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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO SEPTEMBER 1989 NUMBER 25 Chicago Fed Letter Telling fortunes: M anufacturing and the G reat Lakes region “Tell me your industries, and I’ll tell you your . . . fortune,” wrote econo mist Wilbur Thompson in describing regional economics. For most of the 20th century, the engine that has driven the Great Lakes economy has been manufacturing.1 Economists predicting the future of the Great Lakes region looked at steel, autos, machine tools and machinery, and other manufacturing industries. But the much-ballyhooed economic shift from manufacturing to services in recent decades raises many impor tant questions about the validity of that long-standing relationship. In earlier years, it was possible to moni tor the Great Lakes economic per formance by examining its manufac turing sector. Now, the region’s growth in manufacturing output trails total regional product, and m anufacturing’s employment share has plummeted. This Chicago Fed Letter asserts that de spite these changes and shifts the manufacturing sector retains its criti cal role as the engine of the Great Lakes economy. When compared to the U.S., the manufacturing sector remains highly concentrated in the region. Moreover, in viewing the manufacturing sector alone, the im portance of manufacturing to the Great Lakes economy proves to be understated. While the manufactur ing sector has lost ground to the service sector, this can be partly ex plained by the transfer of some work from manufacturing companies to the service sector. These activities include such functions as clerical, maintenance, R&D, legal services, advertising, and data processing, which are often purchased by m anu facturing companies from service sector firms. When the manufactur ing sector is broadly defined to in clude such activities, the region’s economic ties to manufacturing re main very strong. Direct earnings from manufacturing The traditional way of measuring a region’s ties to the manufacturing sector is to look at labor earnings paid out to the region’s residents by manufacturing firms. These earnings indicate the current share of income flowing into the pockets of the re gion’s residents from the manufac turing sector. As recently as 1967, 38% of the re gion’s earnings were derived from manufacturing in comparison to 26% for the rem ainder of nation. These shares were about the same in 1947 (see Figure 1). By 1987, how ever, m anufacturing’s share of labor income had dropped precipitously in 1. Manufacturing incom e down percent of labor incom e 45 --------------------------------------------------------------------------------- j----------1--------- 1---------1--------- 1--------- l 1947 1957 1967 1977 1987 both the Great Lakes region and the U.S. Nationally, manufacturing ac counted for only 18-19% of labor income by 1987. In the Great Lakes region, the share had fallen to 29% of labor income. In absolute terms the manufacturing industry has been shrinking as a source of earnings for the region. Relative to the nation, however, the region remains highly specialized in manufacturing even with this narrow definition. The implication is that manufacturing fortunes continue to have a magnified effect on the house hold incomes of Great Lakes resi dents in comparison to the nation. Purchased services: The hidden manufacturing sector In tracking the manufacturing sec tor’s contribution to the region’s income, we must examine the other components as well. Many activities involved in producing a product can be transferred from the manufactur ing sector to service firms as the underlying economics of the firm dictate. For example, a steel-produc ing company may shed its mainte nance workforce and contract out or “outsource” maintenance work to a service sector company in order to trim overhead costs. Accordingly, an activity which was formerly counted as manufacturing output could now be counted in the service sector even though the physical am ount of steel produced by the economy has re mained the same. Recently, the corporate structure of U.S. companies has been rapidly changing through takeovers and mergers as U.S. companies have divested and regrouped activities under new corporate umbrellas. This is seen as part of a broader restruc turing in which organizations of all kinds, including manufacturing com panies, have been “unbundling” support services such as clerical and maintenance.2 In order to boost productivity and to trim costs, companies choose to pur chase these support services from outside firms rather than continue to generate the services in-house. The overall effect of these changes on the manufacturing sector has been the shedding of service activi ties by manufacturers. This can be seen by examining the growing pur chases of services by manufacturers from other industry sectors.3 In the process of producing manufactured goods, manufacturing companies purchase im portant services whose value becomes embodied into the final value of the manufactured goods. These business service sectors include computer and data process ing, telecommunications, temporary office help, accounting, finance, insurance, real estate, wholesaling, advertising, and managerial consult ing. Purchased services as a share of value added in manufacturing can be seen in Figure 2. These services made up less than 10% of manufac turing value added in 1957. By 1977, this figure had climbed to over 18%. In 1987, the last reported year, pur chased services were estimated to -----1 l 1-1 I 1 1 . J—I I I I U - 1 I I l - L .I I I I 1 I I I I I I I 1957 '62 ’67 ’72 '77 ’82 ’87 represent 25% of overall manufactur ing activity.4 Augmented manufacturing The upshot of the increasing service orientation of manufacturing is that a growing segment of the Great Lakes economy that was formerly recognized as manufacturing has moved into the service sector. Con sequently, by attributing these activi ties to the service sector, we may be understating m anufacturing’s contri bution to the national and regional economy. Accordingly, it is helpful to redefine the manufacturing-related sector to include these services to identify any real changes to the region’s eco nomic base. Services purchased locally by manufacturers, as part of the region’s traded-goods sector, are conceptually the same as manufactur ing so that we can define the m anu facturing sector broadly to include these purchased services. In doing so, our reckoning of the region’s economic structure and base will not be affected by the movement of these services between the manufacturing and service industry sectors. In considering such an augmented manufacturing sector that includes purchased services, a far different picture of the importance of m anu facturing to the region emerges (see Figure 3). For the United States (excluding the Great Lakes) the decline in the share of manufactur ing earnings is significantly m uted by the inclusion of purchased services, although it has still declined, from 32% to 24% over the past 24 years.5 In the Great Lakes region, the role of augmented manufacturing as a source of regional income is also pronounced. When services pur chased by Great Lakes manufacturers are included in the manufacturing sector proper, labor income derived from this sector am ounted to 37% in 1987. Moreover, the region’s con centration in manufacturing contin ued to exceed the nation’s by more than half (see Figure 3). 1963 1983 1987 A word of caution is required. These estimates depend on the crucial assumption that the region contains a proportionate share of manufactur ing-related activities in its service sector. This means that services pur chased by Great Lakes manufactur ing companies are purchased locally and not from outside the region. Or, alternatively, service exports by the region’s service sectors to outside manufacturers are sufficient to offset any “leakages”, i.e., services pur chased by Great Lakes manufacturers from outside the region. Where do the services come from? There is a wide geographic range over which services are traded. Serv ices are increasingly “exported” across regional boundaries.6 This implies that services purchased by manufacturers cannot be thought lessly assigned to the same location as the manufacturers themselves. There is little direct evidence on the inter-regional flows of services. How ever, studies suggest that service flows will, if anything, tend to originate in those regions that have concentra tions of corporate headquarters of manufacturers and flow toward those peripheral regions that are special ized in branch production plants.7 Those regions with ample shares of corporate headquarters, R&D labs, and other specialized service estab- lishments of manufacturing compa nies—the so-called “auxiliary estab lishments”—are also likely to retain a healthy share of services that are directly purchased by manufacturers from service firms. Frequently, cen tral administrative offices are large purchasers of specialized services, many of which are then distributed to operating plants within the firm. In addition, the amenities that attract central administrative offices to a region are also those that attract manufacturing-related service firms, so there is a tendency for business service firms and auxiliary establish ments to locate in the same regions. The Great Lakes region has managed to hold on to its share of the nation’s auxiliary activities over the past three decades. The Great Lakes’ share of the nation’s payroll for auxiliary manufacturing establishments has held constant at 31-32% of the na tional total. This is surprising in light of the fact that the region’s share of total payroll has concur rently slipped to 27% and payroll at operating establishments (including production plants) slipped to 26%. ing activity in auxiliary activity than the nation suggests that the region is a net exporter of inter-regional serv ice flows between the service and manufacturing sectors. The oftenoverlooked service purchases by manufacturers are, if anything, more pronounced in the Great Lakes than in the nation. Conclusion The role of the Great Lakes region continues to evolve away from m anu facturing production and towards service activity. But this does not mean that the region now has a weak link to manufacturing. In fact, much of the apparent growth in service activity is closely tied to manufactur ing activity within the region and elsewhere. Moreover, manufacturing activity itself, as measured by labor income derived from this industry, remains significantly above the na tional average. For these reasons, the manufacturing sector’s fortunes will continue to call the tune of the Great Lakes economy in the foresee able future. —William A. Testa As a result, the region’s economic specialization in auxiliary activity has increased. In 1958, the region’s economy was no more specialized in these auxiliary service activities than the nation. Since that time, the Great Lakes region has developed a presence in auxiliary activity that was approximately 19% greater than the nation’s in 1986.8 Nor has the region’s increasing auxil iary activity specialization occurred solely because manufacturing pro duction activity has migrated to other regions, leaving behind an isolated corporate headquarters presence. The auxiliary establishment base has grown in absolute terms. While the region lost over 500,000 jobs in total manufacturing between 1976 and 1986, manufacturing employment at auxiliary establishments is estimated to have increased by over 33,000.9 The fact that the region has a signifi cantly larger share of its manufactur co n v erts th e m to a re p la c e m e n t cost v a lu a tio n (see U.S. B u re au o f th e C e n sus, Census o f Manufactures, 1977, p. X X III). T h i s only suggests th e overall gro w th o f th e service in p u ts in to th e m a n u fa c tu r in g process. T h e value o f p u rc h a s e d services them selves will in c lu d e p u r chases fro m o th e r secto rs in c lu d in g m a n u fa c tu rin g , c o n stru c tio n , a n d gov e rn m e n t. In o th e r w ords, th e value o f p u rc h a s e d services is n o t strictly a “value a d d e d ” by th e service secto r alo n e. T h e m e th o d o lo g y is as follows: we esti m a te d th e p u rc h a s e d services p e rc e n t o f m a n u fa c tu rin g value a d d e d (BEA) fo r ea c h 2-digit m a n u fa c tu rin g in d u stry u sin g th e 1963 a n d 1983 I n p u t- O u tp u t T ab les o f th e U n ite d S tates w hich are p ro d u c e d by th e B u re a u o f E co n o m ic Analysis. F o r e a c h in d u stry, this p e rc e n t o r a u g m e n ta tio n fa c to r was th e n a p p lie d to b o th th e industry-specific e a rn in g s d is trib u tio n fo r th e G re a t Lakes re g io n a n d fo r th e U.S. A ccordingly, th e d iffer in g in d u stry m ix b etw een th e re g io n a n d U.S. a ffected th e e stim a te d v olum e a n d p ro p o r tio n o f p u rc h a s e d services. T o r a lite ra tu re review see W illiam A. T esta, M anufacturing and Related Services in the Great Lakes Economy, R egional W o rk in g P a p e r, F e d e ra l R eserve B ank o f C h icag o , 1989. 7ibid. T h e G re a t Lakes re g io n is d e fin e d to in c lu d e th e six states o f Illinois, In d i an a, M ich ig an , M in n eso ta, O h io , a n d W isconsin. T o r a d iscussion see P e te r F. D ru c k e r, “Sell th e M a ilro o m ,” Wall Street Journal, Ju ly 25, 1989, p. 16. T h i s tr e n d can b e illu stra te d fo r th e G re a t Lakes m a n u fa c tu rin g se c to r by tak in g th e sim ple d iffe re n c e b e tw e e n th e B u re a u o f th e C en su s v alue a d d e d fo r th e n a tio n a n d th e B u re a u o f E co n o m ic A nalysis’ e stim ate o f m a n u fa c tu rin g activity. T h e BEA’s “gross p ro d u c t o rig i n a tin g ” in m a n u fa c tu rin g in c lu d e s in d i re c t taxes (e x c e p t p ro p e rty ) w hile C en su s value a d d e d in m a n u fa c tu rin g d o e s n o t. F o r c o m p a riso n p u rp o se s w ith C en su s v alue a d d e d , th e BEA fig u re is a c c o rd ingly re d u c e d by 4% . T h e o th e r n o ta b le d iffe re n c e is th a t th e C en su s calc u lates in v e n to ry c h a n g e u sin g th e d a ta as re p o rte d by th e m a n u fa c tu re r. BEA ad d s to th ese “b o o k v a lu e ” in v e n to rie s an in v en to ry v alu a tio n a d ju s tm e n t w hich 8 m e a s u re d by payroll d a ta fro m th e As Census o f Manufactures. 9 c c o rd in g to U.S. D e p a rtm e n t o f A C o m m e rc e , County Business Patterns data. ■ lillll■ liB — — ■ 1 ■ ■ Il ■1 Karl A. S cheld, S en io r Vice P re sid e n t an d D irecto r o f R esearch; David R. A llardice, Vice P re sid e n t a n d A ssistant D irecto r o f R esearch; E dw ard G. N ash, E ditor. Chicago Fed Letter is p u b lish e d m o n th ly by th e R esearch D e p a rtm e n t o f th e F ed eral Reserve B ank o f C hicago. T h e views ex p ressed are th e a u th o rs ’ a n d are n o t necessarily th o se o f th e F ed eral Reserve B ank o f C hicago o r th e F ed eral Reserve System. A rticles m ay be re p rin te d if th e source is c re d ite d a n d th e R esearch D e p a rtm e n t is p ro v id ed w ith copies o f th e rep rin ts. Chicago Fed Letter is available w ith o u t ch arg e fro m th e Public In fo rm a tio n C e n te r, F ed eral Reserve B ank o f C hicago, P.O. Box 834, C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 Manufacturing activity in the nation, measured by the U.S. Manufacturing Index, was unchanged in May. A solid gain in the food and kindred products industry was offset by modest declines in most of the other sixteen industries comprising the index. Midwest manufacturing activity declined 0.4% in May. The chemical industry ac counted for nearly half of that drop, after the industry recorded a strong gain in April. Since March the region has kept pace with the nation, however, and has outperformed the nation on a year-over-year basis. Chicago Fed Letter F E D E R A L R E S E R V E B A N K O F C H IC A G O P u b lic I n fo rm a tio n C en ter P .O . Box 834 C h ica g o , Illin o is 60690 (312) 322-5111 N O T E: T h e MMI a n d th e USMI are co m p o site in d ex es o f 17 m a n u fa c tu rin g in d u stries a n d are deriv ed fro m e c o m o n o m e tric m o d els th a t estim ate o u tp u t fro m m o n th ly h o u rs w o rk ed a n d kilow att h o u rs d ata. F or a discussion o f th e m eth o d o lo g y , see “R eco n sid erin g th e R egional M an u fac tu rin g In d e x e s,” Economic Perspectives, F ed eral Reserve B ank o f C hicago, Vol. XIII, No. 4, Ju ly /A u g u s t 1989.
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