some acceleration in growth between the 1970s and the early 1980s. Employ ment is the summary indicator most commonly used by regional economists to measure the performance of metropolitan area economies. Employment is fairly well correlated with over all regional economic production (also termed Gross Regional Product, a statistic which is not consistently available for metropolitan areas), and employment is available on a much more timely basis than income.2 The differences between the two employment measures stem 2Currently Gross Regional Product figures are not avail able for the Philadelphia PMSA. In the past they were esti mated by W harton Econometric Forecasting Associates (quarterly), and by the City Economist for the City of Phila delphia (annually). Both sets of estimates were based primar ily on payroll employment data. John M. L. Gruenstein from a variety of factors; a good part of the faster growth in residential employment in recent years probably reflects larger percentage gains in the number of self-employed people compared to those on company payrolls. (See MEASURING EMPLOYMENT: A JOB IS A JOB IS A JOB?) Data on income growth gave a more favorable reading. Between 1980 and 1983, the last year for which data are available, total real personal income grew at a 2.0 percent annual rate—double the 1.0 percent rate of the prior decade. Total real income grew faster than employment prin cipally because of faster growth in non-labor incom e—dividends, interest, rent, and transfer payments—rather than growth in wages and salaries. Per capita income growth also acceler ated, but at a slower rate than total income, because of a rise in population in the 1980s compared to a loss in the 1970s. Unemployment was up, a negative signal. Despite the fact that employment growth ex ceeded population growth, the 1980s marked a MEASURING EM PLOYMENT: A JOB IS A JOB IS A JOB? There are two generally available monthly employment series for the Philadelphia PMSA, payroll employment and residential employment. While these two series give about the same picture for the region's performance relative to the nation, they have significant differences in definition and coverage. The payroll employment series (also referred to as the establishment or nonagricultural series) is derived from a monthly survey of a sample of business establishments conducted in conjunction with the state unemployment compensation program. The residential employment series (also referred to as the household survey) is derived from the monthly Current Population Survey of households. There are a number of conceptual and practical differences between the two series. Payroll employment does not include the self-employed, unpaid family workers, domestic workers, and workers absent from their jobs without pay. All are included in the residential series. Payroll employment measures employment by place of work, whereas residential employment measures it by place of residence, so commuters into or out of the metropolitan area would cause a divergence between the two series. Multiple jobholders are counted more than once in the payroll series, but only once in the residential series. Only workers over 16 are included in the residential series, but workers of all ages are included in the payroll series. Finally, since each series is derived from a sample, each is subject to variations in the particular sample drawn, which may be different from the entire group of business establishments and households. Since the samples for the two surveys are totally different, this sampling variation would also be different for the two groups. For more information about the difference between the two series, see John F. Stinson, Jr., "Comparison of Nonagricultural Employment Estimates from Two Surveys," Employment and Earnings, March, 1984 and Gloria P. Green," Comparing Employment Estimates from Household and Payroll Surveys," Monthly Labor Review, December, 1969. 15 BUSINESS REVIEW hefty increase in the local unemployment rate.3 The rise was caused by a larger percentage of the population entering the labor force in the 1980s. Broad Relative Improvement. Judging the Philadelphia area's econom y in isolation gives a somewhat misleading picture of the region's underlying economic performance, however. As with all regions, the Philadelphia area's eco nomic fate is linked closely to that of the national economy. One linkage is through demand for locally produced products. According to esti mates by Professor Anita Summers of the Wharton School of the University of Pennsyl vania, almost 90 percent of this area's manufac turing output and 25 percent of its non manufacturing output is sold outside the region, fairly typical figures for regions of this size.4 Because of this strong demand-side linkage, the region's economy is greatly affected by national business cycles. Other examples of linkages are through national demographic shifts and national government policies, both of which have had strong impacts on unemployment rates and the growth of different income components.5 Look 3 As with employment data, there is more than one source for unemployment data. The series presented in the text is an annual average of Current Population Survey data, which is the basis for the U.S. rate; this is generally regarded as the most accurate figure for unemployment on an annual basis. A second series, which is prepared monthly by the Pennsyl vania State Office of Employment Security from a survey of firms, shows an even more dramatic regional turnaround, with the Philadelphia rate falling below the U.S. rate at the very beginning of the 1980s. 4 See Anita A. Summers and Thomas F. Luce, Economic Report on the Philadelphia Metropolitan Area, 1985 (Philadelphia: University of Pennsylvania Press, 1985). 5Thus, national comparisons can help adjust for changes over time in the way some regional econom ic indicators reflect actual underlying conditions. High unemployment rates in many regions of the U.S. over the last ten years, for example, probably reflect much more than specifically re gional economic conditions; rather, high rates are related to a host of nationwide factors, including changes in the age structure of the population, increased participation of women in the labor force, changes in regulations regarding unemploy ment compensation and welfare, and cultural attitudes. For 16 SEPTEMBER/OCTOBER 1985 ing at the Philadelphia area economy's perform ance relative to the national economy's helps separate out national from local economic factors and shows a very clear picture of improvement in the early 1980s. A common way to compare the region's per formance to the nation's over time is to look at the gap—that is, the difference—between the national rate of growth of some measure of eco nomic activity, like employment or income, and the regional growth rate for the same indicator.6 Improvement in the region's economic per formance relative to the nation can be defined as a reduction in the resulting gap, if it was negative to begin with, or a change from a negative to a positive gap. Using this definition, all of the commonly used broad economic indicators relay the same message: substantial relative improve ment in the Philadelphia area's economy between the 1970s and the 1980s (Table 2). The payroll employment growth gap between the Philadelphia metropolitan area and the nation has shrunk from 1.8 percentage points per year in the 1970s to only 0.5 percentage points per year during the last five years. Residential em ployment showed virtually the same improve ment relative to the nation as payroll employ ment. Income showed even larger gains relative to the nation than its absolute gains over the period. Total real income grew more slowly in the region than in the nation in the 1970s, but in the early 1980s the gap reversed, with the Philadelphia area outstripping the U.S. The change in relative terms was a gain of 1.7 percentage points, com pared to an absolute improvement of 1.0. Per capita income also reversed a negative gap, to post a 1.1 percentage point per year improve ment relative to the nation, about double its further discussion, see Norman Barrens, "Have Employment Patterns in Recessions Changed?", Monthly Labor Review, February, 1981, pp. 15-28. 6Ratios of growth rates have been calculated for the vari ables examined in this study and the results show a picture similar to those for differences. FEDERAL RESERVE BANK OF PHILADELPHIA Philadelphia Economy in the 1980s )ohn M. L. Gruenstein TABLE 2 PHILADELPHIA PM SA— U.S. REGIONAL GAP Percentage Change (Average Annual Rate) 1970s 1980s Payroll Employment Residential Employment -1.8 -1.4 -0.5 -0.2 Real Personal Income -1.4 +0.3 Real Income Per Capita Unemployment Rate (level) Population 0.1 + 1.0 +0.6 +0.3 -1.3 -0.7 - NOTE: See Table 1. improvement in absolute terms. Unemployment also showed a large relative improvement in the region, even though in an absolute sense it worsened. During the latter half of the 1970s, the region's unemployment rate remained suspended above the U.S. rate— by as much as 2 percentage points toward the end of the period. This positive gap persisted in 1980 and 1981, but in 1982 the situation turned around dramatically. Over the past three years, the Philadelphia region's unemployment rate has been lower than the nation's, with the differ ence reaching almost a full percentage point by 1984. Overall, the average gap between the Phila delphia area and U.S. unemployment rates shrank from 0.6 percentage points in the 1970s to half that size during the first five years of the current decade. These figures suggest that Philadelphia's per formance improved relative to the nation for all the commonly used broad indicators of economic performance in the first half of the 1980s. But is the improvement likely to persist? The answer to that question hinges on understanding the source of the improvement. Two of the most prominent explanations involve the region's reaction to the national business cycle and the shift of employment from manufacturing to services. And each leads to different expecta tions about the future. PHILADELPHIA'S REACTION TO BUSINESS CYCLES Any region's economy is likely to fluctuate with the nation's— + 1.3 more specifically, the absolute + 1.2 rate of economic growth will + 1.7 rise and fall over the business + 1.1 cycle, almost invariably moving in the same direction as national -0.3 growth. What is less obvious is +0.6 that the pattern of relative per formance—the difference be tween a region's rate of growth and the nation's—may also vary systemically between expansions and contrac tions. The pattern of the Philadelphia area's relative rate of growth over the national business cycle could account for the region's relative improve ment in the early 1980s. Somewhat paradoxically, while the longer period of recessions in the 1980s than in the 1970s probably depressed the region's absolute performance, it could actually have contributed to the area's improved per formance relative to the nation. This is because the Philadelphia area's economic structure is such that historically the gap between national and regional economic growth has been smaller during recessions than during expansions. Smaller Gaps in Recessions. The best com monly available indicator for investigating the cyclical pattern of a metropolitan area's relative economic performance is payroll employment.7 Difference 7 Employment data are available monthly, allowing a more precise division of the period under study into business cycles than annual data such as income, and are also much more up-to-date than income data for metropolitan areas. Payroll employment data are also available as a consistent series for a much longer time period than residential employ ment and unemployment data. 17 BUSINESS REVIEW SEPTEM BER/OCTOBER 1985 In the Philadelphia metropoli TABLE 3 tan area this indicator has shown PAYROLL EMPLOYMENT CHANGE a very consistent pattern relative to the nation (Table 3). The gap EXPANSIONS AND RECESSIONS, between payroll employment 1 9 5 8 -1 9 8 4 growth in the region and the (Average Annual Rate) nation narrows and sometimes even reverses—that is, turns Philadelphia — Date Recessions positive— during recessions or +0.8% 1960s 4/ 60— 2/61 periods of slow national growth. During expansions, however, -0.9% 12/69 — 11/70 1970s the gap widens.8 In fact between -0.6% 11/73— 3/75 1958 and 1985, the gap between employment growth in the Phila +0.8% 1/80— 7/80 1980s delphia region and the nation +0.9% 7/81 — 11/82 has been larger (more negative) during any expansion compared Philadelphia — Date Expansions to any recession. The region's pattern of rela -1.8% 4/ 58— 4/60 1960s tive performance over the busi -1.0% 2/61 — 12/69 ness cycle—smaller gaps in re -2.3% 11/70 — 11/73 1970s cessions and larger gaps in -1.9% 3/75— 1/80 expansions—probably stems from several factors. For one -0.9% 7/ 70— 7/81 1980s thing, Philadelphia's economy 11/82— 2/85 -1.3% is very diversified, and there fore more resistant to swings in particular indus Longer Recessions Key to Relative Improve tries. In addition the Philadelphia area's economy ment? Whatever the reason for the Philadelphia is probably better at retaining jobs in existing firms than it is at generating jobs through ex pansions of area firms, openings of new branch that, in general, the difference between fast- and slowplants, and start-ups of new firms.9 Since more growing areas is that the former have a greater rate of new job generation takes place nationally during ex job creation through expansions of existing firms and open ings of new firms and branch plants. Birch has not looked pansions than recessions, this would tend to en explicitly at business cycle behavior of different places, but large the employment growth gap during ex since more job generation takes place during expansions, his results would seem to imply that the employment growth pansions and reduce it during recessions.10 8This is equivalent to saying that employment in the Philadelphia region is more stable over the business cycle than national employment. 9For a general discussion of this issue, see John M.L. Gruenstein, "Targeting High Tech in the Delaware Valley", this Business Review, May-June, 1984. 10See David Birch, The Job Generation Process, M.I.T. Pro gram on Neighborhood and Regional Change, Final Report to Economic Development Administration, 1979. Birch finds 18 gap between fast- and slow-growing places should be larger during expansions than during contractions. Empirical studies do not show this pattern to be a characteristic of slowgrowing areas generally, however, even though it does clearly describe Philadelphia's reaction to business cycles. Two somewhat different sets of results are presented in Janet Rothenberg Pack, Regional Growth: Historic Perspective (Washington, D.C.: Advisory Council on Intergovern mental Relations, 1980) and Marie Howland, "The Business Cycle and Long-Run Regional G row th" in William C. Wheaton, ed., Interregional Movements and Regional Growth (Washington, D.C.: Urban Institute, 1979). FEDERAL RESERVE BANK OF PHILADELPHIA Philadelphia Economy in the 1980s area's smaller employment growth gaps during recessions than during expansions, this clearcut cyclical pattern may provide the key to the area's improved relative performance during the 1980s. About 36 percent of the time between January 1980 and February 1985 was spent in recession, when the gap usually narrows or reverses. Only 22 percent of the 1970s was spent in recession, however. So Philadelphia's relative improvement in the early 1980s could be due just to the unfortunate fact that substantially more time than in the 1970s was spent in reces sions, periods when the region's relative eco nomic performance generally improves. To the extent that the relative improvement of the 1980s was a result of longer periods of national recession, Philadelphia's relative eco nomic improvement cannot be interpreted as a change for the better in the underlying structure of the local economy. Rather it would represent an unchanged response to external forces. If the second half of the 1980s were to be marked by mostly expansionary periods, this would tend to weaken the area's relative performance once again. Further, this cause of relative improve ment presents a kind of Catch-22—a better rela tive performance due solely to longer recessions would almost certainly imply a worse absolute performance. If this explanation holds, then we should find that the employment growth gaps of the region during the expansions of the 1980s were about the same as during the expansions of the 1970s, and similarly for recessions. But, in fact, the gaps for the expansions of the 1980s were uniformly smaller. The largest gap during the two expan sions of the 1980s, -1.3 percent, was smaller than the smallest gap during the 1970s, -1.9 percent. Comparing recessions from both periods shows an even more striking pattern. In both recessions of the 1970s the Philadelphia region lost jobs at a faster rate than the nation. In the 1980s the oppo site occurred; the Philadelphia region outper formed the nation in the sense that it lost jobs more slowly during recessions. To help settle the issue of how much the longer John M. L. Gruenstein period of recessions in the 1980s added to the Philadelphia area's relative improvement, we can ask a hypothetical question. What would the relative growth rate of employment have been in the early 1980s if the percentage of time spent in recession had been as low as that of the 1970s? The total employment growth gap for each period is the sum of the gaps during the expansions and recessions of that period, weighted according to their length. So the calculation is made by com bining the growth gaps of the 1980s expansions and recessions with the weights of the 1970s. This calculation shows that most of the reduction in the employment growth gap between the two periods would have occurred even if the total time spent in recession in the 1980s had been the same as in the 1970s. The longer period of recessions in the 1980s accounts for less than 25 percent of the reduction in the gap.11 Thus, most of the closure of the relative employ ment growth gap was due to better relative per formance during both expansions and recessions in the early 1980s, rather than just the longer period of recessions characterizing that period. This indicates that the relative improvement is the result of fundamental changes in the struc- 11 To calculate how much the longer period of recessions of the 1980s contributed to the improved relative perform ance of the region, assume that the percentage of time spent in recessions in the early 1980s was 22 percent, as it was in the 1970s, rather than the actual figure of 36 percent. Apply this lower percentage to the average employment growth gap of the 1980s during recessions, which was + 0 .9 percent. Make a similar calculation for the expansions, using the higher percentage of time spent in the expansions of the 1970s, 78 percent, applied to the average employment growth gap during the expansions of the 1980s, -1.1 percent. Add the two results. The sum, -0.8 percent, is the employment growth gap for the 1980s that would have obtained if the percentage of time spent in recession in the early 1980s had been as low as it was in the 1970s. The actual employment growth gap for the early 1980s was -0.5, which is 0.3 percentage points smaller than the -0.8 calculated. Since the actual reduction in the gap from the 1970s to the 1980s was 1.3 percentage points, the longer period of recession in the 1980s accounted for 23 percent (0.3/1.3) of the reduction in the gap. 19 SEPTEM BER/OCTOBER 1985 BUSINESS REVIEW ture of the Philadelphia area's economy relative to the nation, which argues for a greater likeli hood that the relative improvement will persist. SHIFT TO SERVICES One fundamental change that has often been advanced as an explanation for the region's rela tive improvement is the shift of employment from goods-producing industries to servicesproducing industries. This is a trend that has been occurring nationally and regionally, and the shift has been more marked in the Phila delphia area. Changing Industrial Composition. Between 1970 and 1980 the national and regional shares of employment declined for goods-producing industries—generally defined to include con struction, manufacturing, and transportation, communications, and public utilities—and rose for services-producing industries—generally defined to include wholesale and retail trade, finance, insurance, and real estate, general ser vices, and government (Table 4). The sharpest changes were the drop in the share of manu facturing employment and the increase in the share of employment in general services; the latter includes such industries as health, higher education, business services, legal services, per sonal services, repair services, and social ser vices. The changes in shares for the U.S. came about because of much faster growth in services than in manufacturing during the 1970s, whereas the change in shares in Philadelphia reflected a large absolute loss of manufacturing jobs combined with gains in the service sectors (Table 5). In the early 1980s, Philadelphia maintained a relatively unchanged growth pattern, in absolute terms, except for increases in the construction and trade sectors and a drop in the government sector. The U.S., however, changed from a gainer to a loser of jobs in all the goods-producing sectors, at the same time that employment in all the services-producing sectors slowed sharply. The shift of employment shares out of manu facturing and into services in the 1970s, both TABLE 4 SECTORAL COM POSITION OF PHILADELPHIA AND THE U.S. HAS SHIFTED TOWARD SERVICES SECTOR Construction Manufacturing Transportation, Communications, and Public Utilities Trade Finance, Insurance, and Real Estate General Services Government EMPLOYMENT SHARES Philadelphia PMSA U.S. 1970 1980 1985 1970 1980 1985 4.5 31.7 4.1 23.3 4.1 19.9 5.1 28.4 5.1 23.3 4.7 20.4 5.9 20.1 5.2 21.7 4.8 23.0 6.4 21.2 5.8 22.7 5.4 23.8 5.6 17.8 14.5 6.5 23.5 15.7 6.9 27.0 14.4 5.1 16.2 17.5 5.7 19.5 17.9 6.1 22.4 17.3 NOTE: Data are seasonally adjusted for Jan. 1970, Jan. 1980, and Feb. 1985. Mining is excluded for the U.S. For the Philadelphia PMSA, the mining sector is small and is included in General Services. 20 FEDERAL RESERVE BANK OF PHILADELPHIA Philadelphia Economy in the 1980s John M. L Gruenstein nationally and regionally, by itself accounted for some of the narrowing of the total employment growth gap in the 1980s. The growth gap for the services sector was smaller than the manufac turing growth gap—indeed, services was the sector with the smallest gap. Because of this, the shift to services essentially increased the weight given to the smallest gap included in the total employment growth gap. The effect of this shift, then, was to narrow the total employment growth gap, and this would have been the case even if the difference between the sectoral growth rates—that is, the sectoral growth gaps—had remained unchanged.12 Most of Improvement Due to Smaller Sectoral Growth Gaps. Although the shift from manu facturing to services explains part of the relative improvement of the regional economy, most is explained by faster relative rates of growth of the individual sectors in the 1980s. The pattern of sectoral growth gaps (Table 6, p. 22) shows clearly the large impact of faster sectoral growth on the reduction in the total employment growth gap in the early 1980s. The growth rate gaps of all major sectors except government have de clined by substantial amounts over the past five years. More than 80 percent of the overall reduc tion in the total employment growth gap in the 12The exact formula for the total employment gap can be expressed as the weighted (by the regional percentage of employment in each sector) sum of the differences between the regional sectoral growth rates and weighted national sectoral growth rates, where the weight on each national sectoral growth rate is the ratio of the national percentage of employment in that sector to the regional percentage of employment in that sector. The greater relative shift of em ployment from manufacturing to services in the region than in the nation, therefore, would have caused a further reduc tion in the total employment growth gap, over and above that caused by the general shift to services in both the region and the nation. Because the percentage composition of em ployment in the region is close to the nation's, however, the simple difference between the regional and national growth rates provides a close approximation to the more precisely defined gap. TABLE 5 GROWTH RATES OF EM PLOYM ENT BY SECTOR (Average Annual Rate) Sector Philadelphia PMSA U.S. 1970s Construction Manufacturing Transportation, Communications, and Public Utilities Trade Finance, Insurance, and Real Estate General Services Government 1980s 1970s 1980s 0.1 -2.3 +0.5 -2.3 +2.6 +0.4 -0.2 -1.4 -0.5 + 1.5 -0.7 + 1.9 + 1.4 +3.1 +2.2 + 2.2 +3.6 + 1.5 +2.0 +3.5 -0.9 +3.5 +4.4 +2.7 +2.6 +3.9 +0.5 - - 0.1 NOTE: Data are seasonally adjusted for Jan. 1970, Jan. 1980, and Feb. 1985. 21 SEPTEMBER/OCTOBER 1985 BUSINESS REVIEW the two components of the re duction in the total employ ALL PRIVATE SECTORS ment growth gap—the shift to SHOW SMALLER sectors with smaller gaps, like the services, and the reduction EM PLOYM ENT GROWTH GAPS in the sectoral growth gaps themIN THE 1980s selves—be viewed with regard Employment to their impact on future relative Growth Gap performance of the region's Sector Philadelphia — U.S. Difference economy? The shift of employment to 1970s 1980s* wards services represents a fun damental change in the area's +3.4 -2.7 +0.7 Construction -0.9 + 1.9 and the nation's economic struc -2.8 Manufacturing Transportation, ture that is unlikely to be greatly Communications, reversed. If it is not, and as long + 1.3 -1.9 -0.6 and Public Utilities as the individual sectoral gaps + 1.3 -1.6 -0.3 Trade remain about the same, this prior Finance, Insurance, and shift would continue to con +0.7 -0.6 -1.3 Real Estate tribute to a permanent narrow +0.4 -0.4 -0.8 General Services ing of the employment growth - 0.1 -1.2 -1.3 Government difference between the region and the nation, but the contri bution would be limited. *Jan. 8 0 — Feb. 85. The fact that most of the Phila delphia area economy's relative 1980s is accounted for by faster relative growth improvement in the early 1980s was due to of individual sectors, and less than 20 percent is smaller gaps for almost all sectors of the economy, due simply to the shift from goods-producing to rather than a shift from one sector to another, is a cause for greater optimism about the region's services-producing sectors of the 1970s.13 Given their relative contribution, how should future relative performance. It implies that there is no necessary limit on how far the total gap could close, or even reverse. And the across-theboard nature of the sectoral improvement would 13This calculation is made by taking the weighted sum of appear to point to general factors at work rather the 1980 Philadelphia sectoral growth rates, using 1970 than special factors that might be more easily employment shares as weights, and subtracting from it a similar weighted sum calculated for the U.S. The reduction reversed. TABLE 6 in the total employment growth gap calculated this way is what would have occurred if no shift of employment to services-producing sectors had taken place in either Phila delphia or the nation between 1970 and 1980. This hypo thetical reduction is less than 20 percent of the actual reduc tion. A further calculation has been done to assess the effect of simultaneously assigning the sectoral weights and the length of recessions their 1970 values. This shows that combining the two effects simultaneously is approximately the same as adding the two effects together. 22 IN SUM During the early 1980s, the absolute perform ance of the Philadelphia area economy strength ened somewhat (except for a rise in the unem ployment rate), despite a substantial slowdown in the growth rates of employment and income at the national level. The result was a very signifi cant improvement in the Philadelphia region's FEDERAL RESERVE BANK OF PHILADELPHIA Philadelphia Economy in the 1980s economic performance relative to the nation. Although it is normal for the region's relative performance to improve during times of slow national econom ic growth, the extent of the improvement indicated that there were more fundamental forces at work than merely longer periods of recessions in the nation. Furthermore, even though the relative improvement was re lated to the shift of employment from goodsproducing sectors to services-producing sectors, which entailed large absolute declines in manu facturing employment in the region during the 1970s, most of the relative improvement of the 1980s has been the result of smaller employment growth gaps for all private sectors of the local economy. The combined effects of the shift to services and longer recessions in the 1980s ac John M. L. Gruenstein count for no more than 45 percent of the reduc tion in the employment growth gap between Philadelphia and the nation. Thus, the trends of the past five years are a source of optimism that the economic perform ance of the region can continue to be close to that of the nation through the end of the decade. Ten years ago, Philadelphia would have been ranked in a low position relative to the rest of the nation in terms of economic growth. Based on experience so far in the 1980s, this would no longer appear to be the case. So businesses and investors scanning the country for relatively fast-growing markets should have more reason than before to conclude that, on the whole, they'd rather be in Philadelphia. 23 Business Review Federal Reserve Bank of Philadelphia Ten Independence Mall Philadelphia, PA 19106 Address Correction Requested
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