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A - .- . _ _ ASSAYS ON ISSUES T H E FEDERAL RESERVE BANK OF CHICAGO SEPTEMBER 19K7 NUMBER I Chicago Fed Letter T h e ordeal of change: W o rk in g it out in the Midwest The Midwest has been undergoing a costly but necessary process of rebuild ing its economy. This ordeal of change has dramatically altered state develop ment policies in recent years. Economic change in the 1930s has been something of a puzzle in the Midwest. The decade began with two short but severe recessions, which raised fears of a collapse of the region's economy. But a strong economic expansion by mid decade prompted some commentators to predict an economic renaissance for the Midwest comparable to the New England experience a decade earlier. Clearly, both images of the Midwest were distorted by a failure to isolate long-term economic forces—the kind economists call “structural changes’’— from short-term economic forces, such as the business cycle. dow ns and dampened the ups. Among the most important of these forces were rising international competition, the energy' dislocations of the 1970s, and a general shift in the nation’s economic center of gravity low'ard the SouLh and West. Making matters worse, an unsustainable boom in agriculture went bust. The effects of these structural forces were often masked in the beginning by the short-term business cycle. But the results of structural change were cu mulative. Businesses failed or cut back; whole industries stagnated or declined: unemployment remained stubbornly in the sense that its output shrank rel ative to the rest of the country, but that its output declined in absolute terms. Now, in 1987, the Midwest has found that the U.S. economy is much less dependent on its industrial heartland than it had been for most of the twen tieth century. This decline in manufacturing output was not accompanied by a shift from manufacturing to service output. In the Midwest, manufacturing's share of the economy has remained fairly stable over the years, as it has at the national level. The Midwest's nonmanufactur ing output, including services, however, State policymakers have been caught in the middle of these economic forces, trying to develop long-run strategies at a time when short-run resources have been dwindling. Policymakers have begun to lake a fresh look at their states' economies and to design new', more flexible policies that meet the needs of the 1980s. The new ap proaches are a direct result of a better understanding of how their states’ economies are changing. The changing economic environment The economy of the region (defined here as Illinois, Indiana, Iowa, Michigan and Wisconsin) received more than its share of battering by the ups and downs of the business cycle. Structural changes amplified those high, and some people “voted with their feet,’’ emigrating South and West to warmth and work. The figures eventually told the story: Midwest manufacturing output began a declin ing trend after 1970. Manufacturing output in the rest of the nation was relatively stable. Thus, the Midwest has been “deindustrializing," not only has lagged the national growth rate, even declining 10 percent between 1978 and 1982. As a result, the decline in manufacturing output has not meant that the Midwest is any less dependent on its manufacturing sector. The general effect was not merely eco nomically depressing, it was psycho- logically depressing. In gloomily as sessing the Midwest, business analysts rounded up the usual suspects— aging manufacturing plants, high wages and taxes, climate, stodgy management— and characterized the region as old, cold, and rusting. What was sometimes forgotten is the economic adage: “the market works.” Economic forces in the long-run tend to move regional growth rates toward the national average—that is, regional growth rates tend to converge rather than diverge. While the Midwest’s economy has undergone often wrench ing changes, these changes ultimately strengthen the region’s economy by forcing businesses to be more efficient in order to meet competition from out side the region. Without a clear understanding of these economic forces, state policymakers can not be effective. New approaches to state policies Deindustrialization forced state gov ernments to reshape their approaches to development. Smokestack chasing—ad hoc programs to attract specific manufacturing plants to a region— proved not terribly useful. Studies on the location decisions of companies cast doubt on the long-run effectiveness of state efforts to attract businesses by offering them tax and fi nancing incentives. Such plans also had the side effect of irritating the ex isting business community, which freauently argued that the newcomers were being provided benefits at the ex pense of established businesses. There are, of course, limits to what a state can do to improve its own econ omy. Most of the structural forces af fecting states are national or interna tional in scope. Accordingly, states have traditionally attempted to ease the burden of structural change with unemployment benefits, retraining programs, and a wide range of social services. But these are relatively pas sive responses. There is a grow ing belief among state policymakers that economic develop ment strategies can slow and even re verse economic decline. If this is true— and the jury is still out— can it only be true when public and private decision makers have a clear view of the strengths and weaknesses of their state's economy and a solid under standing of the structural changes af fecting their state. Since 1934, Illinois, Indiana, Iowa, Michigan, and Wisconsin have each produced new development plans, de signed to address the structural changes in their economies.1 Unlike their “quick-fix” predecessors, these plans are more strongly founded on data col lection and analysis and stress long term strategies. While each plan reflects the unique features of its state, three common themes emerge from them: 1) A need to revitalize each stale’s manufacturing sector, 2) A stress on technology transfer to provide the spark for renewed grow th: and 3) The nurturing of an economic cli mate in which firms can thrive. The interest in manufacturing seems appropriate, since the District histor ically has had its highest degree of eco nomic specialization in. and has derived its highest contribution to, value added from its manufacturing sector. Moreover, the association be tween declining manufacturing output and weakness in nonmanufacturing and services suggests that attention fo cused on manufacturing will also bene fit nonmanufacturing. For example, Michigan has targeted the automotive industry' in an effort to assist in im proving the worldwide competitiveness of the state’s most important industry. One of the most effective ways to revi talize any economy is through techno logical advancement, the second common theme of the states’ plans. Stressing both the implementation of existing technology, such as robotics and computer-aided design and manu facturing (CAD/CAM), and the search for new technology, policymakers hope to assist industries in lowering labor costs, improving productivity, and thus boosting competitiveness. For exam ple, both Michigan and Illinois are currently striving to attract a multi billion dollar subatomic research facilitv to their state. Indiana intends to set up technology transfer centers to facili tate the transfer of new technology to existing firms. Finally, the attention to economic cli mate, the third common theme, is de signed to create an atmosphere that is conducive to growth. The focus on a state’s economic “climate" goes far be yond appeasing business people with low taxes and tax abatement, which have widely been challenged as effec tive tools for economic development. Policymakers are becoming increas ingly aware that the quality of services they provide affects their state’s competitiveness. Like any other input into the production process, poor qual ity in roads, water, and other types of state-provided services can raise pro duction costs and reduce competitive ness. Moreover, poor quality of public services inhibits the creation of new firms and the attraction of out-of-state firms, just as easily as it harms existing firms. In improving the region’s economic climate, all types of firms— large and small, new and old—benefit, thus cre ating a balanced approach to quality and cost of services for both existing and new firms. For example, Illinois’ program allocates public funds to infrastructure improvements and small business loans while trying to keep taxes in line with neighboring states. Iowa’s plan, Rebuilding Iowa’s Economy, exemplifies how these common themes relate to the state’s unique economy. Iowa's high degree of economic spe cialization in agriculture-related indus tries served it well until the “farm crisis” of the 1980s. Yet, when the need arose for increased state development activity in the late 1970s, Iowa focused on its existing strengths in agriculture by searching for ways to broaden its narrow dependence on two crops— corn and soybeans. One of its approaches, which relates to the theme of economic climate, has been to search for entrepreneurial gaps that can broaden its agricultural base. In addition, it stressed the importance of technology through its support of technologyoriented agronomy and biotechnology. Encouraging signs for the future Although smokestack chasing has not totally lost its appeal, state develop ment programs have vastly improved in the 1980s. In contrast to state poli cies that once lacked coordination and a clear economic underpinning, current development strategies are more com prehensive in scope. Increasing em phasis is being placed on the long-run costs and benefits of programs, priori ties established among competing pro grams, and coordination of programs and institutions to achieve the desired results. Are the state plans working? It is loo early to say, and their impact may never be clearly known. But they are pointed in the right direction. They recognize, as did the economist Joseph Schumpeter, that capitalism is “by na ture a form or method of economic change and not only never is but never can be stationary." Notably, the plans do not resist the structural change tak ing place in the Midwest’s economy. They accept it and try to adapt the advantages the Midwest already has to the change it is undergoing. In the summer of 1987, there are a few hopeful signs. The Conference Board says that “help-wanted” linage in Midwestern newspapers is well abov e that in other areas of the country. The agricultural decline shows signs of bottoming out, although the national policies and internauonal market structures that led to the decline are still operating. In manufacturing, the auto industry continues to post profits, despite a marked slowdown in sales from several years ago. These are modest signs, to be sure, but may reflect a favorable restructuring of the Midwest’s underlying economy. To test for permanent improvements in the region’s economy, economists at the Federal Reserve Bank of Chicago per formed a simple experiment. With the aid of a recent Wharton Econometrics forecast of industrial production growth by industry betvveen 1986 and 1996, we calculated what industrial pro duction growth would be for the Mid west, using first its current industrial structure and second its industrial structure in 1972. The result was that the current structure would provide a slightly higher growth rate than the 1972 structure. Although many other factors will determine the actual growth performance of Midwest man ufacturing over the next ten years, the experiment indicates the region's cur rent structure is more conducive to growth than in the past. Economic change is a collection of gradual processes. Short-run gains could be obliterated by some national or international event beyond the con trol of state policymakers. But the combination of market forces and in telligent state policymaking in recent years prompts cautious hope. Winston Churchill, speaking on another matter, said. “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” We may be seeing the end of the be ginning of the Midwest's revitalization. At such a time it is important to re member that, while the way down was painful, the way back up will be hard work. — David R. Allardice and Robert H. Schnorbus 1 The plans are: Illinois, Building Illinois: A Five Tear Strategic Plan fo r the Development o f the Illinois Economy (1 9 8 5 ); Indiana, In Step W ith the fu tu re ... Indiana's Strategic Economic Development Plan (1 9 8 4 ). Iowa, Rebuilding Iowa’s Economy: A Comprehensive State Economic Development Plan (1 9 8 5 ); Michigan, The Path to Prosperity (1 9 8 4 ); and Wisconsin, The Final Report o f the Wisconsin Strategic Development Commission (1 985). Karl A. Schcld, Senior Vice President and Director of Research: David R. .Allardice, Vice President and Assistant Director of Research: Edward G. Nash. Editor. Chicago Fed Letter is published monthly by the Research Departm ent of the Federal Reserve Bank of Chicago. The views expressed arc the authors' and are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve Svstem. Articles may be reprinted if the source is credited and the Research Departm ent is provided with copies of the reprints. Chicago Fed Letter is available without charge from the Public Information Center. Federal Reserve Bank of Chicago. P.Q. Box 834. Chicago. Illinois 60690. or telephone (312) 322-5 III. ISSN 0893-0164 Manufacturing activity in the Midwest (defined here as comprising Illinois, Indiana, Iowa, Michigan, and Wisconsin) rose 0.9 percent in June, following two months of decline from its peak in the current expansion. In contrast, activity nationally was virtually flat, after rising steadily throughout the year. Manufacturing activity in the Midwest experienced a marked slowdown in 1984 similar to the national slowdown. Since then, the pace in the Midwest has lagged the nation. For example, the current level in the Midwest is only 1.4 percent above its year-ago mark, or less than half the national gain of 3.6 percent. Chicago Fed Letter fed era T r e s e rT IT btvnk o f c h i c a c o Public Inform ation Center P.O. Box 834 Chicago. Illinois 60690 (312)322-5111 N O TE: T he MM I is a composite index of 15 m anufacturing industries and is constructed from a weighted combination of monthly hours worked, and kilowatt hours data. See "Midwest M anufacturing Index: T he Chicago Fed's new regional economic indicator," Economic Perspectives, Federal Reserve Bank of Chicago, Vol. X I, No. 5, S eptem ber October, 1987. The United States represents the Federal Reserve Board's Index of Industrial Production, M anufacturing.
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