Full text of Econ Focus (Federal Reserve Bank of Richmond) : Spring 2003, Volume 7, Number 2

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»They’re All Ears »A Difficult Diagnosis »Up in Smoke
»An Interview With Vernon Smith »Baltimore: Story of a Port Town

SS PP RR II NN GG 22 00 00 33

Running on

Empty?
Water Shortages Prompt
Policymakers to Consider
Market-Based Reforms

TT HH EE FF EE DD EE RR AA LL RR EE SS EE RR VV EE BB AA NN KK OO FF RR II CC HH M
M OO NN DD

VOLUME 7
NUMBER 2
SPRING 2003

COVER STORY
10

Running on Empty? While the Fifth District’s water
supply outlook isn’t as dry as you might think, the
region could benefit from water policy reform.
The Eastern United States hasn’t suffered from severe
droughts in the same way as some other parts of the country.
But recent water shortages have led policymakers to look
West, where innovative market-based policies have been
adopted on a small scale.

FEATURES
18

A Difficult Diagnosis: The shortage of affordable
malpractice insurance in West Virginia and elsewhere
won’t be easy to solve.
Steep medical malpractice premiums have forced some West
Virginia hospitals to close units that perform high-risk
procedures. Is the state’s tort system to blame or are there
more fundamental economic factors at work?

Our mission is to provide
authoritative information
and analysis about the Fifth
Federal Reserve District
economy and the Federal
Reserve System. The Fifth
District consists of the District
of Columbia, Maryland, North
Carolina, South Carolina,
Virginia, and most of West
Virginia. The material
appearing in Region Focus
is collected and developed by
the Research Department of
the Federal Reserve Bank
of Richmond.
DIRECTOR OF RESEARCH

Jeffrey M. Lacker
SENIOR EDITOR

Aaron Steelman
MANAGING EDITOR

21

Rowena Johnson

Up in Smoke: Fifth District States Are Burning Through
Tobacco Settlement Funds to Balance Their Books

BUSINESS WRITERS

In 1998, the country’s major cigarette manufacturers agreed to
help the states pay for health care expenses related to tobacco
use. Some funds are going toward that goal, but the money is
also being used to help reduce mounting fiscal deficits.

P RO D U C T I O N A S S I STA N T

26

Charles Gerena
Betty Joyce Nash
Bridgette Craney
CONTRIBUTORS

Elaine Mandaleris
Christian Pascasio
Karl Rhodes
Roy Webb
ECONOMICS ADVISERS

To Tax or Not to Tax? States Ponder New Ways to
Collect Taxes on Online Sales
The “Streamlined Sales Tax Project” seems to be gaining
momentum. And some retailers have already decided to come
along for the ride.
28

A Delicate Balance: Constructing an Intellectual
Property Regime That Promotes Both Innovation and
Social Welfare
The Supreme Court recently upheld a federal law that extends
copyright terms by 20 years. The decision has raised serious
questions about what level of intellectual property protection
is economically desirable.

Andrea Holland
Robert Lacy
Ray Owens
John Weinberg
C I RC U L AT I O N

Joyce Eberly
Nichole Richardson
DESIGN

AURAS Design/
Maureen Gregory
Published quarterly by
the Federal Reserve Bank
of Richmond
P.O. Box 27622
Richmond, VA 23261
Phone: (804) 697-8000
Fax: (804) 697-8287
E-mail: rich.regionfocus@rich.frb.org
www.rich.frb.org/pubs/regionfocus

DEPARTMENTS

AP PHOTO/RICKY CARIOTI

1 Noteworthy
2 Federal Reserve/They’re All Ears
5 Legislative Update/Terrorism Insurance
6 Short Takes
9 Jargon Alert/Inflation
32 Interview/Vernon Smith
36 Economic History/Story of a Port Town
40 Regional/District Economic Developments
48 Opinion/The More the Merrier

COVER PHOTO: BUDDY MAYS/GETTY IMAGES

Subscriptions and additional copies:
Available free of charge by
calling the Public Affairs
Division at (804) 697-8109.
Reprints: Text may be reprinted
with the disclaimer in italics below.
Permission from the editor is
required before reprinting photos,
charts, and tables. Credit Region
Focus and send the editor a copy
of the publication in which the
reprinted material appears.
The views expressed in Region Focus
are those of the contributors and not
necessarily those of the Federal Reserve
Bank of Richmond or the Federal
Reserve System.
ISSN 1093-1767

NOTEWORTHY
Water Rights

I
Price systems can
work for difficult
allocation problems,
including cases in
which the government
seeks to allocate
some resource for
private use.

n the early chapters of an
introductory economics
textbook, one is likely to
find a reference to something
called the “diamond-water
paradox,” meant to demonstrate the difference between
economic value and other
notions we might have of the
relative importance of different commodities. Can the
price of something be a good
measure of its inherent worth
if water, something essential
to life, bears a miniscule price
compared to diamonds, something with merely ornamental
uses? A moment’s reflection,
however, reveals that there is
no real paradox here. The
difference derives from the
abundance of water and the
scarcity of diamonds. In fact,
water historically has been so
plentiful that it typically has
not been treated as an economic commodity subject to
the laws of supply and demand.
Surely, if there were rivers and
lakes of diamonds, they would
be just as cheap—and engagements might be marked in a
very different way.
What happens when
water’s abundance begins to
recede? This issue of Region
Focus features a story on the
growing challenges facing
Fifth District communities
and public utilities as expanding populations squeeze the
ability of ground and surface
water resources to quench
the growing thirst. Latent
problems with traditional
approaches to water allocation have risen to the surface
during the recent drought.
Frequent readers of this
column will not be surprised if

I suggest that market-based
approaches to water allocation
problems deserve serious consideration. At one level, water
seems very much like a standard economic commodity
suitable for allocation guided
by market prices. Measuring
an individual’s or a business’
use of water does not pose significant difficulties. Why then
shouldn’t users pay a price that
reflects the full social costs of
their use? Usage may not be
very sensitive to price in the
short run, but higher prices
would surely make individuals
more willing to consider
longer-term changes in behavior or the purchase of watersaving devices.
Of course, the technology
of water delivery may make
this a market that is not well
suited to competition. A system for carrying water has
some of the characteristics of a
natural monopoly, since a competing system would have to
duplicate the costs of building
an infrastructure. Such duplication is usually wasteful from
a social point of view. Markets
with natural monopoly characteristics are often subject to
government regulation to prevent a monopolist provider
from extracting excess profits.
There may also be political
constraints that limit our ability to treat water as a standard
economic commodity. Pricing
water use at full social cost
may simply not be a politically
acceptable option, given that
it would represent a substantial departure from the traditional approach, in which
users pay at most for the
resource costs of water treat-

ment and distribution. As
water becomes more scarce,
the opportunity cost associated with alternative uses
rises. Standard public utility
pricing of water does not take
such costs into account.
So setting prices for water
may not be an easy task. Still,
price systems can work for
more difficult allocation problems as well, including cases in
which the government seeks
to allocate some resource for
private use. In fact, the laboratory experiments of Nobel
Prize economist Vernon
Smith, the subject of this
issue’s Interview, have deepened our understanding of
such allocation questions. For
example, his work on the
design of institutions for the
allocation of airport landing
rights showed how the careful
design of market institutions
can align private incentives
with social objectives. Now
I’m not suggesting that
Professor Smith begin conducting experiments aimed at
solving water allocation problems. His work proves, however, that the interplay
between academic research
and public policy problems
can yield creative approaches
to difficult questions concerning the allocation problems
that local, state, and even
national governments sometimes face. I don’t expect this
flow of benefits to dry up any
time soon.

AL BROADDUS
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND

Spring 2003 • Region Focus

1

FEDERALRESERVE

They’re All Ears
The Richmond Fed’s
Regional Economics
Team Listens
Carefully to the
District’s Economic
Heartbeat
BY BET TY JOYCE NASH

The “Beige Book”
is published two
weeks before each
Federal Open Market
Committee meeting.

2

Region Focus • Spring 2003

A

n old woman who was getting
up in years went to the doctor.
After running a battery of
tests, the doctor came back and told
her that, unfortunately, she had perhaps
six months to live. Naturally, she was
distraught. After thinking about it a
few moments, she asked her doctor
what she should do. ‘I suggest you
marry an economist and move to
North Dakota,’ the doctor said. The
woman was a bit baffled … She asked,
‘How will that make me better?’ ‘It
won’t, but it’ll make your remaining
time seem like an eternity.’ ”
Hoots of laughter fill a meeting
room, proving that even at this early
hour — 7:30 a.m. — the members of the
Construction Financial Management
Association are wide awake. Several
dozen people have gathered over
bacon and eggs to hear the latest
on the regional and national
economy. The featured speaker
is Raymond Owens, a vice president of the Federal Reserve
Bank of Richmond, who told
the above joke to disarm the
crowd and poke gentle fun at
his own profession.
Keeping a good joke at
the ready is a big part of
Owens’ job. He travels
throughout the Fifth District to discuss economic
conditions at various gatherings, as many as 60 in a year. Those economics gigs run two ways, though,
Owens says. He gets as good as he gives.
“Not only do you show up and talk
about the national economic condition,
but you also meet and greet and talk
to people,” he says. “You learn about
the local economy. You get more insight

“

than you ever could by sitting here
reading reports.”
True. Before the talk even starts, the
group launches a roundtable discussion
about the difficulty of finding construction workers and various incentives
to lure them. That’s information Owens
stores and ponders later in the office.
“Why 90 days?” he wonders aloud at
the set time a new employee must stay
for a referral to be rewarded. It could
be a question he’ll use in personal interviews to collect anecdotal information
about the Fifth District economy.
Owens and six colleagues in the
regional economics group of the Richmond Fed analyze plenty of data. In
2002, they put out 128 separate verbal
and written reports and articles. The
researchers also produce massive reports
on the Richmond Fed’s Web site, including a new monthly publication, “5E
Economic Indicators,” that tracks the
District’s most recent activity.
Regional group members Robert
Lacy and Andrea Holland also contribute a regular section on the District
economy to Region Focus.
Some of the timeliest information
the regional group gathers, though, isn’t
online or on paper — it flows from the
people they meet and talk to on the
telephone. These snapshots of the Fifth
Federal Reserve District are ultimately
folded into the “Summary of Commentary on Current Economic Conditions,” more commonly known as the
“Beige Book.” It’s published two weeks
before each Federal Open Market
Committee (FOMC) meeting. The
regional group uses the District information gathered for the book to
prepare briefings for the Bank president as part of the FOMC cycle (see

LARRY CAIN/FRB OF RICHMOND

the Summer 2002 issue of Region Focus
for more on the FOMC). Owens and
his group also contribute additional
research on topics requested by the
Board of Governors.
“When there are issues thought to
be important to the national economy,
we are asked to provide special reports
to the FOMC,” he says. “Let’s say
there’s a big natural disaster — a hurricane or 9/11 — we’ll often compile
information on the impact on businesses and households.”
The Fifth District section of the
Beige Book is a current overview of
retail, services, manufacturing, finance,
real estate, tourism, temporary employment agencies, and agriculture.
Each Federal Reserve Bank contributes summaries noting anecdotal
information about its region’s economic sectors. Have orders expanded
for manufacturers? What is the residential and commercial real estate
market like? Are firms planning to hire
or fire? How about inventories? The
book in its entirety, then, becomes an
instant picture of the national
economy. “To understand the Beige
Book, you have to understand what you
hope to get out of it,” Owens says.
“There’s this idea that regional economic information is important. It [the
Beige Book] captures information that
isn’t captured in a timely fashion [by
traditional numerical measures]. The
theory is that those numbers are
missing important information that can
be useful. The economy is dynamic,
fluid. You don’t want to diminish the
value of those economic numbers, but
they don’t tell the whole story. One way
to fill in those missing parts is with
timely, detailed information at the
regional level.”
Interviews with sources in each
sector contribute to insights about the
economy. The monthly manufacturing
and retail/services surveys, nearly 10
years old in their present form, offer a
wealth of data, especially when fleshed
out with personal interviews, say Judy
Cox and Aileen Watson, assistant economists in the regional unit. The
surveys, intended for up-to-the-minute

Raymond Owens, a vice president at the
Richmond Fed, travels throughout the
Fifth District to discuss economic
conditions. Talking and listening to the
people he meets on these trips provide
valuable insights into the local economy.

internal briefings for Richmond Fed
economists, are released on the second
Tuesday of each month. Cox and
Watson often follow up survey
responses with telephone calls or emails to glean more information. The
personal interviews, Owens observes,
add depth to the data.
“Government enumerators have a
set of questions,” Owens says. “Those
might be important, but they might
not [be the right questions]. If you’re
having a personal conversation with
someone, they’ll tell you what’s on their
mind.” In working the Fifth District
over the past 20 years, Owens has
picked up tidbits that inform his analysis of economic conditions. For
instance, in a conversation with a fellow
from Wilmington, N.C., he found out
that two chemical companies had an
arrangement to share production at
certain times. “It gives you a better
sense of how the capacity in an industry might be stretched,” he explains.
Lacy, who collects information for
the Beige Book and also drafts the Fifth
District’s summary before Owens edits
the final document, interviews bankers
and others working in the financial services industry. He typically calls the same
people he has nurtured in his eight years

with the Bank. “We try to talk with
people who are working directly with
customers,” Lacy says. “We try also to
have a mixture of small banks and big
banks and banks in different states, so
it’s fairly representative.”
Keeping an open mind, as well as
asking the standard sets of questions,
can inspire colorful comments, remarks
Faye Ball, who calls residential real
estate contacts and temporary employment agencies. Here are a few examples from a recent Beige Book:
● A banker reports that borrowing
is sluggish, except among beer
and wine retailers. “People drink
more in a bad economy,” guesses
a source.
● There appear to be some bright
signs in manufacturing. A respondent notes that his industry has
“cleansed itself of weaker companies,” enabling it to “put up
the sail and go with the wind.”
t’s hard to know exactly what these
bits and pieces of information say
about the economy. Yet the
comments can often point to a trend in
the making. Owens cites an example.
“Some years ago, the general impression was that inflation in the United
States was at a moderate rate and perhaps
price pressures were likely to accelerate,”
he recalls, adding that Fifth District
respondents had reported little change in
prices even though significant forecasts
were reporting the opposite. “By the
time we looked back, their reports were
correct. I thought at first they were
perhaps misinterpreting the question. But
their responses were accurate.”
Speaking of accuracy, does the Beige
Book actually get it right? Nathan
Balke and D’Ann Petersen, economists
at Southern Methodist University and
AMRESCO Commercial Finance Inc.,
respectively, evaluated how well the
book reflects economic activity.
“My co-author and I read all the
Beige Books, over about a threemonth period,” Balke says, adding that
they focused on books from 1983
through 1996. They tried to infer what
the descriptions were saying about

I

Spring 2003 • Region Focus

3

Surveys of the
manufacturing and retail/
services sectors are released on
the second Tuesday of each month.

economic growth and then attached a
numerical score to the description.
“We shuffled the Beige Books so we
didn’t know what time period they
were referring to. We tried to guard
against using our knowledge of what
actually happened.”
The two found that the Beige
Books “do have significant predictive
content for current and next quarter
real GDP growth. Furthermore, the
Beige Book has information about
current quarter real GDP growth not
present in other indicators such as the

Blue Chip Consensus Forecast or time
series models that use real-time data.”
Economists in research departments throughout the Federal Reserve
System filter anecdotal information,
says Balke, transforming it into keen
insights. “They use that information
and use their own judgment about
what that information is saying about
the economy. It’s hard to sort it out,
whether it’s the information from the
contacts or the judgment of the staff
that’s providing most of the information. My sense is that probably both
are important.”
Each District’s Beige Book contribution reflects its unique regional economy.
For example, the Federal Reserve Bank
of Dallas calls on energy companies—
including refineries, chemical companies,
and oil and gas extraction industries
—which continue to play an important
role in the area’s economy.
“It’s [energy] still pretty big here, it’s
about 6 percent to 7 percent of output
right now,” says Mine Yücel, senior
economist and vice president of the
Dallas Fed.

The people who provide information to the Federal Reserve Banks for
the Beige Book become valuable contacts who may be called on for quick
facts. For example, after 9/11, the
regional group hit the telephones to
find out from real estate agents
whether deals in progress would go
through, among other investigations.
“We get this very rich information,”
Owens notes. “We can quickly and efficiently get accurate, on-the-ground
assessments of what’s going on.”
The ability to interview is as handy
as a head for figures, Owens notes. But
many economists haven’t honed this skill.
“You’re taught in school the econometric techniques, to pound on the
numbers,” he says. “What you’re never
taught in school is to go out and talk
to people and listen to people. That’s
the lesson the whole regional section
has taken to heart.”
RF
Visit www.rich.frb.org/pubs/
regionfocus for links to relevant
Web sites.

An Update on Check Services
The Winter 2003 issue of Region Focus included
an article on the Federal Reserve’s role in the
check clearing process. (See “The Check
Business,” pp. 2-4.) Since publication, the Federal
Reserve System has announced a major
restructuring of its check services.
All Reserve Banks, including the Federal
Reserve Bank of Richmond, will reduce the
operating costs of their check services by taking
such measures as streamlining the check
management structure, reducing staff, decreasing
the number of processing locations, and
increasing processing capacity at remaining
locations. These changes are in response to
nationwide declines in check volume as
consumers and businesses increasingly use
electronic methods of payment.
Currently, 45 locations in the Federal
Reserve System process checks and 43 locations
perform check adjustments. By the end of
2004, 13 processing sites and 31 adjustment sites
will close. As many as 1,300 positions at these
locations may be eliminated, but approximately

4

900 jobs will be created at the remaining sites
to handle the extra volume transferred to them.
In the Fifth District, check services are
provided in Baltimore, Md.; Charleston, W.Va.;
Charlotte, N.C.; Columbia, S.C.; and Richmond,
Va. The restructuring plan calls for the
Charleston office to transfer its processing and
adjustment operations to Cincinnati and
Cleveland, respectively, while the Columbia
office will move both operations to Charlotte.
Since the Charleston and Columbia offices
provide only check services, they will be closed.
In addition, Richmond’s check processing will
move to Baltimore and its check adjustments
will relocate to Charlotte.
All told, about 225 check services positions in
the Fifth District will be eliminated. However, the
Richmond Fed expects to add about 100 positions
in Baltimore and Charlotte to handle their
increased processing and adjustment workloads.
The restructuring plan is expected to reduce
annual systemwide operating costs for check
services by about $60 million starting in 2005.

Region Focus • Spring 2003

The goal is to help the Federal Reserve System
recover the cost of providing payment services
to financial institutions, a requirement of the
federal Monetary Control Act of 1980. While
the Fed earned an average annual after-tax
return on equity (ROE) of 12.2 percent for its
payment services from 1992 to 2001, declining
check volumes and other factors reduced its
after-tax ROE to 4.2 percent in 2002.
“Nationwide, consumers and businesses have
made a significant shift in how they make
payments, substituting electronic payments for
checks. This development is good news for the
nation’s payments system,” says Cathy Minehan,
president and CEO of the Federal Reserve Bank
of Boston and chair of the Federal Reserve
System’s Financial Services Policy Committee.
“But declining check volumes are requiring the
Reserve Banks to make changes in their check
operations to address the challenges posed by
the changing market. [The restructuring plan]
will help us meet these challenges.”
—C H A R L E S G E R E N A

LEGISLATIVEUPDATE
Covering the Cost of Terrorism
BY C H A R L E S G E R E N A

T

I
I
I
I

PERCENTAGE

OF

RESPONDENTS

I

required insurers to cover terrorism in a manner that “does
he tragic events of Sept. 11, 2001, made it frighteningly
not differ materially” from other aspects of their policies.
clear that the United States was vulnerable to terrorist
The bill also created a federal program that will back the
attacks. Fear suddenly gripped the nation, including
insurance industry when an attack results in claims exceeding
insurers faced with claims that surpassed the record $17 billion
$5 million. For each claim, the program will cover 90 percent
in insured losses from Hurricane Andrew in 1992. Uncertainty
of insured losses paid to policyholders. But this coverage kicks
about future attacks led to a much-publicized shortage of terin only after the insurer meets a deductible based on its prerorism coverage that rippled through the economy. In response,
miums received in the previous year. In 2003, the deductible
Congress approved a bill last November that puts Uncle Sam
will be 7 percent of premiums collected, then it will rise to 10
in the terrorism reinsurance business.
percent of premiums in 2004, and 15 percent in 2005.
Reinsurance companies provide primary insurers with addiLawmakers were concerned that the high costs of terrorism
tional capital to cover extraordinary claims after a major disinsurance could damage an already soft economy. In particular,
aster. But the Sept. 11 attacks forced reinsurers to reassess the
they worried that, without government action, many new conlikelihood and extent of damage from terrorists. Many firms
struction projects would be postponed or foregone.
decided to stop underwriting terrorism risks when policies
Some insurance experts argue, though,
came up for renewal in 2002. With fewer
Independent Insurance Brokers and Agents
that Congress didn’t need to create a broad
reinsurers willing to risk their capital,
Who Reported a Change in Commercial
reinsurance program. That’s because the
primary insurers were forced to lower their
Property Premiums During the Quarter
shortage of terrorism coverage has affected
maximum payouts on terrorism-related
80
mostly high-profile properties and densely
claims, increase premiums to cover terrorpopulated cities. The Consumer Federation
ist attacks separately, or exclude coverage
Increased more
60
of America recently researched the availaltogether.
than 50%
Increased 10-50%
ability of coverage and found that “there
England faced the same problem in the
Increased 1-10%
40
were very few problems, mostly centered in
1990s. Reinsurance firms dropped or limited
No change
New York City,” says J. Robert Hunter, directheir terrorism coverage in response to a
tor of insurance of the Arlington, Va., group.
long string of bombings perpetrated by the
20
“The problem with New York is that all of
Irish Republican Army. This led business
the buildings are right up against each other.
interruption and building insurers to reduce
0 I
I
I
I
Q4
Q1
Q2
Q3
If a bombing occurs, it hits a whole bunch
their exposure to terrorism-related risks. The
2001
2002
2002
2002
of places at once. Insurers were worried
British government responded by creating
SOURCE: Commercial Insurance Market Index surveys,
about concentration of risk.” Chicago also
a mutual company that provides reinsurance
The Council of Insurance Agents and Brokers
had problems, but not Los Angeles since it
to its member firms. Spain, France, and
is spread out over a larger geographical area.
Germany also have federal reinsurance programs that cover
Another argument against federal terrorism reinsurance
terrorism risks, while Israel has a special fund that pays for
is that insurers were already making progress in calculating
property damage triggered by politically motivated violence.
and pricing terrorist risks. Premiums for some policies were
Why have governments stepped into the private marfalling and new risk models were in the works.
ketplace to cover terrorism risks? After a major disaster, “covFinally, Hunter and others worry about the economic implierage declines and prices go up because insurers don’t have
cations of the federal government providing reinsurance at no
as much capital” to cover claims in the near term, says Anne
cost. Will the private sector be less willing to offer reinsurance
Gron, assistant professor of management and strategy at
because they won’t want to compete? Will insurers be less likely
Northwestern University. Eventually, however, rising prices
to encourage their policyholders to reduce their terrorism risks
“encourage capital to come into the industry” and insurers
because they won’t suffer the full financial consequences?
determine how to cover a similar disaster in the future.
Despite these concerns, the new program will hopefully
Robert Hartwig, senior vice president and chief econointroduce certainty into the insurance industry. “Insurers
mist at the Insurance Information Institute, believes that it
understand that in the event of a future terrorist attack they
would have taken awhile for the terrorism insurance market
are going to sustain losses,” concludes Hartwig. Now, “insurin the United States to adjust. “And some insurers wouldn’t
ers know what their maximum possible loss is. [And] they
have participated [in the market] at all,” he adds.
can make sure they have adequate capital to handle the worstCongress decided not to wait. The Terrorism Risk Insurcase scenario.”
RF
ance Act nullified existing exclusions of terrorist acts and

Spring 2003 • Region Focus

5

SHORTTAKES
T R A N S P O R TAT I O N P L A N N I N G

Charlotte Tackles
Transit and Land
Use Together

C

The Charlotte Area Transit
System will use a combination of rapid-transit buses,
streetcars, and light-rail
trains, depending on
population density.

HARLOTTE, N.C. —
The freedom and convenience of automobiles is
tough to beat, especially in
metropolitan areas where
multiple commercial and
residential centers are spread
out over long distances. Mass
transit can’t serve these areas as
efficiently because the population is too dispersed.
Charlotte is hoping to
tackle this conundrum by
simultaneously planning
denser development and a
regional transit system. Work

CHARLOTTE AREA TRANSIT SYSTEM

6

Region Focus • Spring 2003

should begin this year on the
first leg of the $3 billion
system, the most expensive
transportation project in the
works for North Carolina.
While sprawl will continue, the city’s integrated
transit and land-use plan will
encourage the creation of traditional neighborhoods where
home, work, and shopping are
just a train or bus ride away.
“[We want] to concentrate the
majority of future growth in
five major travel corridors;
create mixed-use, pedestrianfriendly developments [along
the corridors]; and construct
a transit system to support
them,” describes Ronald
Tober, chief executive of the
Charlotte Area Transit System.
“It will take time [but] it will
be better from an environmental standpoint by keeping
down the loss of trees and
farmland, as well as keeping
down vehicle miles traveled.”
John Silvia was skeptical
about this plan at first.
Silvia, chief economist at
Wachovia Corp., says Charlotte is fairly dense, but not
as dense as other cities with
transit systems like Chicago.
Now, he is more optimistic about the success of
Charlotte’s transit system
because of its flexible implementation. In areas with
sparser development, like the
southeast corridor leading to
suburban Matthews, rapidtransit buses will operate
along roadways separated
from traffic. In more developed areas, like the southern
route to the town of Pineville,
light rail with greater passenger capacity is planned.
Charlotte’s approach is
innovative, but will it relieve

congested highways? According to research by transportation consultant Wendell Cox,
new rail routes tend to draw
commuters away from bus
lines, not out of their cars.
Moreover, “Charlotte does
not have a strong bus ridership base to feed light rail,”
Cox wrote in a recent report.
Also, can mass transit
accelerate economic activity,
or does the activity have to
occur first? Silvia believes it
can happen either way, but a
train station or bus stop
doesn’t guarantee development of the surrounding area.
He points to some stations in
Chicago where little has
changed and others that have
become bustling centers of
commerce. The key is having
other elements in place to
support growth, such as sufficient land for development.
Of course, the community must want more growth.
Pineville was supposed to
have a light-rail station
serving its downtown, but
local officials opposed it
because of their concerns
about traffic. A small town
can get overwhelmed by
people, notes Silvia.
—C H A R L E S G E R E N A

MEASURING HAPPINESS

How Happy
Are You?

E

conomists have entered the
realm of happiness research,
asking such questions as how
do economic conditions and
legal institutions affect people’s
perceptions of well-being? The
results reveal a great deal about
economic behavior, says Carol
Graham, vice president and

trialized nations, average happiness hasn’t kept pace with
rising per capita incomes, so
money may not buy happiness
after all. For example, in the
United States, per capita real
income increased 2.5 times
from 1946 to 1991, but happiness, on average, remained
constant, according to established findings. The same
thing happened in Japan,
according to several scholars.
In 1991, people in Japan made
six times the amount of
money they did in 1958, but
average life satisfaction
remained exactly the same as
it did in 1958. So what gives?
Economist Richard Easterlin
of the University of Southern
California published an article
in the Economic Journal in
2001 that shows that as people
earn more money, they want
more money. Easterlin says he
searches for patterns among
the data. “For the population
as a whole, the pursuit of
income as a source of happiness is illusory,” he says.
Investigations into happiness open “a whole new
way of thinking about economic
measures
and
progress, based on one of
the oldest concepts in
history,” Graham says.
—B E T T Y J OYC E N A S H

I N D U ST RY C L U ST E R S

Bringing Biometrics
to West Virginia

W

est Virginia has fostered
its high-tech industry
for years, especially in
communities along a 35-mile
stretch of Interstate 79 in the
north central portion of the
state. With the help of state

and federal officials, a growing
number of scientists in the
region are expanding the
frontiers of biometrics,
technologies that identify
individuals by their physical
and behavioral characteristics.
What will it take to translate
this research activity into
commercial activity and jobs?
The global biometrics
market was worth around
$119 million in 2000. Terrorism threats have accelerated efforts to control
access to buildings and sensitive information, leading
industry analysts to expect
the market to finally take
off. Until now, widespread
adoption of biometrics
technology — ranging from
retinal scanners to voice verification systems — has
been slow and the industry
has remained fragmented.
Given the nature of the
biometrics industry, companies will need compelling
reasons to cluster in north
central West Virginia. Economist Michael Hicks at Marshall University describes a
few economic factors that
generally lead to an agglomeration of industry.
First, a region could have
attributes that make it
cheaper to produce a particular product or service,
such as easy access to
human capital and technology. In the case of the biometrics industry, Hicks says
that companies save money
by locating where there are
scientists and laborers who
work with electronics.
The I-79 corridor has this
human capital. The FBI’s fingerprint database is headquartered in Clarksburg, the

WEST VIRGINIA UNIVERSITY

director of the Governance
Studies Program at the
Brookings Institution. “Things
like economic security, employment status, health, and marital
status are much more important
than the standard [economic]
models assume,” Graham notes.
In a book published on
the subject in 2002, Graham
and co-author Stefano Pettinato examine data from 17
Latin American countries
and from Russia. Among
other things, they find that
relative income differences
have important effects on
how people assess their
well-being, and that those
people in the middle or
lower middle of the income
distribution are more likely
to be dissatisfied than are
the very poorest groups.
In a working paper called
“Does Happiness Pay?”
Graham and co-author
Maria Fitzpatrick investigated panel data for 6,500
respondents in Russia from
1995 to 2000. The paper
found that “static variables
such as gender, stable
marital status, and education levels are more likely to
have effects on normal happiness levels, while changes
in socioeconomic or marital
status (particularly divorce)
are more likely to cause fluctuations in happiness levels.”
What’s more, happiness and
positive expectations about
the future correlated positively with higher future
income, while low selfesteem and negative perceptions were linked to
smaller increases in income.
In
other
happiness
research, economists have
found that in western indus-

Biometric technologies like
this hand reader identify
individuals by their physical
characteristics.

Department of Defense’s
Biometrics Fusion Center is
temporarily based in Bridgeport, and West Virginia University has developed a
Center for Identification
Technology Research in
Morgantown. In addition,
the university teaches biometrics as part of its forensic science program.
Second, Hicks says companies could be drawn to a
region where many people
need a particular product or
service. While locating factories near such a customer
base doesn’t always save
money, there are marketing
advantages to having a sales
or service office close by.
“It’s easier to give a call to a
local guy,” notes Hicks.
Consequently, biometrics
companies serving government agencies in the midAtlantic may establish a
presence in the region.
Ralph Bean Jr., chairman
of the I-79 Development
Council,
believes
the
region’s good quality of life
and its telecommunications
infrastructure should attract
biometrics firms. However,
West Virginia needs more

Spring 2003 • Region Focus

7

B A LT I M O R E B O O S T S PAY
FOR SOME WORKERS

Living Wage Laws

A

cross the country, roughly
90 communities have
passed “living wage” laws. The
measures require companies that
do business with city or county
governments to pay their
workers more than the federal
minimum wage of $5.15 an hour.
The exact amount varies, but the
wage is supposed to be sufficient
to support a family of four at a
level above the federal poverty
line, according to theAssociation
of Community Organizations
for Reform Now (ACORN). In
some cases, the living wage has
been set as high as $12 an hour.
The living wage movement is generally acknowledged to have gotten its start
in Baltimore. In 1994, the city
passed a law requiring private
companies with city contracts to pay their workers
$6.10 an hour. Over time,
that figure has risen and now
stands at $8.49.
The law was controversial
from the beginning. Many

8

people predicted that it would
harm Baltimore’s already struggling economy and bust the
city’s budget. Others argued
that a living wage would reduce
government spending on
social-service programs aimed
at helping the poor.
Eight years later, the law
remains controversial. The
Employment Policies Institute, for instance, claims
that “contract costs did,
indeed, rise rather than fall
after the implementation of
Baltimore’s living wage legislation.” But a report from
the Economic Policy Institute (EPI) says that the law
has helped “workers in Baltimore without significant
financial cost to the city.
Moreover, the evidence suggests that higher wages and
hours improve the stability
and reliability of the work
force.” The EPI report concedes, though, that the living
wage has aided only a small
group of workers and that
employer noncompliance
remains a serious problem.
David Neumark, an economist at Michigan State University, has tried to reconcile
such varying claims. In a
nationwide study of living
wage laws, Neumark argues
that the measures have had
modest success combating
poverty. The reason: since
coverage is limited to employees of city contractors, only a
tiny fraction of low-income
workers are affected. Instead,
the major benefits have
accrued to unionized municipal workers. By raising the
wages that private firms have
to pay, Neumark writes,
“living wage laws may reduce
the incentives for cities to

Region Focus • Spring 2003

contract out work that otherwise would be done by
municipal employees, hence
increasing the bargaining
power of municipal unions
and leading to higher wages.”
According to ACORN, four
other Fifth District communities — Alexandria, Va., Charlottesville, Va., Durham, N.C.,
and Montgomery County, Md.
— have already passed living
wage laws. Richmond, Va., is
also considering doing so.
—A A RO N S T E E L M A N

TUITION COSTS CLIMB

But Enrollment Is
Still Up

S

tate budget cuts have
forced public colleges and
universities to raise tuition.
Nationally, tuition costs at
public colleges increased
almost 7 percent in the most
recent year, up from roughly 3
to 4 percent in previous years.
State schools in the Fifth
District likewise saw unprecedented tuition hikes. At West
Virginia University (WVU),
for instance, tuition increased
by 9.5 percent from the 2001
to the 2002 academic year.
Statewide budget cuts, which
have hit higher education particularly hard, have forced “the
school to recoup some [of the
loss] by raising tuition,” says
Bill Nevin, external communications manager at WVU.

MATT KINGSLEY/FRB RICHMOND

venture capital to really get
the industry off the ground.
So far, California-based
Ethentica by Security First
Corp. plans to move to Fairmont this year, and there are
rumors of other companies
considering a similar move.
Nonetheless, an agglomeration
of biometrics firms may be
years away from forming in a
state with a history of natural
resources-based industry.
“Changing
economic
forces is like moving the
Titanic,” says Hicks.
—C H A R L E S G E R E N A

“Yet last fall, the school
enrolled 23,000, its highest
enrollment in several years.
And graduate enrollment
increased by 1.8 percent.”
In January, the Board of
Regents of the University
System of Maryland approved
a mid-year 5 percent tuition
hike. “This is a cyclical
pattern, it has happened
before, it will happen again,”
says Laura Perna, assistant
professor of education policy
at the University of Maryland,
College Park. “The real danger
is that these tuition increases
are occurring at a time when
families are facing a lot of
other financial challenges
brought on by layoffs and
declines in their personal portfolios. Just like the states, families are finding they also have
fewer financial resources.”
Despite the increases in
tuition, enrollment figures
at the Fifth District’s public
universities continue to rise.
Graduate enrollment, in particular, may be positively
affected by the sluggish
economy. The reason: unemployed workers having a hard
time returning to the job
market may decide to go to
school to improve their skills.
—E L A I N E M A N DA L E R I S
Tuition at West Virginia
University increased by 9.5
percent from the 2001 to the
2002 academic year.

JARGONALERT
Inflation
BY A A RO N ST E E L M A N

M

ost people have a general idea of what inflation
means: a rise in prices. But the issue can get confusing
when you move to specifics, because inflation is
measured in so many different ways. Three of the most common
measures are examined below.

ILLUSTRATION BY TIMOTHY COOK

Consumer Price Index
When you hear a news item about inflation, chances are the
reporter is talking about the Consumer Price Index (CPI).
The CPI tracks the change in prices paid by urban consumers
for a market basket of goods and services. That basket is
made up of more than 200 categories, arranged into eight
major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services.
The CPI also includes governmentcharged user fees (such as auto registration fees) and taxes that are
directly related to the sale of a good
or service (such as sales taxes).
More than 2 million workers are
covered by collective bargaining
arrangements that tie wage increases to
the CPI. What’s more, the CPI is used to
adjust tax brackets and transfer payments,
such as Social Security.
The prices of certain items within the
CPI basket tend to change more than others.
The “core CPI” is an attempt to control for that
problem. It excludes food and energy, because
their prices are often volatile on a month-to-month
basis. The core CPI usually gives a better measure of where
inflation is headed in the near future.
Recently, the CPI has been criticized for overstating inflation, for a variety of technical reasons. Consider the problem
of “quality bias.” “New and improved products often cost
more because of their enhanced features. In theory, however,
such improvements should not count as a net price increase
to the consumer,” writes Kevin Kliesen of the St. Louis Fed.
“Examples that improve living standards include new medical
procedures and more energy-efficient central air conditioners. While difficult, accounting for this quality change is nevertheless necessary.” The Bureau of Labor Statistics (BLS),
which compiles inflation figures and reams of other economic
data, is refining the way it estimates the CPI in response to
such criticisms.

Producer Price Index
While the CPI measures the prices paid by the consumer,

after production is complete and the item is ready for sale,
the Producer Price Indexes (PPIs) measure prices earlier in
the process, when companies are buying the materials they
need to make finished products.
PPIs are available for more than 10,000 individual items
and are frequently used as the basis for contract escalator
clauses. For instance, a long-term contract for bread could
be indexed to account for changes in the PPI for wheat.
“Seasonally adjusted” PPI and CPI numbers are also available. According to the BLS, seasonal adjustment is a statistical
technique that “eliminates the influences of weather, holidays,
the opening and closing of schools, and other recurring seasonal events from economic time series. This permits easier
observation and analysis of cyclical, trend, and other nonseasonal movements in the data. By eliminating seasonal fluctuations, the series
becomes smoother and it is easier to
compare data from month to month.”

Personal Consumption
Expenditures Price Index
The Department of Commerce’s
Bureau of Economic Analysis compiles
the Personal Consumption Expenditures
Price Index (PCEPI). The PCEPI differs
from the CPI in important ways. First, the
formula it uses for combining component prices
is known to better approximate true changes in standards of living. Second, it tracks the prices of several
items that are completely left out of the CPI. Third, it
assigns different weights to certain categories of goods
and services. For example, in 1996, physician expenses
amounted to roughly 3.77 percent of the total spending that
falls within the scope of the PCEPI, but just 1.89 percent of
the CPI market basket. Finally, the PCEPI takes into account
“substitution effects” — that is, when consumers replace one
product with a lower-priced alternative, over time the weights
on those products shift accordingly. The weights in the CPI,
in contrast, remain fixed for years at a time.
The CPI and the PCEPI often track fairly closely. But in
a recent paper, Dennis Fixler and Ted Jaditz of the BLS note
that there have been “several periods where the differences
between the two inflation rates is large.” For instance, CPI
inflation was 2.4 percent from December 2001 to December 2002, while inflation as measured by the PCEPI was 2
percent over the same period.
The PCEPI hasn’t replaced the CPI as the inflation
measure of choice. But it’s increasingly popular with economists and policymakers.
RF

Spring 2003 • Region Focus

9

Running on

Empty?
While the Fifth District’s water supply
outlook isn’t as dry as you might think,
the region could benefit from water
policy reform.
BY BET TY JOYCE NASH

The Hollow Creek Golf Club
has been working with the
town of Middletown, Md.,
on a plan to use water from
the town’s wastewater
treatment plant to irrigate the
drought-stricken golf course.

hen rainfall swells streams,
water supply worries wash
away. But when the rain stops,
questions over ownership, supply, use,
allocation, and price bubble to the surface,
creating turbulence among users.
Water knows no boundaries.
Whether it flows through the deep
aquifers beneath the earth or in the
powerful rivers on the planet’s surface,
water quenches the thirst of industry,
households, agriculture, and recreation,
keeping daily life processes and commerce flowing.
Like much of the East, the Fifth District has historically been awash in water.
And still is, says Leonard Shabman, a
resident scholar in environmental policy
with Resources for the Future (RFF), a
Washington, D.C., think tank.
“I don’t want to underplay the
drought,” he says, adding that the economic and ecological system has
adapted to the amount of water that’s
there, whether it rains every day or
once a year. “And then the question
becomes, given that resource, to what
uses will you put it?”
In other words, water, like any other
commodity, can become scarce. The
trick is to determine how to best
manage its allocation, given competing
social needs.
The 2002 drought is prompting
states to manage water differently, says
Terry Wagner, director of water
resources management for the Virginia
Department of Environmental Quality.
Virginia’s latest drought, one of the
worst in a century, highlighted supply
issues and exacerbated conflicts.
“Whether the drought continues or
not … we will see increases in potential
for competition for water resources,”
Wagner says.

W

Free Water

AP PHOTO/RICKY CARIOTI

There’s nothing like scarcity to bring
about change.
“When there are no droughts, there
are no choices — people don’t think
about it,” Shabman notes. But the
legacy of recent droughts coupled with
exploding populations in the District’s
urban areas has put water allocation,
along with pricing and conservation
measures, in the spotlight.

AP PHOTO/THE DAILY PROGRESS, ANDREW SHURTLEFF

?

Water conservation signs were prominent all over the University of Virginia campus as
students and faculty worked together in an effort to conserve water at the University and
the surrounding Charlottesville, Va., area during the 2002 drought.

Traditionally, people pay for water
based on provision of plants, pipes, and
treatment services. Pricing the water
itself is an idea economists sometimes
advocate but is politically unpalatable,
says Jim Boyd, an economist at RFF.
People perceive water, like air, as a
birthright. Water comes from God, the
joke goes, but he forgot to put the
pipes in the ground.
“The fact is, people waste water,”
says Boyd. “It’s free.”
Echoing Boyd’s observations is
Stephen Ragone, science and technology director of the National Groundwater Association.
Complicating the consumption issue
is the required value now attached to
leaving water in place, Ragone says.
There’s an inherent tension between
private uses of water and its public-good
attributes, those that benefit everyone.
Ragone notes water’s commodity
and common-good values, each serving
the other. For example, low river levels
have docked industrial barges, preventing commerce as well as fostering
pollution. Water protects endangered
species and dilutes potentially toxic
pollutants, a public service. “If you
don’t have surface water, you don’t have
ecosystems,” Ragone says. And the
same goes for groundwater. In many
parts of the country, he says, excessive
groundwater withdrawals have caused
the earth to sink in spots. “When you
pump out the water, you remove the
pressure that water conveys on the
clays and sands and then it collapses.
“When you create imbalance by

only pricing water for its commodity
use, we’re building in future problems.
… A lot of people are saying, we have
to get back to more natural use patterns. Use it where you live and return
it to where you live.”
Water experts throughout the District are reaching similar conclusions.
“We used to be in the Garden of
Eden: there was so much water we
didn’t need to worry about it. You could
just pluck fruit from the tree. Now
there are more of us and we use more
water,” says John Morris, director of
the North Carolina Division of Water
Resources. His state’s water supply is
being stretched by a 21 percent increase
in population between 1990 and 2000
— much of that in urban and coastal
areas. “There’s still enough to meet our
social needs, but we have to plan ahead
and manage it better, make our users
manage it efficiently.”

Price Tag
Though the East may be years away
from pricing raw water, the cost of
service can help regulate water flow.
Water rates are undoubtedly headed up
as stringent federal drinking water laws
and aging water infrastructure drive up
costs. The General Accounting Office
estimates future investments in drinking water systems could range from a
low of $12 billion annually to a high of
$20 billion. Experts seem to agree that
higher prices are on the way and that
could help spur conservation.
Water appears to be a “natural
monopoly;” that is, it requires substantial

Spring 2003 • Region Focus

11

conveyance infrastructure so it is efficient
for one enterprise to invest rather than
many. Most water treatment plants that
serve municipalities are publicly operated
as self-funding entities. But private corporations are increasingly buying water
systems and competing for management
contracts (see sidebar on p. 14).
Historically, the Southeast has used
declining rate structures to price water,
partly as an incentive to lure industry.
The more water used, the less it costs.
Such thinking was particularly beneficial to heavy water users, such as textile
producers. But as the South’s industrial
base has changed and as water becomes
more precious, the philosophy behind
water rates is changing too, according
to Lex Warmath. He is vice president
of Raftelis Environmental Consulting
Group Inc. of Charlotte, N.C.
It’s the average homeowner who uses
the most water in urban areas, Warmath
says. “In communities like Charlotte and
Cary, N.C., residential usage is 75
percent to 90 percent of total usage.
“[There have been] some technological innovations that allow industries to
use less water. But [with] residential

growth, neighborhoods continue to
expand … with a lot of green areas,” he
says. And along with the suburbanization
of the Southeast comes the big house
with the big yard, expected to be green
12 months a year. It’s not uncommon to
find new homes with five bathrooms
instead of the two bathrooms common
decades ago, he notes.
“People continue to build houses with
large lawns and that creates a huge, seasonal water demand,” Warmath says.
Warmath consults with public utilities to set rates that recover costs as well
as other objectives, which vary by community. “[One] objective that is coming
to the forefront is what can we do with
our rates that encourages people to use
water more wisely? You can be aggressive
in your rates or just send a little
reminder,” Warmath says, depending on
the political climate and level of affluence
in the community.
One community he’s worked with is
Cary, N.C., just outside Raleigh and
home to such mega-employers as IBM
and SAS Institute. Cary sought water
solutions as its population jumped from
about 3,300 people in 1960 to 105,000

Water Goes Where the Demand Is
Daily water withdrawals increased 721 percent in Brunswick County from 1990 to 2000,
even though population growth in that county was only 15 percent during the same
period. Part of that increase is due to withdrawals from Lake Gaston, where up to 60
million gallons of water are transported daily to the city of Virginia Beach.

Change in Water Withdrawals
Negative
0 to 100%
100 to 200%
200 to 400%
More than 400%

Halifax County

Mecklenburg County Brunswick County

SOURCE: National Water-Use Information Program, U.S. Geological Survey

12

Region Focus • Spring 2003

City of
Chesapeake

City of
Virginia Beach

today, says Kim Fisher, director of public
utilities. The town put in place a water
conservation program in 1996, including a plan to sell reclaimed water, or
treated wastewater, to customers with
underground irrigation systems.
“We estimated on a peak day we could
divert a million gallons a day if we had a
reclaimed water system,” Fisher says. “…
this past June, when it was so stinking
hot and dry, our peak day was 1.2 million
gallons.” In the summer, he explains,
between 40 percent to 50 percent of
water demand can be for irrigation.
Cary aims also to change water use
patterns through behavior. Advertising,
increased water rates, and water use
restrictions send the message that the
water supply is finite.
“Over the last three to four years,
our total water sales revenues have been
pretty level,” Fisher notes. The rate
structure is now an increasing block
rate, meaning that if customers use less
water, they’ll get a discount. As they use
more, they’ll pay for that luxury.
Cary may be atypical because of its
affluent and educated populace, but
many communities are being forced to
review prices, Warmath says. Historically, the federal government provided
money to build water treatment plants,
but that money dried up in the 1980s,
as responsibility for infrastructure was
pushed down to state and local levels.
Raising the price of water may conserve supply, but the price elasticity for
water suggests that a 10 percent
increase would decrease demand by
only about 2 percent. Only a dramatic
price hike would get people’s attention,
Warmath says. “You’d be amazed at how
much you have to raise the price to
make people stop using water. Realistically, people’s water bills still tend to be
about half what their cable bills are.”
Doubling the price of water does
get results, Warmath says. Still, price
isn’t everything. “The price does
matter, but it’s not a solution in getting
people to significantly change their
habits in the short term.”
Even with aggressive water reduction targets, there’s bound to be a
supply problem if the population keeps
growing. Say a community cuts water
use by 20 percent in 10 years but is

Coastal communities in the Fifth District have
supported a growing number of thirsty residents
and businesses for decades. As they continue to
deplete their freshwater sources, however, supply
constraints loom. Many have resorted to
desalination to develop saltwater sources.
Distillation, the most common method of
removing salt from water, has been around for
centuries. Saltwater is heated until it evaporates,
then the vapor is condensed into freshwater.
Two other desalination methods were developed
during the latter half of the 20th century,
electrodialysis and reverse osmosis. Both filter salt
using membranes, thin barriers that permit only
particles of a certain size or type to pass through.
All three methods consume a lot of energy,
accounting for up to half of a desalination
plant’s operating costs. They also require
specialty materials that can withstand
corrosion. As a result, desalination is relatively
expensive compared to traditional water
treatment techniques. “For the typical city with
freshwater sources that are not environmentally sensitive, a utility would not look at
desalination because of the cost,” notes Ben
Movahed, a Beltsville, Md.-based engineer and
president of the American Membrane
Technology Association.
However, desalination is becoming more cost
competitive. One reason is the rising fiscal and
ecological toll of building reservoirs, pipelines,
wells, and other infrastructure to meet water
demand. “There are more cities, especially coastal
cities, that are running out of freshwater. . . or
cannot withdraw it without an environmental
impact,” explains Movahed. “Those are the cities
that are looking at desalination.”
At the same time, the cost of desalination has
fallen. “In the last five to seven years, the
membranes have dropped 50 percent in price,”
says Neil Callahan, who heads the Tampa office of
R. W. Beck Inc., a consulting and engineering firm.
This has helped broaden the market for
desalination. In addition to unlocking new
water supplies, membranes are used to remove
heavy metals, bacteria, and other contaminants
from water.
Still, water utilities can’t afford to produce
potable water from the blue seas surrounding
coastal communities. Seawater, as well as
groundwater near the surface, is very salty,
requiring more energy for the desalination process.
In addition, the water must be pre-filtered.

DARE COUNTY WATER DEPARTMENT, DARE COUNTY, N.C.

Desalination Opens a New Spigot for Water Utilities

Parts of coastal North Carolina depend on desalted groundwater to supplement their water
supply. Dare County, N.C., has built three desalination plants over the last 14 years to support
their burgeoning residential development and tourist trade.

Instead, utilities typically desalt water far
below the surface in deep aquifers, which are
relatively abundant along the Atlantic Coast.
This water isn’t as salty because it has seeped
through layers of clay and sand before
collecting in the aquifers.
On the Virginia Peninsula, Newport News
Waterworks operates a desalination plant that
taps into aquifers as deep as 1,000 feet. The
water produced from the plant is “two to three
times more expensive” than water from the
utility’s four reservoirs, according to Ronald Harris,
chief of water resources. Nevertheless, he believes
the cost to the utility’s customers in Hampton,
Newport News, Poquoson, York County, and James
City County is justified.
Harris says the desalination plant is needed to
augment the Peninsula’s water supply until the
King William Reservoir is built. During the last
drought, surface water supplied about 55 million
gallons a day to Waterworks’ customers, but daily
demand almost reached that level. Without the
four-year-old desalination plant, Harris says there
would have been a risk of a shortage.
Other Peninsula communities have turned
to desalination to supplement their water
supplies because the new reservoir could take
at least 10 years to complete. James City
County is one of them.
“Based on our projected demand, we knew
that we didn’t have adequate water to meet
our needs in four years,” says Larry Foster,
general manager of the James City Service
Authority. Even now, the county has a tough
time in the summer, when outdoor water use
increases demand by 60 percent to 80 percent
compared to the winter season.
While these communities supplement their

water supply with desalted groundwater, parts of
coastal North Carolina depend on it.
For example, Dare County has built three
desalination plants over the last 14 years, pushing
up wholesale water rates for beachfront towns
like Nags Head from 75 cents per thousand
gallons in the 1980s to as high as $1.35, according
to utilities director Robert Oreskovich. The towns
had to pay the higher cost of desalted water to
support their burgeoning residential development
and tourist trade. “Groundwater desalination was
the least expensive alternative,” he says.
In Southern California, water utilities built
desalination plants to avoid the expense of
new aqueducts, notes engineer Neil Callahan.
Florida also has a significant number of plants
because the state has lots of coastline and
certain areas are hot and dry, he explains,
limiting freshwater supplies.
Tampa Bay officials hope to achieve seawater
desalination on a large scale where Key West and
Santa Barbara, Calif., failed to do so economically.
Their strategy is to operate a 25-million-gallon
desalination plant within a power generation
facility. This enables the plant to utilize some of
the seawater drawn from Tampa Bay to cool the
power facility’s generators. Also, the plant’s briny
waste product is mixed into the water that the
power facility already discharges into the bay.
Consequently, Callahan says the plant needed
fewer permits since its environmental impact is
minimized, and it requires less pumping and
discharge equipment.
If the Tampa Bay project succeeds, Movahed
and others believe the approach of co-locating
desalting and power generation facilities could
serve as a model for future desalination projects.
—C H A R L E S G E R E N A

Spring 2003 • Region Focus

13

growing at 5 percent a year. “Your water
use will still go up, and if you’ve got a
supply problem, your situation is going
to get worse.”
In Concord, N.C., a bedroom community for Charlotte, town officials knew
their water and sewer rates didn’t reflect
the true cost of operations. The town
recently implemented rate structures for
residential and industrial users aimed at
conserving their limited water supply.
In Eastern North Carolina, the
town of Kinston relies on deep groundwater in the Black Creek Aquifer. Historically, industries such as textiles and
tobacco processing, along with domestic and agricultural water use, have
sucked too much from the aquifer for
it to properly recharge. The state is
requiring Kinston to reduce withdrawals. That means that, by 2016, it
will need to cut its dependence on the
aquifer by 75 percent, according to
Ralph Clark, Kinston’s city manager.

He explains that the deep water was
cheap and good. Maybe too cheap and
too good. “What’s happening is we’re
taking out more than is being
recharged,” he says. “Now is the time
to address the problem rather than
waiting until you’re 100 feet down.” The
water needed virtually no treatment, he
says, admitting the city was spoiled.
“We had been used to getting this highquality water at virtually no cost.”
But all that’s changing, as Kinston
recently formed a water and sewer
authority to build a surface water
treatment plant to take the burden off
the slow-to-recharge aquifer. It won’t
be cheap. Estimates have come in at
$110 million.
Clark says that selling that change
to consumers will be a tough job.
“The consumers are going to be reeducated one way or the other,
through pricing or conservation. It’s
going to be a real challenge.”

Hot Water
During the dry spell in the summer of
2002, the pressure on water supplies
intensified debates among water users
sharing a single source. Such conflicts
are common, but they are often about
issues other than water, notes economist
Shabman. He consulted on the Lake
Gaston project, an effort that pipes
water from the Roanoke River Basin 125
miles to Virginia Beach, Va., approved
after years of court wrangling. “In that
case it was about, ‘This [was] our water
and you can’t have it,’ ” he says. Virginia
Beach succeeded in its efforts largely
because the opposition could not make
the case they would be harmed by the
withdrawal, Shabman says.
Like all flowing waters, the YadkinPee Dee River system respects no manmade boundaries. It runs from the
foothills of the Appalachian Mountains
to the Atlantic Ocean near Myrtle
Beach, S.C. In North Carolina, six

The Privatization Wave
Most Americans get their water from public
utilities, including some whose aging pipes and
treatment plants are reaching the end of their
useful life. A growing number of local governments are turning to privatization to address
these infrastructure needs, as well as to reduce
operating costs and to meet stricter water
quality and safety standards.
In some cases, a private firm will acquire
a region’s water facilities outright. But more
commonly, it will simply manage the facilities
of a public water system. When this occurs, the
locality continues to own the system and set
water rates, while the firm agrees to perform a
variety of tasks, from billing and meter reading
to operating and maintaining facilities. The
reasoning is that private contractors can run a
water system more efficiently.
“If [a public utility] can’t get rid of
incompetent people, privatization can be a way
of getting around that restraint,” notes Gary
Wolff, principal economist and engineer at the
Pacific Institute for Studies in Development,
Environment, and Security in Oakland, Calif.
Also, utilities may be unable to keep up with
the latest regulations and cost-saving technologies, especially those in smaller communities
that can’t afford to train workers and attract
the best talent. “A private company that

14

services . . . different utilities can have a
[knowledge] base that is top notch and can
be shared with every community,” says Wolff.
In general, such economies of scale are
possible when a company manages enough
utilities such that adding an additional client
has a small impact on total costs.
But private companies aren’t always more
efficient, says Michael Arceneaux, deputy
director of the Association of Metropolitan
Water Agencies in Washington, D.C. “There are
plenty of public water utilities that can do
things just as efficiently or better.” Many have
sought ways to trim the fat from their
operations and improve their asset management,
Arceneaux claims.
In the final analysis, smaller water utilities
appear to have the greatest chance of benefiting
from partnering with private industry. “The most
fertile ground for privatization is in small and
medium-sized communities that are, in most
cases, strapped for cash,” explains Jeffrey Jacobs
of the National Research Council’s Water Science
and Technology Board, which recently published
an assessment of the effectiveness of privatizing
water utilities. “These communities have a small
number of users [and] often don’t have a
healthy tax base to generate the resources for
its utility.”

Region Focus • Spring 2003

This was the case with Reidsville, N.C. The
city of 14,500 residents awarded a five-year
contract to Hydro Management Services Inc. to
operate and maintain its small water system.
Steve Routh, public works director, says Hydro’s
managers have broader expertise than the city’s
longtime staff because they work at more than
a dozen water utilities other than Reidsville’s.
“We use the expertise of the management staff,
and the company keeps us informed of when
we will need upgrades,” says Routh.
Still, the contract doesn’t relieve Reidsville
of the financial burden of making major repairs
and improvements — Hydro pays only for
repairs under $300 — and Routh admits that
significant labor savings weren’t achieved.
Other private-public agreements have been
more problematic. United Water managed
Atlanta’s water system since 1999, but was
repeatedly accused of responding too slowly to
customer complaints and service calls. The 20year contract was dissolved in January.
The lesson is that privatization can be a
useful option, but management contracts
between municipalities and private water
companies must be written “in a way that
benefits both sides, and maintains the public
interest,” notes Arceneaux.
—C H A R L E S G E R E N A

Major Rivers and Lakes
About 95 percent of water withdrawals in
the Fifth District come from surface sources,
according to 1995 estimates from the U.S.
Geological Survey. The rivers with the largest
withdrawals in each state are highlighted
below, as well as a few other sources
of drinking water.

Pretty Boy
Reservoir

Potomac

Cheat

hela
onga
Mon

io
Oh

Liberty
Reservoir

m
to
Po

Po

ac

tom

Pa

tap

sc

o

ac

Pa
tu
xe
nt

Kan

awh

a

Pa

wm

un

Rivers

ke

y

Jam

es

Maryland:
Potomac, Severn, Patapsco,
Patuxent
North Carolina:
Catawba, Cape Fear,
Dan, Yadkin, Neuse
South Carolina:
Seneca, Broad, Cooper,
Savannah,
Saluda

rk

w

Ne

Smith
Mountain Lake

Dan

John H. Kerr
Reservoir

Lake Gaston

Yadkin

Lake Norman
Ca
ta
w
ba

Ne
us
e

Ca
pe

Bro

a
nec
Se

ad

Virginia:
James, Pawmunkey,
Potomac, York,
New
West Virginia:
Potomac, Ohio, Kanawha,
Monongahela, Cheat

Yo

Fe
ar

Hartwell Lake
Sa

lud

a

Lakes

Lake Murray

Lake Marion
Sa

va

ah

per

Coo

nn

Maryland: Liberty Reservoir,
Pretty Boy Reservoir
North Carolina: Lake Gaston,
John H. Kerr Reservoir, Lake Norman
South Carolina: Lake Marion,
Lake Murray, Hartwell Lake
Virginia: Smith Mountain Lake
SOURCE: National Water-Use Information Program, U.S. Geological Survey

hydroelectric dams on the Yadkin River
store water in lakes, which supply
power, recreation, habitat, and drinking water. The Yadkin River dams,
which must be relicensed by 2008 by
the Federal Energy Regulatory Commission (FERC), are required to release
water to keep the river flowing to users
downstream in South Carolina. There,
the waters dilute wastewater discharges
of industry and keep saltwater from
intruding inland into the river, which
Myrtle Beach and the Grand Strand
tourist area taps for drinking water.
But during the drought, the FERCmandated release of 1,400 cubic feet
per second dropped lake levels dramatically. Negotiations ensued.
“We were able to negotiate with the

state of South Carolina, FERC, and the
utility companies to come up with a different plan,” says Morris of North Carolina’s Division of Water Resources.
“Basically, we said to South Carolina,
‘You’re happy you’re getting this water
now, but if we keep doing this, we’re going
to run out of water.’ That would have
been a real disaster for them. What we
worked out was an agreement that South
Carolina would accept a lower flow …
900 cubic feet per second. That slowed
down the process of emptying the lakes.”
Happily, by September, it rained and
the lakes filled.
“But it shows us when new licenses
are issued, we need a flexible, thoughtout plan that would go into the
licenses that would minimize damage

and have a fair sharing of the burdens
should we have to go into emergency
operations again.”
The Yadkin River water issues are
likely to play a central role in public
comment during the relicensing process.
The drought got everybody’s attention in a big way, says Monty Crump,
who is the city manager of Rockingham, N.C., and also works with the
Yadkin-Pee Dee Licensing Coalition.
“For years, we were all fat, happy, and
sassy and thought there was an unlimited resource,” he says. “You got this
drought and boom … all of a sudden you
have all these folks coming to the table.”
While water supplies may not be in
a state of constant crisis, North Carolina
has nevertheless required jurisdictions to

Spring 2003 • Region Focus

15

Water Systems on Guard
The Sept. 11 terrorist attacks have prompted a
major reallocation of resources throughout the
economy. More money is going towards securing
the nation’s critical infrastructure, from airports
to seaports to utilities.
However, the nation’s water systems are
inherently difficult to protect in the view of
Stephen Schmitt, vice president of security
programs at American Water Works Company
Inc., headquartered in Voorhees, N.J. He says
that plants and pipes weren’t built to be secure
against terrorist attack. Schmitt and others in
the water industry believe that much work lies
ahead to identify potential threats, assess the
vulnerability of water utilities to those threats,
and install monitoring and communications
systems to warn against an attack.
Terrorists don’t have a shortage of recipes
for disaster. A cyber attack could cripple a
water facility’s automated equipment. Or a
bomb could destroy a facility’s pumps and
reduce water pressure for firefighters and other
critical users. While few scenarios would likely
affect a large number of people, attacking key
elements of a water system would cause
“significant economic cost, inconvenience, and a
loss of confidence,” says Dr. Nabil Adam,
director of Rutgers’ Center for Information
Management Integration and Connectivity
(CIMIC). Adam led CIMIC’s effort to form a
Laboratory for Water Security.
Since the anthrax scare in 2001, many people
worry about terrorists poisoning an entire water
system. In fact, water experts say that many
toxins would probably become too diluted to be
effective if they were dumped into a river or
reservoir, or they would be neutralized during the

treatment process. A few chemical and biological
agents are resistant to chlorine, but it would take
large quantities of these substances — or
anything else — to have a systemwide effect.
Given the difficulties of attacking the water
supply at its source, a more effective option
would be to introduce toxins at a water
treatment facility. Or terrorists could target
certain neighborhoods or buildings by contaminating their pipes. In general, distribution
systems are harder to protect than water
sources. Pipes and valves form vast networks
under major cities, and all of them can’t be
locked up or placed under 24-hour surveillance.
The scope of these security challenges will
force municipal and private water utilities to
make hard choices about how much they can
do. European countries installed early warning
systems at major rivers, despite the expense of
installing and maintaining these systems.
Government officials didn’t want to be caught
off guard again after a warehouse fire in 1986
dumped 30 tons of toxic chemicals into the
Rhine River.
Back in America, drinking water is closely
scrutinized. Real-time monitoring systems at
plants detect minute changes in temperature,
mineral content, and other factors that affect
water quality, but they can’t detect biological
and chemical agents. And they only know when
something is wrong — further tests must be
done in order to determine the problem.
Before water utilities can effectively guard
against terrorism, water monitoring systems must
become more advanced. But the market may
take a while to develop.
Some utilities may not want to increase

provide water supply plans since the early
1990s. The state also regulates inter-basin
transfers of water. In gathering this data,
the state can plug the leaks in wasteful
use and theoretically avoid serious water
troubles in the future.
“These [supply plans] have been fabulous data sources to any kind of
inquiry,” Morris says. “You can use it to
see whether there are conflicts among
the different plans. The next frontier
is to do plans by river basins. We try to
look 50 years ahead and determine if
those water needs can be borne by that
basin and, if not, what adjustments
might be needed.”
16

Region Focus • Spring 2003

their capital and maintenance costs to improve
water monitoring.
In the Washington, D.C., metropolitan area,
utilities are already under pressure to rehabilitate
their infrastructure and adhere to new regulatory
standards, says James Shell Jr., principal water
resources planner for the 18-member Metropolitan Washington Council of Governments. “They
have to prioritize and determine what is more
critical to do. A lot of them . . . think the
Potomac River would be a difficult target to
contaminate because of its size and the volume
of water that is coming through.”
Also, utilities are interested in systems that
“have multiple uses, and won’t just be fire
alarms,” says Christopher Owen, president and
COO of Apprise Technologies Inc. in Duluth,
Minn. But companies like Apprise are reluctant
to begin the research and development process
until they know what federal standards for
water security might need to be met.
Until new monitoring technology is commercially available, water utilities are relying on
existing equipment. Some use sensors to
“extrapolate” or estimate the presence of toxic
substances in water, describes Glenn Patterson at
the U.S. Geological Survey’s Office of Water
Quality. Others employ Mother Nature. They
expose sentinel species such as bacteria, algae,
clams, and fish to the water supply and observe
their behavior. If they react to a foreign substance,
the water is tested to see what the substance is.
In the end, water utilities alone may not be
able to secure the nation’s water supply. Regional
partnerships between utilities, state regulators,
and federal agencies could prove essential.

Virginia Gov. Mark Warner is proposing water policy reform to encourage local governments to develop water
supply plans. Such reforms have previously failed, but the recent drought
may still be fresh in legislators’ minds.
The Commonwealth has had its
share of water fights, with the states
allowing conflicts to be resolved in the
courts, such as the Lake Gaston issue.
Virginia is currently sparring with
Maryland over Fairfax County’s application to build a new intake pipe in the
Potomac River for its 1.2 million customers. Maryland claims ownership of
the river bottom by right of a colonial

—C H A R L E S G E R E N A

grant, but Virginia is entitled to certain
rights under a 1785 pact. Agreements
are under way among stakeholders
along the James River as a water treatment plant is under construction just
upstream from Richmond. The list
goes on.

Foresight Keeps Water Flowing
While disputes have garnered headlines, there are cases where jurisdictions have cooperated to keep water
supplies flowing.
In the Washington, D.C., metropolitan area, for example, three major
water utilities operate independently.

AP PHOTO/THE CHARLOTTE OBSERVER, ROBERT LAHSER

Marketing Water

Workers connect the first section of water
line at the Kings Mountain City reservoir
at Moss Lake near Shelby, N.C. The city
of Shelby is paying for 8,000 feet of water
line to connect Shelby’s water system to
the reservoir.

But 20 years ago, the utilities agreed to
share the $100 million cost of storing
water for use during dry spells in the
Jennings Randolph Reservoir on the
Potomac River. Officials at the Interstate Commission decide when and
how much water should be released.
“Without cooperation, these guys
could end up in court battling each
other,” says Curtis Dalpra, communications manager for the commission.
“They have given up a little power to
create a very healthy situation.”
As competition for water supplies
grows, states’ roles could expand as well.
“The state has not been forced to take
a position up to this point on what is the
appropriate role in the management of
the resources,” says Terry Wagner of Virginia’s Department of Environmental
Quality. “Until you have physical conflicts,
you’ll never develop the political will necessary [to change]. We’re just starting to
see the physical conflicts.
“We’re moving to a point where we
have to consider the effects of water
resource withdrawals on other users.
That’s a major shift. Until you really
have problems, it’s tough to get over
that entropy of the last 200 years.”

A murky question surrounding water
use in the East is that of ownership.
Exactly who owns water anyway?
Under Eastern water law, anyone can
take water from a stream as long as so
doing won’t harm others, says RFF’s
Shabman. “You don’t own the water
rights in the sense that you own your
car and can sell it to somebody else.”
In some places in the West, people who
use a certain amount of flow in streams
establish a right to that water. Under
those circumstances, they can sell or
rent those rights.
In California, for example, a controversial proposal still in negotiation
includes diversion of water from the
Imperial Valley Irrigation District for
Southern California. That district has
held rights to 70 percent of California’s water from the Colorado River
for 100 years under the first-come,
first-served doctrine.
Water transfers and trading would
require some definition of rights in the
East, says Clay Landry, an economist
located in Wyoming who values and
prices water for jurisdictions interested
in creating markets for water. Landry
has begun consulting with some clients
in the East, he says, as droughts deepen
thoughts on creative solutions.
The first step in establishing workable markets, Landry says, would be to
establish a property right that could be
transferred and traded. Florida, he says,
has begun looking into the idea.
Creating a market for buyers and
sellers, he says, reallocates a scarce
resource using money. In times of
scarcity, water can be allocated by regulation or through markets. Voluntary
agreements have a niche in the marketplace, he says, but negotiations
tend to drag and sometimes culminate
in court actions.
“The fundamental difference? With
a trading program, there’s money
involved,” he says. “When you put
cash on the table, things just move a
little quicker.”
In some Western states, he says, irrigation districts have hammered out
agreements that compensate them
when water is transferred to cities
during a drought. Conversely, a district

will buy extra water to irrigate during
critical watering periods for agricultural
products. For example, a water market
emerged in 2001 in Yakima, Wash.
Apple growers needed water to protect
future yields of orchards. The market
was established and monitored by a
partnership between the state and the
federal Bureau of Reclamation, according to Landry.
“Basically, there were uses in the
basin that had lower values placed on
the water, and they were able to sell
some of that water to orchards who
were willing to pay quite a bit of money
to save their orchards,” he says. “Essentially, [the market] allowed the water
to move to its higher valued use for
that time. Federal and state agencies
also purchased some water for flow
augmentation for salmon recovery,” he
says. In that particular instance, it was
a one-time deal, but the state is now
working to establish rules that would
allow the market to occur in any year.
Whether the East’s water woes
bring about changes to the East’s property rights regime, or increased state
oversight, improved cooperation, or all
three, water will flow to people,
Shabman says.
“We’re not going to relocate people
to the Great Lakes from Atlanta,” he
jokes. “It’s just a matter of cost and
decisionmaking, and if in the next 50
years, 50 percent of our population
chooses to move to Southern California, we’ll get water to them.”
RF

READINGS
Frederick, Kenneth D. “Marketing Water: The
Obstacles and the Impetus,” Resources for the
Future Resources, Summer 1998, Issue 132, pp. 7-10.
Gleick, Peter H., Gary Wolff, Elizabeth L.
Chalecki, Rachel Reyes. “The New Economy of
Water: The Risks and Benefits of Globalization and
Privatization of Fresh Water.” Pacific Institute for
Studies in Development, Environment, and
Security, February 2002.
Landry, Clay J. “Saving Our Streams Through Water
Markets: A Practical Guide.” Political Economy
Research Center, 1998.
Visit www.rich.frb.org/pubs/regionfocus for links
to relevant Web sites.

Spring 2003 • Region Focus

17

The shortage of affordable malpractice insurance in
West Virginia and elsewhere won’t be easy to solve.

A Difficult Diagnosis
BY CHARLES GERENA

hen malpractice insurance
premiums started rising in
West Virginia three years ago,
doctors had few options. They could either
find a way to lower their premiums or quit.
Medical professionals throughout
West Virginia made some tough
choices. City Hospital in Martinsburg
closed its psychiatric unit, and hospitals in Putnam and Jackson counties
shuttered their obstetrics units. Bluefield Regional Medical Center in southern West Virginia stopped performing
angioplasties and open-heart surgeries.
“Obstetrics, orthopedics, neurosurgery, and general surgery are among
the highest-risk medical fields,”
describes Tony Gregory, director of communications for the West Virginia Hospital Association. Since they are riskier,
“they produce the most medical liability suits,” and their practitioners pay the
highest premiums. At the same time,
reduced reimbursements from governmental payers have resulted in less
revenue to offset premium increases.
Shortages of affordable malpractice
insurance have occurred throughout
the United States, with critical shortfalls in at least 12 states, including West
Virginia, Pennsylvania, New Jersey,
Nevada, and Mississippi. This problem
is merely one symptom of larger issues
facing insurers and a range of health
care providers, from physicians to dentists to nursing homes.

W

eports of doctors marching in
front of government buildings
and patients crossing state lines
in search of care seem unprecedented.
In fact, malpractice shortages occurred
twice in the last 30 years.
An insurance company makes
money in two ways, and both income
sources are vulnerable to economic

R

cycles. First, it achieves an underwriting profit, or loss, based on the difference between the premiums it collects
and the expense of servicing policies,
which includes claims paid and other
administrative costs.
Second, the insurer can earn income
to offset an underwriting loss by investing premiums in stocks, bonds, and
other appreciable assets. “If an insurer
knows that the payout is five or six
years from now and it has certain
administrative costs, it has to decide
what to do with that money in the
meantime,” explains economist Frank
Sloan of Duke University.
During the mid-1970s and mid-1980s,
malpractice insurers faced poor investment returns. They also had more claims.
According to economist Patricia Danzon
of the University of Pennsylvania, the frequency of malpractice claims per 100
doctors jumped 10 percent annually
between 1975 and 1985. During these
“hard markets,” insurers had to adjust
other variables in their revenue-expense
equation to maintain profitability. Premiums increased and requirements tightened for policyholders.
Many malpractice premiums dropped
or increased modestly during the 1990s,
until signs of a hard market emerged in
the latter part of the decade. Underwriting losses started rising as claims outpaced premiums. Insurers say they were
adrift in the choppy waters of tort law,
which compensates injured patients and
serves as a deterrent against future acts
of malpractice.
“If an insurer has the perception that
there is a lot of uncertainty with respect
to judgments … it doesn’t know how to
price the coverage,” says Sloan. The firm
could raise premiums or concentrate on
other lines that are less volatile.
According to the West Virginia

More Malpractice in the
Mountain State?
The number of malpractice payments in West
Virginia rose modestly from 147 in 1995 to 207 in
2001. But these numbers tell another story when
taking the state’s population into account.
Compared to the rest of the Fifth District and the
United States, West Virginia’s payment experience
per 100,000 people is quite high.

WV
5th District (except WV)
United States

6

I

I

I

9

I

I

I

12

I

Number of Medical Malpractice Payment
Reports, Per 100,000

3

I

T

I

he new millennium brought two
major shocks to the insurance
market that quickly made matters
worse for malpractice insurers. The Sept.
11 terrorist attacks caused many primary
insurers to pay more for reinsurance and to
increase their reserves for covering claims.
Also, three straight years of stock market
declines that began in 2000 evaporated
insurers’ investment returns.
Given the hardening of the malpractice insurance market, something had to
change. Premiums jumped nationwide
starting in 2000.
Not only did malpractice insurance
become pricier, it also was hard to find.
Many small insurers had such low
reserves that they ceased operations,
including PHICO Insurance Co. in
Pennsylvania. A few large insurers
stopped offering malpractice coverage,
including The St. Paul Companies. “We
determined that even with the doubledigit rate increases that we’re working
on getting approved, we wouldn’t be
able to maintain profitability in that
line of business,” explains Wood.
In the Fifth District, some doctors
in the Carolinas lost their malpractice
coverage, but they had alternatives. A
physician-owned mutual insurance

company covers half of North Carolina’s doctors in private practice, while
a state-operated Patients’ Compensation Fund provides excess coverage for
more than three-quarters of South Carolina’s private physicians. Still, malpractice insurance costs a lot more in
both states and elsewhere in the region.
With an already limited supply of
insurers, the Mountain State has been
hit hard by the lack of affordable malpractice coverage. St. Paul’s departure
was devastating since the company
insured about one-third of the state’s
doctors. Then the withdrawal of a
smaller firm, OHIC Insurance, in
2002 added insult to injury. Only one
major malpractice provider remains,
Medical Assurance, and its policy standards are tighter.
Now, the malpractice market is narrower and more selective. Eugene
Pawlowski, president of Bluefield
Regional, says that just one lawsuit can
cause a doctor to lose coverage, and
then it’s difficult to find another
provider. “Smaller communities in West
Virginia don’t have the alternatives that
bigger states like Virginia and North
Carolina have.”
Why are fewer insurers willing to
do business in West Virginia? Some
observers blame the state’s reputation
as a haven for litigation, due to its relatively lax tort system and sympathetic
juries. While such a link is hard to
prove, data from the National Practitioner Data Bank suggest that the state
stands out. The number of malpractice
payments in West Virginia rose from
8.1 to 11.5 per 100,000 people between
1995 and 2001, while the rest of the
Fifth District had far fewer payments
per capita (see graph at right).

I

Hospital Association, several insurers
merged or left the state in the early to
mid-1990s, and a major carrier declared
insolvency in 1997.
The picture was just as cloudy nationwide, recalls Andrea Wood, spokesperson for The St. Paul Companies, formerly
one of the nation’s largest malpractice
insurers. But firms like St. Paul believed
they had enough reinsurance and good
investment returns to carry them
through to better days.

NUMBER OF REPORTS
PER 100,000 P EOPLE

WEST VIRGINIA STATE MEDICAL ASSOCIATION

Drs. Elizabeth Spangler, Kenneth Wright, and Michael Fidler speak with Senate Minority
Leader Vic Sprouse (center) about West Virginia’s malpractice insurance crisis.

Perhaps West Virginia’s relatively
unhealthy population makes it an expensive market to serve. The state’s mortality rate for heart disease was 22 percent
higher than the national average in 2000,
the cancer rate was 14 percent higher,
and the rate for chronic lower respiratory disease was 44 percent higher.
To make sure that West Virginians
have access to health care, state lawmakers approved a temporary malpractice insurance plan during a special
session in December 2001. Physicians
can be insured for up to $1 million by
the state’s Board of Risk and Insurance
Management (BRIM), which provides
general liability coverage for state agencies, county and municipal governments, and nonprofit organizations.
Nearly 1,100 doctors and 12 hospitals have purchased malpractice insurance from BRIM so far. While BRIM’s
base rate was 5 percent lower than the
commercial rate in West Virginia in late
January, premiums still were higher for
certain specialties like neurosurgery.

I

1995

I

I

1998

I

I

I

I

2001

NOTE: Per capita figures calculated using population estimates,
except for actual Census count for 2000.
SOURCES: National Practitioner Data Bank, U.S. Department of Health and
Human Services; U.S. Census Bureau

Spring 2003 • Region Focus

19

Fixing the Tort System
In January, West Virginia Gov. Bob Wise and President Bush proposed tort reform plans. Here’s how they stack up.
Proposed by
Gov. Wise?

Proposed by
Pres. Bush?

Adopted in
5th District

YES a,d

YES

YES
(MD, VA, WV)

NO

YES

YES
(NC, VA)

Defendant is not liable for paying the entire judgment, but only for
his/her share of responsibility for an injury

YES b,d

YES

YES
(DC) c

Change collateral
source rule

Damages can be reduced by all or part of the value of lost wages or
medical bills paid by third parties, including workers’ compensation
and health insurers

YES d

YES

NO

Permit periodic
payment of damages

Instead of a lump sum, damages can be disbursed over time; this is
typically done through an annuity that pays out periodically

NO

YES

YES
(DC, MD, VA)

Reform

Explanation

Limit noneconomic damages

Awards for pain and suffering are capped; exceptions for cases of
wrongful death and gross negligence are often made

Limit
punitive damages

Awards to compensate plaintiffs in excess of actual damages are
capped; commonly used to punish defendants for reckless misconduct
and deter others

Eliminate joint-andseveral liability

a Gov. Wise proposed lower noneconomic damages from a cap of $1 million to a base cap of $250,000, with a sliding scale based on severity of injury.
b Joint-and-several liability rules were relaxed somewhat in West Virginia in 1986. Doctors are liable for the entire judgment only when their share of responsibility exceeds 25 percent.
c In the District of Columbia, liability for punitive damages is apportioned by relative fault.
d Proposal included in legislation passed by General Assembly in March 2003.
SOURCES: “State Laws Chart: Liability Reforms,” American Medical Association, April 2002; “Summary of Medical Malpractice Law,” McCullough, Campbell & Lane, 1998; “State Laws on Medical Liability,” American Tort
Reform Association Web site, 1994

Costs for malpractice coverage are
still high, argue tort reform advocates,
because not enough has been done to
reduce the frequency and size of tort
claims. In his State of the State speech
in January, Gov. Bob Wise proposed
several reforms to address this concern.
His recommendations included a base
cap of $250,000 for pain and suffering
and other noneconomic damages and
a limit of $500,000 for damages
against trauma care providers. Wise
also proposed creating a three-year, $20
million fund to offset premiums paid
by doctors in the BRIM program. (See
sidebar above for a summary of Wise’s
proposals and similar reforms proposed
by President Bush.)
n response to malpractice insurance
shortages during the 1970s and 1980s,
some states modified their tort law.
Did these changes lead to more affordable
coverage? According to a report by the U.S.
Congress’ Office of Technology Assessment, only caps on damage awards were
consistently effective.
Tort reform hasn’t been the cure-all
some had imagined. That’s because

I

20

Region Focus • Spring 2003

damage awards account for just part of
a malpractice insurer’s expenses. When
setting premiums, an insurer must
factor in the price of reinsurance, the
administrative costs of investigating
claims, and lawyers’ fees for defending
claims in court.
Therefore, buyers and sellers in the
malpractice insurance market also must
find solutions to the current shortage.
Some hospitals have started self-insuring. Bluefield Regional uses its own
money to cover the first $5 million in
claims, and reinsurance from AP Capital
to pay for claims above that amount.
So far, the hospital has succeeded in
providing insurance at cheaper rates
than BRIM. “I have better risks,” notes
Pawlowski. “The state takes the bad
doctors with the good doctors. I’m just
taking the good doctors.”
But not all hospitals will be able to
afford to do this. Some medical professionals will probably have to face the
choice of paying more for malpractice
insurance, retiring early, or moving out
of the state.
If history is any guide, though, the
overall ranks of the medical profession

will continue to swell. Despite past
spikes in malpractice premiums,
America’s supply of doctors has steadily
grown from 366,000 in 1975 to 750,000
in 2001. So far, a sense of purpose and
the promise of profits seem to have
outweighed the increasing cost of
doing business.
RF
READINGS
Danzon, Patricia M. “Liability for
Medical Malpractice.” Journal of
Economic Perspectives, Summer 1991,
vol. 5, no. 3, pp. 51-69.
Hunter, J. Robert. Medical Malpractice
Insurance: Stable Losses/Unstable Rates.
New York: Americans for Insurance
Reform, October 2002.
Impact of Legal Reforms on Medical
Malpractice Costs. Washington, D.C.:
Office of Technology Assessment,
September 1993.
Kessler, David P., and Mark B.
McClellan. How Liability Law Affects
Medical Productivity. Cambridge,
Mass.: National Bureau of Economic
Research, February 2000.
Visit www.rich.frb.org/pubs/region
focus for links to relevant Web sites.

up in

Smoke
Fifth District States Are
Burning Through
Tobacco Settlement Funds
to Balance Their Books
BY KARL RHODES

orth Carolina Gov. Michael
Easley was the state’s attorney
general in 1998 when major U.S.
cigarette manufacturers negotiated a
master settlement agreement (MSA) with
46 states and the District of Columbia.
The manufacturers agreed to pay an
estimated $206 billion to reimburse the
states for health care expenses related to
tobacco use. It was the largest product
liability settlement ever, but Easley and
several other state attorneys general
demanded more.
They insisted that the manufacturers should pay an additional $5.15 billion
to tobacco farmers and quota owners
in 14 tobacco-producing states over 12
years. These “Phase II” settlement payments were designed to indemnify
farmers against declining demand for
tobacco caused by several provisions of
the MSA. Since North Carolina grows
far more tobacco than any other state,
its farmers receive the lion’s share of
these payments. But North Carolina’s
legislators decided to do more to help
the state’s struggling farmers, so they
earmarked 25 percent of North Carolina’s MSA payments to benefit
tobacco growers and quota owners.
The tobacco farmers cheered, but
their good fortune was short-lived.
Easley, who had championed their cause
as attorney general, moved up to the
governor’s office, where he was greeted
by a huge deficit in 2001 and an even
bigger one in 2002. To ease these financial pressures, he turned to the Tobacco
Trust Fund Commission, the organization charged with using the 25 percent
of North Carolina’s MSA payments to
help the state’s tobacco farmers.
Easley intercepted a $32 million
tobacco settlement payment in April
2002; he removed $50 million from the
trust fund in June 2002; and the General
Assembly is
diverting
another
$38 million
from the trust fund’s
2003 tobacco settlement payments.
North Carolina desperately needs
the money to balance its budget, and so
do the other states in the Fifth District.
All of them are using tobacco settlement payments to balance their budgets

N

Spring 2003 • Region Focus

21

to some extent. The spectrum ranges
from Maryland, which is using nearly
all of its settlement payments to fund
health care programs, to the District of
Columbia, which securitized all of its
settlement payments into one lump
sum to pay down debt. Securitization

is achieved by selling bonds that are
secured by payments from the MSA. In
exchange for its rights to future MSA
payments, D.C. got an immediate infusion of cash, and it avoided the uncertainties of receiving payments from
companies in a declining industry.

A Trip Down Tobacco Road
1612

1620s

1640s

1660s

1730

1776

1794
1839

1850s

1865

1875
1880
1890

1902

22

Jamestown colonist John Rolfe plants
Nicotiana Tabacum seeds from the West
Indies. Growing this variety of tobacco
for export to England becomes the first
successful industry in Virginia.
Tobacco dominates the economy of the
Chesapeake Bay region for the next 150
years. It is commonly used as currency
throughout the Southern colonies. People
literally grow cash on their farms or in
their gardens.
Looking for fresh land for tobacco
production, Virginians begin migrating into
the Carolinas.
A glut of tobacco in England devastates
the colonial economy, but by 1700 the
colonies are once again exporting a
record level of the crop.
Virginia requires growers to bring tobacco
to public warehouses for inspection.
Maryland, North Carolina, and South
Carolina eventually adopt similar systems.
Tobacco helps finance the Revolutionary
War by serving as collateral on loans
from France.
Congress passes the first U.S. tax on
tobacco.
Stephen, a slave in Caswell County, N.C.,
discovers bright leaf tobacco, which is
later used extensively in cigarettes.
Tobacco harvests hit record levels in
Virginia, but the state’s soil is nearly
exhausted from growing too much
tobacco.
Tobacco growers struggle to recover from
the Civil War and their dependency on
slave labor.
R. J. Reynolds begins to mass-produce
chewing tobacco in Winston, N.C.
The first cigarette-making machine is
patented.
The Duke family of Durham, N.C., consolidates the major U.S. cigarette manufacturers
into the American Tobacco Co.
Philip Morris begins marketing cigarettes
in the United States.

1911

1913

1914
1933

1941
1944

1955
1964
1966
1971
1985
1991

1994

1998

Trust busters split the American Tobacco
Co. into several of its component
companies including Liggett and Myers,
P. Lorillard, R. J. Reynolds, and the new
American Tobacco Co.
R. J. Reynolds introduces Camels, the first
cigarette brand to gain nationwide
popularity.
Cigarette consumption explodes during
World War I.
The Agricultural Adjustment Act of 1933
institutes price supports for tobacco —
the beginning of the quota system.
American soldiers get cigarettes in their
rations during World War II.
The American Cancer Society begins to
warn people about the potential risks
of smoking.
Philip Morris introduces the Marlboro
Cowboy in advertising campaigns.
The Surgeon General issues a landmark
report on “Smoking and Health.”
Health warnings from the Surgeon
General are required on cigarette packs.
The United States bans cigarette
advertising on radio and television.
Philip Morris buys General Foods, and
R. J. Reynolds buys Nabisco.
A Medical College of Georgia study
shows that Joe Camel is as familiar to
young children as Mickey Mouse.
Seven tobacco industry CEOs say tobacco
is not addictive in testimony before
Congress. Mississippi sues the major
tobacco manufacturers to recover the
cost of treating diseases related to
tobacco use.
Major tobacco manufacturers sign a
master settlement agreement that calls
for payments to 46 states estimated at
$206 billion over 25 years. The other four
states negotiate separate agreements.

SOURCES: www.tobacco.org; www.historian.org; R. J. Reynolds Tobacco
Co.; Facts on File; www.druglibrary.org; The Duke Homestead; North
Carolina State University; Pennsylvania Tobacco Prevention Network;
and Walter Reed Army Medical Center

Region Focus • Spring 2003

Payments from the MSA are supposed to be made in perpetuity, but
they will decrease if domestic tobacco
consumption falls below certain benchmarks. Based on the original estimate
of $206 billion over 25 years, the Fifth
District states were looking at the following projected revenue streams:
North Carolina ($4.6 billion), Maryland
($4.4 billion), Virginia ($4.1 billion),
South Carolina ($2.2 billion), West Virginia ($1.7 billion), and Washington,
D.C. ($1.2 billion).
All of the states devised ambitious
plans to spend this money, but as the
first payments started to arrive, the
stock market went into a tailspin and
the national economy dipped into a
recession followed by a sluggish recovery. The states are now faced with
severe budget deficits, and they are
struggling with the question of how
much tobacco settlement money they
should use to balance their budgets.
In addition to cash-strapped state
governments, there are many other
interests competing for the same
dollars. They include smoking prevention programs, health care initiatives,
economic development programs, and
the tobacco farmers themselves.
In North Carolina, the intense
debate over who gets what is complicated by the Phase II payments to
tobacco farmers and quota holders. Are
these Phase II payments enough to
offset the hardship caused by the
MSA? North Carolina’s Tobacco Trust
Fund Commission put that question to
A. Blake Brown, professor of agricultural and resource economics at North
Carolina State University. Brown’s
study, co-authored by Jonathan Perry,
concluded that the present value of
projected losses attributed to the MSA
was $654.9 million to $764 million for
the state’s tobacco farmers and quota
owners. In sharp contrast, they concluded that the present value of Phase
II payments to North Carolina growers
and quota owners was $1.216 billion to
$1.223 billion.
Before Brown and Perry conducted
their study, Brown warned the Tobacco
Trust Fund Commission that the
numbers probably would shake out that
way, but the commissioners insisted that

State Cigarette Taxes
Per Pack
Rank Among
State
Cents States & D.C.
Maryland
100.0
11th
District of Columbia 100.0
11th
West Virginia
17.0
44th
South Carolina
7.0
48th
North Carolina
5.0
49th
Virginia
2.5
51st
NOTE: State taxes are in addition to a federal
tax of 39 cents per pack.
SOURCE: Campaign for Tobacco-Free Kids

The tobacco trust fund is one of
three organizations that North Carolina created as stewards of its tobacco
settlement money. Half of the payments — about $82 million per year —
go to the state’s Golden LEAF Foundation, an organization that promotes
economic development in North Carolina with an emphasis on regions that
have been hurt the most by declines in
the tobacco industry. The remaining 25
percent is supposed to bankroll the
North Carolina Health & Wellness
Trust Fund.
In August 2002, the Golden LEAF
Foundation announced an $85.4 million
economic stimulus package designed
to promote North Carolina’s biosciences industry.
So far, the Golden LEAF’s funding

NC
VA
SC
MD
WV

I
I

I

600

I

0

I

200

I

I

400

I

POUNDS

800

I

I

1000

I

Fifth District Tobacco Production

OF

has remained intact, but the Health &
Wellness Trust Fund has not been as fortunate. Gov. Easley intercepted $32
million headed for that fund in April
2002, and the General Assembly is diverting another $40 million from the fund’s
2003 tobacco settlement payments.
It’s more difficult to take money
from the Golden LEAF because Easley
set it up as a foundation, explains
William Upchurch, executive director
of the Tobacco Trust Fund Commission. The trust funds, on the other
hand, are full-fledged state commissions. “Our money is in a special
account, but it’s under state control,”
Upchurch says. “A couple of keystrokes
and it’s gone.”
The diversion of dollars from North
Carolina’s trust funds is “unfortunate,”
says Carthan F. Currin, executive director of the Virginia Tobacco Indemnification and Community Revitalization
Commission. “But states are independent political subdivisions, and they
can make their own decisions about
how to spend the funds.”
Currin’s commission, which receives
half of Virginia’s tobacco settlement
payments, has not been raided by the
General Assembly, perhaps because 40
percent of Virginia’s tobacco settlement
payments routinely flow into the state’s
general fund. The remaining 10 percent
goes to the Virginia Tobacco Settlement Foundation, which funds
smoking-prevention programs.
Currin’s commission helps Virginia’s
tobacco farmers, and it promotes economic development in southside and
southwest Virginia, the regions of the
state that are the most dependent on
the tobacco industry. These areas also
have been devastated by declining
employment in textile manufacturing
and coal mining, which were mainstays
of their economies for most of the 20th
century.
“Based on where the economies of
these two regions are, the money is a
godsend,” says Currin. “I don’t think it’s
too dramatic to compare our challenge
to the Marshall Plan, which aimed to
rebuild Europe after World War II.”
Initially the commission focused on
indemnification payments to tobacco
farmers and quota holders. These pay-

MILLIONS

they needed an independent analysis.
Gov. Easley used the study to
further justify his raids on the tobacco
trust fund. Brown notes, however, that
the plight of North Carolina’s tobacco
farmers goes far beyond the impact of
the MSA. “Total projected losses
(attributable to all factors, such as
MSA, excise tax increases, and declines
in tobacco exports) to North Carolina
burley and flue-cured tobacco growers
and quota owners do exceed the projected value of Phase II payments,” the
study said.
But that bottom-line reality was
overshadowed by the state’s looming
budget deficit. “Frankly, the governor
was looking for an excuse to take away
their funding,” Brown says.

I

1952

I

I

I

I

I

1962

1972

1982

1992

2002

SOURCE: National Agricultural Statistics Service

ments are in addition to Virginia’s
Phase II settlement dollars, and they
totaled $91 million in 2001 and 2002.
After the indemnification is complete,
the commission plans to focus all of its
resources on economic development.
Last year the commission reviewed
about 100 applications for economic
development grants. Most of the applicants received some funding, but
Currin says the review process is
becoming “tighter” this year.
Virginia also is in the process of
securitizing its funding for the Tobacco
Indemnification and Community Revitalization Commission. This bond deal
would convert the commission’s estimated 25-year revenue stream of $2
billion into a present-day endowment
of $600 million to $700 million. Securitization will insulate the commission
from potential reductions in tobacco
settlement payments, and it will make
the commission’s funding “not bulletproof, but harder for future General
Assemblies to raid,” Currin says.
That seems to be the case in South
Carolina, a state that securitized all of
its tobacco settlement payments in the
spring of 2001. South Carolina issued
bonds that converted its projected
revenue stream of $2.2 billion into a
lump sum of $791 million. The state
put $101 million of that sum into its
Medicaid program to balance its
current budget, but the structure of the
bond deal will all but eliminate South
Carolina’s ability to use the funds to
cover future deficits, says Les Boles,

Spring 2003 • Region Focus

23

© PATRICK SHEANDELL O’CARROLL/PHOTOALTO/PICTUREQUEST

Half of West Virginia’s tobacco settlement payments flow into this trust
fund, while the other half goes to the
state’s Department of Health and
Human Resources, primarily to help
fund state-supported hospitals. This
money has been a budget-balancing
tool all along because it merely replaces
dollars that were already allocated to
the hospitals before the tobacco settlement. The new funds have solidified
the department’s budget, but they have
not boosted it, Law says.
One exception to this rule has been
the department’s Division of Tobacco
Prevention, which has received $5.8
million annually since the tobacco
money started flowing. Adkins says he’s
fairly confident that West Virginia will
maintain that funding level. It’s significantly below the minimum amount of
$14 million recommended by the U.S.
Centers for Disease Control and Prevention, but it’s far more than the state
used to spend.
A report produced by the Campaign
for Tobacco-Free Kids puts West Virginia in the middle of the pack among
Fifth District states when it comes to
spending money on smoking prevention. The report blasts all but a few U.S.
states for failing to keep their promise
“to use a significant portion of the settlement funds … to attack the enormous public health problem posed by
tobacco use.”

director of the Office of State Budget.
Of the original $791 million, South
Carolina spent 15 percent to help
indemnify its tobacco farmers, quota
owners, and warehouse operators. It
allocated 12 percent for economic
development initiatives, with an emphasis on the state’s tobacco-producing
region, and it used 73 percent to create
the Healthcare Tobacco Settlement
Trust Fund. Most of the indemnification and economic development money
has already been spent or spoken for,
and the health care trust fund is down
to about $400 million, Boles says.
All of South Carolina’s budget-balancing Medicaid money came out of
the health care trust fund, leaving just
enough to endow a new prescription
drug plan for senior citizens and a

modest tobacco-prevention program.
An attempt to securitize West Virginia’s tobacco settlement payments
failed in last year’s legislature, and now
the state is facing a $200 million
budget deficit for the coming year,
says Bruce W. Adkins, acting director
of the West Virginia Division of
Tobacco Prevention.
To help close that gap, Gov. Bob
Wise has proposed using $20 million
from the state’s medical trust fund to
alleviate a medical malpractice insurance
crisis, says John Law, a spokesman for
the state’s Department of Health and
Human Resources. This would mark the
first time West Virginia has touched its
medical trust fund, which was set aside
by the legislature to cover future healthrelated costs of tobacco use.

How Fifth District States Allocated Master Settlement Agreement Money
Original Estimated
Revenue Stream a

Securitized?

$4.6 billion

No

25%*

Maryland

4.4 billion

No

94%*

Virginia

4.1 billion

Pending

10%

South Carolina

2.2 billion

Yes

73%*

12%

West Virginia

1.7 billion

No

100%*

District of Columbia

1.2 billion

Yes

None d

State
North Carolina

Health
Careb

Economic
Development

Tobacco
Farmersc

General
Fund

Debt
Reductiond

50%

25%*

None

None

None

6%

None

None

40%*

None

15%

None

None

None

None

None

None

None

None

None

100%*

50%**

* These funds have been used for budget-balancing to some extent
** Fifty percent split between economic development and tobacco farmers
a Based on 25-year projections made in 1998
b Includes funding of tobacco-prevention programs
c Does not include any Phase II payments
d Washington’s debt-service savings are earmarked for Medicaid and other health care programs in fiscal 2003 and 2004

24

Region Focus • Spring 2003

SOURCE: Individual states

State Funding for Tobacco Prevention
CDC
Recommendation b

Percent of
Recommendation

$30.0 million

$30.3 million

99

22.2 million

38.9 million

57

West Virginia

5.8 million

14.2 million

41

North Carolina

6.2 million

42.6 million

15

South Carolina

2.0 million

23.9 million

8

None

7.5 million

0

State
Maryland
Virginia

Annual
Funding a

District of Columbia

a For fiscal 2003
b Minimum amount recommended for each state by the Centers for Disease Control and Prevention
SOURCE: Campaign for Tobacco-Free Kids

Maryland was the only Fifth District
state to win praise in the report for
raising its smoking-prevention program
to the minimum level recommended by
the Centers for Disease Control. Maryland and three other states have
“heeded the evidence that tobacco prevention is both good public health
policy that will reduce smoking and save
lives and good fiscal policy that will help
solve their budgetary challenges by
reducing the tremendous amounts they
spend to treat smoking-caused disease
under Medicaid and other state-funded
health care programs.”
While praising smoking prevention as
a worthy goal, some economists disagree
with the idea that smoking prevention
saves states money — particularly states
that have high cigarette taxes.
People who smoke don’t live as long
and, as a result, aren’t as much of a
burden on state finances as one might
think. “On balance, all the states make
money” from tobacco use, says W. Kip
Viscusi, professor of law and economics at Harvard University.
Viscusi — author of Smoke-Filled
Rooms: A Postmortem on the Tobacco Deal
— also suggests that the effectiveness
of smoking-prevention campaigns may
be overstated. “Most of the states where
they claim great success also have ratcheted up cigarette taxes as well,” he says.
“I’ve not seen a study that separates the
two.”
Viscusi agrees, however, that the states
have broken their promise to use tobacco
settlement money to improve public

health. “The main rationale for getting
all that money was to save the kids,” he
says. “Now that they have the money, no
one’s talking about the kids much.”
Brown, the professor of agricultural
economics at N.C. State, sees it the
same way. “Smoking prevention is not
the priority right now. The priorities
are budget balancing and other things,”
he says. “States have a huge incentive
to keep people smoking. If people stop
smoking, the states would have no
[tobacco] money.”
If the states and the tobacco manufacturers were winking at each other
all along, Maryland Gov. Parris Glendening must have missed the signal. In
June 1999, he put out a press release
outlining what Maryland would do with
its tobacco settlement proceeds.
“I see this as an opportunity to take
the tobacco industry’s blood money
and make Maryland a healthier state
for everyone,” he said.
That’s pretty much what Maryland
has done, says Carlessia Hussein, director of the state’s Cigarette Restitution
Fund Program. Forty percent of the
state’s settlement money has gone to
cancer prevention, treatment, and
research, while 31 percent is being spent
on tobacco-prevention programs. Most
of these dollars go to local coalitions that
decide how to use them most effectively
in their individual cities and counties.
Maryland has put 18 percent of its
settlement money into substance-abuse
programs, and 3 percent has been earmarked to treat tobacco-related dis-

eases such as emphysema. Another 2
percent has flowed into a health care
foundation that serves uninsured and
underinsured residents.
Maryland is using 6 percent of the
money to buy out tobacco farmers who
agree to pursue other agricultural endeavors and legally encumber their land so
that no one will ever be allowed to grow
tobacco on it. Based on their average
tobacco output between 1997 and 1999,
Maryland pays participating farmers $1
per pound per year for 10 years.
Before the buyout, Maryland had
1,200 to 1,250 eligible tobacco farmers,
and most of them have accepted the
offer, says Pat McMillan, special assistant to Maryland’s secretary of agriculture. The main exception has been the
state’s Amish farmers, who “have opted
out of the program for religious reasons.”
Maryland has used some of its
tobacco settlement funds for Medicaid, and that helps balance the budget,
Hussein admits. “But some would say
that all the money should go back to
Medicaid. Fortunately, our state hasn’t
seen it that way.”
Not yet, but Maryland swore in a
new governor in January, and he’s facing
a $1.6 billion budget deficit for 2004.
And so far, he has played his tobacco
cards very close to the vest.
“Certainly we’re going to have some
cuts,” Hussein says, “but I feel sure that
the new administration will see the
value in what we are doing.”
RF

READINGS
Brown, A. Blake, and Jonathan Perry. “The Impact
of the Master Settlement Agreement on North
Carolina.” Working Paper, North Carolina State
University Department of Agricultural and Resource
Economics, June 11, 2002.
Campaign for Tobacco-Free Kids, et al. “Show Us
the Money: A Report on the States’ Allocation of the
Tobacco Settlement Dollars,” January 22, 2003.
Cutler, David M., et al. “The Economic Impacts of
the Tobacco Settlement.” Journal of Policy Analysis
and Management, 2002, vol. 21, no. 1., pp. 1-19.
Viscusi, W. Kip. Smoke-Filled Rooms: A Postmortem on
the Tobacco Deal. Chicago: University of Chicago
Press, 2002.
Visit www.rich.frb.org/pubs/regionfocus for links
to relevant Web sites.

Spring 2003 • Region Focus

25

To Tax or Not toTax?
States Ponder New
Ways to Collect Taxes
on Online Sales
BY BET TY JOYCE NASH

nline transactions are still only a
fraction of total retail sales—
about 1.3 percent in 2002. But
they are nevertheless at the center of a
growing controversy: to tax or not to tax?
In February, several major retailers
who sell online agreed to begin voluntary sales tax collections. The stores in
question prefer to remain anonymous.
The move likely started with stores that
have ties to retailers with brick-andmortar locations. The Supreme Court
ruled, in 1967 and again in 1992, that
out-of-state sellers without a physical
presence in the state, or “nexus,” as the
Court called it, cannot be required to
collect. But several large firms apparently began to suffer “nexus nerves” and
agreed to pay the sales taxes. The firms
will be forgiven any back taxes.

O

“I think it’s certainly a good step
forward,” says Sabra Faires of the North
Carolina Department of Revenue. “But
make no mistake about it — they owe
the money in those states, and they
don’t want to pay the back taxes.”
The announcement comes at a time
when retailers, legislators, and state officials are re-examining the idea of Internet taxation as a federal moratorium
nears expiration in November of this year.
State officials and traditional retailers like the idea of the taxes — sales
taxes, after all, make up a good chunk
of states’ general fund revenues, about
28 percent in North Carolina, for
example. And times are tough right
now. Most states need cash to close
perilously large revenue shortfalls.
There’s also the idea of evening out the
retail playing field for traditional brickand-mortar merchants. But many on
Capitol Hill say that electronic commerce should remain unfettered by the
burden of collecting taxes, which can
vary widely from state to state, county
to county, city to city. There have been
bills introduced in both chambers of
the U.S. Congress that would extend
indefinitely the current ban on taxes
on Internet sales. The backer of one
bill, Sen. Ron Wyden (D-Ore.), holds
that taxing Internet sales could weaken
the growing Internet economy.
While that idea has held sway thus
far, the states, eyeing potential revenue
sources, have come up with plans of
their own, which they hope will ultimately serve as a blueprint when and
if they get the OK to capture taxes on

3

I

1

I

2

5
4.5

4.5

I

4

5

I

5

6

5.75

I

6

I

State Sales Tax Rates in the
Fifth District

0

I

Under the new rule, it would be rounded
down to $1 and taxed accordingly.
The Mountain State is facing a $30
million deficit this year and a projected
shortfall of $200 million next year. Policymakers would love to find a way to
help put the state’s books in the black,
and some see taxing online sales as an
attractive option. A study by Donald
Bruce and William Fox of the University of Tennessee estimated West Virginia’s lost e-commerce revenues at $70
million in 2001. “Our people think that
is a high number,” Steager notes. “But
we don’t really have the ability to come
up with a more precise number.”
Bruce says that, ultimately, Congress should redefine the concept of
nexus. “You don’t need a physical presence to conduct business,” he says. “I
think the states would like an economic definition.”
Austan Goolsbee, an economist at
the University of Chicago, has written
a paper suggesting that people living in
locales with high sales taxes are much
more likely to buy goods online. Applying existing taxes could reduce the
number of online buyers somewhere in
the neighborhood of 15 percent, a
number he revised downward in 2000
from 24 percent in 1999.
“Using an extensive data source of
approximately 25,000 people with
online access, the results suggest that
local taxation plays an influential role
in online commerce,” he wrote in 1999.
“Controlling for individual characteristics, people living in places with
higher tax rates are significantly more
likely to buy things over the Internet.
… In total, the results give empirical
support to the idea that taxes (and
other price differences) will play an
important role for individuals living in
a ‘world without borders,’ and they
motivate further empirical work on
demand in an open economy such as
the Internet.”
While the magnitude of the tax
effect seems large, Bruce believes that
the “infant industry argument” is dead
—Internet sellers now have a strong
presence in the market — and that
local businesses are not being subsidized in the same way that the Internet industry’s major players are. “Is

PERCENTAGES

goods sold in cyberspace. And, in fact,
the effort did receive a symbolic boost
in February when the retailers
announced plans to collect.
Using simplification as a mantra, the
“Streamlined Sales Tax Project”
approved a multistate agreement in
November, the culmination of more
than a year’s work by representatives
from more than 40 states. Under the
agreement, state legislatures will consider laws to help simplify collection of
sales taxes. Fifth District states, including the District of Columbia, are considering proposals or forming study
committees in support of the effort
during this legislative session. Sabra
Faires says the North Carolina State
Legislature has additional work to do
in the upcoming session to simplify
sales tax rules even further.
“When the retailers sat in on the
streamlined sales tax meetings, they said
the differences in bases and caps and
thresholds is what made it hard for them
to pay up,” she explains. “We’ve got quite
a few differences.” For example, the state
does not tax food, but some localities tax
food. “We do not have a uniform, local
base.” The state also has certain tax caps,
for example an $80 cap on farm machinery. “[We need to] either tax it at the
state rate or exempt it,” she says.
“The hope is that taxes get simpler,
and if [they] get simpler, retailers will
collect,” she says. What’s more, the simplification could make a difference should
the issue be challenged in court again or
could inspire Congress to change the law,
forcing retailers to collect.
“I think the fact that these large
corporations are on board strengthens
their [states] case,” says Larry Walters,
professor of public policy at George
Mason University. But Walters says it
isn’t clear whether there is the political will to push simplification through
the state legislatures.
In West Virginia, legislation has been
introduced to end the aggressive bracketing system and adopt a rounding rule
for the state’s 6 percent sales tax, according to Dale Steager, general counsel for
the West Virginia Department of Tax
and Revenue. For example, a $1 purchase is taxed 6 cents, while a $1.01 purchase is taxed 7 cents, Steager says.

DC

MD

NC*

SC*

VA*

WV

*Allow localities to impose additional sales taxes
SOURCES: Federation of Tax Administrators, Sales Tax Clearinghouse, Inc.

there a public benefit to giving these
companies a benefit that’s not earned?”
echnically, consumers already owe
taxes on goods they buy over the
Internet. Typically a line on state
income tax forms asks for a list of such
purchases. But few pay this “use tax.”
“The compliance level is virtually
zero,” says Bruce. “My sense is the
revenue department would probably
have a nice laugh if they got a check
from somebody.”
But it’s important to note that consumer purchases represent only a small
portion of electronic commerce. “In
our study and in the real world, it’s not
just a retail question,” Bruce says. “It’s
all transactions between businesses.
More than nine of 10 dollars spent
online is [through] business-to-business
transactions. While we like to think
business purchases are tax exempt, they
aren’t always.” And states would love to
cash in on that business.
RF

T

READINGS
Bruce, Donald, and William F. Fox. “State and
Local Sales Tax Revenue Losses from E-Commerce: Updated Estimates.” State Tax Notes,
October 15, 2001, vol. 22, no. 3, pp. 203-214.
Goolsbee, Austan. “In a World Without Borders:
The Impact of Taxes on Internet Commerce.”
Quarterly Journal of Economics, May 2000, vol. 115,
no. 2, pp. 561-576.
Visit www.rich.frb.org/pubs/regionfocus for
links to relevant Web sites.

Spring 2003 • Region Focus

27

Constructing an Intellectual
Property Regime That
Promotes Both Innovation
and Social Welfare

A Delicate

Balance

BY AARON STEELMAN

n January, the Supreme Court considered
what the Framers of the United States
Constitution had in mind when they
granted Congress the power “To promote the
Progress of Science and useful Arts, by
securing for limited Times to Authors and
Inventors the exclusive Right to their
respective Writings and Discoveries.” In
particular, the Court had to determine what
the Framers meant by the term “limited.”
The country’s first intellectual property
laws established copyright terms of 14
years, renewable once. Over time, those
terms have been extended 11 times, most
recently in 1998, when Congress passed the
Copyright Term Extension Act (CTEA).

I

28

Region Focus • Spring 2003

or as long as laws have aimed at
protecting intellectual property,
disputes have raged over which
work to protect, for how long, and to what
extent,” write Stanley Besen and Leo
Raskind in an introduction to a
symposium on intellectual property
published in the Journal of Economic
Perspectives. And while economists may
differ over the details, most agree in
principle “that economic efficiency
requires government support for
innovative and creative activity.”
There have been some notable dissenters, though. In 1934, the distinguished British economist Arnold Plant

“

F

STANFORD LAW SCHOOL

The CTEA, often called the “Sonny
Bono Act” after the late congressman
from California who championed the
law, added 20 years to all copyright terms.
That means copyrights are now protected for the lifetime of a work’s creator
plus 70 years following death, and copyrights held by corporations are good for
95 years. After a copyright expires, the
property enters the “public domain.”
Eric Eldred, a New Hampshire publisher who posts on his Web site literature that has entered the public
domain, challenged the law, arguing
that the CTEA sets terms that are
neither “limited” nor necessary to
promote the “Progress of Science and
useful Arts.” What it did instead, he
claimed, was give an unfair monopoly
grant to a few copyright holders at the
expense of millions of potential consumers. In other words, Walt Disney
Co. would benefit from the CTEA,
because without copyright extension
some of Disney’s most famous images,
such as Mickey Mouse, would have
entered the public domain. But people
who would like to read, say, an out-ofprint but still copyrighted Robert Frost
poem would be hurt, because Eldred
and other online publishers would not
be allowed to post it electronically.
The Supreme Court wasn’t persuaded by the case presented by Eldred
and his attorney, Lawrence Lessig of
Stanford Law School. It upheld the
CTEA by a vote of 7-2. But the issue of
how to design an optimal intellectual
property rights regime is still a pressing
issue for economists and legal scholars.

Stanford University law professor
Lawrence Lessig argued before the
Supreme Court that the Copyright Term
Extension Act was unconstitutional.

argued against both copyright and
patent protections. His case was
straightforward: Economists generally
oppose state grants of monopoly privilege, so why should intellectual property be any different? The “evils of
monopoly,” Plant maintained, extend
to all spheres of economic activity, and
“the science of economics as it stands
today furnishes no basis of justification” for exceptions to that rule.
Many authors are not driven by
profit, Plant argued, and thus copyright
protection provides no incentive to
them. It only drives up the cost of their
works. “There is … an important group
of authors who desire simply free publication; they may welcome, but they
certainly do not live in expectation of,
direct monetary reward. Some of the
most valuable literature that we possess
has seen the light in this way. The writings of scientific and other academic
authors have always bulked large in this
class,” he wrote. “For such writers copyright has few charms. Like public
speakers who hope for a good Press,
they welcome the spread of their ideas.
Erasmus went to Basle in 1522, not
apparently to expostulate with Frobenius for daring to print his manuscript
writings, but to assist the printer in the
good work. The wider the circulation,
the more universal the recognition the
author would receive.”

Still, Plant did concede that more
“authors write books because copyright
exists, and a greater variety of books is
published.” However, “there are fewer
copies of the books which people want
to read.” He advocated a gradual elimination of copyright protection. The
first step would be to reduce the copyright term from the life of the author
plus 25 years (the standard at the time
Plant was writing) to five years after
first publication. Such a change would
help to “ensure low prices for books as
early as possible after the fate of the
first edition has revealed that a demand
exists for them.”
In the 1950s, economist Fritz
Machlup, then of Johns Hopkins University, expressed ambivalence about
the utility of the patent system. No one
could “possibly state with certainty that
the patent system, as it now operates,
confers a net benefit or a net loss upon
society,” he stated. And if one does not
know whether a system is good or bad,
the safest policy “is to ‘muddle through’
— either with it, if one has lived long
with it, or without it, if one has lived
without it. If we did not have a patent
system, it would be irresponsible, on
the basis of our present knowledge of
its consequences, to recommend instituting one. But since we have had a
patent system for a long time, it would
be irresponsible, on the basis of our
present knowledge, to recommend
abolishing it.”
Similarly, Princeton University economist Robert Hurt registered his
doubts about copyright protection in a
1966 article for the American Economic
Review. The “traditional assumption
that copyrights enhance the general
welfare is at least subject to attack on
theoretical grounds; the subject certainly deserves more investigation and
less self-righteous moral defense.”
Recently, economists Michele
Boldrin of the University of Minnesota
and David Levine of the University of
California at Los Angeles have taken
up this challenge and developed a
model that they argue demonstrates
that “current legislation on copyrights,
licensing, and patents plays a harmful
role in the innovation process.” In addition to the example of the aspiring

Spring 2003 • Region Focus

29

UNIVERSITY OF CHICAGO LAW SCHOOL

Richard Posner of the University of
Chicago maintains that a system of
“indefinitely renewable copyrights”
would work more efficiently than the
current regime.

author cited by Plant, they discuss
basic scientific research, open source
software development, and innovation
in the fashion industry, all of which
continue to proceed without intellectual property protection. Moreover,
they question whether many musicians
would stop composing, producing, and
recording music should the copyright
regime be eliminated. Some economists
have argued that Boldrin and Levine’s
model makes unrealistic assumptions.
Yet most agree it is a serious challenge
to mainstream thinking on the law and
economics of intellectual property. (For
a nice discussion of Boldrin and
Levine’s paper and its critics, see
Douglas Clement’s article “Was
Napster Right?” in the September 2002
issue of The Region, published by the
Federal Reserve Bank of Minneapolis.)
nd if there is one figure who could
be said to represent such
mainstream thinking it is Richard
Posner, a lecturer at the University of
Chicago Law School and judge on the U.S.
Court of Appeals for the Seventh Circuit.
Posner, along with his Chicago colleagues
Ronald Coase, Richard Epstein, and
William Landes, essentially founded the
modern law and economics movement,
which attempts to use the findings of social
science to make the law more efficient.
To Posner, property rights are purely
instrumental. They are valuable

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30

Region Focus • Spring 2003

because, in general, they enhance social
welfare. But when the cost of creating
or enforcing a particular property right
is especially high, he contends, that
right should be withheld. Consider the
extreme case of a hiker who has strayed
from his course and is without food or
shelter. If he stumbles along a vacant
house and breaks in to save his life, in
general the state will not prosecute
him. The benefit of saving his life outweighs the cost inflicted on the property owner. Now consider a more
mundane case: parking lots at shopping
malls. Those lots are generally privately
owned and the owners could, by right,
charge people to park in them. But
they usually don’t. The reason: It is
better for the shopping malls’ merchants to effectively treat their parking
lots as common pastures, because it
encourages more people to visit their
stores than if there were a fee to park.
Such a principle sometimes applies
in the case of intellectual property too.
Consider music. People often make
tapes or burn compact discs of officially released music to give to their
friends. Technically, this is a violation
of copyright. But the music industry
hasn’t aggressively prosecuted people
who engage in this practice. (The
industry has, of course, gone after filesharing Web sites that make such music
available to literally millions of potential listeners, though.) The reason: The
cost of prosecution is just too high. It
is hard to track down all the unauthorized tapes and burned CDs out there.
And, what’s more, those tapes and
burned CDs often create a following
for an upstart band. The recipients may
decide that they really like what they
hear and go out and buy more of that
band’s official releases. Indeed, this is
precisely what happened in the case of
several “alternative rock” groups who
played mainly on college campuses,
before tape-swapping made them
national figures. It also is true of J. R. R.
Tolkien’s brilliant trilogy, The Lord of
the Rings. In the 1960s, when the books
were acquiring cult status, especially in
England, unauthorized copies made
their way onto the market. Many
enthralled readers eventually turned to
the real deal and bought the author-

ized versions. Whether Tolkien, his
estate, and his publisher were made
better off by the distribution of illegal
copies is unclear, but a good case could
be made that they were.
Indeed, such examples have bolstered the arguments of people who
wish to see intellectual property protections eliminated. One line of argument goes like this. The use of
intellectual property — unlike physical
property — does not reduce the value
of its use by another. Put more formally,
the marginal cost of intellectual property — the expense of adding one more
user — is very low and can even be negative in certain cases. So why not make
property available to anyone who
wanted to use it, since optimal output
is generally achieved by equating price
to marginal cost? (A monopoly, in contrast, typically sets price above marginal
cost, resulting in “too little” output.)
Posner acknowledges the charm of
this argument. But he says that “such
a policy would be disastrous.” It would,
he argues, “kill the incentive to create
the intellectual property in the first
place, outside of the relatively rare
cases in which the creators have powerful nonmonetary incentives to create
such property, or in which its creation
is financed other than by sale or lease
of the property (by taxation, for
example, or charitable donation —
such as the patronage of authors by
wealthy people, in the old days.) We
need not suppose that most creative
people are greedy to realize that if they
cannot obtain a pecuniary benefit from
producing intellectual property, they
will not be able to finance the costs
(including the costs of their time)
required to produce it.”
Still, this does not mean that the
duration of copyrights and patents
should be boundless. There are many
reasons why this is true. One of the
more significant is the “tracing problem.”
Unlike physical property, intellectual
property is not visibly distinct. It is relatively easy to say where one piece of
land ends and another begins. But it is
much harder to do the same with ideas.
Ideas, by their very nature, build on one
another in a cumulative process. Great
writers, musicians, and scholars usually

don’t come up with their thoughts out
of thin air. They are inspired and influenced by their predecessors.
Posner puts the tracing problem this
way: “If copyright were perpetual,
James Joyce or his publisher would have
become embroiled in litigation with
the heirs of Homer over whether
Ulysses infringed The Odyssey, and
Leonard Bernstein with the heirs of
Ovid over whether West Side Story
infringed Pyramus and Thisbe (not to
mention Romeo and Juliet and A Midsummer Night’s Dream, themselves
arguably infringements of Ovid’s story).
If patents were perpetual, heirs of
Leonardo da Vinci would be litigating
over rights to basic aircraft technology.”
Another reason to limit copyright
protection is that doing so may increase
the “distribution and hence use of intellectual property.” Indeed, this is the
crux of the argument made by Eldred
and by 17 economists (including five
Nobel laureates) who filed a “friend of
the court” brief, arguing that the CTEA
was economically inefficient.
xtending copyright by 20 years, the
economists maintained, provides
little incentive for the production
of new works. The reason: The further
away in time a royalty is paid, the less that
payment is worth in present value.
Consider the case of an author who writes
a book and lives for 30 more years. Under
the pre-CTEA copyright regime, “the
author or his assignee would receive
royalties for 80 years. If the interest rate is
7 percent, each dollar of royalties from
year 80 has a present value of $0.0045.
Under the CTEA, this same author will
receive royalties for 100 years. Each dollar
of royalties from year 100 has a present
value of $0.0012.”
What’s more, extending copyright for
existing works “makes no significant contribution to the author’s economic incentive to create, since in this case the
additional compensation was granted
after the relevant investment had already
been made.” It does, however, provide a
significant benefit to those copyright
holders who can continue to make
money from their intellectual property.
But the number of such copyright
holders is relatively small. Most of the

E

intellectual property that would have
entered the public domain in the absence
of copyright extension is out of print.
Indeed, according to Eldred’s attorney,
Lawrence Lessig, only 2 percent of the
work copyrighted between 1923 and 1942
remains commercially viable. The other
98 percent presumably could have been
posted on Web sites like Eldred’s without
harming anyone, except, perhaps, a few
used book stores.
hat can be done? The
prescription offered by
economists Boldrin and
Levine is unlikely to be adopted.
Intellectual property protection is here to
stay. But are there ways to design a system
that would improve overall welfare without
drawing the ire of powerful media
companies like Walt Disney and AOL
Time Warner? Lessig has come up with a
proposal that he thinks might fly. In an
opinion piece for The New York Times he
floated the following idea: Fifty years after
a work’s creation, copyright holders would
be required to pay an annual tax to keep
that work from entering the public
domain. If the tax is not paid for three
years in a row, then copyright protection
would expire, and anyone “would then be
free to build upon and cultivate that part
of our culture as he sees fit.”
The CTEA’s major supporters
shouldn’t have any complaint about
such a proposal, Lessig says. “All of
them argued that they needed the term
increased so they could continue to get
revenue from their works that supported their other artistic endeavors.
But if a work is not earning any commercial return, then the extension is
pointless.” This compromise would put
fewer works into the public domain
than if the Supreme Court had ruled
the CTEA unconstitutional. “But it
would nonetheless make available an
extraordinary amount of material. If
Congress is listening to the frustration
that the Court’s decision has created,
this would be a simple and effective
way for the First Branch to respond.”
Lessig’s proposal is very similar to
one made by Posner. The major difference is the size of the tax involved.
Lessig would keep it small, so that
holders of copyrights to material that

W

is not commercially viable could
protect their intellectual property if
they wished. Posner would make the
tax high, so as to discourage such
actions. But they agree that a politically feasible solution lies in a system
of “indefinitely renewable copyrights.”
t heart, the matter of intellectual
property comes down to an issue
of competing interests. On the
one hand, we want to encourage
innovation and artistic creation. On the
other hand, we want as many people to
have access to as much material as possible.
The task is to create a legal regime that
strikes the right balance.
And this, writes Posner, “requires a
comparison of these benefits and costs
— and really, it seems to me, nothing
more. The problems are not conceptual; the concepts are straightforward.
The problems are entirely empirical.
They are problems of measurement.”
That may well be true. But such problems are not trivial. In fact, as Posner
admits, they are “acute.” Economists
and legal scholars have their work cut
out for them — but it is work that
could yield huge societal benefits. RF

A

READINGS
Akerlof, George A., et al. Brief submitted to the
United States Supreme Court in the case of Eric
Eldred, et al., v. John D. Ashcroft, May 20, 2002.
Besen, Stanley M., and Leo J. Raskind. “An
Introduction to the Law and Economics of
Intellectual Property.” Journal of Economic
Perspectives, 1991, vol. 5, no. 1, pp. 3-27.
Boldrin, Michele, and David K. Levine. “Perfectly
Competitive Innovation.” Minneapolis: Federal
Reserve Bank of Minneapolis Research Department
Staff Report 303, March 2002.
Lessig, Lawrence. “Protecting Mickey Mouse at Art’s
Expense.” The New York Times, January 18, 2003.
Plant, Arnold. “The Economic Theory Concerning
Patents for Inventions.” Economica, 1934, vol. 1, no. 1,
pp. 30-51.
Plant, Arnold. “The Economic Aspects of Copyright
in Books.” Economica, 1934, vol. 1, no. 2, pp. 167-195.
Posner, Richard A. “The Law & Economics of
Intellectual Property.” Daedalus, Spring 2002, pp. 5-12.
Visit www.rich.frb.org/pubs/regionfocus for links
to relevant Web sites.

Spring 2003 • Region Focus

31

INTERVIEW

Vernon
Smith
Economic theory is based on several assumptions of
how markets work and people behave. Vernon Smith
has spent his career testing those assumptions in the
laboratory. The result is the burgeoning field of “experimental economics.”
Experimental economists observe people’s actions in
controlled environments to determine, among other
things, how and why markets react to changes in legal
and regulatory rules. The insights drawn from such
simulated market transactions can be applied to a number of issues, including financial market theory, natural
resource economics, and the deregulation of industry.
In 2001, Smith joined the faculty of George Mason
University in Fairfax, Va., where he directs the
Interdisciplinary Center for Economic Science (ICES).
And last year, he and Daniel Kahneman of Princeton
University were jointly awarded the Nobel Memorial
Prize in Economic Sciences. This made Smith George
Mason’s second Nobel Prize economist: James
Buchanan took home the award in 1986 for his pioneering work in the field of Public Choice economics.
Smith, 76, heads a team of seven researchers at ICES,
all of whom came with him from the University of
Arizona, where he taught for 25 years. Aaron Steelman
interviewed Smith at the Federal Reserve Bank of
Richmond on January 27, 2003.

RF: You majored in engineering in college. Why
did you make the switch to economics?
Smith: When I was a senior at CalTech, I took
an economics course and I got interested in the
topic. I went to the library, and among other
things, I ran across a copy of Paul Samuelson’s
Foundations of Economic Analysis. It looked to me a
lot like physics, which I was already doing. I also
subscribed to the Quarterly Journal of Economics,
and in one of the first issues there was an article
by Hollis Chenery on engineering production
functions — so it was engineering too! Little did
I know that that was a very unrepresentative issue
of the journal. But, in general, the discipline was
mathematical and had an important applied
empirical dimension, which appealed to me.
I then went on to the University of Kansas,
where I received my master’s degree. One of my
best teachers there was Richard Howey, who was
an expert in the history of economic thought. I
learned what deep scholarship was from him and
developed an appreciation of where economics
was coming from in the 18th and 19th centuries.
From there, I went to Harvard, where I did my
Ph.D. Among my teachers at Harvard was Gottfried Haberler, who warned us of the dangers of
inflation. It was, as Joseph Schumpeter called it,
“ze monster.”
RF: In addition to changing disciplines, you also
changed worldviews. You entered college as a
socialist, right?
Smith: Yes, I grew up in a socialist family. My
mother was a socialist and was very proud that
she had cast her first vote for president for Eugene
Victor Debs. I held many of those views also. But
gradually, as I developed a deeper understanding
of economics, I began to rethink things. And the
final blow came when I started doing experiments
and my subjects taught me that markets work.
That transition took place over a number of years
and became stronger and stronger. Certainly by
the time I had been at Purdue for five or six years
— this would be in the early 1960s — I had
changed my mind.
RF: You had been on many economists’ short
list for the Nobel Prize for some time. Were
you surprised to finally get the call last year?

32

Region Focus • Spring 2003

RF: George Mason University has a reputation for
being a haven for free-market academics. What,
in your view, has contributed to the development
of this relatively unique intellectual environment?
Smith: I don’t know that much about the history
of George Mason. But I think a pretty crucial
factor was that they were able to attract Jim
Buchanan, who, in turn, attracted other Public
Choice economists to the faculty and graduate
students who wanted to work with them. In addition, they have a number of excellent Austrian
School economists who have strong free-market
views. Also, I think the administration realized
that they couldn’t be like Harvard, Yale, Chicago,
and other major research universities. So they
needed to find a niche to become well known. But
I really can’t give you a complete answer to that
question. The topic would make for an interesting historical study.
RF: When you came to George Mason, you
brought several faculty members from the University of Arizona along with you. In a way, this
isn’t surprising: Many academics benefit from
working with colleagues with similar interests.
But is this particularly true in the case of experimental economics? Is there something about
the nuts and bolts of actually doing the experiments that requires a core group of researchers?
Smith: Many contributions to economics are made

by lone wolves. That is, there
are an awful lot of papers with
single authors, much more so
than in the hard sciences. For
instance, you can find papers
in Science and Nature that will
have 100 authors. I think
experimental economics lends
itself far more to that type of
approach. Certainly, it’s always
helpful if you have a certain
mass of people to talk to, but
here the actual problems of
covering the operations and
doing the work require multiple skills that often aren’t
embodied in one person. I feel
that a really important part of
my development with experimental economics occurred
when I was no longer working
alone. That started in the
1970s with Charlie Plott, Ross
Miller, and other people at
CalTech. And by the time I
arrived at the University of
Arizona in 1975, most of the
efforts were joint.
RF: How was your work
received by the profession
when you first started conducting experiments?

GEEP SCHURMAN/FRB OF RICHMOND

Smith: I have been hearing rumors about the
Nobel Prize for 20 years. In 1997, for instance, I
was called by someone from Reuters, who told me
that he had it on good authority that I would be
awarded the prize that year, and it would be
announced the following Sunday. I said, “Well, they
don’t announce the awards on Sunday.” But clearly
I had been getting some nominations since the
early 1980s, and my friends all thought that I was
poised to receive the prize. So, after a while, you
get pretty thick skinned about it all and just try to
do your work. The only thing that made this year
any different was that in 2001 the committee had
a symposium on experimental economics in Stockholm. They invited 12 of us to be the main speakers and 12 people to discuss those papers. There
was speculation they were going to pick somebody
out of that group, but we couldn’t be sure who it
was or if it would be multiple people.

We have examples where
people don’t do as well as
rational models predict.
We have examples where they
do better. And we are trying
to understand why.

Smith: Not particularly well. I first started giving
seminars in the late 1950s and early 1960s, and at
the time people didn’t know what I was doing or
why I was doing it. It didn’t look like economics
to them. But I found it very interesting and exciting, and I was careful enough to do other things
in the meantime to get promoted.
RF: Tell us about the relationship between
experimental economics and public policy.
Smith: I should say that we don’t set out to do policy
research or to answer policy questions. We’re interested in the performance and function of markets,
and that often gets you into policy questions.
The first problem that we addressed, after we
got into computerized experiments, was the question of how you might design a market for airport

Spring 2003 • Region Focus

33

access rights. In the late 1970s, the deregulation
of the airline industry began. This involved the
routes that airlines could fly and the prices they
could charge. But nobody was thinking about the
airports, where, of course, airplanes have to land
and take off. If access to the airports were going
to continue to be allocated by some bureaucratic
organization, then the airline industry in a sense
wasn’t really being deregulated.
Take-off and landing slots are a commodity that
have greater value in packages than in singles,
because for every take-off, you have to have a
landing, and the flight schedules need to be compatible. We saw this early on as a combinatorial
problem. So we designed an auction mechanism
to try to solve this problem and tested it in the
laboratory. Much later, of course, combinatorial
auctions became of interest to people who were
thinking about how to allocate rights to the electromagnetic spectrum.
RF: Your Nobel lecture seemed to draw heavily
upon the work of F. A. Hayek, especially his
ideas about rationality. Briefly talk about the difference between “constructivist rationality” and
what you have termed “ecological rationality.”
Smith: Economic theory is dominated by constructivist models, involving optimal knowledge
for individuals, equilibrium in markets, and efficiency. But what we observe in experiments and
the real world is often different: people’s knowledge is incomplete, and they may not have any
idea what it means to talk about equilibrium and
supply and demand. Remarkably, though, the first
time I got people together in the lab, the market
they formed converged toward a competitive equilibrium. And I think that the history of experimental economics is, to some extent, the story of
people achieving these outcomes that are unintended and unknown to them. This type of knowledge is what I call “ecological rationality.” It may
or may not correspond to the rational model that
constructivism posits. We have examples where
people don’t do as well as rational models predict.
We have examples where they do better. And we
are trying to understand why.
All of our work is driven by the notion that
information is fundamentally asymmetric, dispersed, not knowable by any one person or group
— and that it is the guy out there with the knowledge who needs to be motivated to reveal what is
necessary to make the system efficient. And this,
of course, is very close to what Hayek argued.
Hayek was incredibly good at the abstract level,
but people read him and have a hard time relating to him because there are few concrete exam34

Region Focus • Spring 2003

ples. In fact, I became influenced by Hayek only
recently, and I now see certain themes that could
integrate a lot of the work in experimental economics. My Nobel lecture was sort of the beginning of that project.
RF: What do you see as the relationship between
game theory and experimental economics?
Smith: There has been a lot of experimental economics research concerned with testing propositions from game theory. When it works, game
theorists love it. When it doesn’t work, they have
a tendency to say that there is something wrong
with the experiments. So we make some modifications to try to explain those anomalies — for
instance, why Dutch auction prices are lower than
first-price sealed-bid auction prices, though game
theory predicts that they are identical. We had
two models, and one did a much better job of
explaining it than the other one. So I guess the
answer is, we have to do it ourselves. I would like
to see a little more division of labor. They are the
experts in game theory, after all.
But, recently, we have collaborated with some
sympathetic game theorists, and it turns out that
they are the very best in their field. John Ledyard
at CalTech and David Kreps and Bob Wilson at
Stanford have been very sympathetic. Wilson has
even tackled the very important and difficult issue
of doing a game-theoretic analysis of the double
auction. It takes someone like Bob to pass up the
temptation of picking all the low apples and going
for a high one instead. And in his paper he points
out the very serious limitations of his own results
and that the limitations are inherent in the gametheoretic framework. It takes great courage,
honesty, and intelligence to make such a claim.
RF: There is an emerging school of thought
called “behavioral finance,” according to which
investors display certain predictable cognitive
biases that can lead to significant deviations
between the behavior of actual markets and the
predictions of models with frictionless markets.
Some even say that these biases can explain dramatic stock market runups like we had in the
late 1990s. Does your experimental work shed
light on this issue?
Smith: The explanations of the behavioral finance
theorists are certainly possible. But I’m not prepared to say that these markets or their participants are irrational. And, by the way, neither is
Daniel Kahneman. As far as Danny is concerned,
that’s the behavior and he’s just reporting it. He
doesn’t really make a judgment.

One of the reasons I’m not prepared to call
this behavior irrational is that, while it may not
be good for the individual, it may be good for
society as a whole. Maybe we are programmed to
do some very risky things in an effort to get back
in the game — and, in so doing, that behavior may
produce benefits for society. We know that people
tend to throw money at innovations and new
entrants to the market, and so we have people
bidding up the price of companies with no net
profits. Many, maybe most, of those companies
will fail. But a few will survive and throw off huge
benefits for the economy, benefits that far exceed
the money that was spent to get them off the
ground. Consider the steam engine. It produced
the steam ship and the locomotive, which were
big drivers of reducing transaction costs and
increasing the speed of things. We spanned a continent with rail in very little time. Well, many individual investors lost money, but there was
long-term value created. The 19th century was an
incredible growth century. And for all I know this
risky, speculative behavior is the cost of that kind
of growth. If I had a formula to protect individuals from their own tomfoolery, it would not necessarily be best for society. I can’t be sure of that.
RF: Some observers have described your experimental work as showing that markets often
misfunction, because in experiments prices
often deviate from “fundamental” values.
Others say your work is broadly supportive of
the efficiency of market mechanisms, because
prices exhibit a strong tendency to clear the
market. Which is it: Do markets work well or
do they often misfunction?

RF: What do you think is the most pressing issue
in economics today?
Smith: I think economists’ work is still colored

RF: Some economists have done
tremendous technical work but
have not been particularly interested in reaching people outside the
profession. Others have had the
desire — and, perhaps more importantly, the skill — to do high-quality
work and make it accessible for lay
audiences. What, in your view,
should be the role between the
economist and the public?

➤ Selected Publications
Author of more than 200 articles in
scholarly journals, some of which
are collected in Bargaining and
Market Behavior: Essays in
Experimental Economics (New York:
Cambridge University Press, 2000)

Smith: I think every economist
should ask himself the brother-in-law
test: Can I explain to my brother-inlaw, who is in a completely different
field, what it is that I do for a living? The physicists try to do this. Some are better than others,
but they try to explain what is implied by quantum
physics or by relativity. And over the years, I think
their ways of explaining these issues have improved.
There are an awful lot of people out there who
don’t have a lot of education but who are smart
and want to know things. For example, my
parents had an eighth-grade education, but they
were always curious. We ought to try to reach
these people.
RF

Spring 2003 • Region Focus

GEEP SCHURMAN/FRB OF RICHMOND

Smith: I distinguish between consumer markets
and asset markets. With the asset markets, we
often get bubbles and crashes in the laboratory,
but the consumer markets tend to converge
quickly. The asset markets eventually get there also,
but it takes longer. We sometimes have to bring
subjects back three times before they will quit
trading away from fundamental value. So there is
confirmation of ultimate fundamental value
trading, but under conditions that are hard to
imagine actually occurring, except for very stable
companies. The distinction between consumer
markets and asset markets is very important. If
people don’t make that distinction, they can get
confused about what my work shows.

too much by their political preferences. You know,
Hayek once wrote a paper called “Why I Am Not
a Conservative.” I sometimes would like to write
a paper about why I’m not a conservative or a liberal or a libertarian, so
that I could state what I think the
Vernon Smith
problems are with all of them.
➤ Present Position
It’s important for economists to
Professor of Law and Economics,
understand the phenomena they are
George Mason University
studying before they start asking
what can be done about it. And it
➤ Previous Faculty Appointments
seems to me that a lot of people are
University of Arizona, California
afraid of getting certain empirical
Institute of Technology, University of
results because of the implications it
Massachusetts, Brown University,
might have for the policies they
Purdue University
favor. You see this in particular in the
➤ Education
resistance to even the slightest sugB.S.E.E., California Institute of
gestion that some of our behavior
Technology (1949); M.A., University
may have an inherited component.
of Kansas (1952); Ph.D., Harvard
You have people like Steve Pinker
University (1955)
who are talking about both the environment and heredity, and yet they
➤ Awards and Honorary Positions
are accused of being genetic deterCo-winner, 2002 Nobel Memorial
minists, when of course the alternaPrize in Economic Sciences;
tive is just plain environmental
Distinguished Fellow, American
determinism. It amazes me how
Economic Association; Fellow,
much people are still arguing over
American Academy of Arts and
nature versus nurture, when it seems
Sciences
clear to me that it’s both.

35

ECONOMICHISTORY

Story of a Port Town
The Evolving
Economic Role
of Baltimore’s
Waterfront and
Location
BY CHARLES GERENA

VANE BROTHERS COMPANY

The history of Baltimore’s harbor, shown
here in 1910, stretches back to colonial days.

36

Region Focus • Spring 2003

y American standards, Baltimore is
an ancient city. Its storied history
stretches back to colonial days, when
its port began to ship farm goods from the
mid-Atlantic to people around the globe.
During the Revolutionary War, for
instance, American soldiers “were fed by
the grain and flour delivered from Baltimore,” describes Geoffrey Footner, a
Baltimore-based author and maritime
historian. Goods also were shipped from
the city to France, where they were
transported to the Dutch Islands and
traded for weapons and gunpowder
needed by the Continental Army.
This is just one of many instances of
how Baltimore’s economic life has been
shaped by armed conflict. More importantly, it illustrates how the city’s waterfront and location
have been central
to its growth and
prosperity — a fact
that continues to
this day.
The city was
founded as Baltimore Town in 1729.
Its 60 acres surrounded one of the
harbors formed by
the Patapsco River,
which flows eastward into the
Chesapeake Bay.
Towns emerged at
other harbors as
well, including Jones
Town in 1732 and
Fells Point in 1763.
(By 1773, the three
towns had merged
to form the city of
Baltimore.)

B

Baltimore’s founders saw the potential for a port. The harbor could access
Atlantic trade routes via the Chesapeake
Bay, yet it was better protected than
Norfolk, Va., and other Bay ports
because it was farther inland. Although
the harbor was shallower and harder to
navigate than Fells Point, the problem
was dealt with by constructing piers that
reached into friendlier waters.
At the same time, Baltimore’s harbor
was close to sources of food production.
Down the Chesapeake Bay were communities where the land was fertile and
the water teemed with seafood. Farmers
in Pennsylvania, Delaware, and western
Maryland were nearby as well.
Finally, Baltimore was on the “fall
line,” a geological transition between
the hard rock of the Piedmont and the
softer soil of the Coastal Plains. When
the Patapsco or any river or stream
flows over this ridge, it creates falls and
rapids that impede water travel. As a
result, Baltimore’s harbor was a good
place to offload goods from ships and
transport them inland using other
means of transportation.
All Baltimore needed were markets
to serve. During the 17th and early 18th
centuries, Maryland had no pressing need
for a major trade center. “The initial
trade… was in tobacco, and it was controlled in London,” says John McCusker,
professor of American history and economics at Trinity University. Also, historians note that tobacco plantations
mostly used their own docks or utilized
ports that were close to the mouth of
the Bay, such as Norfolk or St. Marys in
southern Maryland.
Baltimore found its market niche
when tobacco prices collapsed and it
became more expensive to cultivate the

AIRLAND-INDUSTRIAL PHOTO CO.

golden leaf in the early 18th century.
Tobacco farmers began seeking more
profitable crops to grow. “They discovered that their land better produced
grains than tobacco, and a market grew
for the former,” says McCusker. “That
gave rise to local merchants who organized the grain trade and the exchange of
other goods to farmers.”
Demand for corn and wheat came
from Europe and Caribbean nations
where French, British, and Swedish plantations operated. “Sugar was such a profitable crop that it was economically
disadvantageous for the plantations ... to
grow their own food. They bought food
from someplace else,” explains Matthew
Crenson, a political science professor at
Johns Hopkins University who has
studied Baltimore’s social and economic
progress for three decades.
Baltimore took advantage of the
growing grain trade. Not only did it
offer access to local grain farmers, but
it had streams like Jones Falls and
Gwynns Falls that flowed downhill into
the harbor. This provided plenty of
waterpower for grinding wheat and
corn into flour, which traveled better
than raw grains.
“Wheat came in wagons from
western Maryland and Pennsylvania
into Baltimore where the mills ground
it into flour,” describes Crenson. Other
accounts describe shipments of
produce coming into Baltimore, produced by farmers who were settling and
developing Maryland’s “backcountry”
in the northern and western part of the
state. Wharves, warehouses, and shipyards arose along the waterfront of Baltimore Town and Fells Point to handle
these commodities.
Despite this growth, other colonial
ports matured faster than Baltimore did.
“You didn’t have to sail the whole way
into the Chesapeake Bay like you do to
get to Baltimore,” notes John Kellett,
director of the Baltimore Maritime
Museum. The distance between Baltimore and the mouth of the Bay in
Norfolk is about 150 miles, “and back in
the days of sailing that was pretty long.”
Also, Kellett says the wind currents
could be “fluky,” adding days to a voyage.

The Maryland Port Administration has geared the Port of Baltimore to serve certain
niches in container transport, including automobiles. Today, the Port is the top East Coast
exporter of vehicles.

istance and wind currents became
irrelevant when the American
Revolution erupted in 1775. While
the British shut down the Bay’s outer ports
and occupied centers of commerce like
Philadelphia, Baltimore managed to stay
out of the clutches of the redcoats and
keep the goods flowing, partly by using
homegrown, locally owned clipper ships.
Food and supplies reached revolutionaries
to the north and south of Baltimore, while
flour and other goods continued into
Caribbean markets.
“The War of Independence ... proved
to be a boon for Baltimore merchants,
not only because rival ports were more
effectively blockaded by the British but
because Spanish ports in the
Caribbean, normally closed to American shipping and flour, were opened for
the war’s duration,” wrote economist
Geoffrey Gilbert in a 1977 journal
article. “In the post-war period, Baltimore’s flour trade to Europe and the
West Indies showed rapid gains.” By
the 1790s, the city commanded 26
percent of America’s flour exports to
the West Indies, where the major ports
of entry for the Caribbean were based.
As more flour moved out of Baltimore, more capital flowed into the city.
“Much of the early commercial development [in Baltimore] was underwritten by Philadelphia merchants,” says
McCusker. Then Maryland businessmen jumped on the bandwagon.
This capital financed the develop-

D

ment of a variety of support industries
in Baltimore. Shipbuilding at Fells
Point expanded, while ironworks
cranked out fittings for ships and parts
for mills.
Additionally, goods started coming
from Caribbean plantations back to
Baltimore. They included sugar, coffee,
and a distinctive commodity called
guano — dried bird and bat excrement
that tobacco and cotton plantations
used as fertilizer. The need to store
these commodities spurred the construction of more warehouses.
Baltimore was an established port
town by the turn of the 19th century,
often benefiting from turmoil abroad
according to historical geographer
Sherry Olson. “Of great importance to
Baltimore were the perennial naval
warfare between England and France,
which drove up flour prices, and the
frequent changes in management in the
sugar islands of the West Indies, major
importers of wheat,” Olson noted in
her 1997 book on the city’s history.
“Baltimore merchants profited from
the interruption of European shipping
and exploited the ups and downs in the
price of flour.”
ew York merchants viewed the
progress of their Southern
competitor with envy. Baltimore
had a strong grain trade with overseas
markets and was in a good position to
increase its domestic trade because it was

N

Spring 2003 • Region Focus

37

Baltimore’s Waterfront Continues to Change
The Inner Harbor was where Baltimore began
to redevelop its waterfront in the 1970s and
1980s. Since then, developers have seen value
in the harbor views and unique structures
of Canton, Fells Point, and other waterfront
communities. Here is a sample of the many
industrial buildings that have found new life
or have been razed to make way for new
retail, office, and residential development.

5
Inner Harbor

4
9

76
Fells Point

3. HarborView—Luxury condominiums and
apartment homes
4. Inner Harbor East—20-acre, mixed-use
development includes two Marriott hotels,
Sylvan Learning Centers headquarters, a luxury
apartment building, and a planned entertainment complex
5. Bagby Furniture Building— Conversion of
warehouse into Class-A office space

10
12

11

1
2
6. Bond Street Wharf— Class-A office complex
built on site of warehouse

10. The Anchorage —Luxury condominiums built
near waterfront for marina access

7. Brown’s Wharf— Renovation of coffee
warehouse to house offices and specialty retail

11. Canton Cove —Redevelopment of factory
into luxury condominiums

8. Henderson’s Wharf— Renovation of tobacco
warehouse into a residential complex, inn, and
marina

12. Lighthouse Point— Licorice factory renovated
into a 16-acre development with apartments,
retail and office space, and a marina

9. The Can Company—American Can Co. plant
converted into a retail and office center

—C H A R L E S G E R E N A

geographically closer to Ohio and other
Midwestern markets than New York. In
addition, the city stood to gain a major
transportation advantage from the
National Road, a federal project begun in
1815 to link Cumberland in northwestern
Maryland to St. Louis. Maryland officials
promised to link Baltimore to Cumberland
by expanding several state roads.
New York countered Baltimore’s geographic advantage by completing the
Erie Canal between the Empire State
and Lake Erie in 1825. The 360-mile
canal transported East Coast goods to
Midwest customers more quickly than
Baltimore could by using the National
Road, which only reached Wheeling,
W.Va., at the time. That meant shipments from Baltimore had to be offloaded onto ships to finish their journey
on the Ohio River. Even when the
National Road was finished in 1833, the
older portion was in poor condition.
The Erie Canal threatened Baltimore’s dominance in another way. It
enabled Midwest agricultural goods to
reach East Coast markets. This eroded
38

Canton

Locust Point

3

1. Tide Point—Proctor & Gamble soap factory
turned into an office complex for technology
and service firms
2. Phillips Foods Inc.— Coca-Cola plant
redeveloped into office and production space
for the seafood manufacturer

8

Region Focus • Spring 2003

demand for grains and produce from
Chesapeake Bay farmers, which were
major users of Baltimore’s port.
After several failed attempts to build
a canal system, a group of Baltimore
merchants and bankers formed a committee to find a way for the city to boost
its Midwest trade. They boldly determined that a railroad would be the best
way to compete with the Erie Canal,
since it would be faster and cheaper to
maintain than the National Road.
The Baltimore and Ohio Railroad
was chartered in 1827 and took about
30 years to finish, creating the country’s
first public railroad that linked Baltimore to St. Louis. Others developed
rail links to Baltimore, including the
state’s Western Maryland Railway and
countless small enterprises.
Although the railroads ultimately
brought more competition for Chesapeake farmers, it enabled Baltimore to
reap the benefits of its port and location
throughout the 19th century. Warehouses in Canton, Fells Point, and other
waterfront neighborhoods were built to

pack seafood and produce for shipping,
while container manufacturers such as
the American Can Co. were established
to support this activity. Bakeries opened
to take advantage of the plentiful supply
of flour. Coal could be delivered to Baltimore cheaply, supporting the growth
of industrial production.
“Baltimore evolved from being the
link between the agrarian world and the
markets of Europe, to being a manufacturing town,” notes Kellett of the Maritime Museum.
y 1860, Baltimore was the nation’s
fourth-largest city and a commercial
hub for the South. But the city
would soon taste the bitter side of war.
A month after a mob attacked a
Massachusetts regiment headed to
Washington, D.C., to protect it from
invasion, federal troops entered Baltimore in 1861 and declared martial law.
Their occupation persisted until the end
of the Civil War four years later.
The war severely damaged Baltimore’s economy. “Suspension of com-

B

munication with Southern customers,
and the liability of capture and repeated
interruptions in Western trade, almost
paralyzed Baltimore’s commerce … and
resulted in its diversion to other cities,”
wrote Pearle Blood in a 1937 journal
article. “South American imports, which
had been carried chiefly in Baltimoreowned sailing vessels, were transferred
to foreign ships” to avoid plundering by
Confederate troops.
While Pittsburgh and other cities
farther away from the fighting developed
their industrial muscle, Baltimore industry atrophied. Its only growth sectors
were tied to the railroad or the port,
both of which served as strategic transit
lines for Union supplies and troops.
Baltimore’s economy continued to
feel the effects of the Civil War long
after the conflict had ended. Plantations
lost the economic efficiencies of slave
labor, increasing the cost of farming and
reducing the flow of agricultural goods
through the city. Worse, local investors
were less willing to bet their capital on
the city’s industrial sector, discouraged
by the loss of the city’s comparative
advantage in manufacturing.
“Firms in Baltimore couldn’t raise
money through the sale of stock [so]
they had smaller work forces,” describes
Johns Hopkins’ Crenson. “The perworker investment in machinery was
lower than it was in other cities, which
indicated that Baltimore wasn’t keeping
up technologically. The result was that
Baltimore industry didn’t grow as
rapidly as it did elsewhere in the postCivil War period.”
altimore entered a prolonged
period of redeveloping the value of
its water access and geography that
lasted throughout the 20th century.
Broader changes in the transportation industry added to the challenge.
The construction of the interstate
highway system provided a better way
of moving goods and people than the
railroad, undermining the advantages
that Baltimore’s rail links had once
afforded. The development of refrigerated trucks meant that warehouses and
packaging facilities no longer had to

B

locate close to the source of production.
These operations gradually relocated
from Baltimore, moving wherever trucking was available and other economic
conditions were more favorable.
The city began losing general cargo
traffic to New York after World War II,
mainly because its port facilities weren’t
up to date. “…The railroads were unwilling to make room for the developing
truck traffic that was changing the face
of American transportation,” noted
Robert Keith in his 1982 chronicle of
Baltimore. Moreover, the thin peninsulas protruding into the harbor were great
for offloading cargo onto trains, but
created bottlenecks for trucks. Finally,
“piers were reaching a state of decay, and
the railroads were neither willing nor
able to maintain them.”
Government officials have tried to
adapt Baltimore’s waterfront to changing times. As ships grew larger to carry
more cargo and accommodate vesselsharing agreements among carriers, city
and federal funds were deployed several
times to deepen and widen the port’s
harbors and channels. The state’s Maryland Port Administration (MPA) took
over operation of most of Baltimore’s
maritime facilities in 1956 to make
much-needed improvements. Three
years later, the MPA started building
Dundalk Marine Terminal on the southern edge of the city’s waterfront to
accommodate truck-borne cargoes.
Across from Dundalk, it devoted $30
million to upgrade the railroad piers in
Locust Point in 1964.
In subsequent years, the MPA geared
the Port of Baltimore to serve certain
niches in container transport, including
forest products and rolling cargo such as
automobiles and farm equipment. Baltimore has become the top East Coast
exporter of vehicles and third in the
nation for total car trade. In the past 10
years, more than 3.5 million vehicles have
rolled through Baltimore.
Meanwhile, port activity gradually
migrated from the shallower Inner Harbor
to Canton and points farther south where
the water is deeper, leaving behind empty
warehouses and industrial sites. Urban
renewal efforts in the 1970s and 1980s

brought retail projects and museums to
the Inner Harbor, while commercial and
residential developers recognized the value
of other sites along Baltimore’s waterfront
in the 1990s (see sidebar on p. 38).
Today, the city’s water-based economy
continues to evolve from shipping and
factories to services and recreation. “The
success of the Inner Harbor has begun to
spread, particularly to the east towards
Fells Point,” describes Walter Sondheim
Jr., a Baltimorean who has been involved
in waterfront redevelopment since 1970.
“The waterfront has become a center for
commercial activity, particularly for office
space and hotels.”
However, Baltimore’s historic harbor
may only be succeeding in refocusing
economic activity in the city. Development of a services sector along the waterfront “has created vacancies in the
financial district downtown,” admits
Sondheim. Some of this space is beginning to be redeveloped, however, benefiting from downtown’s proximity to the
waterfront. Also, income levels are higher
for residents who live by the water compared to other neighborhoods.
Sondheim argues that there are ways
to spread around that growth. “Some of
the tax revenues produced by the Inner
Harbor finds its way into neighborhood
development,” he notes. As new waterfront development increases the property tax base and attracts tourism
dollars, the economic role of Baltimore’s
harbor will continue to evolve.
RF

READINGS
Blood, Pearle. “Factors in the Economic Development of Baltimore, Maryland.” Economic
Geography, April 1937, vol. 13, no. 2, pp. 187-208.
Gilbert, Geoffrey N. “Baltimore’s Flour Trade to
the Caribbean, 1750-1815.” Journal of Economic
History, March 1977, vol. 37, no. 1, pp. 249-251.
Keith, Robert C. Baltimore Harbor: A Picture History.
Baltimore: Ocean World Publishing Co., 1982.
Olson, Sherry H. Baltimore: The Building of an
American City. Baltimore: Johns Hopkins University
Press, 1997 (revised edition).
Visit www.rich.frb.org/pubs/regionfocus for
links to relevant Web sites.

Spring 2003 • Region Focus

39

District Economic D
BY ROBERT LACY

Apprehension about
terrorism and political developments
regarding Iraq cast
a pall over the Fifth
District economy
in the last three
months of 2002.
Many businesses
continued to place
investment plans
on hold in light of
the uncertainty of
potential military
conflict. Consumers
were out in force
during the holiday
season, but sales
were disappointing
for most retailers.

Did You Know. . .
Fourteen percent of
the highway bridges
in the country are
considered structurally deficient. The
Federal Highway
Administration
considers a bridge
structurally deficient
if it has been
restricted to light
vehicle traffic,
requires immediate
rehabilitation to
remain open, or is
closed. Among Fifth
District states,
Maryland has the
lowest percentage
of deficient bridges,
while West Virginia
has the highest.

40

Economic growth in the Fifth District slowed
substantially in the fourth quarter of 2002.
Retailers tell us that holiday season sales were
lackluster — if not for upbeat postholiday
sales, December would have been dismal for
many District retailers. Manufacturers had
some good news: new orders trended higher
during the quarter. But they said that shipments were generally flat and noted that
employment continued to decline.

Economic Anxiety
Participants in our monthly survey of retailers
and services businesses reported that revenues
declined in the fourth quarter of 2002. Retail
revenues were particularly weak — shopper
traffic in District stores was generally light, and
merchants tell us that shoppers shied away
from big-ticket purchases. Retailers continued
to trim payrolls. In fact, retail employment in
the Fifth District is at its lowest level in three
years. Services sector jobs also declined, albeit
at a slower pace than in retail.
District manufacturers managed to keep
their heads above water in the fourth quarter,
despite sagging consumer demand and heated
competition from foreign producers. New
orders picked up in the fall and shipments
leveled off after slipping in late summer. But
manufacturing employment continued to fall —
19,000 jobs were lost during the fourth quarter
— and some manufacturers believed the sector
remained in recession. “Things are very flat right
now; some new glimmers of work coming … but
this recession has been long,” according to a
plastics manufacturer in North Carolina.
18
16

Structurally Deficient Bridges, 2001
(Percent)

14
12
10
8
6
4
2
0

MD

Region Focus • Spring 2003

VA

DC

SC

US

NC

WV

Government Sector Buoyant
Bucking the trend in total employment, government employment in Fifth District states
was 1.5 percent higher in the fourth quarter
compared to a year ago. It’s a huge sector,
accounting for 19 percent of total nonfarm
employment in the Fifth District, swelled by
the large number of federal employees in and
around Washington, D.C.
It’s also a diverse sector, and trends in local,
state, and federal government employment have
diverged. Local government employment growth
has been fairly steady at around 2 to 3 percent
over the last three years. State employment,
meanwhile, has declined as states have wrestled
with revenue shortfalls. Federal government
employment, which fell throughout 2001,
showed modest growth by the end of 2002.

Unemployment Rates Steady
The unemployment rate in the Fifth District
stood at 5.1 percent in the fourth quarter of
2002. This rate was little changed from the
third quarter of 2002 and was 0.2 percentage
points below the level of a year ago.
The Fifth District’s current unemployment
rate is almost a full percentage point below
the U.S. rate of 5.9 percent. Unemployment
rates in Maryland and Virginia, at around 4
percent, are among the lowest in the country.
The unemployment rates in West Virginia
and D.C. are now just above the national rate.
But both of these jurisdictions have seen their
unemployment rate converge to the national
rate, after remaining well above the national
average in the late 1990s.

Personal Income Growth Picks Up
Third-quarter personal income in the Fifth District was 3.7 percent higher than a year ago.
This rate was faster than in the first half of
2002, but slower than the exceptional growth
recorded in the late 1990s. Personal income
growth in Maryland and the District of Columbia exceeded 4 percent in the third quarter.

c Developments
Nonfarm Employment

Unemployment Rate

Personal Income

Fourth Quarter 2002

Percent

Third Quarter 2002

DC
MD
NC
SC
VA
WV
5th District
US

Employment
(Thousands)
650
2,473
3,881
1,832
3,497
727
13,060
130,806

% Change
(Year Ago)
0.1
0.1
-0.1
-0.1
-0.2
-0.9
-0.1
-0.2

4th Qtr.
2002
6.3
4.0
6.2
6.0
3.9
6.0
5.1
5.9

DC
MD
NC
SC
VA
WV
5th District
US

4th Qtr.
2001
6.6
4.4
6.4
6.0
4.4
4.6
5.3
5.6

Fifth District

DC
MD
NC
SC
VA
WV
5th District
US

Income
($ billions)
24.0
198.1
233.2
105.1
241.4
42.8
844.6
8,984.2

United States

Nonfarm Employment

Unemployment Rate

Personal Income

Change From Prior Year

First Quarter 1992 - Fourth Quarter 2002

Change From Prior Year

First Quarter 1992 - Fourth Quarter 2002

4%

8%

3%

7%

% Change
(Year Ago)
4.4
4.3
3.6
3.5
3.5
3.3
3.7
3.3

First Quarter 1992 - Third Quarter 2002

9%
8%
7%

2%

6%

6%

5%

1%
5%

4%

0

3%

4%

-1%

2%

-2%
1992

1994

1996

1998

2000

2002

3%

1992

1994

1996

1998

2000

FRB—Richmond
Services Revenues Index

FRB—Richmond
Manufacturing Shipments Index

First Quarter 1994 - Fourth Quarter 2002

First Quarter 1994 - Fourth Quarter 2002

2002

1%

30

30

4%

20

20

2%

10

10

0

0

0

-2%

-10

-10

-4%

-20

-20

-6%

2000

2002

2000

2002

Local

State

Federal

-8%

-30
1998

1998

First Quarter 2000 - Fourth Quarter 2002

6%

1996

1996

Change From Prior Year

40

1994

1994

Fifth District Government Employment

40

-30

1992

1994

1996

1998

2000

2002

2000

2001

2002

NOTES:

SOURCES:

1) All data series are seasonally adjusted.
2) FRB-Richmond survey indexes are diffusion indexes. Positive numbers represent expansion, negative
numbers contraction.
3) State nonfarm employment estimates are based on surveys of establishments. These employment
figures differ from those used to calculate state unemployment rates.

Income: Bureau of Economic Analysis, U.S. Department of Commerce, http://www.bea.doc.gov
Unemployment rate: LAUS Program, Bureau of Labor Statistics, U.S. Department of Labor,
http://stats.bls.gov
Employment: CES Survey, Bureau of Labor Statistics, U.S. Department of Labor, http://stats.bls.gov

For more information, contact Robert Lacy at 804-697-8703 or e-mail Robert.Lacy@rich.frb.org.

Spring 2003 • Region Focus

41

DISTRICT OF COLUMBIA

BY ANDREA HOLLAND

ver time, personal income and gross state product (GSP) tend to track fairly closely. But data on
personal income are available well before information
on GSP. Personal income data are released on a quarterly basis (with a two-quarter lag), while GSP data are
released on an annual basis (with a two-year lag).
Consequently, analysts often rely on personal income
to estimate a state’s recent economic activity.

O

Third-quarter real personal income data show that the
District of Columbia’s economy was strengthening
late last year. In fact, the rise in the third quarter
capped off 12 consecutive months of income growth in
the jurisdiction.
Overall, personal income in the District of Columbia
grew by 0.8 percent in the third quarter of 2002. By category, net earnings and transfer payments expanded,
while dividends, interest, and rental income contracted.
Net earnings, the largest component of personal income,
rose 1.1 percent in the third quarter, matching the
national rate of growth in the category. Wage and salary
earnings were higher in all industry sectors, resulting in
the first across-the-board gain since early 1999.
In addition to income growth, other economic indicators also improved. The number of new business bankruptcy filings dropped off, marking the third consecutive
period of decline. Also favorable, venture capital investment picked up — though not by much— reversing the
negative trend seen in the first two quarters of 2002.
In the real estate sector, performance in the District of
Columbia’s commercial and residential markets remains
relatively sound. Though office vacancy rates have risen,
the jurisdiction boasts some of the lowest rates nationally. Likewise, the residential market continued to
advance late last year— in the fourth quarter, existing
home sales reached their highest level since 1997.
Despite generally positive readings, the D.C. economy
still faces possible problems. Fourth-quarter employment data were weak—the jobless rate crept back up
to 6.3 percent and payrolls declined 0.4 percent. On
the consumer side, the rate of mortgage loans past due
ticked up slightly in the third quarter, after holding
steady the first half of the year. Similarly, nonbusiness
bankruptcy filings edged higher in the third quarter,
following a slight decline in the second quarter.

42

Region Focus • Spring 2003

DC Personal Income and GSP Growth
Annual Percent Change, 1990 to 2002

8
State Personal Income
Gross State Product

6
4
2
0
-2
-4
-6
1990

1992

1994

1996

1998

2000

2002

SOURCES:
Venture Capital Investment, PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association
MoneyTreeTM Survey
Personal Income, U.S. Department of Commerce, Bureau of Economic Analysis/Haver Analytics
Business and Nonbusiness Bankruptcy Filings, Administrative Office of the U.S. Courts/Haver Analytics
Mortgage Loans Past Due, Mortgage Bankers Association of America/Haver Analytics
Metro Area Office Vacancy Rates, CB Richard Ellis/Haver Analytics

4th Qtr
2002

Nonfarm Employment
Manufacturing
Services
Construction
Civilian Labor Force
Home Sales

Unemployment Rate
Housing Permits

Percent Change
at Annual Rate From
3rd Qtr
4th Qtr
2002
2001

650.3
11.0
309.0
10.2
268.3
15.1

-0.4
0.0
3.8
8.2
-3.9
93.7

0.1
-1.8
1.5
-4.1
-2.9
18.9

4th Qtr
2002

3rd Qtr
2002

4th Qtr
2001

6.3
394

6.0
1,045

6.6
313

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, SA; BLS/Haver Analytics
Services, thousands of jobs, SA; BLS/Haver Analytics
Construction, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Housing Permits, number of permits, not seasonally adjusted; U.S. Census Bureau/Haver Analytics

U

MARYL AND

BY ANDREA HOLLAND

ersonal income and employment data are two frequently used measures of state economic activity
— due largely to the comprehensive nature of personal
income statistics combined with the lack of timely
gross state product statistics. Recent figures from
both sources suggest that the current economic downturn has been less severe in Maryland than in many
other parts of the country.

P

MD Personal Income and GSP Growth
Annual Percent Change, 1990 to 2002

7
State Personal Income
Gross State Product

6
5

Maryland is the only Fifth District state where personal income has continued to expand each quarter
since the onset of recession. Additionally, on the
employment front, payroll levels in Maryland are 0.2
percent higher now than when the recession began. In
contrast, national and Fifth District-wide payrolls
have contracted by 1.2 and 1 percent, respectively.

4
3
2
1
0
-1
-2
1990

1992

1994

1996

1998

2000

2002

SOURCES:
Venture Capital Investment, PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association
MoneyTreeTM Survey
Personal Income, U.S. Department of Commerce, Bureau of Economic Analysis/Haver Analytics
Business and Nonbusiness Bankruptcy Filings, Administrative Office of the U.S. Courts/Haver Analytics
Mortgage Loans Past Due, Mortgage Bankers Association of America/Haver Analytics
Metro Area Office Vacancy Rates, CB Richard Ellis/Haver Analytics

4th Qtr
2002

Nonfarm Employment
Manufacturing
Services
Construction
Civilian Labor Force
Home Sales

Unemployment Rate
Housing Permits

Percent Change
at Annual Rate From
3rd Qtr
4th Qtr
2002
2001

2,473.1
170.0
868.3
169.3
2,902.1
123.5

4.8
-3.2
4.8
27.6
-0.5
24.6

0.1
-3.5
0.7
5.3
1.8
6.8

4th Qtr
2002

3rd Qtr
2002

4th Qtr
2001

4.0
6,488

4.2
7,289

4.4
7,015

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, SA; BLS/Haver Analytics
Services, thousands of jobs, SA; BLS/Haver Analytics
Construction, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Housing Permits, number of permits, not seasonally adjusted; U.S. Census Bureau/Haver Analytics

The state’s personal income growth is noteworthy.
Total personal income in Maryland rose by 1.0 percent
in the third quarter of 2002, outpacing the national
0.9 percent rate of growth. By category, net earnings
and transfer payments expanded, but dividends, interest, and rental income contracted somewhat. By
industry, earnings growth was the weakest in manufacturing and trade, and earnings contracted in the transportation and public utilities sector. Subsequently,
these were the only industries in Maryland that did
not add jobs in the fourth quarter.
Nevertheless, Maryland posted a 4.8 percent employment gain in the fourth quarter of last year—easily
exceeding the pace of growth nationally — and the
unemployment rate dropped 0.2 percentage points to
reach 4 percent.
Besides stronger-than-average income and employment data, other positive indicators were apparent in
Maryland late last year. Consumers continued to take
advantage of favorable interest rates and sales of existing housing units reached a series high in the fourth
quarter. Also solid, the number of nonbusiness bankruptcy filings fell for the second consecutive period in
the third quarter.
But conditions were less bright for Maryland businesses. Reflecting continued softness, office vacancy
rates and bankruptcy filings inched up a bit in the third
and fourth quarters, respectively. But there was some
good news for Maryland firms. Venture capital flows
into Maryland rose in the third quarter and remained
higher over the year — hopefully encouraging greater
business investment spending in the future.

Spring 2003 • Region Focus

43

hN O R T H

CAROLINA

BY ANDREA HOLLAND

ross domestic product (GDP) data —the measure of the size of the U.S. economy — are released
quarterly with a minimal lag. Unfortunately, GDP’s
regional counterpart, gross state product (GSP), is not
as readily available — data are released only annually
with a two-year lag. But as shown in the figure, personal income closely tracks with GSP and, as such, is
often used by analysts as a timely measure.

G

During the recent recession, personal income in
North Carolina contracted at a faster rate than the
national average —due in part to the state’s heavier
dependence on the manufacturing sector. In the third
quarter of 2002, for example, the manufacturing sector contributed 18.4 percent to total North Carolina
wage and salary earnings compared to only 14.1 percent nationwide.
Earnings for North Carolina factory workers began to
erode in early 2000 —and have contracted in six of the
last eight quarters. But recent data have been more
positive for state workers.
Manufacturing wage and salary earnings grew by 1.3
percent in the third quarter of 2002—the largest quarterly expansion recorded in nearly three years. In addition, after bottoming out in 2001, average weekly
hours continued to edge higher in manufacturing. In
spite of strong earnings and hours data, however, manufacturing payrolls continued to weaken in late 2002,
suggesting that factories could be relying primarily on
increasing worker hours to meet demand.
Outside of manufacturing, wage and salary earnings
rose in the third quarter in all North Carolina sectors
except for construction, resulting in total income
growth of 1.2 percent statewide. Also positive, new
building permits grew 18.5 percent in the fourth quarter and vacancy rates for office space in the Charlotte
area stabilized in the third quarter. Venture capital
investment into state firms also rose significantly in the
third quarter of the year. And for consumers, fourthquarter existing home sales capped off a record year.
But the employment situation remained mixed in the
state. On the upside, North Carolina’s unemployment
rate dropped 0.2 percentage points to reach 6.2 percent
in the fourth quarter. In contrast, total payrolls declined
by 1.1 percent during the same time period — due largely
to the 3 percent drop in manufacturing employment.
But services sector payrolls continued to expand in the
fourth quarter, cementing a year of job growth.
44

Region Focus • Spring 2003

NC Personal Income and GSP Growth
Annual Percent Change, 1990 to 2002

7
6
5
4
3
2
State Personal Income
Gross State Product

1
0
-1
-2
1990

1992

1994

1996

1998

2000

2002

SOURCES:
Venture Capital Investment, PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association
MoneyTreeTM Survey
Personal Income, U.S. Department of Commerce, Bureau of Economic Analysis/Haver Analytics
Business and Nonbusiness Bankruptcy Filings, Administrative Office of the U.S. Courts/Haver Analytics
Mortgage Loans Past Due, Mortgage Bankers Association of America/Haver Analytics
Metro Area Office Vacancy Rates, CB Richard Ellis/Haver Analytics

4th Qtr
2002

Nonfarm Employment
Manufacturing
Services
Construction
Civilian Labor Force
Home Sales

Unemployment Rate
Housing Permits

Percent Change
at Annual Rate From
3rd Qtr
4th Qtr
2002
2001

3,881.3
696.0
1,067.6
220.6
3,956.8
236.0

-1.1
-3.0
1.0
-2.4
-1.5
-1.7

-0.1
-2.5
2.0
-2.6
-1.4
5.4

4th Qtr
2002

3rd Qtr
2002

4th Qtr
2001

6.2
20,963

6.4
20,092

6.4
18,206

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, SA; BLS/Haver Analytics
Services, thousands of jobs, SA; BLS/Haver Analytics
Construction, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Housing Permits, number of permits, not seasonally adjusted; U.S. Census Bureau/Haver Analytics

SOUTH CAROLINA

o

BY ANDREA HOLLAND

he economic downturn hit South Carolina early.
Employment and personal income levels in South
Carolina began to weaken about two quarters before
the national recession began in March 2001.

T

SC Personal Income and GSP Growth
Annual Percent Change, 1990 to 2002

But the gap between activity in the state and in the
nation appears to be shrinking. Personal income in
South Carolina expanded by 1 percent in the third
quarter of 2002, outpacing the national growth rate of
0.9 percent.

7
6
5
4

Gross state product (GSP) and personal income tend
to track closely in the long run. And because personal
income data are released relatively quickly— with
about a two-quarter lag — they are used by analysts as
a proxy for GSP data, which are available annually with
a two-year lag.

3
2
State Personal Income
Gross State Product

1
0
-1
1990

1992

1994

1996

1998

2000

2002

SOURCES:
Venture Capital Investment, PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association
MoneyTreeTM Survey
Personal Income, U.S. Department of Commerce, Bureau of Economic Analysis/Haver Analytics
Business and Nonbusiness Bankruptcy Filings, Administrative Office of the U.S. Courts/Haver Analytics
Mortgage Loans Past Due, Mortgage Bankers Association of America/Haver Analytics
Metro Area Office Vacancy Rates, CB Richard Ellis/Haver Analytics

4th Qtr
2002

Nonfarm Employment
Manufacturing
Services
Construction
Civilian Labor Force
Home Sales

Unemployment Rate
Housing Permits

Percent Change
at Annual Rate From
3rd Qtr
4th Qtr
2002
2001

1,832.0
308.1
473.5
110.7
2,021.5
122.2

0.7
-8.3
4.8
-3.9
2.8
30.2

-0.1
-4.9
2.2
-0.8
4.1
12.4

4th Qtr
2002

3rd Qtr
2002

4th Qtr
2001

6.0
6,711

5.3
7,930

6.0
6,920

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, SA; BLS/Haver Analytics
Services, thousands of jobs, SA; BLS/Haver Analytics
Construction, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Housing Permits, number of permits, not seasonally adjusted; U.S. Census Bureau/Haver Analytics

The most recent personal income data for South
Carolina are encouraging. In the third quarter, income
increased for the third consecutive quarter — suggesting growth in the state’s economy. Wage and salary
earnings rose 1.3 percent statewide, with income picking up in all industries except mining. The most notable
turnaround occurred in the manufacturing sector—
earnings were higher in both the second and third quarters, following nearly two years of contraction.
In addition to strong income growth, news was also
bright on the job front. South Carolina added 3,100
jobs in the fourth quarter, marking the second quarter
of expansion. Payrolls rose in services, transportation
and public utilities, government, and finance, insurance, and real estate, but fell in manufacturing, construction, and trade.
On the downside, although fourth-quarter existing
home sales soared to record levels, the number of new
building permits authorized remained lower over the
year. Also, the percentage of mortgage loans with installments past due ticked up slightly in the third quarter and
personal bankruptcy filings edged higher.
And in spite of positive employment numbers, South
Carolina’s jobless rate kicked up 0.7 percentage points
to reach 6 percent in the fourth quarter, due mainly to
a seasonal rise in the labor force coupled with weakerthan-average holiday hiring.

Spring 2003 • Region Focus

45

uVIRGINIA
BY ANDREA HOLLAND

ersonal income in Virginia continued to expand in
the third quarter of 2002, although at a slower
pace than in the second quarter. Despite the deceleration, income growth has shown considerable strength
over the last 12 months for which data are available.
Expanding by 1 percent in the third quarter, Virginia’s
growth matched the Fifth District’s rate and exceeded
the national rate.

P

In the third quarter, wage and salary gains were
recorded in all of Virginia’s sectors. Growth was most
robust in government, wholesale trade, manufacturing, and finance, insurance, and real estate. In addition
to strong earnings by factory workers, average weekly
hours reached an all-time peak at both durable and
nondurable goods manufacturers —suggesting that
operators may be increasing hours worked, instead of
payrolls, to meet demand.
As in most other Fifth District states, Virginia data
generally suggest that the consumer sector remains
sound. Virginia’s jobless rate fell by 0.1 percentage
points to 3.9 percent in the fourth quarter, the lowest
rate among Fifth District jurisdictions. In addition,
consumers in the state have continued to spend
throughout the downturn. In the fourth quarter, for
example, new home sales reached a series high in
Virginia. And in the third quarter, new vehicle registrations and taxable retail sales remained above levels
recorded a year ago.
On the flipside, the percentage of mortgage loans with
installments past due ticked up slightly in the third
quarter of last year, but remained well below Fifth
District and national rates. In addition, softness persisted in personal bankruptcy data, though there have
been some bright signs recently. Filings have generally
trended upward since mid-2000, but some improvement was apparent in the third quarter — the last
period for which data are available.
Other Virginia data continue to have an upbeat tone.
The number of new business bankruptcy filings
dropped off in the third quarter, marking the second
consecutive period of decline. Also, nonfarm employment data showed promise — payrolls expanded by 0.2
percent in the fourth quarter. By sector, large job additions in services, government, and finance, insurance,
and real estate offset declining payrolls in manufacturing, construction, government, trade, and transportation and public utilities.

46

Region Focus • Spring 2003

VA Personal Income and GSP Growth
Annual Percent Change, 1990 to 2002

7
State Personal Income
Gross State Product

6
5
4
3
2
1
0
-1
1990

1992

1994

1996

1998

2000

2002

SOURCES:
Venture Capital Investment, PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association
MoneyTreeTM Survey
Personal Income, U.S. Department of Commerce, Bureau of Economic Analysis/Haver Analytics
Business and Nonbusiness Bankruptcy Filings, Administrative Office of the U.S. Courts/Haver Analytics
Mortgage Loans Past Due, Mortgage Bankers Association of America/Haver Analytics
Metro Area Office Vacancy Rates, CB Richard Ellis/Haver Analytics

4th Qtr
2002

Nonfarm Employment
Manufacturing
Services
Construction
Civilian Labor Force
Home Sales

Unemployment Rate
Housing Permits

Percent Change
at Annual Rate From
3rd Qtr
4th Qtr
2002
2001

3,497.1
355.9
1,162.4
206.6
3,782.6
161.2

0.2
-1.1
2.2
-0.3
0.5
56.6

-0.2
-1.6
0.9
-2.3
2.1
11.9

4th Qtr
2002

3rd Qtr
2002

4th Qtr
2001

3.9
14,262

4.0
15,038

4.4
11,664

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, SA; BLS/Haver Analytics
Services, thousands of jobs, SA; BLS/Haver Analytics
Construction, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Housing Permits, number of permits, not seasonally adjusted; U.S. Census Bureau/Haver Analytics

WEST VIRGINIA

w

BY ANDREA HOLLAND

ver time, a state’s personal income data and its
gross state product (GSP) data tend to track fairly
closely. But in recent years, West Virginia’s personal
income growth appears to lead the state’s GSP growth.
As the figure suggests, personal income growth picked
up and declined prior to GSP in the late 1990s. The figure also shows that, unlike in other Fifth District states,
income growth is only now beginning to erode in West
Virginia. But it is dropping relatively sharply.

O

WV Personal Income and GSP Growth
Annual Percent Change, 1990 to 2002

6
State Personal Income
Gross State Product

5
4

Total personal income in West Virginia expanded by
only 0.6 percent in the third quarter, the lowest
growth rate among Fifth District jurisdictions. In
addition, wage and salary earnings growth was anemic
across most industry sectors — only government, services, and finance, insurance, and real estate topped the
1 percent mark. In contrast, employee earnings contracted in the mining and construction industries.

3
2
1
0
-1
1990

1992

1994

1996

1998

2000

2002

SOURCES:
Venture Capital Investment, PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association
MoneyTreeTM Survey
Personal Income, U.S. Department of Commerce, Bureau of Economic Analysis/Haver Analytics
Business and Nonbusiness Bankruptcy Filings, Administrative Office of the U.S. Courts/Haver Analytics
Mortgage Loans Past Due, Mortgage Bankers Association of America/Haver Analytics
Metro Area Office Vacancy Rates, CB Richard Ellis/Haver Analytics

4th Qtr
2002

Nonfarm Employment
Manufacturing
Services
Construction
Civilian Labor Force
Home Sales

Unemployment Rate
Housing Permits

Percent Change
at Annual Rate From
3rd Qtr
4th Qtr
2002
2001

726.5
72.2
234.7
31.7
808.9
29.1

-0.5
-6.9
-1.7
-7.6
-0.2
13.4

-0.9
-4.4
1.2
-5.6
-2.9
3.6

4th Qtr
2002

3rd Qtr
2002

4th Qtr
2001

6.0
992

6.1
1,132

4.6
855

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, SA; BLS/Haver Analytics
Services, thousands of jobs, SA; BLS/Haver Analytics
Construction, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Housing Permits, number of permits, not seasonally adjusted; U.S. Census Bureau/Haver Analytics

News on the job front was also lackluster. West
Virginia posted a 0.5 percent loss in nonfarm employment in the fourth quarter. Payrolls rose in the trade,
government, mining, and finance, insurance, and real
estate sectors, but were shaved in the manufacturing,
services, construction, and transportation and public
utilities sectors. The loss of services jobs marked the
first decline in the series in exactly one year and is of
particular concern since the sector accounts for over
32 percent of jobs statewide.
Other indicators point to a weakening of conditions
for West Virginia’s consumers and businesses. On a
year-over-year basis, the rate of personal bankruptcy
filings in the state rose considerably in the third quarter, after declining in the second quarter of last year.
And the number of business bankruptcy filings edged
higher in the third quarter, reaching levels not
recorded since 1997. Also, the percentage of mortgages past due edged higher in the third quarter.
But some bright spots continue to exist, mainly in the
residential real estate market. Consumers continued
to take advantage of favorable interest rates, with
fourth-quarter sales of existing housing units finishing
the year on a strong note. Also, the number of building
permits for single-family and multifamily dwellings
remained strong, easily outpacing year-ago levels.

For more information regarding state summaries, call 804-697-8273 or
e-mail Andrea.Holland@rich.frb.org.

Spring 2003 • Region Focus

47

OPINION
The More the Merrier
BY A A RO N ST E E L M A N

I

sector appears, rising population continues to shift effort
n October 1999, the world’s population surpassed 6 billion.
from the household to the market sector because the latter
You might have expected people to rejoice over this
is more efficient at larger scales of operation. The pace of
development. After all, it meant that the human condition
urbanization is dictated by the rate of population growth in
was no longer “solitary, poor, nasty, brutish, and short,” as
the preindustrial economy,” they write.
Thomas Hobbes famously put it. Indeed, mankind had come
“Population must attain a second critical level to get indusa long way: infant mortality rates had dropped, life spans had
trial growth going. The human-capital or knowledge accuincreased, and prosperity had spread to areas of the world where
mulation that characterizes modern industrial growth does
despair had once been common.
not begin until market size has expanded the range of speBut, instead, many observers viewed this historic event
cialized goods sufficiently to make routine innovation worthas cause for alarm. For instance, Lester Brown, head of the
while. Market size, perhaps through trade, is a necessary
Earth Policy Institute, claimed that without “clearly defined
precondition for industrialization.”
strategies by governments in countries with rapid populaAll right, one might argue, popution growth to quickly lower birth
lation growth was good for the West
rates and a commitment by the interEstimate of World Population
centuries ago, but it surely isn’t good
national community to support them,
(in millions)
for the poorest parts of the world
one-third of humanity could slide into
today, right? Perhaps. But Nicholas
a demographic dark hole.”
Year
People
Eberstadt of the American Enterprise
Such arguments are hardly new.
1000
310
Institute has challenged such thinkThe classical economist Thomas
ing. “In the 1990s, sub-Saharan Africa
Robert Malthus predicted that the
1250
400
was estimated to have the world’s very
rate of population growth would
1500
500
highest rate of population growth —
exceed the rate of growth of the
1750
790
the United Nations Population Divimeans of subsistence. In other words,
1800
980
sion put its pace at over 2.5 percent a
population expansion would lead to
year for the period 1995-2000 — and
mass starvation. Malthus, of course,
1850
1,260
sub-Saharan Africa is clearly a trouwas wrong. In those rare cases in
1900
1,650
bled area these days. However, if we
which famine was a serious problem
1950
2,520
look back in history, we discover that
during the 20th century, despotic gov2000
6,079
the United States had an even higher
ernments were often to blame.
rate of population growth at the end
So how should we look at populaSOURCES: United Nations (1000 to 1950 data) and U.S. Census
Bureau (2000 data)
of the 18th century,” he notes. “Some
tion growth: boon or bane? This questoday may believe that sub-Saharan
tion, like many others, is hard to
Africa has too many people — but
answer in black-and-white terms. But,
would they say the same about early frontier America?”
on balance, population growth tends to be positive for the
Eberstadt argues that it is a mistake to assume that
economy.
poverty is a “population problem” simply because it is manIncreased population can create economies of scale. That
ifest in large numbers of people. There are many reasons why
means “that more people constitute bigger markets, which
sub-Saharan Africa is poor — corrupt governments, poorly
can often be served by more efficient production facilities.
defined property rights, and so on — but population growth
And increased population density can make economical the
is not near the top of the list. Indeed, it may not make the
building of transportation, communication, educational
list at all.
systems, and other kinds of ‘infrastructure’ that are unecoOpponents of population growth often “mention a greater
nomical for a less-dense population,” wrote the late econonumber of mouths coming into the world, and even more
mist Julian Simon of the University of Maryland.
pairs of hands, but they never mention more brains arrivEconomists Marvin Goodfriend of the Richmond Fed
ing,” Simon argued. This is a crucial point. More people mean
and John McDermott of the University of South Carolina
more ideas — and ideas are, in many ways, the lifeblood of
have developed a model of early economic development in
today’s economy. We should look at population growth as a
which population growth plays a key role, much like Simon
positive development. Or, at the very least, not as the catasdescribed. “Population must grow to a threshold before our
trophe that many people claim.
RF
economy can support an urban-market sector. After this
48

Region Focus • Spring 2003

NEXTISSUE
Guns, Butter, and Money
The Fifth District has a large military presence, from the U.S.
Naval Academy in Maryland, to the Pentagon near Washington, D.C., to big installations in the coastal areas of Virginia
and the Carolinas. What does this mean for the Fifth District
economy — both in times of peace and national emergency?

Liquid Assets
Jurisdictions throughout the Fifth District regulate the sale
and distribution of alcohol in a wide variety of ways. What
drives these policies and are some more efficient than others?

Who Protects the Consumer?
Occupational licensure laws are designed to keep the unqualified from entering certain professions. But instead of protecting
the consumer, these rules often drive up the price of services
without necessarily increasing quality. An economic view of a
supposedly “essential” form of government regulation.

Jargon Alert
Have you read about the “wealth effect” but
weren’t sure what it meant? Here’s a chance
to find out.
Legislative Update
Recent fiscal-policy decisions mean that the
federal budget deficit will be on the rise. Will
long-term interest rates be too? A look at
contemporary economic thought on the issue.
Opinion
There are proposals in Congress to reinstitute
the military draft. But there is little
economic rationale for a conscript army.
Research Spotlight
This new department will discuss an
important academic paper of interest to
economists and noneconomists alike.

At the Window
Open Market operations represent the Federal Reserve’s most
significant monetary policy tool. But the Discount Window
is also important. The Fed has recently changed the rules
guiding Discount Window loans, but the mission is the same:
to provide immediate liquidity to commercial banks.

On the Road
By some measures, NASCAR is now America’s most popular
spectator sport. But it wasn’t always so. Come with us for a
look at how stock-car racing went from a regional activity
centered in the Fifth District to a national phenomenon.

The Summer 2003 REGIONFOCUS
will be published in July.
Articles will also be available
online at www.rich.frb.org/
pubs/regionfocus.
To receive an e-mail notice
when each new issue of
REGIONFOCUS can be viewed
online, please contact
rich.regionfocus@rich.frb.org.

Stay Current
with a New Publication from the Richmond Fed

Fifth District Economic Indicators is a monthly online publication of the Research Department’s
Regional Economics Section. Indicators tracks and summarizes recent Fifth District economic
activity, as well as providing historical economic statistics for the District of Columbia,
Maryland, North Carolina, South Carolina, Virginia, and West Virginia.
Get the latest state-level data on the following:

Labor
Market
Conditions
Personal
Income
Financial
Conditions

Surveys of
Business
Activity
Real
Estate
http://www.rich.frb.org/research/indicators
For further information, call 804-697-8273 or e-mail Andrea.Holland@rich.frb.org.

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