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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO MAY 1998 NUMBER 129 Chicago Fed Letter Interstate trade among Midwest economies If Illinois were an in d ep en d en t co u n try whose Congress was in the process o f determ in in g which econ om ies should be granted Most Favored Nation status, the countries shown in the top part o f figure 1 would be the prim e can d id ates, assum in g Illinois ad o p ted a policy o f m axim izing self-interest. However, if the set o f potential can d i dates were expan ded to include states, the entries in the bottom half o f figure 1 would offer far su p erior benefits to Illinois. E ach state entry in figure 1 is larger than the sum o f the international entries. U p to now, however, little has been known abo u t interstate trade flows. While detailed m onthly an d annual data are kept on international trad e, the last survey-based interstate trade flow data were collected in 1967. In the last 30 years, significant changes have taken place in the structure o f state econ om ies— particularly those in the Midwest— an d in the relation ship betw een the U.S. an d the rest of the world. O u r analysis o f the C hicago re gio n ’s economy brings to light the enorm ous im portan ce o f interstate trade. U sing 1. Destinations of largest exports From Illinois, 1995 Canada Japan Mexico UK Germany $6 $2 $2 $1 $1 billion billion billion billion billion From Illinois, 1993 Ohio Wisconsin Indiana Michigan $20 $18 $18 $18 billion billion billion billion Note: Values have been rounde d to nearest b illio n . Source: Regional Econom ics A p p lic a tio n s Laboratory. a detailed econ om etric in p u t-o u tp u t m odel, we were able to construct an an n u al econom ic ph otograp h o f the region’s economy for the period 1970 95.1 We n oted that, over tim e, output in m ost sectors was increasing (in real term s), but the d egree o f in terdepen dence was decreasing. This process, referred to as hollowing out, im plied that the average firm was buying less from oth er firm s within the region an d selling less within the region, which raised the following questions: 1) Where are the new sources of inputs an d m arkets for C hicago producers?, 2) Why are these ch an ges occurring?, 3) T o what extent is the tren d ben efi cial to the region?, and 4) What, if any, related public policies m ight be con sidered to enh an ce the re gio n ’s eco nom ic well bein g? m anufacturing) rath er than total flows (which would in clude a variety o f service activities). Midwest commodity flows Figure 2 shows the origin an d desti nation o f all gross com m odity flows within the five-state region. N ote the m agn itude o f the interstate flows in the Midwest (calculated to be over $262 billion) and the degree o f depen dence that each state has on the other four states. T he total volum e o f trade rivals that in the early 1990s for NAFTA participants (U.S., Canada, an d M exi co ), yet these trading relationships have received alm ost no atten tion in region al public policy discussions. Notable exceptions are T esta’s (1992)2 call for a regional agen d a an d N agel’s (1995) prom otion o f trade corridors an d call for considering broadly based regions as a whole.3 Each o f these states has a high degree o f dependence on its Midwest neighbors; on average, 34% of total outflows (exports) from any state goes to the rem aining four Analyzing the reasons for C h icago’s ch an gin g trade relationships, it was clear that globalization offered only a partial explanation; C h icag o ’s trade with foreign nations accoun ted for no m ore than 10% to 15% o f total inflows an d outflows. Although we now know that C hicago trades 2. Midwest commodity flows prim arily with other U.S. states, until the Total value of % outflows to other com m odity outflows M id w est states publication of the Com ($1993 bil.) modity Flow Statistics (CFS) in 1993, it was Illinois 228 32.1 difficult to allocate Indiana 128 40.7 Michigan 130 37.1 the flows to specific Ohio 196 29.2 locations. We have Wisconsin 93 34.9 been able to allocate Total 775 34.0 these flows, based on Total value of % inflows from other the CFS data and esti com m odity inflows M id w est states m ates generated from ($1993 bil.) our m odels for each of Illinois 185 31.7 the five Midwest states, Indiana 99 46.8 Wisconsin, Illinois, In Michigan 151 44.9 diana, Ohio, an d M ich Ohio 171 35.1 igan. In this Chicago Fed Wisconsin 73 41.5 Total 679 38.7 Letter, we focus on com m odity flows (agricul Source: R egional E conom ics A p p lic a tio n s Laboratory. ture, construction, an d states, while alm ost 39% o f inflows (im ports) for any state com es from the other m idwestern states. Indiana shows the highest level of dependence on the Midwest at 41% o f exports an d 47% o f im ports, while O h io has the lowest exp ort d ep en d en ce (29% ) an d Illinois the lowest im port d ep en dence (32% ). Figure 3 sum m arizes the effects o f this depen den ce through the creation of a net balan ce o f trade indicator. A positive sign indicates that the state in that row exports m ore to the state at the top o f that colum n than it im ports from that state. Illinois enjoys a positive net trade balance with M ichigan, O hio, an d the rest o f the U.S., while it has a negative balance with Indian a an d W isconsin. O h io is a net im porter o f com m odities from the other four states; it also has a neg ative trade balance with the rest o f the U.S. Wisconsin, on the other hand, enjoys a positive trade balance with all parties shown in figure 3. As with the U.S. in tern ation al trade figures, these data focus only on com m odity flows. We are still calculating total trade an d we expect that som e o f these net balan ces may ch an ge when both com m odity an d noncom m odity trade are included. Interindustry or intraindustry trade? Over the last two decades, the five state econ om ies have becom e m ore sim ilar in structure, as d efin ed by the percen tage o f total state p rod u ct allo cated across all two-digit SIC sectors. As a result, one m ight have expected them to trade m ore heavily with areas that prod u ce goo d s an d services not fo u n d in the Midwest. What ap p ears 3. Balance of trade, 1993 IL IL IN MI OH WI Rest o f U.S. N MI OH + + + + + + - + + + + WI - - - + - Source: Regional Econom ics A p p lic a tio n s Laboratory. Rest of U.S. + + + + to be h appen in g is that the p ro p o r tion o f intraindustry trade, as opposed to interindustry trade, is increasing, due to industries becom ing ever m ore specialized. T he in dex o f trade overlap in figure 4 confirm s this trend. As the in dex ap p roach es 1.0, trade is dom in ated by intraindustry m ovem ents; for the m ost part, the values are in excess of 0.7 an d m any state-to-state pairs ex ceed 0.9. This suggests that Midwest firm s are exploitin g scale an d scope econ om ies over m uch b ro ad er g e o g raphies than was the case in the 1960s. Specific products for the Midwest Source: R egional Econom ics A p p lic a tio n s Laboratory. m arket are bein g m an u factu red in one location to exploit econ om ies of the top ten com m odity shipm ents scale, rath er than bein g sp read over between Midwest states ($54 billion several establishm ents in different in 1993). As shown in figure 6, the states. Firm s are also exploitin g econ O h io-M ich igan exchan ge in trans om ies o f scope (the ability to produce portation equ ipm en t is valued at m ultiple produ cts m ore efficiently over $14 billion. For prim ary m etals, than single products) across m ulti we fo u n d that In dian a ships over $3 state establishm ents. H ence, the state billion to Illinois, while Illinois ex structures ap p ea r to converge, while ports $1.4 billion to Indiana, m aking individual establishm ents within the In d ian a’s m arket in ju st one sector sam e sector are specializing in differ m ore im portan t for Illinois than the ent products. We fo u n d that the aver UK or G erm any is for all sectors age establishm ent in a four-digit (refer to figure 1). m an ufacturin g sector in the C hicago region p ro d u ced fewer secondary Policy implications products than corresponding national How sh o u ld these results be in ter establishm ents (aggregation s across preted? R egional developm ent policy all states). Firm s are exploitin g scale often exam in es the tension between econ om ies in specific establishm ents the exploitation o f specialization an d an d tran sporting interm ediate p ro d com parative advantage an d the risks ucts at various stages o f the p rod u c o f con cen tration an d the attendant tion chain across the region before policy o f diversification. O ne could they are delivered to consum ers. This argue that in the Midwest as a whole, is possible due to reduction s in trans portation costs, gen er ated by deregulation, 5. Value of top Midwest commodity shipments the com pletion an d u p grad in g o f the inter Rank Commodity SIC Value state highway system, ($1993 bil.) im provem ents in the com petitive i Transportation equipment 37 54 2 Food and kindred products 20 30 position o f railroads, 3 Primary metals 33 23 an d the adoption o f 4 Chemicals 28 23 new tech n ologies such 5 Machinery (excl. electrical) 35 19 as global position ing 6 Fabricated metals 34 17 systems to track ship 7 Electrical machinery 36 12 8 Apparel 23 10 m ents m ore efficiently. T aking transportation equipm ent as an exam ple, figure 5 shows that the sector dom inates 9 10 Rubber and plastics Pulp and paper 30 26 Note: Figure show s in te rsta te s h ip m e n ts only. Source: R egional Econom ics A p p lic a tio n s Laboratory. 10 9 6. Midwest transportation equipment commodity flows % o f origin Rank Origin Destination Value % of destination Outflows to M idw est Total outflows Inflows from M idw est Total inflows 57.3 57.9 48.8 35.0 24.7 20.7 20.0 19.3 23.5 55.9 18.2 28.2 13.4 18.2 12.0 5.7 6.4 5.3 12.2 27.7 37.4 33.4 53.1 18.0 23.4 40.2 34.5 33.7 43.4 11.1 20.8 18.5 29.5 10.0 13.0 20.7 22.1 21.6 30.5 6.2 com petitiveness will be critical in m ain taining the prosperity that the region has enjoyed o f late. — G eoffrey J. D. Hewings G rah am R. Sch in dler Regional Economics Applications Laboratory ($ mil.) 1 2 3 4 5 6 7 8 9 10 Ohio Indiana Michigan Illinois Indiana Michigan Ohio Michigan Illinois Wisconsin Michigan Michigan Ohio Michigan Ohio Illinois Indiana Indiana Wisconsin Michigan 7,800 6,956 6,721 3,758 2,968 2,848 2,722 2,657 2,525 2,323 Source: R egional Econom ics A p p lic a tio n s Laboratory. both o f these characteristics can be observed. Within a given state, estab lishm ents within each sector have becom e m ore specialized. However, a gg regated over the region, con sider able diversification rem ains. O ver the last 30 years, the Midwest states have becom e a m ore integrated market, with the result that their econom ic fates are no lon ger determ ined by decisions m ade within the state alone. As lon g as the m ix o f activities that characterizes the Midwest econom y is nationally an d internationally com petitive, the region will thrive. How ever, when a m ajor sector in one state loses its com petitive edge, it will have significant ripple effects on the rest o f the Midwest. Figure 7 shows the im pact o f a change in one state’s activity levels in the transportation equipm ent sector on that state, on the other Midwest states, an d on the rest o f the U.S. For exam ple, a loss o f $1 m il lion in auto production in Michigan would create a further loss o f over $500,000 within M ichigan itself, $50,000 in Indiana, $40,000 in Illinois, an d $80,000 in O hio. T he losses in the Midwest represen t 43% o f the im pact outside o f M ichigan. T h ere are m any rem aining issues to be explored. T he m ost im portan t one is the relationship between inter national an d interstate trade, because many interstate trade flows en d up in products that are exp o rted from the U.S. A seco n d issue is the de gree to which this trade exchan ge can be m ain tain ed an d enhanced. Clearly, infrastructure plays a key role; however, it is difficult to dem onstrate the benefits from additions to this infrastructure. Finally, one m ight voice som e skepticism abo u t in 7. Effects of changes in transportation production dividual states p ro m oting clusters of Rest activity within the IL IN MI OH WI of U.S. state. Individual ----------- $ m il.-------------(--firm s have clearly IL 1.51 0.09 0.04 0.08 0.05 0.02 been able to grasp IN 0.05 1.73 0.05 0.09 0.02 0.01 the idea that any MI 0.03 0.08 1.53 0.11 0.02 0.02 OH 0.05 0.13 0.08 2.04 0.02 0.03 clustering now is WI 0.02 0.02 0.02 0.02 1.31 0.01 at the level o f the Rest o f U.S. 0.30 0.40 0.24 0.57 0.19 1.53 Midwest region. Total 1.98 2.46 1.96 2.90 1.61 1.63 If that is the case, Midwest states n eed Midwest 35% 45% 43% 34% 36% to see themselves more Note: M id w e s t is th e percent o f im p a c t o u ts id e the state th a t is concen trated e lsew he re in the M idw est. M id w e s t percentages w e re calculated as an integrated eco using actual, n o t rounded, num bers. nom ic market, whose Source: R egional Econom ics A p p lic a tio n s Laboratory. Philip R. Israilevich4 Regional Economics Applications Laboratory and Federal Reserve Bank o f Chicago 1This economic photograph portrayed the strength of what is referred to as interde pendence in the economy—the degree to which firms bought and sold goods and services from one another within the Chicago region (see Philip R. Israilevich, Geoffrey J. D. Hewings, Michael Sonis, and Graham R. Schindler, “Forecasting structural change with a regional econo metric input-output m odel,” Journal of Regional Science, 1997). 2William A. Testa, “Emerging development strategies,” in Shaping the Great Lakes Economy, Federal Reserve Bank of Chicago, 1992. Je rry Nagel, published remarks, in State and Local Economic Development Strategy Summit, University of Minnesota, 1995. 4Philip R. Israilevich passed away on December 15, 1997. Michael H. Moskow, President; William C. Hunter, Senior Vice President and Director ofResearch; Douglas Evanoff, Vice President, financial studies; Charles Evans, Vice President, macroeconomic policy research; Daniel Sullivan, Vice President, microeconomic policy research; William Testa, Vice President, regional programs; Vance Lancaster, Administrative Officer; Helen O ’D. Koshy, Editor. Chicago Fed Letter is published monthly by the Research Department o f the Federal Reserve Bank o f Chicago. T h e views expressed are the auth ors’ and are not necessarily those of the Federal Reserve Bank o f Chicago or the Federal Reserve System. Articles may be rep rin ted if the source is credited an d the Research Department is provided with copies o f the reprints. Chicago Fed Letter is available without charge from the Public Inform ation Center, Federal Reserve Bank o f Chicago, P.O. Box 834, Chicago, Illinois 60690-0834, tel. 312-322-5111 or fax 312-322-5515. Chicago Fed Letter and other Bank publications are available on the World Wide Web at http://w w w.frbchi.org. ISSN 0 8 9 5 - 0 1 6 4 Tracking Midwest manufacturing activity Purchasing managers’ surveys (production index) 80 Manufacturing output indexes (1992=100) Feb. Month ago Year ago CFMMI 126.1 127.3 120.8 IP 131.3 131.3 124.4 70 _______________________________________ Motor vehicle production (millions, seasonally adj. annual rate) Cars Light trucks Feb. Month ago 5.4 5.9 6.0 6.1 5.9 6.3 Purchasing m anagers' surveys: net % reporting production growth Mar. Month ago Midwest Year ago u T~ (v 50 Year ago MW 66.0 59.0 63.4 U.S. 57.6 55.3 56.8 40 --------------------------------------------------------------------------------------------------------------------------------------------- _______ I__ I__ I__ I__ I__I__ I__ I__ I__ I__I__ I__I__ I__ I__ I__ I__I__ I__ I__ I__ I__I__ I__I__ I__ I__ I__ I__I__ I__ I__ I__ I__I__ I__I__ I__ I__ I__ I__I__ I__ I__ I__ I__I__ L 1995 1996 T he Midwest purchasing m an agers’ com posite index for production increased to 66.0% in M arch from 59.0% in February. Purchasing m an ag ers’ in dexes in creased in C hicago an d Detroit. T he national purch asin g m an agers’ com posite in d ex in creased from 55.3% in February to 57.6% in March. Total light m otor vehicle production decreased from 12.0 m illion units in Jan u ary to 11.7 million units in February. Ligh t truck production increased from 6.1 million units in January to 6.3 m illion units in February an d car production decreased from 5.9 million units to 5.4 m illion units. T he C hicago Fed Midwest M anufacturing Index (CFMMI) decreased from 127.3 in January to 126.1 in February. By com parison, the Federal Reserve B o a rd ’s Industrial Production Index for m anufacturing (IP) was constant at 131.3 for January an d February. 1997 1998 Sources: The Chicago Fed Midwest Manufacturing Index (CFMMI) is a composite index of 16 industries, based on monthly hours worked and kilowatt hours. IP represents the Federal Reserve Board’s Indus trial Production Index for the U.S. manufacturing sector. Autos and light trucks are measured in an nualized units, using seasonal adjustments devel oped by the Board. 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