Full text of Economic Perspectives (Federal Reserve Bank of Chicago) : March/April 1993, Volume XVII, Issue 2

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■viMnun/MmiL

ECONOMIC PERSPECTIVES
A review from the
Federal Reserve Bank
of Chicago

Consumer debt and
home equity borrowing
1993 Bank Structure
Conference program
highlights
Assessing global auto trends
Trends and prospects
for rural manufacturing




Contents
Consumer debt and
home equity borrowing............................................................................ 2
Francesca Eugeni

Have consumers reduced their debt levels significantly
compared to the 1980s? The author suggests that
the traditional method for measuring consumer debt
fails to take into account changes in consumer
borrowing habits. According to the author’s estimates,
which do take into account recent borrowing trends,
consumers have not significantly reduced their debt
levels in the past few years.

Assessing global auto trends................................................................ 1 5
Paul D. B atlew and
Robert H. Schnorbus

The authors discuss global trends in auto sales
and production and their significance for U.S.
automakers, especially in the Midwest.

Trends and prospects
for rural manufacturing............................................................................ 27
W illiam A . Testa

How are you going to keep them down in the rural
factory? The author discusses recent events affecting
rural manufacturing, including the rise of flexible
manufacturing, the increasing service orientation of
manufacturing, and trade negotiations among the
U.S., Canada, and Mexico.

ECONOMIC PERSPECTIVES
Karl A. Scheld, Senior Vice President and
Director of Research
Editorial direction
Carolyn McMullen, editor, David R. Allardice, regional
studies, Herbert Baer, financial structure and regulation,
Steven Strongin, monetary policy,
Anne Weaver, administration
Production
Nancy Ahlstrom, typesetting coordinator,
Rita M olloy, Yvonne Peeples, typesetters,
Kathleen Solotroff, graphics coordinator
Roger Thryselius, Thomas O’Connell,
Lynn Busby-Ward, John Dixon, graphics
Kathryn Moran, assistant editor




M arch/A p ril 1993 V o lum e XV II, Issue 2

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ISSN 0164-0682

Consumer debt and home
equity borrowing

Francesca Eugeni

Consumer debt ratios are im­
portant analytical tools because
they allow economists and
business people alike to evalu­
ate households’ financial con­
ditions and forecast consumer spending, which
is a crucial component of our economy. Be­
cause consumer spending represents two-thirds
of the United States’ gross domestic product,
fluctuations in households’ consumption affect
the economy’s output. Typically, rising levels
of personal consumption expenditures stimulate
the economy, while slower growth or declines in
this component have a dampening effect on
economic growth.
In general, individuals base their spending
decisions on several factors, including the level
of their existing indebtedness and their dispos­
able income. Therefore, we need to measure
household debt appropriately in order to forecast
consumer spending behavior. To evaluate con­
sumer indebtedness and consumer liquidity,
analysts often use debt to income ratios, which
measure the ability of consumers to cover out­
standing obligations with income.
The analyst’s most difficult task when cal­
culating debt to income ratios is to choose the
debt measure that can best reflect the full weight
of consumer indebtedness. If the measure of
debt is too narrow, the resulting debt to income
ratio will understate the true magnitude of con­
sumer debt, while a debt measure that is too
broad will inflate the real level of indebtedness.
In either case, the resulting forecast of consumer
spending behavior will be inaccurate.

2




For example, the most commonly used
measure of consumer indebtedness, the ratio of
consumer installment credit to disposable per­
sonal income, has been declining consistently
since the beginning of 1990, reaching a seven
year low in the second quarter of 1992. It has
been widely suggested that the recent decline in
this commonly used ratio indicates that consum­
ers finally have strengthened their balance sheets
by lowering the level of their indebtedness, and
will be able to sustain rising levels of spending
in the future. However, a close look at the major
components of household debt indicates that,
over the last six years, consumers have been
substituting home equity borrowing for other
types of credit. Moreover, a recent increase in
auto leases suggests that consumers also have
been replacing traditional automobile loans with
less costly auto leasing agreements. One of the
results of these substitution trends is a decline in
consumer installment credit outstanding which,
in turn, causes the ratio of installment credit to
disposable personal income to overstate the true
change in consumer indebtedness. Because
consumer borrowing behavior has changed over
time, we need to adjust our gauging tools ac­
cordingly and find a debt measure that can best
reflect such changes.
This article proposes more comprehensive
debt to income ratios that take into account the
Francesca Eugeni is an economist at the Federal
Reserve Bank of Chicago. The author is especially
grateful to Steven Strongin for his guidance and
insightful comments. The author would also like to
thank Anne Marie Gonczy and Carolyn McMullen
for helpful comments.

ECONOMIC PERSPECTIVES

substitution of home equity borrowing for con­
sumer installment credit. The analysis indicates
that, when total home equity lending is included
in the measure of consumer indebtedness, the
consumer debt ratio has not declined consistent­
ly during the last two years, and it is much high­
er than the ratio of consumer installment credit
to disposable personal income. Moreover, the
analysis indicates that the substitution of auto
leasing for automobile loans causes an under­
statement in the real magnitude of automobile
credit outstanding.
The evidence presented in this article sug­
gests that the recent restructuring of consumers’
balance sheets may not have been as significant
as the traditional debt ratio indicates, and that the
apparent improvement mostly reflects a reclassi­
fication of consumer liabilities among the differ­
ent components of household debt. Further­
more, although the rate of growth of household
debt has slowed in the early 1990s, the analysis
indicates that the more appropriate measure of
consumer credit has not declined dramatically
since 1989, which also suggests that households
might not be able to sustain higher levels of
spending in the near future.
T h e c o m p o n e n ts o f h o u se h o ld d ebt

The two major components of household
debt are consumer credit and home mortgage
debt. As of the third quarter of 1992, consumer
credit represents approximately 19.3 percent of
total household debt, and it consists of install­
ment credit and noninstallment credit. Nonin­
stallment credit represents only 7 percent of total
consumer credit and consists mostly of short
term credit, such as charges on credit cards that
require payment in full within the billing cycle.
Because noninstallment credit is such a small
component of consumer debt, it is normally
excluded when calculating debt to income ratios.
Clearly more important, consumer installment
credit represents 93 percent of total consumer
credit, and it is comprised of automobile loans,
revolving credit, and “other” installment credit.1
Total household debt as measured by the Federal
Reserve Board2 also includes “all other” debt
(tax exempt debt, other mortgages, bank loans
n.e.c., and other loans) which currently repre­
sents 10.3 percent of total household debt. In the
remainder of this article, household debt will
include only its two major components, home
mortgages and consumer credit.

FEDERAL RESERVE



BANK OF CHICAGO

Home mortgage debt currently represents
70.4 percent of total household debt, and it con­
sists of all loans secured by one-to-four family
residential properties, including home equity
loans and home equity lines of credit, which are
loans secured by the equity in the borrower’s
primary residence. Home equity loans are tradi­
tional closed end loans that require scheduled
monthly repayments of principal and interest for
a predetermined period of time. Home equity
lines of credit are revolving accounts (open end
lines) that allow borrowers to make withdrawals
against an approved dollar amount.
Separate data on total home equity lending
are not available, as loans secured by residential
property are all grouped together in the all inclu­
sive category of home mortgages. However,
data on home equity lines of credit outstanding
at commercial banks and thrifts are available in
the Report o f Condition, which summarizes
balance sheet data of insured depository institu­
tions.3 Moreover, because of the increased pop­
ularity of home equity lines of credit during the
last six years, different entities have been pub­
lishing survey data on home equity lending since
1987.4 Nevertheless, none of these sources
offers complete historical data on both home
equity loans and lines of credit for the lending
industry as a whole. Therefore, the data on
home equity lending used in this article to calcu­
late adjusted debt to income ratios are estimated.
T h e sh ift to hom e e q u ity b o rro w in g

As shown in Figure 1, during the last ten
years, household debt (consumer credit and
home mortgages) grew rapidly until 1990, when
the rate of growth, although still positive, started
to slow down. However, from the second half of
1983 to the end of 1985 total debt growth was
boosted mainly by sharp increases in consumer
installment credit, while from 1986 to the
present the growth in total debt has been fueled
mostly by home mortgages.
In fact, home mortgages, including home
equity lending, grew at an average seasonally
adjusted annual rate of 15 percent from 1986
through 1987, compared to 11 percent in 1984.
On the other hand, the growth in consumer in­
stallment credit slowed to an average 8 percent
rate from 1986 through 1987, compared to 19
percent in 1984.
In the early 1990s, the accumulation of both
home mortgage debt and consumer installment
credit slowed down considerably compared to

3

the 1980s. Installment credit actually declined
0.9 percent in 1991, and 1.2 percent in 1992.5 On
the other hand, home mortgage debt continued to
rise during the last three years, although at an
average annual rate of approximately 6.5 percent.
Typically, when the level of home mortgage
debt increases, we expect home sales to rise ac­
cordingly, especially when nominal mortgage
interest rates are declining. However, home sales
were relatively weak from 1987 to 1991. Part of
this anomaly can be explained by the fact that
home mortgage debt does not consist exclusively
of acquisition mortgages. Other components,
such as home equity borrowing, are included in
home mortgage debt and changes in these items
are not correlated with changes in home sales.
Home equity lending, and especially lines of
credit, became extremely popular between 1986
and 1988, soon after the enactment of the Tax
Reform Act of 1986. “Surveys of Consumer
Attitudes,” conducted in 1987 and 1988 by the
University of Michigan, show that 11 percent
of homeowners had home equity loans in the
second half of 1988, compared to 6.8 percent in
1983. Moreover, 76 percent of all the lines of
credit in existence at the time of the surveys were
opened in 1986 or 1987, compared to only 3
percent in 1983.6
The Tax Reform Act of 1986 phased out
personal interest expense on nonmortgage loans
as a tax deduction over a five year period (reach­
ing zero deductibility in 1991). This meant that
the tax deductibility of personal interest on credit
cards, auto loans, and personal loans disappeared

4



gradually while mortgage interest
remained deductible. Because
home equity loans (closed end
loans) and lines of credit (open end
lines) are secured by a lien on
residential property, they are clas­
sified as mortgage loans, therefore
allowing almost full deductibility
of interest expense. The only
restriction is that the amount of
home equity debt on which the
interest is deductible may not
exceed the lesser of the home’s
true equity (home’s fair market
value less acquisition debt) or
$ 100, 000 .
It is clear, therefore, that most
of the initial surge in home equity
lending, from 1986 through 1988,
occurred as consumers were trying
to take advantage of the interest deductibility on
mortgage loans, and were using home equity
borrowing as a substitute for other types of cred­
it and as a source of funds to repay more expen­
sive outstanding debt. This view is also support­
ed by the fact that the initial slowdown in con­
sumer installment credit coincided with the first
surge in home equity lending in 1986. In 1987,
total consumer installment credit outstanding
grew at one-third the average pace of 1984 and
1985. The growth in automobile loans started to
slow down in 1987, and “other” credit was nega­
tive at the end of 1986 and remained consider­
ably weak thereafter. At the same time, survey
data show that the median debt outstanding
under home equity lines of credit at the typical
lender rose from $6.8 million in 1986 to $15.6
million in 1987, a jump of 130 percent. Debt
outstanding under closed end loans rose from a
median of $7.4 million in 1986 to $10.7 million
in 1987, a gain of 44 percent (see Figure 2).7
Although mortgage interest expense re­
mained deductible on both closed end loans and
open end lines of credit, the Tax Reform Act of
1986 initially had a stronger impact on home
equity lines of credit, as shown in Figure 2. This
phenomenon can be attributed to the way homeowners originally used these two forms of home
equity borrowing. Because home equity lines of
credit are structured as simple revolving ac­
counts, initially they were considered the closest
substitute for more expensive types of consumer
credit, while traditional closed end loans contin-

ECONOMIC PERSPECTIVES

to indicate that consumers recently have been
using home equity loans also as a substitute for
traditional consumer loans. As Table 1 shows,
in 1991,43 percent of closed end loans were
used for debt consolidation, and 26 percent were
allocated to expenditures on goods and services.
In the same year, 36 percent of open end lines
were used for debt consolidation, and 32 percent
were allocated to expenditures on consumer
goods and services.
Overall, home equity lines of credit have
become extremely popular over the last six years
for the many tax and nontax advantages they
offer to consumers compared to other forms of
credit. For example, the interest rate charged on
open end lines (approximately 2 percentage
points over the prime rate) is usually much lower
than interest rates on credit cards, car loans, and
personal loans. Also, borrowers can use lines of
credit on a need-only basis by means of checks,
credit cards, and automatic teller machines.
ued to be used mostly for home improvements.
Usually, the amounts approved under open end
As Table 1 shows, in 1987, of the amounts bor­
lines are larger than closed end loans and are
rowed under open end lines, 53 percent were
based on loan to value ratios ranging from 70
used for debt consolidation, 19 percent for ex­
penditures on consumer goods and services, and
percent to 90 percent. For example, in 1991, the
most common loan amount approved at the
25 percent for home improvements. In the same
typical lender was $28,000 under a revolving
year, of the amounts borrowed under closed end
account, and $19,000 under a closed end loan
loans, only 35 percent were allocated to debt
consolidation, 16 percent were used for expendi­
commitment.8 Finally, repayment methods
under lines of credit are more flexible than the
tures on goods and services, and 45 percent for
monthly repayment schedules of principal and
home improvements. While the difference be­
tween the uses of closed end loans and open end
interest under closed end loans. Although mini­
mum monthly payments usually are required
lines was very pronounced in 1987, this differ­
under lines of credit, lenders offer different
ence narrowed somewhat in 1991, which seems
methods of repayment. Some lend­
ers require minimum monthly pay­
TABLE 1
ments calculated as a fixed percent­
age of the outstanding balance.
Uses of home equity debt
Other lenders require only interest
(percent of totals)
payments for the duration of the
1987
1991
loan, which typically is between 5
Open
Open
Closed
Closed
and 10 years, and one “balloon”
end
end
end
end
payment when the loan matures.
After the initial surge from
Debt consolidation
53
35
36
43
1986 through 1988, home equity
29
Home improvements
25
45
28
4
5
11
10
Autos
lending, and especially lines of
Education
1
9
7
3
credit, continued to increase steadi­
4
4
Investments
3
2
ly. As shown in Figure 2, in 1991,
Other
12
10
12
9
the typical lender had a median of
$79 million open end lines outstand­
NOTE: "O th e r" includes m edical expenses, vacations, tax paym ents,
m ajor purchases, and business expenses.
ing, and $52 million closed end
SOURCE: C onsum er Bankers Association, Home Equity Loan
loans, compared to approximately
Study, 1989 and 1992; Canner, et. al., Federal Reserve Bulletin,
1988 and 1989.
$7 million in 1986 for each type of


FEDERAL RESERVE


BANK OF CHICAGO

5

home equity lending.9 At the same
FIGURE 3
time, as shown in Figure 1, growth
Selected household debt components
in consumer installment credit
percent
percent
slowed considerably from 1987 to
19
1990 and declined in 1991 and
1992.
18
Although replacing other kinds
of consumer loans with home equi­
- 17
ty borrowing might have no effect
on the total stock of household debt,
16
it causes consumer installment
credit outstanding to decline. For
15
example, expenditures on automo­
biles, consumer goods, and services
14
that are made with funds borrowed
under home equity programs in­
13
crease the home mortgage compo­
SOURCE: Federal Reserve Board, Flow of Funds;
nent of household debt instead of
U.S. Department of Commerce.
consumer installment credit. Simi­
larly, the use of home equity loans
debt, some might conclude that consumers final­
for debt consolidation might cause consumer
ly have restructured their balance sheets by
credit outstanding to decline as existing liabili­
appreciably reducing their liabilities.
ties are reclassified on the balance sheets of
However, other broader measures of house­
consumers. In fact, when consumers repay their
hold debt clearly show that, although the overall
outstanding debts with home equity loans and
accumulation of debt has slowed down since
lines of credit, they do not reduce the total level
1990, the true weight of consumer debt has not
of their liabilities. Instead, the amount of the
declined considerably during the same period.
original debt is shifted from consumer install­
In fact, the debt to income ratio calculated using
ment credit outstanding to home mortgages,
home mortgages continues to increase in the
where home equity borrowings are included.
early 1990s (see Figure 3). In the third quarter
Although the total amount of household debt has
of 1992, the ratio stood at 64.3 percent, which is
not changed on the balance sheets of consumers
(assuming that the new home equity loan equals
almost 20 percentage points above its level in
the original debt), we understate the true magni­
1980. Therefore, while the debt measure using
tude of consumer indebtedness if we continue to
installment credit fell 2.3 percentage points from
use only consumer installment credit to calculate
the third quarter of 1989 to the third quarter of
debt ratios.
1992, the ratio of home mortgages to disposable
personal income increased approximately 4
C o n s u m e r d ebt ra tio s
points over the same period. The end result is an
Consumer installment credit as a percent of
increase of 1.1 percentage points in the ratio of
disposable personal income is the debt ratio
household debt (consumer credit plus home
most often used to assess consumer liquidity, as
mortgages) to disposable personal income over
it matches disposable personal income with short
the same time period.
and medium term obligations. As Figure 3
However, we have to be careful in the
shows, this debt to income ratio increased con­
choice of a more comprehensive measure of
siderably throughout the 1980s, reaching an
consumer indebtedness. Including home mort­
unprecedented level of 18.9 percent in the sec­
gages in our measure of debt would actually
ond quarter of 1989. However, from the peak in
cause the debt to income ratio to overstate the
1989, the ratio has declined consistently, falling
real magnitude of consumer liabilities. This is
to a seven year low of 16.7 percent in the second
because home mortgage debt includes acquisi­
quarter of 1992, and to 16.6 percent in the third
tion mortgages, which are long term commit­
quarter of 1992. After over two years of de­
ments where only a small portion of the total
clines in the most popular measure of household
debt has to be repaid each month. For example,


6


ECONOMIC PERSPECTIVES

if we were to divide the entire amount outstand­
ing of a 30 year mortgage loan by annual
amounts of disposable personal income, clearly
we would be inflating our debt measure.
On the other hand, although home equity
borrowing is classified as mortgage debt, it
differs from acquisition mortgages for two main
reasons: 1) its uses, which are mostly debt con­
solidation and expenditures on consumer goods
and services, and 2) its maturity, which is typi­
cally much shorter than the average life of first
mortgages. Because these differences increase
comparability between home equity borrowing
and disposable personal income when calculat­
ing debt to income ratios, debt outstanding under
home equity loans and lines of credit should be
included in measures of consumer debt.
H om e e q u ity le n d in g e stim ate d

Before introducing adjusted consumer debt
measures that take into account the substitution
of home equity borrowing for consumer install­
ment credit, it is useful to discuss the methodolo­
gy used in this article to estimate the data on
home equity loans and lines of credit. Estima­
tion of the data was necessary for several rea­
sons. First, although data on home equity lines
of credit are available starting with the 1988
Report o f Condition of most depository institu­
tions (commercial banks, savings and loans,
savings banks, and credit unions), data on home
equity loans are often grouped together with first
mortgages. Second, separate data on home
equity lending at investment banks and finance
companies are not available in the Report o f
Condition, and third, data on home equity lend­
ing at depository institutions are somewhat un­
derstated due to the recent increase in securitiza­
tion of home equity loans and lines of credit.
In general, securitization is a transaction
whereby assets of an institution, such as residen­
tial mortgages, credit card receivables, automo­
bile loans, and, recently, home equity loans and
lines of credit, are pooled together and repack­
aged into securities which are then sold to inves­
tors. When the seller of the securities transfers
all risks and benefits associated with the assets to
the purchaser, the sale is said to be without re­
course, and the assets are removed from the
balance sheet of the loan originator. Because
securitization is almost always without recourse,
home equity loans and lines of credit outstand­
ing reported by depository institutions are under­
stated by those amounts that are securitized and


FEDERAL RESERVE


BANK OF CHICAGO

eliminated from the balance sheets of the finan­
cial institutions.
Although securitization of home equity
loans and lines of credit is a fairly recent phe­
nomenon, it has been growing at a very rapid
pace since 1989. In 1991, new issues of securi­
ties backed by home equity loans and lines of
credit reached an unprecedented $10 billion,
with 37 percent of home equity lines of credit
securitized. This compares to $2.7 billion in
1989, and $5.6 billion in 1990.1 In 1992, ana­
0
lysts estimate another $10 billion in total new
issues, with 42 percent of home equity lines of
credit securitized."
Available depository institution data on
home equity lines of credit were first collected1
2
and then total debt outstanding under home
equity loans and lines of credit was estimated for
the entire lending industry. The estimating
process starts with the following findings from
the 1987 and 1988 “Surveys of Consumer Atti­
tudes:”1 1) insured domestic commercial banks
3
had 40 percent of the home equity lending mar­
ket at the end of 1987, and 2) home equity lines
of credit represented approximately 30 percent
of the total home equity loan portfolio of the
typical lender in 1988.
The 40 percent market share was applied to
home equity lines of credit outstanding at com­
mercial banks to calculate a total for the industry
in the first quarter of 1988 ($32 billion/.40=$80
billion). Then, data on lines of credit outstand­
ing at commercial banks and thrifts were used to
calculate a new market share ($52 billion/$80
billion=.65) which was used to estimate total
lines of credit outstanding from 1988 to 1992.
Then, since survey data show that lines of credit
represented approximately 30 percent of total
home equity lending in 1988, this proportion
was used to calculate home equity lending for
the industry as a whole from 1988 to 1992.
The estimated total home equity lending
was then adjusted for the amounts of home equi­
ty loans and lines of credit securitized from 1989
to 1992. Finally, it is important to note that the
understatement in depository institution data
cannot be completely eliminated as information
on whole loan sales and private placements of
home equity loans and lines of credit are not
available at this time.
As shown in Figure 4, the estimated total
home equity lending increased 75 percent from
1988 to 1992, with increases of 110 percent for

7

open end lines and 60 percent for closed end loans
during this same period. In the third quarter of
1992, total home equity lending reached an esti­
mated $469 billion, with 36 percent in home
equity lines of credit. This compares to an esti­
mated total of $268 billion at the beginning of
1988, with 30 percent in open end lines of credit.
A d ju ste d c o n su m e r d ebt ratios

The three adjusted debt to
income ratios shown in Table 2 all
have disposable personal income
(DPI) as the denominator, while
each ratio has a different measure of
consumer debt as the numerator.
HE1CI/DPI uses the sum of total
estimated home equity lines of
credit and consumer installment
credit. HE2CI/DPI uses the sum of
consumer installment credit, total
estimated home equity lines of
credit, and the portion of estimated
home equity loans that is used for
expenditures on goods and services
that typically are purchased with
consumer credit. Finally, HE3CI/
DPI uses the sum of total estimated
home equity borrowing (total debt
outstanding under loans and lines of credit) and
consumer installment credit. Table 2 also shows
CI/DPI, which is the traditional unadjusted ratio
of consumer installment credit to disposable
personal income.
The three adjusted ratios are graphed in
Figure 5 together with the traditional consumer
debt ratio (CI/DPI). HE 1CI/DPI is the least in­
clusive of the adjusted measures of debt, account­
ing only for the substitution of home equity re-

The foregoing analysis and survey data on
home equity loans and lines of credit clearly show
that home equity lending increased
dramatically during the mid-1980s
TABLE 2
and continues to increase in the
Adjusted consumer debt ratios
early 1990s. Because the substitu­
(percent of disposable personal income)
tion of home equity borrowing for
other types of credit causes the
(1)
(2)
(3)
(4)
traditional consumer debt ratio
CI/DPI
HE1CI/DPI
HE2CI/DPI
HE3CI/DPI
(installment credit to disposable
1989-Q1
18.7
21.3
22.3
26.6
personal income) to understate the
1989-Q2
18.9
21.6
22.8
27.3
true magnitude of consumer indebt­
1989-Q3
18.9
21.9
23.1
27.9
edness, this article proposes three
1989-Q4
18.9
21.9
23.0
27.6
debt ratios that take into account
1990-Q1
18.6
21.7
23.2
27.5
this substitution trend. To develop
1990-Q2
18.5
21.7
27.7
23.3
an accurate formula for measuring
18.4
1990-Q3
21.7
23.4
28.0
1990-Q4
18.1
21.6
23.2
27.9
debt, it is helpful to aggregate dif­
ferent components of debt and look
1991-Q1
23.2
27.9
18.0
21.6
at different ratios. For this reason,
1991-Q2
17.7
21.3
23.0
27.8
1991-Q3
17.5
21.2
23.0
28.0
each of the three adjusted ratios
1991-Q4
17.3
21.1
22.8
27.8
presented in this article uses a dif­
ferent level of the estimated debt
1992-Q1
17.0
20.7
22.6
27.3
1992-Q2
20.4
16.7
22.3
27.1
outstanding under home equity
20.4
1992-Q3
16.6
22.3
27.2
loans and lines of credit, ranging
from a very conservative measure
SOURCE: Column (1), U.S. Department of Commerce and Federal
Reserve Board. Columns (2), (3), and (4) are calculated by the author.
to a more inclusive one.


8


ECONOMIC PERSPECTIVES

Therefore, both HE 1CI/DPI
and HE2CI/DPI, which account for
Adjusted consumer debt ratios
only part of the substitution of
percent
home equity borrowing for other
types of consumer credit, indicate
that even with very conservative
debt measures, consumer debt
ratios have not declined signifi­
cantly in the 1990s.
Finally, HE3CI/DPI, which is
the most comprehensive adjusted
measure of consumer debt, ac­
counts for the substitution of all
forms of home equity borrowing
for consumer installment credit,
and it shows a more complete
picture of consumer indebtedness.
SOURCES: Federal Reserve Board and U.S. Department of Commerce.
Recall that evidence on the uses of
home equity borrowing shows that
consumer credit recently has been
volving accounts for consumer credit, and it
replaced with both home equity loans and lines
represents a very conservative adjustment of the
of credit. Therefore, the inclusion of both forms
traditional debt ratio. As shown in Figure 5,
of home equity borrowing in our measure of
while CI/DPI fell 2.3 percentage points from the
debt is not likely to overstate the full weight of
third quarter of 1989 to the third quarter of 1992,
consumer indebtedness.
HE 1CI/DPI fell only 1.5 points over the same
The debt to income ratio adjusted for total
period and has not declined since March 1992.
home equity lending (HE3CI/DPI) clearly shows
Therefore, although HE 1CI/DPI still is a very
that consumers have not been considerably re­
conservative measure of consumer indebtedness,
ducing the true magnitude of their indebtedness,
it shows that the recent restructuring of the bal­
as the traditional debt ratio indicates. In fact,
ance sheets of consumers has not been as dra­
HE3CI/DPI has ranged between 27 percent and
matic as CI/DPI indicates, since HE 1CI/DPI has
28 percent for the past three years and stood at
not declined as much. Moreover, it is important
27.2 percent in the third quarter of 1992, which
to remember that HE 1CI/DPI recently edged
is only 0.7 percentage points below its peak level
down because it accounts only for a portion of
in 1989 (see Figure 5). Moreover, in 1990 and
the total substitution of home equity borrowing
1991, HE3CI/DPI averaged 27.7 percent and
for consumer credit. The most comprehensive
27.9 percent, respectively, compared to an aver­
adjusted measure of consumer leverage, HE3CI/
age of 27.4 percent in 1989. For the three quar­
DPI, will account for this phenomenon in its
ters of 1992, the ratio averaged 27.2 percent,
entirety.
which is virtually unchanged from 1989.
HE2CI/DPI adds to home equity lines of
All of the adjusted debt measures discussed
credit that portion of home equity loans that is
in this section show that the recent restructuring
allocated to the purchase of consumer goods and
of consumers’ balance sheets has not been as
to expenditures on services, such as education,
dramatic as the traditional measure suggests.
vacation, and medical services, that typically are
HE3CI/DPI, the most inclusive ratio and conse­
purchased with consumer credit. This portion
quently a more accurate representation of con­
represented 26 percent of total closed end loans
sumer debt, is the most dramatic, indicating that
in 1991, compared to 16 percent in 1987 (see
the true measure of consumer credit remains
Table 1). As Figure 5 shows, in the third quarter
virtually unchanged in the 1990s.
of 1992, HE2CI/DPI stood at 22.3 percent,
which is much higher than the 16.6 percent level
D e b t se rv ice p aym en t ra tio s
of CI/DPI, and only 0.8 percentage point below
Another important debt ratio used to evalu­
its level in the third quarter of 1989.
ate consumer liquidity is the ratio of debt service

FEDERAL RESERVE



FIGURE 5

BANK OF CHICAGO

9

payments to disposable personal income, which
measures the ability of consumers to meet sched­
uled repayments of principal and interest on their
outstanding debts. One measure of this consumer
debt service burden, estimated by staff of the
Federal Reserve Board, indicates that the ratio of
debt service payments on total outstanding debt to
disposable personal income has been declining
steadily since the beginning of 1991, reaching a
six year low of 16.6 percent in the third quarter of
1992. As estimated by the Federal Reserve Board
staff, debt service payments on both consumer
installment credit and home mortgages relative to
disposable income also declined over this period.
The recent reduction in these debt service
ratios appears to conflict with the above conclu­
sion that consumers have not substantially re­
duced their indebtedness and strengthened their
balance sheets considerably. However, debt ser­
vice payments on consumer installment credit
outstanding do not include repayments on home
equity loans and lines of credit, causing this ratio
to understate the true size of consumers’ current
liabilities. Moreover, although debt service pay­
ments on home mortgages include servicing of
home equity borrowings, most of the recent de­
cline in mortgage repayments reflects heavy refi­
nancing and repricing of outstanding mortgages at
lower nominal interest rates.
After the Federal Reserve Board lowered the
discount rate to 3.5 percent on December 20,
1991, and to 3 percent on July 2, 1992, borrowers
started replacing their outstanding mortgages with
new loan commitments at lower nominal mort­
gage rates, thereby reducing their monthly pay­
ments. In January and July 1992, mortgage appli­
cations for refinancings represented approximate­
ly 70 percent of all originations in both months,
compared to about 30 percent for all of 1991.1
4
In summary, the recent reduction in debt
service payments on consumer installment credit
outstanding relative to disposable income seems
to overestimate the apparent restructuring of con­
sumers’ balance sheets, as this debt measure does
not include monthly disbursements on home equi­
ty borrowings. Moreover, although the ratio of
total household debt service payments to dispos­
able income is calculated using the most compre­
hensive measure of debt (including home equity
borrowings), part of the recent decline in this ratio
was due to lower nominal interest rates. There­
fore, although this reduction in debt servicing
obligations lessened the repayment burden of

10




consumers, it cannot be attributed entirely to a
retrenchment of household debt.
T he sh ift to auto lea sin g

Another recent trend in consumer spending
behavior is the substitution of auto leases for
traditional automobile loans. In this case, the
substitution phenomenon also causes an under­
statement in the real measure of consumer credit
and should be taken into account when we eval­
uate the full weight of consumer indebtedness.
Auto leasing has become extremely popular
during the last six years mostly because it allows
consumers to lower their monthly payments of
principal and interest on a new vehicle. This is
possible because the individual who leases the
vehicle (lessee) finances only a portion of the
total value of the car. Then, at the end of the
lease, the lessee can either purchase the car for a
set residual price or simply return the vehicle to
the lessor. Moreover, because of the favorable
lease terms and rates, consumers often can lease
a more expensive vehicle without considerably
increasing their monthly disbursements.
Automotive leasing data collected by CNW
Marketing/Research1 show that 24 percent of
5
total passenger cars delivered were leased in
1992. This compares to 12 percent in 1986, and
to a projected 28 percent in 1997. Moreover, as
Table 3 shows, the total value of the consumer
lease fleet of passenger cars went from $13.1
billion in 1986 to $27.7 billion in 1992, an in­
crease of over 100 percent. During the same
period, the amount paid by consumers for new
auto leases rose from $8.3 billion to $12.7 bil­
lion, a gain of 53 percent. This increase is re­
markable especially if we consider that, in 1992,
consumers financed only 46 percent of the total
value of the lease fleet, compared to 63 percent
in 1986. This decline in the lessee’s debt expo­
sure is mostly due to shorter maturities on new
car leases in 1992 compared to 1986.
The increase in auto leasing during the last
six years coincided with a slowdown in the
growth of automobile credit. From 1987
through 1989, automobile credit outstanding
grew at an average annual rate of 6 percent,
while it fell at an average of 4 percent during the
last three years. This compares to average annu­
al increases of approximately 20 percent from
1984 through 1986. The earlier analysis of
recent changes in consumer borrowing habits
indicated that the use of home equity borrowings

ECONOMIC PERSPECTIVES

TABLE 3

Automobile leasing
(1)

(2)

Lessee's
debt exposure

Value of
lease fleet

(3)
Value of
lease fleet
cum ulated

( ...................... .... billion $ .......... ............ ;
1986
1987
1988
1989
1990
1991
1992

8.3
10.7
13.2
11.5
10.0
10.7
12.7

13.1
17.3
21.0
20.2
17.8
20.5
27.7

13.1
27.1
40.5
47.9
47.8
49.2
57.0

(4)
Ratio of
consum er
installm ent
credit/D P I

(5)
Ratio
adjusted for
auto leases

( ............. percent............. )
18.3
18.2
18.4
18.9
18.1
17.3
16.6

18.7
19.0
19.5
20.1
19.3
18.5
17.9

NOTES: A m o unts in colum n (3) are first am ortized over four years and then cum ulated. Th e ratio in
colum n (5) is the sum of consum er in stallm ent credit and the cum ulated value of the lease fleet in
colum n (3) as a percent of disposable personal incom e.
SOURCE: Colum ns (1) and (2), C N W M arketing/R esearch, Lease Trak Reports/8, A ugust 1992.
Colum ns (3) and (5) are calculated by the author. C olum n (4), U.S. D ep artm ent of C om m erce and
Federal Reserve Board.

to purchase new autos and pay off more expen­
sive automobile loans outstanding contributed in
part to the recent slowdown in the growth of
automobile credit. Here, the effects of the sub­
stitution of auto leases for traditional auto loans
are evaluated and a measure of debt adjusted for
such phenomenon is estimated.
First of all, it is necessary to express the
value of the lease fleet in terms comparable to
outstanding amounts of consumer installment
credit. Table 3 shows the annual value of the
lease fleet and the lessee’s debt exposure from
1986 to 1992. For example, if the same cars
were financed with traditional auto loans instead
of leases, then consumers’ debt exposure would
equal the value Of the lease fleet (assuming 100
percent financing of the vehicle total cost for a
purchase). Moreover, the value of the leased
vehicles should be cumulated, since auto loans
typically are repaid in approximately four years.
Also, only a portion of the total value of the
lease fleet should be cumulated each year to
allow for amortization of the auto loans over the
four years. Therefore, the value rolled over each
year is gradually reduced by one-fourth of its
original amount to reach full amortization by the
fifth year. Because at this time data on the value
of leased vehicles are not available before 1986,
the cumulated value of the lease fleet from 1986
to 1989 is not exactly comparable to the num­
bers cumulated for later years. However, the

FEDERAL RESERVE



BANK OF CHICAGO

purpose of these calculations is to give a general
indication of the significance of the increase in
auto leasing. At this point, the cumulated value
of the lease fleet is added to consumer installment
credit outstanding to obtain an estimated measure
of debt adjusted for the shift to auto leases. As
shown in Table 3, the new estimated measure
is then used to calculate an adjusted debt to in­
come ratio.
As Table 3 shows, although the ratio adjust­
ed for auto leases has declined since 1989, it is
much higher than the traditional ratio of install­
ment credit to disposable personal income at any
point. Moreover, the adjusted debt ratio does not
take into account the substitution of home equity
borrowing for other types of consumer credit,
which causes installment credit to decline. Final­
ly, if automobile loans outstanding are adjusted
for the increase in auto leases, automobile credit
fell only 7 percent from the third quarter of 1989
to the third quarter of 1992, compared to a 12
percent drop in the unadjusted measure of auto­
mobile credit during the same period.
The above analysis, once again, highlights
the importance of choosing a measure of debt
that takes into account the changes in consumer
financing behavior and further suggests that even
the most comprehensive adjusted debt ratio dis­
cussed earlier in this article (HE3CI/DPI) may
still understate the full weight of consumer in­
debtedness.

11

C o n c lu s io n

The evidence presented in this article shows
that consumer borrowing patterns have changed
during the last six years, as households have
been taking advantage of less costly sources of
credit. The substitution of home equity borrow­
ing for other types of credit and the replacement
of traditional auto loans with auto leases are
clearly two important changes in consumer
borrowing behavior.
One of the results of these substitution
trends is a decline in consumer installment credit
outstanding, which, in turn, causes the most
commonly used debt ratio (consumer installment
credit to disposable personal income) to under­
state the full weight of consumer indebtedness.
Therefore, to appropriately gauge consumer
liabilities, we need to use a debt measure that is
more inclusive, but not too broad, and more
responsive to changes in consumer borrowing
patterns. This article has proposed three con­
sumer debt ratios that take into account the sub­
stitution of home equity borrowing for other
types of credit. These adjusted debt to income
ratios indicate that, although the rate of accumu­

lation of total household debt has slowed down
since 1990, the real magnitude of consumer
indebtedness has not been consistently declin­
ing during the last two years, as the traditional
measure of consumer debt suggests.
Moreover, the recent substitution of auto­
mobile leases for traditional auto loans also
causes an understatement in the true level of
automobile credit, and its effects should be
taken into account in assessing consumer in­
debtedness.
Finally, a fundamental result of this analy­
sis is to suggest that the choice of an appropri­
ate measure of debt can turn an overstated
decline in consumer indebtedness into a virtual­
ly unchanged reality. In fact, in light of all the
findings presented in this article it is reasonable
to conclude that, although the burden of debt
servicing has declined due to lower nominal
interest rates, consumers have not significantly
reduced their debt levels. This, in turn, seems
to indicate that, after all, households might not
be able to appreciably increase their level of
spending in the near future.

FOOTNOTES
'"Other” installment credit includes mobile home loans,
and secured and unsecured loans for education, boats,
trailers, and vacations.
2Federal Reserve Board, Flow o f Funds Accounts.
3The Report o f Condition contains balance sheet and
income statement information o f insured commercial banks
and thrifts. In general, insured depository institutions must
file statements o f condition and income with their respec­
tive federal government regulatory agencies on a quarterly
or semiannual basis.
4The Consumer Bankers Association publishes annual
Home Equity Loan Studies, and the American Bankers
Association publishes annual Home Equity Lines o f Credit

Reports.
5Data for 1992 are through the third quarter, unless other­
wise noted.
6Data from the 1987 and 1988 “Surveys of Consumer
Attitudes” o f the University o f Michigan are from Canner,
et. al. (1988) and (1989).

extreme observations. Moreover, Figure 2 seems to indi­
cate that the typical lender maintains a higher portfolio of
open end lines than closed end loans. Note, however, that
Figure 2 plots only the middle results of the studies and that
all o f the respondents in the CBA ’s surveys offer both
home equity lines and loans. Data from the Report of
Condition indicate, however, that only 60 percent o f com­
mercial banks offer home equity lines o f credit and that,
overall, closed end loans represent a much larger share of
the real estate loan market than open end lines.
8Consumer Bankers Association (1992).
9Ibid.
l0Dean Witter Reynolds Inc. (1992); D uff & Phelps Credit
Rating Co. (1992); and American Banker Bond Buyer
(1992).
"Estimated total issues for 1992 are from David Olson
Research Co., Columbia, MD.
12Federal Reserve Board database.
"Canner, et. al. (1988) and (1989).

7The data are from the 1987 and 1989 Consumer Bankers
Association’s (CBA) Home Equity Loan Studies. Although
the CBA’s studies report both the mean and the median as
measures o f central tendency, in this article only the medi­
an will be used, as mean results can be at times skewed by

12




"Mortgage Bankers Association (1992).
I5CNW Marketing/Research, Lease Trak Reports/8 , (1992).

ECONOMIC PERSPECTIVES

REFERENCES

American Banker Bond Buyer, Asset Sales
Report, October-December 1992.

Duff & Phelps Credit Rating Co., AssetBacked Monitor, 1991 and 1992.

American Bankers Association, Home Equity
Lines o f Credit Report, 1990 and 1992.

Federal Reserve Board, Flow o f Funds Ac­
counts, various years.

Boemio, Thomas R., and G.A. Edwards, Jr.,
“Asset securitization: a supervisory perspec­
tive,” Federal Reserve Bulletin, October 1989,
pp. 659-669.

Mortgage Bankers Association, Real Estate
Finance Today, November 14, 1991 and July 20,
1992.

Canner, Glenn B., and C.A. Luckett, “Pay­
ment of household debts,” Federal Reserve
Bulletin, April 1991, pp. 218-229.
Canner, Glenn B., C.A. Luckett, and T. A.
Durkin, “Home equity lending,” Federal Re­
serve Bulletin, May 1989, pp. 333-344.
Canner, Glenn B., J.T. Fergus, and C.A.
Luckett, “Home equity lines of credit,” Federal
Reserve Bulletin, June 1988, pp. 361-373.
CNW Marketing/Research, Lease Trak Re­
ports/8, Bandon, OR, May, August, and Novem­
ber 1992.
Consumer Bankers Association, Home Equity
Loan Study, 1986-1992.

Pavel, Christine A., The Analysis and Develop­
ment o f the Loan-based/Asset-backed Securities
Markets, Probus Publishing, Chicago, IL, 1989.
_________________ , “Securitization,” Econom­
ic Perspectives, Federal Reserve Bank of Chica­
go, July/August 1986, pp. 16-31.
Pozdena, Randall J., “Home equity lending:
boon or bane?,” Weekly Letter, Federal Reserve
Bank of San Francisco, June 2, 1989.
Swonk, Diane C., “Consumer debt: hitting a
wall in the 1990s,” Trend Watch, First National
Bank of Chicago, August 1992.
United States Banker, “HELs in heaven,” May
1992, pp. 20-23.

Dean Witter Reynolds Inc., Asset Backed Se­
curities Reference Guide, first half 1992.


FEDERAL RESERVE BANK


OF CHICAGO

13

The 2 9 th A n n u a l Conference on B ank Structure a n d Competition, M ay 5-7, 1993

FDICIA
A n Appraisal
The Federal Reserve Bank of Chicago will hold
its 29th annual Conference on Bank Structure
and Competition at the Westin Hotel in Chicago,
Illinois, May 5-7, 1993.
Attended each year by several hundred academics,
regulators, and financial institution executives, the
conference serves as a major forum for the exchange
of ideas regarding public policy toward the financial
services industry.
This year’s conference will provide a broad based
assessment of the merits and shortcomings of the
Federal Deposit Insurance Corporation Improve­
ment Act (FDICIA) of 1991.
Among the highlights of this year’s program
will be:
I The keynote address by Federal Reserve Board
Chairman Alan Greenspan.
I A panel discussion on the topic, “FDICIA:
Renaissance or Requiem?” Prominent
members of the academic, regulatory, and
banking communities will discuss the impact
of the new legislation.
I A luncheon address on banking reform by
John G. Heimann, chairman of the Global
Financial Institutions Group of Merrill Lynch
& Company, Inc. and former superintendent
of banks for New York State and Comptroller
of the Currency.


14


I A panel discussion on the potential for
systemic risk resulting from the rapid increase
in over-the-counter trading of derivative and
foreign exchange products. The panel will
include leading experts on derivatives trading
and interbank risk exposures.
I A luncheon panel, “The Outlook for Banking:
Is the Crisis Over?,” featuring L. William
Seidman, former chairman of the Federal
Deposit Insurance Corporation and currently
chief commentator of CNBC; George M. Salem,
first vice president of Prudential Securities;
and Edward J. Kane, James F. Cleary Professor
of Finance at Boston College.
As usual, our Wednesday sessions will showcase a
wide array of more technical papers of primary
interest to researchers in academia and government.
If you are currently not on our mailing list or have
changed your address and would like to receive an
invitation to the conference, please write or call:
Sandy B lazina
Public A ffa irs Department
Federal Reserve B ank o f Chicago
P .0. Box 8 3 4
Chicago, Illinois 6 0 6 9 0 -0 8 3 4
Telephone 3 1 2 -3 2 2 -5 1 1 4

ECONOMIC PERSPECTIVES

Assessing global auto trends

Paul D. B allew and
Robert H. Schnorbus

The global automobile indus­
try has gone through over­
whelming restructuring during
the last twenty years. This
restructuring has produced,
among other effects, massive downsizing and
relocation for the Midwest, the birthplace of the
mass production of vehicles. Assessment of
current and future changes in the industry pre­
dict further adjustments, especially within the
region. The factors prompting these adjust­
ments are frequently depicted dramatically as
emanating in large part from economic forces
endemic to the U.S. market. Although this
domestic emphasis is understandable, one sub­
ject that has received less attention is how the
U.S. market has been impacted by the rapidly
evolving global environment. For instance, the
U.S. market constitutes only 25 percent of new
vehicle sales in the world and its growth is
slowing relative to the rest of the world. In­
deed, an expanding portion of future economic
growth and increases in consumer spending on
autos is likely to originate abroad.
A current assessment of the domestic U.S.
industry within this global marketplace indi­
cates that the Big 3 (GM, Ford, and Chrysler)
are almost exclusively concentrated in the
North American and European markets. A
sales dependency ratio for each of the Big 3 of
North American sales to worldwide sales is
presented in Figure 1. As indicated, Chrysler
has the highest concentration in North America
with a ratio of .96. This ratio has been increas­
ing throughout the latter half of the 1980s,
although the recent expansion of Chrysler in

FEDERAL RESERVE



BANK OF CHICAGO

Europe should offset part of this concentration.
Ford’s North American ratio is .63, while GM’s
is slightly higher at approximately .67. Both of
these levels are significant improvements over
Chrysler. However, their North American and
European to world sales ratios provide evidence
of the degree of concentration and the depen­
dency of Ford and GM in these markets collec­
tively, with GM’s combined ratio over .90 and
Ford’s combined ratio almost .95.
A major factor in this dependence is the
limited presence of the Big 3 in developing
markets, with the possible exception of Latin
America. Of particular concern is the Big 3’s
absence in Asian markets where their combined
sales are still less than 500,000 units annually.
Eastern and central Europe are two potentially
key emerging markets for the Big 3. However,
competition from VW, Fiat, and, eventually,
Japanese manufacturers will be intense. These
markets are unlikely to achieve rapid growth in
auto purchases before the end of the decade.
In an attempt to achieve an integrated
analysis for the auto industry, this article ana­
lyzes each major and emerging market for
Paul D. Ballew is an economist and information coor­
dinator at the Detroit branch of the Federal Reserve
Bank of Chicago. Robert H. Schnorbus is senior
businesseconomistand research officeratthe Feder­
al ReserveBankofChicago. Theauthorswishtothank
Professor Don Byrne of the University of Detroit for
providing access to much of the data used in this
study. The authors would also like to thank David
Allardice, Assistant Director of Research atthe Feder­
al Reserve Bank of Chicago, and Roby Sloan, Senior
Vice President of the Detroit branch, for helpful com­
ments and support in completing this study.

15

FIGURE 1

Dependency ratio— Big 3 sales
percent (sales in region/total sales)

world’s production and sales of vehicles. Of
these markets the U.S., Japan, and Germany are
the most important. However, because of the
degree of integration between the U.S. and Can­
ada and among the seventeen major nations of
western Europe, these markets have been
grouped into U.S.-Canada, Japan, and western
Europe. All three major markets are large pro­
ducers with similar market shares. One differ­
ence is that Japan is export oriented, while U.S.Canada and western Europe are domestically
oriented. Western Europe and U.S.-Canada
represent over 60 percent of all vehicle sales in
the world, with Japanese domestic sales being
significantly less, approximately 15 percent.
U.S.-Canada

North America

North America +
western Europe

SOURCE: U S. Department of Commerce and
Federal Reserve Bank of Chicago.

vehicles first individually and then in aggre­
gate. The purpose of this systematic approach
is to reach some comprehensive insights and
conclusions into the prospects for the U.S.
nameplates in a marketplace where they must
compete with foreign nameplates not only in
their own backyard but also in markets through­
out the world, most of which are less than hos­
pitable. This article will also emphasize how
these global developments impact auto produc­
ers in the Midwest, a region where the domestic
industry is still highly concentrated.'
G lo b a l d em a n d fo r v e h ic le s in
p e rsp e c tiv e

Global sales of motor vehicles today are
nearly 50 million units annually. In the last few
years, sales have been approximately 4 to 5
million units below trend annually, with sales
in the U.S. accounting for roughly half of this
deficiency. This trend level of roughly 55
million units is well above the ten year average
of 41.5 million units; and in fact, growth in the
overall vehicle market has been significant in
the last ten years, up almost 25 percent during
the 1980s. Furthermore, market forecasts antic­
ipate vehicle sales in excess of 60 million by
the turn of the century.2
Currently, the market can be segmented
into three mature markets and three important
emerging markets. The mature markets collec­
tively account for over three-quarters of the


16


Among the mature markets, average light
vehicle sales in the U.S.-Canada market over the
past decade have reflected cyclical patterns as
well as trend growth of the U.S. economy. Sales
dropped significantly in 1981 and 1982 and
rebounded to record levels in the 1984 to 1987
period. Since 1989, sales have declined as the
U.S. and Canadian economies have slowed sig­
nificantly, with combined sales declining to 16
million units in 1990 and bottoming out in 1991
with a decline to 14.5 million units. Further­
more, the sharp decline since 1989 had been
preceded by a slow decline from the peak of 18
million units in 1986 toward a rate below the ten
year average of just over 16 million units.3
The U.S.-Canada market has experienced
significant competition over the last 20 years as
foreign nameplates have eroded the stranglehold
that the Big 3 once had on the market.4 The
market share for the Big 3 has steadily declined
from over 90 percent to its current levels of 70
percent for light truck and cars combined and 65
percent for passenger cars. GM has been the
biggest loser in the passenger car market with a
loss in market share of more than 10 percent
over the last decade. This erosion has been
largely the result of market penetration of for­
eign nameplates, of which the Japanese brands
have been most successful, with a market share
today of approximately 25 percent in North
America. This market share equals approxi­
mately 4 million units in annual sales.
Despite setbacks in the passenger car mar­
ket, domestic nameplates have done extremely
well in the growing light truck segment. This
segment, increasingly dominated by Ford and
Chrysler, represents, in large part, a shift in con­

ECONOMIC PERSPECTIVES

sumer preference from cars to passenger light
trucks, such as minivans and sports utility vehi­
cles. During the past decade the number of light
trucks sold annually has doubled, reaching al­
most five million in 1992. This growing market,
along with product strength, traditional know­
how of the segment, and trade restrictions, has
allowed the Big 3 to maintain a market share of
approximately 85 percent (even in 1991). Cur­
rent vehicle introductions and redesigned ver­
sions have further stimulated sales at the expense
of Japanese producers in particular. However,
Japanese and domestic producers are responding
to this growing demand with increased product
development. For example, the recent introduc­
tion of Nissan’s minivan, the Quest model, has
been well received by auto critics. And Toyota
has recently entered the mid-sized pickup truck
market, perhaps as a stepping stone to the intro­
duction of a full sized model.5 Therefore, the
continued dominance of even this segment by
domestic producers is not guaranteed.
Expansion of foreign nameplates into luxury
and sport cars as well as minivans and pickup
trucks will continue to put pressure on domestic
nameplates to retain market share.6 Product
development schedules are decreasing in length,
price containment pressures are intense, and
quality and safety improvements continue to
accelerate. The pressure is intense for all pro­
ducers and significant restructuring is prevalent
even for Japanese nameplates. In fact, Isuzu has
announced its intention to exit the light truck
market in the U.S., and Mazda has delayed its
entry into the luxury car segment by cancelling
the Amati. The prospects for a North American
free trade area or customs union may dampen
some external competition due to domestic con­
tent requirements. However, it should foster
intraregional competition, including transplant
operations. Therefore, the U.S.-Canada market
will likely continue to be one of the most com­
petitive markets in the world, despite its relative­
ly slow growth.
Western Europe

Unlike the U.S.-Canada market, the western
Europe market—the second largest in the
world—continues to have significant vehicle
sales. Although sales declined slightly in the
weaker economic environment in 1992, sales
have trended steadily upward in the last 5 years.
With access to central and eastern Europe, this
market is rapidly becoming one of the most

FEDERAL RESERVE BANK OF CHICAGO




important areas of growth in the industrialized
world. With prospects for economic unification
strong in the region, the presence of numerous
firms, both local and foreign, continues to be a
dominant character of the market. Thus, the
key question concerns the consequences of
economic integration for all auto manufacturers
involved in western Europe.
Sales in the market, due primarily to a one
time boost from German unification, were
robust in 1990 and 1991. Sales in 1991 reached
15 million units and, although sales in 1992-93
are being depressed by the economic difficul­
ties in Germany, the outlook is for sales of
more than 15 million units annually into the
late 1990s. Continued growth in certain Euro­
pean Community (EC) countries (notably Spain
and Portugal) and the economic stimulus from
further integration in the EC are expected to
support these sales levels. Some of the demo­
graphics of a mature market that exist in the
U.S., such as an aging population with modest
income growth, are also present in Germany,
the U.K., and France. However, these factors
should be offset by further market integration
and stronger economic growth.
Current sales in western Europe are divid­
ed among six major producers, with limited
Japanese imports (approximately 12 percent),
and a second tier of product or market specific
manufacturers. Unlike other major markets, no
producer has even marginal dominance of the
western European market. Volkswagen, the
market leader, comes closest with a western
European market share of 17 percent, a strong­
hold in Germany (over 25 percent market
share), and a significant share in every other
market in Europe. Fiat and PSA (PeugeotCitroen) are next with market shares of approx­
imately 13 to 14 percent. Both producers are
heavily concentrated in their domestic markets.
PSA is more diversified than Fiat, but Fiat has
increased its efforts in central Europe in recog­
nition of this fact. A large portion of Fiat’s
dependency on the Italian market is due to the
Italian government’s decision to limit foreign
imports.7 Ford and GM both have significant
sales presences in Germany and the United
Kingdom and each has a market share above 12
percent. Both companies have been rapidly
expanding in other markets; Ford in Italy and
Germany and GM in Spain and the United
Kingdom (a long time stronghold of Ford).

17

State owned Renault rounds out the major man­
ufacturers with a market share of approximately
10 percent. The company focuses almost ex­
clusively on the French market with only limit­
ed sales in other European markets. Recently,
Renault has attempted to expand its reach
through joint operating agreements, especially
in Scandinavia.
A number of companies with significant
market presences in specific markets recently
have been acquired wholly or in part by larger
firms. For instance, Saab has been partially
acquired by GM, and Jaguar by Ford. Japanese
manufacturers are also trying to increase their
share of the market, but face a quota of 16
percent in the EC. Therefore, transplants have
increased, although additional limits on these
developments, labor costs, and other concerns
may dampen this movement somewhat.
Japan

Annual vehicle sales in Japan currently
constitute the second largest single country
vehicle market in the world. Sales in the late
1980s and in 1990 approached almost 8 million
units a year. The continued growth of the mar­
ket throughout the post-war era has resulted in
per capita vehicle registration level comparable
to the U.S. However, a variety of factors are
currently reducing sales growth, including the
current economic slowdown, an aging popula­
tion, low population growth, parking and regu­
latory difficulties, and a maturing market.8
The domestic Japanese sales market is
dominated by Toyota (35 percent), Nissan (20
percent), Honda (10 percent), Mazda (7 to 8
percent), and Mitsubishi (more than 5 percent),
with other Japanese producers active in specific
market segments. The bulk of the remaining
market is comprised of foreign nameplates,
although they have not reached any significant
market penetration. In the past, trade restric­
tions limited foreign nameplate penetration. In
recent years, other barriers, such as limited
distribution networks and adaptation to local
customers’ tastes, have limited penetration.
Annual sales volumes by foreign producers are
still below 250,000 units (approximately 3
percent), and most of this activity is concentrat­
ed among European nameplates.
Overall, the market is currently in flux and
the two dominant producers, Toyota and Nis­
san, have recently experienced significant sales
setbacks. The current economic slowdown in a

18




mature and potentially stagnant market will
continue to pose problems for these producers,
although they will probably continue to domi­
nate the market for the foreseeable future.
Smaller Japanese manufacturers have experi­
enced greater difficulty because they do not
have the financial wherewithal to wage a com­
petitive battle in multiple market segments.
Asia-Pacific region (excluding Japan)

Overall sales in 1991 in the Asia-Pacific
market, excluding Japan, were slightly less than
4 million units. This level is not significant
relative to mature markets. However, the po­
tential for growth is phenomenal. Sales in
South Korea, for instance, are currently in ex­
cess of 1 million units and have more than
doubled in last 15 years. Sales in Taiwan have
also experienced strong growth in the 1980s:
total vehicle sales annually are almost 500,000
units. Overall in the 1980s, non-Japanese sales
in Asia grew in excess of 8 percent annually, a
trend which is widely expected to continue in
the 1990s. The remaining parts of the region
represent an underserved, emerging market
with strong income and population growth.9
Additionally, economic reforms in the two most
populous countries of the world, China and
India, could potentially provide significant
growth in consumer product sales.
In the early stages of development, con­
sumers typically do not buy vehicles. Howev­
er, gains in income eventually produce signifi­
cant gains in vehicle purchases in underserved
markets such as Asia. An estimate of these
potential sales gains for China is indicated by
Figures 2 and 3, which compare income levels
and vehicle sales in South Korea during its
phenomenal economic acceleration in the
1970s and 1980s to projected levels for China.
As shown, growth in vehicle sales and all con­
sumer durables in South Korea exploded once
per capita income reached approximately
$3,500 a year. That is, at this level vehicle
sales begin an upward swing which accelerated
as income continued to gain. If China mirrors
this trend, the gains in vehicle sales in the next
twenty years may be surprisingly strong. For
instance, if China’s vehicle concentration is
similar to the Korean experience, total vehicle
registrations in China may approach 40 million
units early in the next century. Current vehicle
registrations in China are only 5 million.

ECONOMIC PERSPECTIVES

with this growth in sales the mar­
ket will continue to be under­
served, given an estimated popu­
lation of 1.3 billion people by
2010. Consequently, future sales
growth may be more rapid, al­
though other constraints, such as
space and regulations, may even­
tually set limits on the market.
Similarly, other nations in the
region may achieve substantial
growth in vehicle sales in the next
few decades. For instance, per
capita registrations in India are
even lower than in China. Eco­
nomic reforms are still in their
infancy in this country, however,
and remain a concern. Other
Asian markets, principally Thai­
land, Indonesia, and Malaysia,
Therefore, assuming some replacement, total
appear well on their way to reform and should
sales could approximate 35 to 40 million units
boost sales of vehicles significantly in the years
ahead.1
0
over the next 10 to 15 years, resulting in annual
sales on average growing at four times their
Market concentration is actually higher in
current sales rate.
some Asian markets than in the more estab­
lished markets. The Korean market, for in­
If this growth seems unbelievable, it should
be noted that mean income levels in the Guang­
stance, is dominated by Hyundai Motors (over
dong Province in southern China, one of the
50 percent), Kia Motors (over 20 percent), and
most successful provinces, are currently esti­
Daewoo Motors (over 20 percent).1 However,
1
mated at above $2,000 a year. Income growth
other markets are more diverse, with foreign
is currently projected at more than 7 percent
nameplates active in Taiwan, where Ford has a
annually, with southern regions experiencing
strong market presence, and Thailand, where
Toyota and other Japanese automakers are
much more rapid growth. Furthermore, even
active. One trend affecting mar­
ket concentration is government
FIGURE 3
activity. Besides trade barriers,
Projected income and vehicle registrations
many Asian markets have govern­
growth in China
ment sponsored companies or
partnership programs that discour­
age market penetration. Japanese
manufacturers have been the most
successful at entering these mar­
kets through unconventional
means. Partnerships as well as
transplant facilities continue to
provide Japanese manufacturers
access to the market.
Eastern and central Europe

Perhaps the most important
emerging market is in eastern and
central Europe. This market cur­
rently is going through a massive
restructuring phase with existing

FEDERAL RESERVE BANK OF CHICAGO




19

state owned firms failing and/or being disas­
sembled and western firms rapidly entering the
market. Sales in the last decade have lagged
due to limited income growth on the part of
individuals. Overall the market is currently
underserved with vehicle registrations well
below western European levels. Pent up de­
mand has been exhibited in many product mar­
kets since liberalization, as indicated by recent
rapid sales growth.
While the near term sales outlook is some­
what bleak, with incomes falling and unem­
ployment rising, the economic transformation is
beginning to take shape and, as the recovery
begins, higher income levels will result in in­
creased demand in this underserved consumer
market over the long term. Consequently, sales
in Hungary, Czechoslovakia, Poland, and the
Baltics should accelerate throughout the mid1990s. Furthermore, the 280 million consumers
in the Commonwealth of Independent States
(CIS), a collection of former Soviet republics,
will likely experience significant income gains
in the late 1990s and, therefore, provide an
added boost. These developments should sig­
nificantly enhance the overall European mar­
ket. A conservative estimate of vehicle sales of
6 million units annually seems likely by the end
of the first decade of the next century, exclud­
ing a rapid economic transformation in the CIS.
It is important to keep in mind that such a sales
level would exceed annual sales in Germany.
Furthermore, even given this sales level, the
market will not be close to western standards.
Latin America

Latin America is another emerging market
that is experiencing a significant economic
transformation. Reform efforts have solidified
growth in Mexico, Argentina, Chile, and Vene­
zuela, and will eventually stimulate demand for
durables in a market of 125 million consumers.
Successful economic reform in Brazil and the
Andean nations, which appears possible if not
probable, could further stimulate the market.
Although political instability is a major con­
cern, democratic reforms and trade liberaliza­
tion have increasingly solidified the gains made
to date.
Current vehicle sales of almost 2 million
units annually reflect the potential in the region.
Given the economic hardship of debt restructur­
ing and economic austerity programs, the cur­
rent sales levels reflect positively on the de­

20




mand for vehicles in the region. The Interna­
tional Monetary Fund and World Bank estimate
that the GDP of the region should continue to
accelerate throughout the decade, averaging 4.5
to 5 percent annually. If the economies expand
at such a rate, the recent annual sales growth in
autos of over 20 percent may not be replicated,
but growth should continue.
Potential growth in Latin America should
boost Big 3 sales as well as European manufac­
turers’ sales (especially Volkswagen), as these
producers have significant presences in Mexico
and Brazil. Recently, Japanese nameplates
have begun to penetrate the market. However,
the efforts have been limited. One wild card is
the outcome of the various trade talks ongoing
in the region. Modifications in domestic con­
tent restrictions and other trade barriers could
significantly alter production and sales activity
for various producers. The general effort to
liberalize existing trade policies will likely
accelerate investment, export activities, and
domestic sales.1
2
C u rre n t and fu tu re p ro d u c tio n a c tiv ity

Production activity mirrors sales activity
within markets as well as export and relocation
activities or producer trends. Changes in pro­
duction activities in regions and between pro­
ducers has been relatively dynamic in recent
years. There has been continued movement
toward lower cost production, an effort to close
excess facilities in some market segments and
expanded production in others in order to ac­
cess new and growing markets. These trends
are often a response to shifts in sales and com­
petition among producers. To understand the
future implications, it is important to under­
stand the current production environment.
The global marketplace is comprised of 12
major manufacturers with annual production
capacity above 1 million units and a second tier
group comprised of manufacturers with produc­
tion capacity below 1 million units, many of
them specializing in specific market segments.
The top six manufacturers account for over half
of global production and the top 12 account for
over three-quarters of all production. But in
comparison to the 1960s and 1970s, the level of
concentration is less and has become more
geographically diverse. For example, GM is
still the number one automaker, but its market
share has fallen below 20 percent, Ford is sec­

ECONOMIC PERSPECTIVES

ond with a 13 percent share, and Toyota is cur­
rently third with a 11 percent share.
Most manufacturers still have a core base in
their traditional markets. Although one would
not classify this core as stable, it still provides a
degree of support and is a major consideration in
most decisions affecting company operations.
The major question for firms in the future may
be whether or not they can maintain their posi­
tion in their traditional market while at the same
time penetrating new markets.1
3
U.S. and Canada

Production during the last decade has aver­
aged approximately 12 million units annually in
the combined U.S.-Canada market with signifi­
cant growth occurring in two primary segments:
light trucks and transplants. Light truck produc­
tion, for instance, has more than doubled since
the late 1970s and early 1980s.1 Transplant
4
production in the U.S. and, to a lesser extent,
Canada, has also soared. Transplant production
in 1982 was only a token level from Honda; by
1991 transplant production exceeded 1.6 million
units annually and new capacity continues to be
added, especially in light trucks.
Within this expansion of production there
has been a change in mix of firms, led by the
continued downsizing of GM, Ford, and Chrys­
ler, especially in the U.S. By the mid-1990s,
Big 3 employment will be more than 400,000
jobs lower than its level in 1980. Production by
the Big 3 exceeded 11 million units in the mid1980s, however, since that time, production has
consistently headed downward, and is currently
near 8 million units. GM is currently planning
to close at least 4 assembly plants totaling over 1
million units of capacity. Gains in market share
by foreigners coupled with the general competi­
tive pressures to do more with less continue to
shape the production decisions of the Big 3 as
well. Future developments in production of
units in North America should reflect the contin­
ued development of transplants, some additional
downsizing of existing domestic nameplate
operations in the U.S. and Canada, and some
shifting of domestic nameplate production to
foreign markets.
Western Europe

Western European production in the last
five years has exceeded 13 million units. Capac­
ity is currently estimated at more than 14 million
units, with new facilities coming online. Current


FEDERAL RESERVE


BANK OF CHICAGO

production is concentrated in four principal
countries: Germany, France, Italy, and the Unit­
ed Kingdom. Germany, where one in six jobs
are linked to the auto industry, easily outstrips
all other production areas, with production in
excess of 5 million in 1991. French and Italian
producers generally comprise a second tier of
companies and are concentrated heavily in their
domestic markets. British production increas­
ingly involves U.S. and Japanese transplants or
wholly owned subsidiaries, and production is
mixed between domestic units and products
exported to the continent.
Western Europe has six large firms and a
second tier comprised of specialized and/or
market specific firms, transplants, and imports.
Volkswagen, PSA, GM, Ford, Fiat, and Renault
are the top producers in this market representing
85 percent of production. The second tier is
dominated by luxury car makers like BMW and
Mercedes and single product firms like Volvo.
Recently, mergers and consolidations have re­
duced the number of independent companies.
Furthermore, competition has also redistributed
market share among the largest firms, with GM
and VW on the ascendancy1 and Fiat and, to a
5
lesser extent, Ford struggling somewhat. NonU.S. transplant production initially involved
Nissan’s entry into Britain. However, Toyota
and Honda have also recently established facili­
ties. By the mid-1990s, Japanese transplant
production capacity in Europe will exceed
500,000 units annually. A primary concern in
these transplant locations is the continuing threat
of trade retaliation and a stated EC policy to
limit Japanese nameplates to a market share of
16 percent or less. (Current sales levels are
still below this target.) The Big 3 have also
added capacity due to stronger sales or, in the
case of Chrysler, reestablishing a position in
the market.1
6
Japan

Japan is the largest single country producer
in the world in combined car and light truck
production. Annual production levels by 1991
exceeded 13 million units annually. Almost 45
percent of this production (over $65 billion a
year) is exported and, consequently, Japan is the
world’s largest exporter of vehicles. Toyota,
Nissan, Honda, Mazda, and Mitsubishi are the
primary, but not necessarily the dominant, pro­
ducers. Altogether, the domestic market actual­
ly is comprised of 10 manufacturers with pro­

21

duction above 500,000 units annually. Of great­
er significance is the fact that certain manufac­
turers, like Fuji and Daihatsu, have significant
influence in important market niches.
In the extended outlook, Japanese produc­
tion will be influenced by three primary trends.
First, production of parts and some finished
assembly are becoming more mobile, for exam­
ple, moving toward offshore sites in Asia and
other developing markets. Due to labor shortag­
es and rising costs in Japan this trend seems
inevitable as an alternative to domestic produc­
tion. Additionally, offshore facilities provide a
means of entry into an expanding global con­
sumer market. Production can then include
exports back to Japan, as well as some produc­
tion for the local market. The potential growth
of these non-Japanese Asian markets may be
significant in the years ahead, and companies
like Toyota and Nissan have attempted to antici­
pate their development.
Second, transplant operations in the U.S.,
Canada, and western Europe continue to in­
crease capacity and plans for further expansion
are in the works. Concern over political pres­
sure, trade barriers, and economic considerations
continue to push Japanese producers toward
local production. As this trend continues, pro­
duction in Japan will be reduced by falling ex­
ports which are being replaced by Japanese
nameplate production in the States and western
Europe. Unless exports from Japan find new
markets, the impact on domestic Japanese pro­
duction may be severe.
Finally, domestic Japanese production is
evolving technically and moving increasingly
toward luxury, mid-size, and sports models to
suit the changing preferences of consumers. In
an economically mature and aging domestic
market, Japanese producers not only must grap­
ple with sales stagnation but a changing product
mix. Their technological gains in these areas
also influence their export product mix and will
continue to do so in the foreseeable future.
Asia-Pacific region (excluding Japan)

Non-Japanese Asian production in 1991 was
almost 4 million units, a level which has in­
creased tenfold in the last decade.1 The fastest
7
growing production area has been South Korean
facilities, which produce almost 1.5 million
vehicles annually. The birth of the Korean in­
dustry is relatively recent. The industry did not
begin in earnest until almost 1980. However,

22



production has grown from 100,000 annually in
the 1980s to a projected level of over 1.6 mil­
lion in 1992. Production in Taiwan has also
grown and now approaches half a million units
annually. Assembly and parts facilities are
also well established in Malaysia, Indonesia,
and Thailand. Additionally, major facilities
have been and are being added in India and
China. Currently, production in these two
markets exceeds 1 million units. Recent expan­
sion in China, in particular, bodes well for
production capacity.
Overall production in Asia has traditionally
had an export flavor, with one-third of the pro­
duction in this region destined for exportation.
The trend is still strong in spite of the establish­
ment of Japanese nameplate production facili­
ties in Europe and North America. Non-Japa­
nese markets are not as export oriented as Ja­
pan, although they are becoming more so.
South Korea may be a reflection of the future;
net exports of vehicles for the country are al­
most 400,000 annually, almost 30 percent of
total production. Other nations in the region
have not experienced such a share of export
orientation. However, there does seem to be a
learning curve, and once facilities are estab­
lished, some export potential will likely exist.1
8
Eastern and central Europe

Almost all current production in eastern
and central Europe involves inefficient state
producers who are or will likely be disbanded.
Current annual production has fallen to approx­
imately 2.5 million units, with the CIS respon­
sible for over 70 percent of combined vehicle
production. The severe economic slump, com­
bined with the break up of the centralized man­
ufacturing system, has produced a contraction
in production in the last two years that is likely
to continue in the near term. The civil war in
Yugoslavia and decline of the Yugo has also
adversely affected the Yugoslavian economy,
which was the second largest producer in the
region prior to 1992. Over the long term, pro­
duction will likely continue its trend away from
state owned production to the private sector.
One element is the inefficiency and quality
concerns with traditional products like the
Yugo, Trabants, and Ladas.1 Increasingly,
9
however, private sector production has come
from western firms that have established bases
in the region. BMW, Volkswagen, and GM all
have major expansion efforts in former commu­

ECONOMIC PERSPECTIVES

nist countries and production from these facili­
ties should maintain or at least partially offset
the decline in state companies which are being
liquidated and/or downsized. Volkswagen’s
presence in Czechoslovakia is indicative of
what the future may bring. The company is
adding facilities to expand production to per­
haps over 200,000 units annually; of this total,
a portion will be exported to the West. This
trend will likely continue as the relatively
cheap skilled labor and the opening of new
markets provides a magnet to U.S., European,
and Japanese firms.

increasing their production capacity in this
region in order to breach the local market as
well as provide exports to established markets.
The potential for future growth also includes
Japanese nameplates, which to date have had
only a minimal presence (with the possible
exception of Nissan). The domestic content
provisions of the North American Free Trade
Agreement may provide a strong impetus for
auto plants locating in Latin American markets,
principally Mexico.

Latin America

Sales data for 1991 indicate the diversity of
activities throughout the world and highlight
the environment U.S. nameplates face as the
decade progresses. In 1991, total vehicle sales
in the world broke down as follows: 33 percent
of all sales occurred in western Europe, 30
percent in North America, 15 percent in Japan,
8 percent in Asia, 7 percent in eastern and cen­
tral Europe, 3 percent in Latin America, and the
remaining 3 percent in the rest of the world.
Prima facie, it would seem that the Big 3 would
be well positioned in the world, given that
almost two-thirds of all sales occur in North
America and western Europe, their two tradi­
tional strongholds. Unfortunately, such a con­
clusion ignores developments discussed in this
article. The most important concern is the fact
that sales growth is accelerating in Asia (ex­
cluding Japan), Latin America, and eastern and
central Europe where the Big 3 generally are
not active, and decelerating in traditional Big 3
strengths: the U.S. and western Europe. At the
same time the current market standing for firms
in traditional markets is under stress from for­
eign competitors and, with the integration of
the EC, competition should accelerate.
The prospects of a sluggish domestic vehi­
cle market with intensifying competition at the
same time developing markets are expanding
abroad poses many questions for the Midwest.
Whether restructuring and downsizing of do­
mestic operations continue is, of course, at the
forefront of these questions, especially if the
Big 3 fail to penetrate new markets through
expansion programs. Moreover, even foreign
market penetration may be insufficient to sup­
plement U.S. domestic development and em­
ployment, unless this penetration involves ex­
ports of U.S. made products.

Currently, Latin America is an important
producer, both for domestic consumption as
well as for exportation. Of course, domestic
content restrictions and other trade barriers
have produced some distortions in domestic
production. However, current production in
excess of 2 million units annually generally
reflects the comparative advantage of these
areas as a low cost production base. Most of
these units are produced in two markets, Mexi­
co and Brazil, with a limited amount of assem­
bly occurring in other markets. In Mexico, a
million units are assembled annually, of which
over 500,000 units are exported.2 In Brazil, a
0
combination of vehicle sales and exports are
responsible for almost 1 million units annually.
Brazilian production is not quite as export ori­
ented as Mexico, primarily due to a larger do­
mestic market as well as economic problems in
the last twenty years.
Current production activity is increasing
due to the rapid expansion of facilities. In fact,
capacity estimates indicate that future expan­
sion plans are accelerating, and production
should continue to grow, especially in Mexico
where a trade agreement with the U.S. should
provide a stimulus to the market. Mexican
capacity and, therefore, production have dou­
bled in the last ten years. This expansion re­
flects the economic reforms in the country as
well as the development of Mexico as an export
center of certain models to the U.S. market.
The competitive position of the Mexican pro­
duction environment bodes well for expansion
of production facilities in North America, espe­
cially due to the continued importance of the
sales market.
U.S. and European firms are expected to
continue the trend of the last twenty years by


FEDERAL RESERVE


BANK OF CHICAGO

G lo b a l tre n d s and im p lic a tio n s fo r
M id w e s t auto p ro d u ce rs

23

same improvement as other manufacturing
Of greatest concern is the further employ­
sectors. As indicated in Figure 4, U.S. mo­
ment and income erosion in the Midwest as Big
tor vehicle wages in 1990 were still one of
3 facilities are streamlined. Current employ­
the highest in the world and may not be fully
ment in auto manufacturing is estimated at
offset by productivity differentials. Higher
slightly over 800,000 jobs in finished and parts
benefit costs push this differential higher,
assembly. Projections of white collar support
especially health care which is currently
staff and retail distribution employees include
estimated at 20 percent of overall payroll
an additional 500,000 workers. A large portion
costs for the Big 3.
of these workers are in the Midwest, which is
2) Competitiveness relative to the developing
still responsible for nearly 60 percent of the
world: as emerging markets reform their
assembled U.S. vehicles and is home to the
economies and integrate into the internation­
headquarters of the Big 3. There is a strong
al marketplace, competition will intensify,
probability of further economic restructuring in
especially in the new sales markets. These
addition to the overwhelming adjustment which
new markets are also a source of competi­
has occurred already. Since 1979 the domestic
tion, and their wage rates may give them a
industry has closed numerous U.S. plants, pared
competitive advantage compared to the
production costs throughout the entire manufac­
industrialized nations. Overall wages in
turing process, and will eliminate more than
Mexico are currently one-seventh the U.S.
400,000 jobs by 1995. The impact of this re­
level for workers in the motor vehicle indus­
structuring has been especially severe in the
try, rates in Korea are still only one-fifth,
Midwest. In Michigan alone, the Big 3 reduced
and so on. Of course, productivity differen­
their work force by more than 150,000 between
tials and other factors are considerations in
1979 and 1991. GM’s planned job cuts through
this environment. However, it is question­
1995 will reduce the work force in the state by
able whether or not the productivity differ­
an additional 25,000 jobs.
entials can or will account for such a wide
A weak sales environment intensifies the
difference of compensation.2
1
need to restructure and will likely prompt fur­
3) Regional and multilateral trade agreements:
ther efforts to speed up the adjustment. This
successful completion of the North Ameri­
factor will also likely encourage all producers,
can Free Trade Agreement (NAFTA) and
domestic and foreign, to explore new opportu­
the General Agreement on Tariffs and Trade
nities, many of which will be external to the
(GATT) round will impact the development
U.S. market. Whether or not these opportuni­
of the industry by shifting some production
ties are or will be available is likely to become
activities between nations, and also by influa major issue which each manufac­
turer will have to address.
Future prospects resulting in
FIGURE 4
adjustment of the current trade
Hourly wages in the auto industry— 1990
flow and stimulation of exports will
dollars
be influenced by a variety of fac­
25
tors. Of primary concern are the
following:
1) Continued improvements in U.S.
manufacturing competitiveness
relative to the international mar­
ketplace: U.S. manufacturing
wages relative to the developed
world have declined in the last
decade. Additionally, productiv­
ity gains have been strong and,
therefore, unit labor costs have
improved in relative terms.
However, the automotive seg­
ment has not experienced the


24


20

15

10

Ger.

U.S.

Can.

Japan

Italy

France

SOURCE: U.S. Department of Commerce.

ECONOMIC PERSPECTIVES

U.K.

Korea Taiwan Mex.

encing income growth, job creation, and
other macroeconomic developments. Of
course, the primary concern for workers in
the industry is the potential increase of pro­
duction shifting to Latin America which
may be facilitated by NAFTA. Unfortunate­
ly, the impact of the agreement is not that
easy to quantify; for example, the agreement
would also open the Mexican market to U.S.
exports and remove many of the current
trade distortions. It is likely, however, that
some labor in certain segments would be
adversely affected, especially in the semi­
skilled categories where the compensation
differentials are the greatest. Segments
affected may include the assembling of light
trucks (which currently face a relatively high
barrier) and some parts components. Of
course, export potential also exists in more
value added components.
4) Other trade developments: from an export
standpoint, U.S. growth will be influenced
significantly by domestic content rules,
tariffs, quotas, and other political restric­
tions. Developing nations prefer to increase
domestic production in lieu of importing
significant quantities. The 2-for-1 rule of
exports to imports which has been imposed
in Mexico is an example of such policy.
Future expansion into other non-North
American markets, especially in Asia, will
have to deal with such policies. Additional­
ly, U.S. trade policies will influence the
degree of competition in the U.S. from

abroad. Japanese voluntary export restraints
are being bypassed by transplant production,
but are such policies mandatory on Korean
or other Asian production? These issues will
impact nameplate activities in the U.S.,
especially the Midwest.
Over the long run, location of manufactur­
ing facilities in the Midwest for domestic
and/or export production depends on the costs
of production, including shipping, trade restric­
tions, and location concerns, relative to other
markets. In a competitive marketplace these
pressures are felt much faster and to a greater
degree than in insulated markets. Consequent­
ly, when evaluating further global integration
and its impact on the Midwest one should also
consider taxation, education and training, regu­
lation, shipping fees, transaction costs, and
overall production costs. These elements deter­
mine the competitiveness of the firm and will,
in the long run, play an important role in deter­
mining location, production activity, and export
growth for any industry. Overall, external
growth and domestic restructuring will continue
to be the dominant issue for the domestic auto
industry, especially in the Midwest. The future
for the motor vehicle industry is increasingly a
global one, both in terms of production and
sales, and hopefully U.S. industry can benefit
and get in the game. Otherwise, change and the
resulting economic pain for the Midwest in
particular may be severe.

FOOTNOTES
lrThe Midwest is defined as the East North Central census
region which includes Illinois, Indiana, Michigan, Ohio,
and Wisconsin.
2Among other estimates the University of Michigan, Euro­
motor, and the Commerce Department all conservatively
estimate sales growth at this level. Estimates provided in
this analysis have come from these sources.
T h e recent sales declines may be a reflection of the general
downward adjustment in the trend in auto sales. Dem o­
graphic shifts, minimal income growth, and price increases
may mean that further expansion in the market is unlikely.
These factors may cause multiple problems for many
producers, especially given the level o f competition that
already exists in the market.
T h e expression “foreign nameplate” refers to vehicles
produced by a company headquartered abroad. Production
activity may well, and in fact does, occur in the U.S. For­

FEDERAL RESERVE



BANK OF CHICAGO

eign transplants refer to U.S. facilities o f foreign name­
plates. The initial development o f transplant facilities
began in 1982 when Honda established U.S. assembly
facilities in Ohio.
sDomestic competition is also increasing. For example,
Chrysler recently unveiled the first full sized model in two
decades to compete with the highly popular Ford (F series)
and GM (Chevy truck) models.
T ig h t trucks in this discussion exclude vehicles classified
as Class 5 and greater.
’Recent EC rulings have encouraged the removal of auto
trade restrictions within the community. These revisions
are forcing significant changes within the Italian market.
®Regulatory procedures, specifically em ission require­
ments, do encourage a higher replacement rate for autos
than would otherwise be expected in a mature economy.

25

However, reduced prices for slightly used vehicles are
beginning to put pressure on new car sales. Along with
other adverse trends, one would expect only modest sales
gains in the future.
’Conservative estimates o f gross domestic product (GDP)
in the dynamic Asian econom ies places growth at approxi­
mately 7 to 8 percent per year throughout the decade.
Southeastern China, with a population equal to the U.S.,
has an economy growing at a 12 to 14 percent annual rate
with industrial production growing in excess of 20 percent
per year.
10Other elements are also important to support an expand­
ing consumer market for vehicles. Infrastructure, especial­
ly roads and parking facilities, is an important factor.
Additionally, there may be constraints on specific markets
which will hamper growth. Hong Kong, for instance,
because o f space difficulties, has a very small vehicle
market in spite o f its relatively high income levels.
n One qualification to the claim o f apparent market domi­
nance by domestic producers to the exclusion o f other
manufacturers is that cross ownership stakes are significant
and therefore other manufacturers successfully permeated
markets through equity stakes. For instance, GM has a 50
percent equity stake in Daewoo, while Ford has a 10 per­
cent equity stake in Kia Motors.

Domestic nameplates’ market share have also been helped
by import quotas and the 25 percent tariff levied on import­
ed light trucks.
lsThe expansion by VW and GM has recently added capac­
ity in excess o f 500,000 units annually.
16Chrysler is building built a facility in Austria and is
targeting production o f at least 150,000 units annually.
17Overall, production in this region (including Japan)
currently exceeds 17 million units annually and estimates
o f additions to current capacity indicate that, by the mid1990s, production will be well in excess o f 18 million units.
An increasing portion o f this production originates in more
diverse areas, including Japanese transplant facilities in
Asia. Additional capacity in mainland China, Thailand,
and Indonesia may increase capacity above 18 million units
by the mid-1990s. Given the difficulties in measuring
existing capacity and additions to capacity, a reasonable
forecast would place the level at more than 18 million units
by 1995.
18A s illustrated by South Korea, emerging producers may
have difficulties in exporting to mature markets due to
quality problems, trade restrictions, and other factors.
However, low labor and other production related costs are
an offsetting factor in export growth to other emerging
markets.

12See Ballew and Schnorbus (1992).
13Recent acquisitions have reduced the number o f indepen­
dent automakers, especially in Europe, where intense
restructuring appears to be occurring. These acquisitions
have not dampened the degree of competition in the mar­
ketplace. If anything, competition has become more
aggressive recently.
14Note that U.S. nameplates have been relatively aggressive
in developing light vehicles that combine the strengths of
trucks with the ride and comfort of cars. Minivans and
many sports utility vehicles possess these characteristics.

'’Production of the Yugo and Trabant has been disrupted
by current events. Production o f the Lada is still occurring
at the Nizhny Novgorod facility, an industrial behemoth
employing 160,000 workers.
20Some Mexican exports are the result o f 2-for-1 import
requirements. However, in general the exports reflect the
cost effectiveness o f Mexican labor.
21Note that product quality is a major concern with regard
to foreign manufacturing locations. These concerns may
offset other competitive disadvantages.

REFERENCES
Automotive News, 1992 Market Data Book,
Crain’s Communications, Detroit, MI, 1992.
Ballew, Paul, and Robert Schnorbus, “NAFTA
and the auto industry: boon or bane?,” Chicago
Fed Letter, Federal Reserve Bank of Chicago,
December 1992.
Berry, Steven, Vittorio Grilli, and Florencio
Lopez-de-Silanes, “Automobile industry and the
Mexican free trade agreement,” NBER Working
Paper, Cambridge, MA, 1992.

Commission of the European Communities,
“The European motor vehicle industry: situation,
issues at stake, and proposals for action,” Brus­
sels, May 8, 1992.
Economic Strategies Institute, The Future of
the Auto Industry, Washington D.C., 1992.
Ministry of Trade and Industry, Profde and
Prospects for the Mexican Automotive Industry,
Mexico, September 1990.
Ward’s Communications, 1992 Automotive
Year Book, Detroit, MI, 1992.

Caldwell, Philip, Berry Eichengreen, and
Charles Parry, “International competition in the
products of U.S. basic industries,” The United
States in the World Economy, NBER, 1988.

U.S. Department of Commerce, U.S. Industrial
Outlook, Washington, D.C., 1992.

26

ECONOMIC PERSPECTIVES




Trends and prospects for
rural manufacturing

W illiam A . Testa

Manufacturing has become the
primary economic base for
many nonmetropolitan coun­
ties in both the Midwest and in
the rest of the nation. At the
same time, services, retail, and other industries
are abandoning remote counties and are central­
izing their operations in urban areas (see Figure
1). While the farm sector’s health has now
stabilized following the downslide of the early
1980s, farm jobs—especially those as a full
time occupation—continue to disappear as the
average size of a farm needed to support to­
day’s American family continues to grow larg­
er. In sum, as one writer has put it, “many
small rural towns ... have been transformed
from farm service centers into minor cogs in
the national manufacturing system.”1
Manufacturing’s importance to rural areas
has been growing for several decades and it will
probably continue to outpace other “basic”
industry sectors in the rural Midwest. Howev­
er, several forces of change, which began or
continued to unfold in the 1980s and which are
expected to continue into the 1990s, are not so
favorable. These changes impacting rural man­
ufacturing are threefold. First, manufacturing
is undergoing a transition from traditional as­
sembly line modes of production, that is, from
“post-Fordism,” to what is being called “flexi­
ble manufacturing” or “just-in-time.” This
change in the organization and mode of produc­
tion is believed by some to favor urban locales
over rural areas as production sites. Secondly,
rural manufacturing differs from its urban coun­
terpart in being more production oriented and

FEDERAL RESERVE RANK OF CHICAGO




less service oriented in the particular activities
that manufacturing companies perform. (Ser­
vice activities of manufacturing companies
include corporate headquarters, general adminis­
tration, and R&D). However, because U.S.
manufacturing companies are becoming more
service oriented, it is expected that manufactur­
ing in rural areas will not fare as well. Finally,
ongoing negotiations among Mexico, Canada,
and the United States are moving toward a tariff
free trading area perhaps as early as 1993. As a
result, low skill or low value added jobs (which
tend to be found in rural areas) are those that are
more likely to flee U.S. borders to Mexico.
T h e ch a n g in g e c o n o m ic base o f
n o n m e tro p o iita n co u n tie s

The primary challenge to rural areas during
this century has been to replace jobs lost by the
declining labor force needs of natural resource
industries. As productivity climbs in farming
and mining, or as natural resources are exhaust­
ed in forests and fisheries, the movement of
labor into other sectors or the outright loss of
jobs is the result.
In many regions, the decentralization of
manufacturing from urban areas to rural areas
has partly replaced jobs lost in other rural indus­
tries. Coupled with population decline in rural
areas, per capita income in metropolitan and
nonmetropolitan counties in the U.S. converged
during most of this century.2 On average, per
W illiam A. Testa is senior regional economist and
research officer at the Federal Reserve Bank of
Chicago. Research assistance was provided by
Virginia Carlson and David D. Weiss.

27

FIGURE 1

Rural share of the Seventh District’s nonfarm jobs
Total

Manufacturing

percent

percent

25

25
23.5
21.5

17

13

21.6

2 1 ^ ^ 2 1 !^ ™

m il

Retail

Services

percent

percent

25

13
1969

-------■ ■ ■ ■ ------ 13 1
1974
1979

1984

1989

1969

1974

1979

1984

1989

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

capita income growth in rural countries outper­
formed urban counties in the 1970s in the Sev­
enth District states of Illinois, Indiana, Iowa,
Michigan, and Wisconsin. Prosperity in natural
resource industries during the 1970s, especially
agriculture, was accompanied by stable or
slightly growing employment in manufacturing.
The convergence of rural and urban per
capita incomes in the Seventh District came to
a halt during the 1980s as both agriculture and
natural resource industries such as mining,
energy production, and forestry fell on hard
times (see Figure 2). Manufacturing located in
urban and rural areas alike also suffered during
the 1980s despite the fact that rural perfor­
mance continued to outpace urban performance
in job creation in both the Seventh District and
the nation (see Figure 3).
Outperformance by rural counties (in the
U.S.) in manufacturing job growth has been
shown to date back at least to the 1950s and
1960s [Carlino (1985)]. Moreover, the conten­
tion that rural manufacturing job growth merely
represents a urban spillover effect of manufac­
turing jobs to outlying counties has also been
found to be either mistaken, inconclusive, or at
least not pervasive from decade to decade

28



[Carlino (1985); Haynes and Machunda,
(1987)]. Those rural counties that are not even
adjacent to metropolitan areas have been found
to be experiencing buoyant or above average
manufacturing job growth. This experience
was replicated in Seventh District states (see
Table 1). From 1969 to 1990, the rate of job
growth in nonadjacent nonmetropolitan coun­
ties exceeded not only growth in metropolitan
counties but adjacent job growth as well.
The causes of this reorientation of manu­
facturing from large urban areas to rural areas
are not difficult to trace. As U.S. factory pro­
ductivity increased sharply during this century,
manufacturing no longer required as many
workers. More modest “factory neighbor­
hoods” of workers could be gathered on a
smaller scale in rural areas than those previous­
ly needed in large cities. In addition, the as­
sembly line methods of production which gath­
ered momentum following Henry Ford’s suc­
cess in automotive production required more
space to organize production efficiently. Ac­
cordingly, the multistory urban factory increas­
ingly gave way to one story sprawling produc­
tion buildings. But this also meant that the
cheaper land costs of suburban and rural sites

ECONOMIC PERSPECTIVES

transportation penalty of remote­
ness was no longer so severe.
The upshot of these changes
has been that, as manufacturing job
growth in rural counties outpaced
growth in the large urban areas,
manufacturing has become a staple
of the job composition in rural
counties. In the Seventh District
for example, manufacturing’s
share of total employment in non­
metropolitan counties exceeds its
share in metropolitan areas (see
Figure 4). Rural counties in the
Seventh District states have a larg­
er share of manufacturing in com­
parison to their U.S. counterparts;
manufacturing employment in
rural District counties accounts for
19.2 percent of total employment
versus 17.2 percent nationally.
Not all nonmetropolitan coun­
ties have fared well in the 1980s
with regard to manufacturing job
growth (see Figure 5). This sug­
gests that active development
policies in rural areas may be
needed if this growth is to be real­
ized. This is especially so owing
to several trends that may be work­
ing against the rural edge in manu­
facturing: the movement toward
flexible manufacturing, the further
opening of the U.S.-Mexico bor­
der, and the increasing service
orientation of U.S. manufacturing.
M a n u fa c tu rin g and se rv ice s

became more important in the production cost
equation. Finally, the transportation system
changed from rail lines converging on a central
terminus—for example, Chicago— to a grid of
interstate highways reaching deep into remote
areas such as Appalachia and Texarkana. Rath­
er than shipping manufactured goods from a
central rail terminal such as Chicago, a remote
branch plant could serve wide market areas
almost as well. At the same time, the evolution
away from producing heavy manufactured
goods such as steel (which required bulky in­
puts of coal and ore), and toward lighter goods
such as computers and plastics, also dispersed
manufacturing toward rural locales because the


FEDERAL RESERVE


BANK OF CHICAGO

Many of the same forces af­
fecting the location decisions of service firms—
especially the so called business services or
producer services—also have a bearing on
manufacturing companies. The reasons for this
are that, aside from plant production activities,
many activities of manufacturing companies
are service activities such as research and de­
velopment, design, management, sales, and
distribution [Israilevich and Testa (1989)]. To
varying degrees, manufacturing industries and
companies can be thought of as an amalgam of
service and production activities so that those
locational forces that motivate service compa­
nies will, to varying degrees, also motivate
manufacturing companies. By the same token,

29

FIGURE 3

Growth in manufacturing employment in the 1970s and 1980s
Seventh District

U.S.

percent change

percent change

18

18

12

12

Nonmetro

Metro

-12
1969-73

FI
1973-80

Nonmetro

J a
Metro

-12

1980-85

1985-89

1969-73

1973-80

1980-85

1985-89

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

service activities and production type or plant
type activities will respond to differing location
pulls. As a result, the service intensity of any
particular manufacturing company or industry
will help to determine its location preferences.
Service industries—especially the rapidly
growing (and higher paying) “producer service
industries” such as advertising, specialized
finance, and management consulting—have
thrived and concentrated in large urban areas
rather than in rural counties [Testa (1992a)].
Similar to producer service jobs, nonproduction
jobs of manufacturing companies have come to
favor more urban areas over rural counties. A
look at nonmetropolitan counties in the Seventh
District shows that, in comparison to the 47
percent nonproduction payroll of manufacturers
in the U.S., rural District counties hover at
just over 30 percent in nonproduction payroll
(see Figure 6).

TABLE 1

Job performance in manufacturing
in Seventh District states
(percent)
1969-79
Metropolitan

-

Nonmetropolitan
Adjacent
Nonadjacent

1 2 .8

2 .7

8 .6

1979-90
-

1 7 .8

-

1969-90
-

2 0 .0

1.9

6 .4

1.7

14.7

SOURCE: U .S. D ep artm ent o f C om m erce, Bureau
of Econom ic Analysis.

30



According to recent studies, improvements
in telecommunications technology such as
facsimile machines, teleconferencing, and other
fiber optics transmission have probably
strengthened the advantages of large urban
areas over rural counties. These improvements
are proving to be complements rather than
substitutes for centralized business service
provision, that is, it is now easier to transmit or
deliver services to remote locations; and more
efficient to do so from a centralized and (usual­
ly) urban locale.
At the same time that producer service
activities are growing in stature—especially in
urban areas—the actual activities and jobs of
manufacturing companies are becoming more
service oriented. Production or so called blue
collar jobs inside of manufacturing companies
continue to dwindle at the same time that jobs
such as R&D, clerical, computer programming
and data processing, advertising, accounting,
and strategic planning are becoming more plen­
tiful. Nonproduction payroll by manufacturing
companies in the United States has increased
from 39 to 49 percent over the 1972-90 period.
The trend toward greater service orienta­
tion among manufacturers, coupled with the
impetus to concentrate service activities in
large urban areas, have exerted a drag on the
expansion of manufacturing employment in
rural areas during the 1980s. Drawing on data
from the Census Bureau from 1980 to 1988,
McGranahan (1991) finds that a significant
shift in job composition occurred in nonmetro-

ECONOMIC PERSPECTIVES

FIGURE 4

Job base: 1989
Seventh District

District vs. U.S. (nonmetro)

percent of total

percent of total

0

6

12

18

24

30

0

6

12

18

24

30

Farm
Ag. services
and forestry

Nonmetro
Metro

Mining

h
b

District
U .S .

Construction
Manufacturing
Transportation
and utilities
Wholesale trade
Retail trade
Finance, insurance,
and real estate
Services
Government
S O U R C E : U.S. Departm ent of Commerce, Bureau of Economic Analysis.

politan versus metropolitan areas within the
manufacturing sector. Within nonmetropolitan
counties, management-research and support type
jobs declined while production jobs increased
slightly. In contrast, management-research jobs
in metropolitan counties soared (by over 30


FEDERAL RESERVE


percent) while production jobs fell by over 10
percent. By implication, insofar as such produc­
tion jobs are becoming a smaller share of em­
ployment in manufacturing, production activi­
ties will be less capable of buoying income and
employment in nonmetropolitan counties.
Fle x ib le m a n u fa c tu rin g

Manufacturing industries are
reportedly changing their manage­
ment and production methods
towards “flexible manufacturing,”
which is also referred to as “flexi­
ble specialization” or “just-intime” [Piore and Sabel (1983);
Scott (1986)]. The U.S. auto in­
dustry is perhaps the most promi­
nent industry that has adopted new
organizational techniques which
are predicated on Japanese innova­
tions. GM, Chrysler, and Ford
have adopted these technologies
through joint ventures with Japa­
nese car makers (Toyota, Mitsub­
ishi, and Mazda, respectively) and
are now adopting many organiza­
tional changes throughout their
firm or at least within divisions
(for example, Saturn of GM). In
addition, other U.S. industries,

BANK OF CHICAGO

31

FIGURE 6

Nonproduction payroll in manufacturing
Nonproduction payroll
percent of total

Seventh District counties, 1987
percent of total payroll
50

U.S.=4 7.0
40
33.0

32.0

30

33.6

3 2 .9

31.6

28.7

20

10

Ml
SOURCES: U.S. Department of Commerce, Bureau of the Census, Census of Manufactures,
Annual Survey of Manufactures.

including photocopiers, cameras, and calcula­
tors, have changed their relationships with
suppliers following the Japanese prototype
[Linge (1991)].
Many features have been used to character­
ize flexible manufacturing, and there is no
universally accepted definition. Perhaps the
most prominent characteristic is that flexible
manufacturing involves smaller production runs
and a more varied or customized product.
However, the processes by which these results
are achieved are equally descriptive of flexible
manufacturing. Innovations in the organization
of design and production allow this customized
small batch production to be carried out quick­
ly, at low cost, and with high quality.
Some of the organizational features include
close relations between firms and their suppli­
ers. In general, flexible firms maintain rela­
tionships with a smaller number of key suppli­
ers. In addition, the supplier relationship can
be characterized as closely knit and cooperative
with regard to capital investment, sharing of
technology, and input to design, rather than
purely contractual in nature. Another key fea­
ture is the maintenance of “lean” inventories
and the use of “just-in-time” delivery of inputs
and parts.
With regard to labor, there is less hierarchy
and more participatory organization of employ­
ees, ranging from the production line to man­
agement and sales activities. Often, employees
are trained to perform many jobs rather than the
single routinized activity which characterized
many assembly lines of yesteryear. There is


32


Wl

Seventh

District

also a technological side to flexible manufac­
turing. Flexible manufacturing systems equip­
ment can change the production line set up
(including tools and dies) in short order. These
systems must be manned by highly skilled and
trained workers.
Some analysts believe that the adoption of
these production methods will work to the
disadvantage of manufacturing in rural areas.
For one reason, skilled and high wage labor
tend to gravitate toward urban areas because
skill demands are higher there. In addition,
flexible manufacturing implies a smaller scale
of operation so that there is a lesser need for
cheap and plentiful rural land. Finally, the
greater need for communication/innovation
among employees in flexible firms, especially
those that are highly innovative and technologi­
cally oriented, may favor urban areas where the
flow and exchange of information can be con­
ducted on a greater scale and at lower cost.
Close proximity also promotes close and coop­
erative relations between assembly operations
and key suppliers, and cuts down on delivery
and inventory costs. Accordingly, manufactur­
ing activity may tend to concentrate into cen­
tralized nodes rather than locating in isolated
rural areas.
Despite these disadvantages, there is also a
growing body of argument and evidence to
suggest that rural areas will not necessarily
wither because of the technological transition
toward flexible manufacturing systems. First,
the alleged benefits of close and dense proximi­
ty as it relates to flows of information may not

ECONOMIC PERSPECTIVES

be universal. Experience in other countries
such as the peripheral Jutland area of Denmark
[Hansen (1991)] has illustrated that a critical
mass of interlinked and cooperating manufac­
turers who practice flexible methods can be
assembled in rural areas.3
Close physical proximity has also been
cited as advantageous because it facilitates justin-time delivery of parts and components from
suppliers, and thereby economizes on delivery
and inventory costs. However, a “growing
separation of assembly plants from their sub­
contractors has also been facilitated by the
parallel growth of specialist freight handling
firms with national and international multimo­
dal networks which have considerably reduced
the tyranny of distance.”4 In comparison to
most other industrialized nations, many rural
regions of the Midwest have access to the inter­
state highway system which greatly shortens
the time and distance from rural factories to
their markets.
With regard to the skilled labor advantages
of urbanized areas, the case can be argued that
the new (flexible) production and organization­
al techniques actually favor rural areas over
urban counties. That is partly because the need
for flexibility in work assignments may be
difficult to achieve in urban counties where the
influence of strong labor unions may resist
flexible work assignments. For example, in the
American Midwest, Knudsen, et. al. (1991)
report in a series of case studies that unions
dislike “flexible labor cells” (where the labor
resource is maximized in production) because
they are viewed as threatening to the seniority
system and are thought to be a device to en­
courage “speed up” of the work process. In­
deed, the location decisions of many Japanese
manufacturers (who were among the pioneers
of flexible methods) such as Honda at Marys­
ville and East Liberty, Ohio, and especially
Toyota at Georgetown, Kentucky, have favored
rural (less union oriented) locales.
Nor has it been established with certainty
that there is any underlying rural skills deficit
which would act as a labor supply impediment
in the location decision of flexible manufactur­
ers. Statistics reporting years of education
completed do show that the adult population of
U.S. nonmetropolitan counties is below the
national average; but this does not necessarily
reflect a shortage of skilled workers. Rather,
the lower stock of educational attainment may

FEDERAI. RESERVE



BANK OF CHICAGO

reflect a historical lack of skilled job opportuni­
ties in rural areas which has induced a migra­
tion of younger and educated workers out of
rural areas and into large urban areas.
McGranahan and Ghelfi (1991) review the
evidence of the rural economic stagnation of
the 1980s against the backdrop of the increased
national demand for educated workers during
the 1980s. The authors conclude that lagging
rural job growth was not driven by faltering
labor supply in rural areas but rather that a
surging demand for skilled workers occurred in
urban areas which accelerated rural outmigra­
tion and widened the rural/urban wage gap.
Furthermore, the educational gap between
nonrural and rural areas is significantly larger
for those with a college education than for
those with a high school education [Swaim and
Teixeira (1991)]; the latter is most likely to be
the level of education which manufacturers
would tend to demand of prospective produc­
tion workers. Moreover, the authors report that
the shortfall for high school completion rates of
adults in rural areas has been falling—from 8.1
percentage points in 1971 to 4.4 percentage
points by 1987.
Likewise, while national statistics report
lagging academic achievements of rural stu­
dents, there is much variation across regions,
with the rural South largely accounting for the
smallest percentage number of high school
graduates. In the Midwest, Swaim and Teixeira
(1991) report that high school drop out rates
among 18-21 year olds in nonmetropolitan
counties were below both metropolitan and
nonmetropolitan counties of the Northeast,
West, and South in 1985. High school gradua­
tion attainment rates for Seventh District states
reveal that nonmetropolitan counties are not
much different in producing high school gradu­
ates in comparison to both its own urban areas
and to national averages.5
While these arguments suggest that the
change toward flexible manufacturing need not
be an insurmountable obstacle to continued
manufacturing growth in rural areas, formal
evidence to date indicates that it has already
impeded rural manufacturing growth in selected
industries.6 Barkley and Hinschberger (1992)
have examined 106 metal working industries
over the 1981-86 period. Their findings sug­
gest that those industries that were restructuring
toward flexible specialization were less likely
to locate in rural locales, especially among the

33

more high technology or rapidly growing metal
working industries. With regard to rural devel­
opment policy, the authors caution that rural
areas with competitive advantages will be those
that are more amenable to flexible manufactur­
ing characteristics such as good transportation,
developed communications, high labor skills,
and the absence of a labor force culture steeped
in older and rigid manufacturing methods.

TABLE 2

Average hourly compensation* costs for
manufacturing production workers
(dollars)
_____________ 1982
United States
Mexico

1985

1987 1989 1991

11.64 12.96

13.40 14.31 15.45

2.54

2.09

1.57

2.32

2.17

SOURCE: Bureau of Labor Statistics, Report 825.

N o rth A m e ric a n Free T rad e
A g re e m e n t (N A FT A )

Despite the recent efforts of the aforemen­
tioned manufacturers to locate state of the art
technology plants in rural areas, the particular
types of manufacturing activity that have his­
torically located in rural areas tend toward the
lower skilled and production activities. Though
it need not be the case, rural areas have been a
haven for those manufacturers searching for
low production costs [Norton and Rees (1979)].
That is, manufacturing in the U.S. has followed
the so called spatial product cycle, which gen­
eralizes a manufacturing product’s progress
from inception to standardization. At incep­
tion, products are either new or are produced
with innovative processes; at this stage, the
products are produced initially near large urban
areas where innovation allegedly has a strong­
hold. As the product and its production are
routinized, standardized, and generally “de­
skilled,” and as the scale of production increas­
es as the product gains wide market acceptance,
the location of the production process is shifted
out toward more rural locales (or overseas)

34



‘ Includes all paym ents m ade directly to the w orker,
before payroll deductions, but including e m p loyer
expenditures for legally required insurance program s
and contractual and private benefit plans.

where production costs are lower (and needed
skills or access to technology are fewer).
To the extent that this paradigm is accu­
rate, it implies that the proposed NAFTA is less
favorable for rural areas. Because average
wages and labor skills in Mexico are lower,
those U.S. jobs most likely to flee to Mexico
would be the lower wage, lower skill, nonser­
vice type jobs—exactly those types that tend to
concentrate in rural areas. Table 2 reflects the
large wage differences between the nations for
production workers (unadjusted for skill differ­
ences). The hourly wage premium for the U.S
as a whole is as large as 6 to 7 times that in
Mexico. In all fairness, it should be noted that
workers with certain production skills may not
be available in Mexico at these lower wages.
Moreover, the advantages of lower transporta­
tion costs and highly developed physical infra­
structure favor U.S. locales. However, these
advantages probably do not favor U.S. rural

ECONOMIC PERSPECTIVES

locales over Mexico to the same extent as U.S.
urban locales.
This is not to say that NAFTA will not be a
net plus for rural counties, but rather that urban
counties may be the greater beneficiaries.
Mexico’s tariffs on U.S. exports are two or
three times greater than U.S. imports from
Mexico so that Midwest manufacturing as a
whole may gain from NAFTA passage.7 This is
especially true given the surging economic
growth and demand for imported capital goods
which Mexico has recently displayed. From
1987 to 1991, nonelectrical machinery exports
to Mexico from the Seventh District states
increased by two and one-half times (to almost
$ 1 billion) while exports of electrical equip­
ment increased by a multiple of 2.25. These
capital goods are just the type of goods—ma­
chinery and electrical equipment—that concen­
trate in the Midwest and which could experi­
ence a further growth in demand arising from
NAFTA’s spur to Mexico’s growth and devel­
opment (see Figure 7). A rapidly developing
Mexico will undoubtedly require growing ma­
chinery investments both for factories and for
construction. Rural counties in the Midwest
would tend to benefit as well, but these benefits
would be diluted by the fact that machinery
establishments are not highly concentrated in
rural counties in the Seventh District, but in­
stead tend to concentrate within the large met­
ropolitan areas.8
C o n c lu s io n

Despite the possible negatives working to
slow rural gains in manufacturing employ­
ment—increasing service orientation of manu­
facturing companies, the movement of lower
skilled production jobs to foreign countries
such as Mexico, and the adoption of flexible
manufacturing methods by domestic compa­

nies—these forces have not been strong enough
to hold back the tide of manufacturing growth in
rural areas to date. Over the course of the
1980s, rural manufacturing in the Midwest con­
tinued to outpace urban counties. From 1985 to
1989, metropolitan counties’ manufacturing jobs
declined by 1.1 percent while rural counties
gained by 8.2 percent. In the face of such a
strong growth difference, it is difficult to imag­
ine any reversal of fortunes. Moreover, increas­
ing Midwest manufacturing growth in general
shows little sign of abating during the remainder
of the 1990s as export growth will continue to be
strong while the region will suffer little of the
fallout from America’s defense reduction. As a
result, the continuing stabilization, if not recov­
ery, in many agriculturally oriented regions in
the Midwest should continue to be helped along
by rising manufacturing fortunes.
However, the experience of Seventh District
states in the 1980s also suggests that not all rural
counties will realize manufacturing job growth
in the 1990s. Those who conduct development
policies in rural areas will need to be aware of
potential difficulties (such as those discussed
above) in assisting the growth and expansion of
manufacturing in rural areas.
In addition, not all manufacturing industries
will find rural areas attractive. The experience
of the 1980s shows widely divergent shifts in the
Seventh District in the urban versus rural pat­
terns of growth of establishments by individual
manufacturing industries.9 For reasons such as
these, some analysts have suggested developing
information on the relative costs and productivi­
ty of individual industries in urban versus rural
locations [Martin, et. al. (1991)]. The somewhat
less sanguine outlook for rural manufacturing in
the 1990s makes this idea more appealing as a
way to concentrate scarce development dollars
for maximum impact.

FOOTNOTES
*See John Fraser Hart (1991), chapter 3, p. 32.

4See Linge (1991), p. 327.

2See McGranahan and Ghelfi (1991).

sSee Testa (1992b), p. 11.

3See Hansen (1991) for a discussion. Hansen cites Lego
Co. (maker o f the plastic toy blocks) and Bang & Olafsen
Co. (maker o f consumer electronics products) as examples
o f successful firms in Jutland. Also, see “Small, flexible
plants may play crucial role in U.S. manufacturing,” Wall
Street Journal, January 13, 1993, p .l.

6See also Glasmier (1991).


FEDERAL RESERVE


7See U.S. Dept, o f Labor (1990).
8See Testa (1992b), p. 27.
’Ibid.

BANK OF CHICAGO

35

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36



______________________ , Census of Manufac­
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ECONOMIC PERSPECTIVES

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