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F E D E R A L R E S E R V E BANK OF SAN F R A N C I S C O MONTHLY REVIEW I N T HI S I S S UE What Price Knowledge? Western Factory Exports Steel and its Rivals JANUAR 1 9 66 y W h a t P ric e K n o w le d g e ? . . . The W est, with its emphasis on education and scientific research, accounts for one-fourth of this crucial growth-creating sector. W estern Factory Exports . . . District manufacturers sell $2 billion of their products in overseas markets—especially aircraft, lumber, food, and metals. Steel a n d its R iv a ls . . . Despite its strong recent performance, the steel industry faces stiff competition from imported steel and domestic substitutes. Editor: W illia m Burke January 1966 MONTHLY REVIEW W h a t Price Knowledge? economists gather together total includes the cost of all types of education -—elementary, secondary, and higher educa these days, they not only exchange knowledge; they also talk about knowledge.tion, plus the knowledge acquired at home, on the job, or in the armed services. More than (Witness the program at the recent American that, it includes the earnings foregone by Economic Association convention, which was those who are absorbing knowledge rather devoted almost entirely to discussions of that than contributing to the community’s physical particular subject.) This intense interest is or knowledge output. due in large part to the rapid growth of the Research and development (R & D) prob knowledge-investment sector of the economy, ably contributed over $20 billion to gross na that is, the nation’s investment in education tional product last year— and roughly $10 and research-and-development. billion, or almost one-half of that total, was The importance of knowledge was recog produced in Twelfth District states. nized as long ago as 1776. Adam Smith at that time argued that “Man educated at the Education + R & D = investment expense of much labor and time may be com Education is designed to produce existing pared to an expensive machine.” And Benja knowledge in new minds and to make these min Franklin, Smith’s contemporary, declared minds more receptive and more capable of that “An investment in knowledge pays the absorbing, transforming, creating, and using best interest.” But only recently has the in knowledge. R & D, meanwhile, is designed to terest of economists been centered on the sub produce new knowledge. Neither education ject of economic growth and on the types of nor R & D creates tangible assets on a balance investment— such as investment in the pro sheet. But both make a contribution to future duction of knowledge— that will pay off in returns, that is, to the increased productivity the future through growth-stimulating in of resources. creases in productivity. A prime example is This crucial segment of the knowledge in the work of Princeton Professor Fritz Machdustry sustains a two-way link between suc lup, The Production and Distribution of cessful investment, which permits the faster Knowledge in the United States. growth of GNP, and GNP growth, which per mits more investment in knowledge produc Crucial categories tion. In underdeveloped countries, the inabil According to Machlup’s all-encompas6ing ity to sustain this link creates a vicious circle definition, the knowledge industry includes of poverty; in developed countries, the suc education, research and development, com cessful operation of this mechanism creates a munications media, information machines, beneficent spiral. Increases in education and and information services. But the crucial technology promote rising incomes, and these categories are education and R & D—the higher incomes afford rising expenditures for knowledge-investment categories — which in education and R & D. 1965 expended roughly $120 billion in the nation and an astonishing $30 billion in the Chicago Professor Theodore Schultz points West alone. out that “The growth of this investment in Education, the largest knowledge sector, human capital may well be the most distinc amounted to roughly $100 billion in the na tive feature of the economic system. Increases tion and $20 billion in the West last year. The in national output have been large, compared W h en ev er F E D E R A L R E S E R V E B A N K OF S A N F R A N C I S C O Higher Education-1965 The Higher Education Act of 1965, signed into law last November at Southwest Texas State College, more than doubles the $410-million annual authorization for colleges and universities established under the Higher Education Act of 1963. The new law lowers to 3 percent the interest rate on Federal loans for undergraduate school construction (about a full percentage point below the current rate) and it also increases the types of facilities for which Federal construction aid may be ob tained. The act, moreover, for the first time provides for: 1. Scholarships averaging $500 a year each for needy students, particularly those whose parents earn $3,000 a year or less. The aim is to ensure that as many as 140,000 poor but talented youths each year are afforded a college education. 2. A low-interest loan program, eventually to total $700 million a year or more, for middle-income students. The loan funds would be provided partly by the Gov ernment and partly by private lending institutions, and a significant portion of the interest payment would be underwritten by the Government if a student’s parents earn less than $15-18,000 a year. 3. A far-ranging “university extension” program to propel colleges and univer sities into a variety of community services. These include research on urban problems — such as air and water pollution, juvenile delinquency, and consumer education— and the training of urban experts and other professionals. 4. A grant program to raise academic standards of small, poorly financed col leges, particularly 106 predominantly Negro schools in the South. Federal assistance would help those schools attract and hold competent faculties; in addition, it would help them establish formal ties with wealthier institutions, in such forms as faculty and student exchanges, joint use of facilities, and postgraduate teacher training. 5. A postgraduate fellowship program to help up to 10,000 elementary- and secondary-school teachers a year obtain masters degrees. This program would ex tend already existing programs which help defray the costs of Ph.D. training. 6. A “teachers corps,” composed eventually of 6,000 volunteers (novices and veterans alike), to teach in poverty-stricken areas where educational problems are severe and school resources scant. Corps members, after a three-month university training period, would be assigned as requested by local school districts, but would be paid completely out of Federal funds. 4 January 1966 MONTHLY REVIEW with increases in land, manhours, and physi cal reproducible capital. The investment in human capital is probably the major explana tion for this difference.” According to the widely cited estimate of Brookings Institution’s Edward Denison, knowledge investment accounted for about 40 percent of the 2.9-percent annual rate of growth in the 1929-1957 period. Denison esti mates that the rising education of the labor force was responsible for 23 percent of the growth in real national income in that period, and that the general advance in knowledge, typified by R & D and improved management techniques, was responsible for another 20 percent of the growth rate. He estimates also that knowledge investment will account for a comparable proportion of the increase in growth between now and 1980. W hat education costs Nonetheless, knowledge investment can be a costly affair, as the West’s educational sta tistics amply demonstrate. In the public-education sector alone, California increased its spending for lower schools from about $lVi billion to about $2 Vi billion between 1958 and 1965, and undoubtedly will substantially exceed the $3 billion mark by 1970. District states as a whole increased their spending in this category from about $2 billion to almost $4 billion in the 1958-1965 period, and may well approach the $5 billion level by 1970. Expansion of higher-education costs has been even more startling. For public institu tions alone, these costs more than doubled in the 1958-1965 period, to roughly $1 billion in California and $lVi billion in all District states. Moreover, according to the Council of State Governments, higher-education costs will soar by 1970 to around $2Vi billion in California and almost $3V2 billion in the Dis trict as a whole. Yet, in view of the region’s long educational tradition, it may be quite willing to sustain costs of this magnitude. W hy it costs The necessity for increased educational in vestment is due in large part to the simple pressure of numbers. These pressures are most obvious in the nation’s most populous state, California. Primary and secondary public-school enrollment in California increased from 2.9 million to 4.1 million between 1958 and 1965, and state officials anticipate further growth to 4.8 million in 1970 and 5.9 million in 1980. Moreover, California’s enrollment of full-time college students increased by twothirds, to 400,000, in the 1960-65 period alone. Already, 53 percent of California’s high-school seniors enter college. (The ratio is much higher in some areas; for example, 62 percent in San Diego.) And, as the lowerschool enrollment figures indicate, there is a rising flood of students behind the present college generation. The same pressure of numbers is seen at the national level. Federal officials expect that degree students at public colleges and univer sities will increase from 4.5 million to 7.7 mil lion in the 1963-1970 period and will then rise to 9.5 million by 1975. But far more than numbers is involved in the rising demand for higher education. With increases in family income, a larger propor tion of the population is able to afford the costs associated with sending children to col lege and foregoing their earnings while there. FE DE RAL R E S E R V E B A N K OF S A N F R A N C I S C O Education costs continue rapid rise, especially at college level B illio n s of D o llars Source: Bureau of the Census; Council of State Governments With the migration of the population to urban industrial areas, a larger proportion of the population resides in communities where fa cilities are available and where higher educa tion is demanded as a job passport. And, with rapid advances in technology, a phenomenal increase in demand has occurred for graduates possessing the necessary skills. 6 W hy it’s worth it The average high-school student and his parents now understand, fully as well as does the average economist, the importance of in creased investment in knowledge. Whether or not they have seen the figure of $100,000 as the value of a college education— that is, the difference in lifetime earnings between the man with a degree and the man without one — they are well aware that inequality in the distribution of income is positively related to inquality in educational background, and that unemployment hits most severely those who have the weakest educational backgrounds. By now, an impressive body of evidence sup ports the thesis that educated and skilled per sons almost always earn more than others— a thesis which is true for different types of de veloped countries (such as the U. S. and the U. S. S. R .), for different types of underde veloped countries (such as India and Cuba), and for completely different time periods (such as the U. S. a century ago as compared with today). A number of attempts have been made to calculate the rate of return on investment in education. According to one such estimate, made by Columbia Professor Gary Becker, the average college entrant obtains a 10-12 percent annual return on his investment— and the urban-white-male college graduate obtains an even higher return. Other specialists would estimate the rate of return differently— some higher, some lower— but few would dispute the fact that those who receive the most edu cation are going to move into virtually all the key jobs. In the words of HEW Secretary John Gardner: “The question, Who should go to college?, translates itself into the more com pelling question, Who is going to manage the society?” The crucial link The university, or multiversity, has in any event become the center of the knowledge in dustry. A heavy demand exists for certain kinds of knowledge and for knowledgeable people to move the nation toward the social and technological goals it sets for itself, and the modern university has come forward to meet those demands. It has done this especi ally by welding a closer association with the other crucial element of the knowledge indus try— research and development. The interlocking of the two types of knowl edge investment was emphasized in a widely quoted report, “The Changing Patterns of Defense Procurement,” issued by the Defense January 1966 MONTHLY REVIEW Department in mid-1962. “Management planners, in considering sites for new or ex panded facilities, have found the availability of trained minds overshadows even such fac tors as the labor market, water supply, and power sources. The evidence is overwhelm ing: Route 128 encircling Boston, the indus trial complex around San Francisco Bay, that related to the institutions in the Los Angeles area, and similar situations are cogent ex amples of the clustering of industry around centers of learning.” And not only do produc tion contracts follow research contracts, but the acquisition of production contracts in turn leads to the ability to strengthen research staffs. “The process is circular; and it re generates itself.” R & D is the only sector of the industry which deals with knowledge production in the narrow sense, that is, production of so cially new knowledge. This sector consists of several activities: basic research, applied re search, and development. Basic research looks for general laws with no regard for practical use; applied research looks for re sults promising some ultimate use. (The for mer searches for discoveries and the latter for inventions.) Development, on the other hand, is technological activity using scientific knowl edge already developed for the production of useful materials, systems, or processes. W hat R & D costs The growth of R & D has been phenomenal, as every reader of the stock-market page can testify. R & D spending increased from about $16 billion in 1940 to $14 billion in 1960— a 20-percent annual rate of growth— and it probably exceeds $20 billion today. The Fed eral Government’s role in financing R & D is conspicuous, but private industry predomi nates in the performance of this activity, and in recent years it has also increased its spend ing for this purpose. Today, stock-market analysts use a corporation’s R & D budget as an index of its future profit performance, and consumers seem more impressed by a firm’s reports on its research activities than they are by the TV programs it sponsors. The R & D sector’s record of rapid growth was affected recently, however, when spend ing restraints were imposed by the industry’s dominant paymaster, the Federal Govern ment. Federal R & D expenditures, after ris ing steeply to $11.3 billion in fiscal 1963 and $13.8 billion in 1964, then leveled off in 1965 near the 1964 level. This setback was caused primarily by a slowdown in the hitherto rapid ly expanding space program, and by the com pletion of the planned buildup in strategicmissile production. California and the other District states, which had been prime beneficiaries of the earlier R & D boom, felt the full impact of the recent shift in Federal policy. Even in heavyspending 1964 (the last year for which de tailed data are available), R & D spending in District states increased less than half as much as in the rest of the country, and California showed an increase only because a heavy in flow of space-research funds offset a reduction in DOD spending. This shift in Federal R & D spending policy, along with the related cutback in defense pro curement, led to a sharp (albeit temporary) reduction in regional aerospace employment, and persuaded California state agencies to encourage the rechanneling of R & D efforts into such diverse fields as transportation, waste disposal, crime detection, and informa tion retrieval. W hy it’s worth it Despite such occasional setbacks, R & D investment remains very attractive, in large part because of the enormously lucrative re turns which are frequently obtainable from R & D projects. The measurement of rate of return is complicated, however, by the likeli hood that the social return will be higher than FEDERAL R E S ERVE B ANK OF S AN F R A N C I S C O the private benefit from each such investment. The investor and the initial user will certainly benefit from the economically successful de velopment of an R & D project, but total bene fits are likely to be much greater. If the proj ect permits reduced prices, consumers will benefit, and if it permits the spread of new technology, competitors also will benefit. A crucial element in R & D investment to day is the computer-based information revolu tion. Spending for computers has expanded rapidly, doubling in the 1959-63 period after an eight-fold increase in the preceding fouryear period. The computer revolution has affected every aspect of the economy, pri marily by providing decision-makers with completely new perspectives on their opera tions. Business management, which formerly dealt with an organization of bits and pieces (engineering, production, inventory, account ing, marketing, etc.), with the help of the computer is now enabled to see the organiza tion in terms of a continuous flow of informa tion which ties all individual operations to gether. All of the above simply measures the extent of the nation’s $ 120-billion knowledge in vestment. But describing this crucial sector does not indicate which regions should receive new funds for knowledge investment, which fields should be emphasized in new education al and R & D spending, and especially, what the eventual consequences of all this will be. Around each of these issues a great deal of controversy now rages. 8 Geography: where allocated? Consider the geographical allocation of R & D spending. For example, Federal R & D allocations (which differ somewhat from the expenditure data cited earlier), reached $12.3 billion in 1963 and $14.3 billion in 1964, and in each of those years the West received more than the next three geographical areas combined. California alone received 35 percent of these Federal funds, or four times as much as New York, the second state in line. Thus, despite the recent slowdown in the inflow of R & D funds, the West retains a dominant position in this crucial growth-generating sector. A similar concentration occurs in the allo cation of funds on an agency basis. The De partment of Defense, the National Aeronau tics and Space Administration, and the Atomic Energy Commission spent 90 percent of all Federal R & D funds in recent years, and each of those agencies allocated the largest single block of its funds to District states. In 1963, for example, the six largest DOD con tracts went to Western firms, five of the first six NASA contracts found their way to the West, and six of the fifteen largest AEC con tracts were spent here. On a university basis, Federal expenditures are heavily focused on a relatively few uni versities which are concentrated in three major geographical areas. (Twenty univer sities—only one-tenth of all universities in the country—have received four-fifths of all such funds in recent years.) These high plateaus of academic excellence are the Western range extending from Berkeley and Stanford to Pasadena and Los Angeles, the Eastern range W estern dom inance in R&D based on strong aerospace research Obligations (1964) B il l i o n s of D o lla rs 0 1.0 20 Source: National Science Foundation 3.0 4.0 January 1966 MONTHLY REVIEW extending from Boston to Washington, and the Midwestern concentration centered around the Big Ten and Chicago. At the uni versity and research laboratories situated in the California concentration are found 36 percent of the Nobel Prize winners in science, and in the Eastern and Midwestern concen trations are found 46 percent and 10 percent, respectively, of the Nobel science laureates. And as a group these universities produce three-fourths of the nation’s Ph.D.’s The concentration of Federal R & D spend ing in these centers has strengthened the hand ful of front-rank institutions and thus has widened the gap between them and all other research institutions. Moreover, since the Federal Government is the major supporter of university-based science, and since scientists (through the project system and other ad visory procedures) determine which institu tions will obtain new project funds, the frontrank institutions have been able to attract more and more research-oriented industry and thereby have generated a faster pace of economic growth in the regions in which they are located. Some dispensers of Federal funds see no alternative to this procedure. One agency spokesman told a Congressional investigat ing committee: “DOD would probably like to see a more uniform distribution, but we have to go where the talent is, and we have to get the best weapons system we can get.” Another agency spokesman added: “NASA cannot, nor can any other agency of the Government, place research projects at universities which do not have the resources to make a valued contribution to the agency’s mission.” But some Congressmen argue that science is too important a matter to be left to the scientists. High-energy politics The question came to a head in a stillcontinuing controversy over the construction of a $300-million high-energy nuclear ac celerator— the world’s most powerful “atom smasher.” Nuclear accelerators, the basic tools of high-energy physics, are employed to probe the structure of the infinitesimally small particles that make up the nucleus of the atom. They utilize energies in the multibillion-electron-volt range to hurl subatomic particles into collision with other particles; the greater the energy, the deeper the physicist can probe into the heart of the atom. In the competition for the construction of this mammoth machine, a scientific advisory committee to the Atomic Energy Commis sion decided on a California design and there by rejected a Midwest-designed accelerator. Most scientists agreed with the decision, but the controversy raised a political storm that was felt at the very highest level. Even now, the site of the proposed machine remains un decided. Proposals were initially received from 126 communities located in 46 of the 50 states; 85 of those communities still remain in contention for the AEC’s award, and all of them feel uniquely qualified to provide a home for a 200 billion-electron-volt nuclear accel erator. The eventual consequence may be a shift from a situation of “intuitive imbalance” to one of “bureaucratic balance,” through a de liberate Federal effort to develop a much larger number of outstanding research cen ters. The National Education Improvement Act of 1963 signalled this shift by providing for the expansion of outstanding research cen ters from 20 to 70, and President Johnson in a recent directive emphasized the new direc tion by stating that research funds “are still too concentrated in too few institutions in too few areas.” But some authorities worry that a shift of such magnitude would draw too heavily upon the very small pool of top-flight scientists and thus hamper research efforts at the leading institutions. Former Presidential adviser George Kistiakowsky, speaking for the Na- F E DE RAL R E S E R V E B A N K OF S A N F R A N C I S C O tional Academy of Sciences, supports this view but also suggests a possible compromise: “The 10,000 research grants now given by the Federal government are chosen on the ba sis of excellence plus past record of achieve ment; these should continue in the same way . . . Quite a separate program should be insti tuted for other institutions— after the selection of these possible new centers of excellence, they can be given temporary grants for a quantum jump to the next level of excellence.” 1o Brains: where allocated? A somewhat related argument centers around the charge that too many of the na tion’s top brains are allocated to the wrong tasks, no matter what region they work in. Critics of the present concentration of top flight talent in aerospace programs contend, for example, that much of this talent could be better utilized in the civilian economy—the nation’s basic growth-creating mechanism. As examples of misallocation of resources, these critics point to the large number of weapons systems developed at great cost but never produced, the large number of firms competing for development and production contracts in such esoteric fields as orbitalguidance equipment, the use of scientific man power in administrative and subprofessional duties (such as the preparation and market ing of project proposals), and the stockpiling of skilled manpower as a hedge against fu ture contract activity. Professor Machlup, in discussing the best uses of knowledge investment, points out that scientific manpower has three alterna tive uses— education, basic research, and ap plied research. The cost of using scientists to produce new technology consists of the loss of either new trained minds (education) or new scientific knowledge (basic research). Despite the obviously high rate of return on R & D, it would be wrong to allocate resources predominantly to applied work, since the con- R&D In modern industry, research, | Has come to be a kind of church, Where rubber-aproned acolytes Perform their Scientific Rites, A nd firms spend funds they do not hafter, In hopes of benefits Hereafter. — Kenneth Boulding centration on R &D in the here and now could be achieved only by sacrificing future R & D . But this opposition of alternative uses does not occur in the case of basic research, where the performer is at the same time a teacher. “The would-be scientist must learn what it is like to do science, and this, which is research, is the most important thing he can be taught.” Future: certain or uncertain? Needless to say, more and more revolu tionary changes lie ahead as a consequence of continuing investments in knowledge. A glimpse at the shape of this future may be afforded by a recent Rand Corporation sur vey, in which 82 experts from a number of fields suggested developments that they con sidered likely to occur by the end of this century. The experts foresee the development of thermonuclear power, the mining of the ocean floor, the production of synthetic protein for food, the establishment of a permanent moon base as well as stations on Mars and the other planets— and the conquering of the common cold. They foresee the displacement of onefourth of the present workforce within a decade through the automation of office work and teaching, and they also predict the de velopment of a computer-based world langu age, of completely automatic highways and skyways, and of automated tax (and garbage) collection. In the field of warfare, they foresee January 1966 MONTHLY REVIEW the development of bio-psychological weap ons that would harm neither life nor property but would destroy the will to resist. (New Yorkers, with their water-power-subway problems, may be forgiven for visualizing themselves as the initial victims.) Yet, despite the forthright nature of these predictions, the most certain thing about knowledge investment is its very uncertainty. Investment resulting in significant scientific advances is universally uncertain, with occa sionally happy and frequently unhappy sur prises being its normal consequences. And, in addition to technological uncertainty, knowl edge investment shares with other types of investment the condition of environmental uncertainty— uncertainty about the kinds of new products that will be useful or saleable in the unknown environment of the future period in which they become available. What response can be made to knowledge investment in this era of uncertainty? The an thropologist Margaret Mead argues that every user of the new technology has mixed atti tudes— “each is a potential supporter and advocate sufficiently entranced by the possi bilities of new devices to use them and dream of a form of life which will be permeated with the new technology and which will yet be human and desirable—yet each is a potential rejector, bemused, frustrated, and left be hind.” To deal with this situation, French historian Raymond Aron agrees that un doubtedly everyone should understand science better and everyone should receive a better education—but “the supreme virtue of the mind in a scientific society and in a revolu tionary era is . . . flexibility, imagination, the capacity of not being a prisoner of stereotypes, of remaining open to new developments.” For the individual, for the nation, and for every region of the nation, there is probably no better response. — William Burke F E D E R A L R E S E R V E B A N K OF S A N F R A N C I S C O W e s t s Factory Exports Reach $2 Billion Twelfth District states exported $2.06 billion of their manufactured products in 1963, and thereby accounted for 12.6 per- j cent of the nation’s total factory exports in that census y e a r.. . . Los Angeles by itself accounted for about 6 percent of the na tion’s total overseas sales. Other California areas accounted for 3.2 percent of the na tional total, and the comparable figures for the Pacific Northwest and the other Dis trict states were 2.4 and 1.0 percent, re spectively. . . . California and the Moun tain states recorded substantial gains in export sales between 1960 and 1963, • (California led all other states in sales in both of those years.) Northwest exports declined because of a drop in aircraft sales. ; W e s t Dominates Several Export Fields Western producers accounted for over 58 percent ($597 million) of the nation’s total aircraft exports in 1963, despite Washington’s export decline that year. Los Angeles producers alone accounted for al[ most half of U. S. aircraft export sales----District states—primarily the Northwest states— also dominated the lumber-andpaper export field, with 31 percent ($200 million) of the national total----- Western manufacturers in 1963 exported $291 mil lion in food products and $300 million in metals and machinery. Their share of the nation’s total overseas sales in those two sectors amounted to 17 and 6 percent, respectively. P tr c e n l of U.S. Exports 0 10 20 30 40 50 60 January 1966 MONTHLY REVIEW Factories Ship 4 Percent O verseas E x p o rts / T o ta l Ship m ents (P e r c e n t ) 0 2 4 6 8 10 12 The West, like the rest of the nation, exported roughly 4 percent of its factory output in the 1963 census year. . . . The aircraft industry dominated the export scene, in relative as well as dollar terms. Its $597 million in overseas sales amounted to about 12 percent of its total shipments — considerably better than the export per formance of the aircraft industry nation wide. . . . The Western lumber-and-paper industry, with about V /i percent of its products going overseas, also bettered the export performance of its industry com petitors. But most other District manufac turers shipped a smaller proportion of their output overseas than did their competitors High Ranking in Sales per W o rker I' ' " " ™” ’ ~” 77 ■1 Alaska led the rest of the nation in terms of export sales per factory worker in the 1963 census year. Alaska’s $6,167 figure far exceeded the national average of $954 per employee, since its exports were con centrated in the highly efficient paper in dustry___Washington and California also exceeded the national average in this re gard. But California, which led the nation in total export sales, lagged behind several other major industrial states (Illinois, Michigan, Ohio) in terms of export sales per worker___Utah, Nevada, and Arizona, with relatively high exports per employee, ranked near the middle of the national distribution. — Paul Ma Rank i n g : Export S a le s Per Em plo ye* I. 5. Idaho - $ SIT F E D E R A L R E S E R V E B A N K OF S A N F R A N C I S C O Steel and its Rivals steelmakers poured 130 mil Western gains lion tons of steel in 1965, and so, for the The Western industry, like the national second straight year, they exceeded the pre industry, has only recently returned to the vious peak of 117 million tons recorded in peak levels of a decade ago. Its performance, 1955. The industry’s performance in the in nonetheless, has consistently exceeded that of tervening decade was somewhat sluggish, the national industry. District mills expanded however, as production year after year held ingot production by one-third, from 5.0 to below the 100-million-ton level. Two reces 6.8 million tons, in the 1955-1965 period— sions and a major steel strike helped account and, in the process, increased their share of for this uninspired performance, but the in national output from 4 to 5 percent. dustry’s declining competitive position was The Western industry’s growth differential also a contributing factor. has reflected the vigorous growth in Western The industry’s critics during steel’s sluggish demand for steel and for everything else be decade suggested that the industry had be sides. The differential has also reflected the come too complacent about its previous run success of District producers in maintaining of successes. Steelmakers, after all, had run up a dominant position, vis-a-vis other domestic a string of new production records through producers, in the regional market. Over the out most of the 1940-1955 period. During decade Western producers have supplied World War II, they consistently were forced about 60 percent of regional receipts of do to allocate tonnage. During the first postwar mestically produced steel-mill products. decade, they continued to strain capacity, first to meet pent-up demands for reconver Customers and challenges sion, then to fulfill Korean War requirements, In any event, the recent strength of the and then again to meet the demands of the national and regional industries cannot dis guise the threat posed by foreign steel proproducer-durables boom of the mid-1950’s. Despite substantial Steel output ex ceed s form er p eak, but production success, however, still lags behind output of major customers frequent shortages (955 = 100 __ Steel Output (T o n i) of supply and con !40 125 Ratio Scale (00 “ stantly rising prices 130 occurred, so that ^ ---- Other U.S. 75 W E S T ---steel users turned 120 increasingly to im ported steel and 110 substitute materials. 100 These shifts, plus a slowdown in dura 90 ble goods produc tion, helped to bring 80 about the industry’s more recent prob70 1965 1955 1957 1959 1961 1963 lems. Source: U. S. Department of Commerce; American Iron and Steel Institute h e n a t i o n ’s T 14 January 1966 MONTHLY REVIEW ducers and by domestic producers of sub stitute materials. The industry’s strong 19641965 performance may testify perhaps more to the recovery of the steel industry’s major customers than to its ability to stave off the strong competitive challenges of foreign steel and domestic substitutes. This point was at issue in the controversy over the industry analysis conducted last year by the Council of Economic Advisers. The Council argued: “The long-term decline in the industry’s operating rate reflects steel’s loss of markets to other materials— mainly alu minum, plastics, cement, and glass— and to foreign steel producers. The doubling of steel prices in the 1950’s played an important role in these losses.” But a leading critic of the Council’s report, New York University’s Pro fessor Jules Backman, replied: “The role of competitive products has been considerably exaggerated by the CEA in its explanation of the loss in steel markets. The lag in steel pro duction and consumption reflected primarily the lag in demand for capital goods and for consumer durable goods. As the rate of growth for capital goods and consumer dur able goods once more has increased, the de mand for steel also has expanded strongly.” The question is still open, although recent data suggest that both the Council and its critics may be correct. The industry’s produc tion has recovered strongly in tandem with the ebullient performance of the major steel consuming industries. At the same time, the industry’s competitors have, if anything, con tinued to increase their market penetration. Derived dem and? During the industry’s sluggish decade, it became abundantly clear that steel demand is a derived demand. Production tended to lag during that period as a consequence of the relatively sluggish performance on the part of such industries as heavy construction, autos, appliances, containers, and machinery. Even so, shipments of finished steel-mill products declined in relation to activity in consuming industries. Construction and dur able goods industries regained their 1955 level of activity by 1961, and then grew by 31 per cent in the 1961-1965 period. But steel ship ments declined 22 percent between 1955 and 1961, before advancing to a point about 7 percent above the decade-ago level in 1965. By 1965, then, steel shipments would have been about 20 million tons above the level actually attained if consuming industries had increased their steel purchases as much as they did their own output. Admittedly, the steel industry’s own tech nological progress has been a major factor in reducing tonnage demand. The declining ratio of shipments to durable goods production re flects the development of stronger yet lighter gauges of steel, so that each ton of steel now yields far more finished products than here tofore. For one example, a ton of new thin tinplate produces 40 percent more citrus-juice cans than does a ton of ordinary electrolytic plate. For another example, a ton of improved line pipe is now capable of transmitting 60 percent more gas than a ton of the standard pipe material of a decade ago. Since steel prices in general have risen very little over the last five years, reduced tonnage resulting from the development of lighter gauges of steel has served to hold down revenues. To cure this problem, the industry has be gun programs designed to bring about sub stantial cost savings. In the 1964-65 period it spent about $1.8 billion annually in moderniz ing and expanding its facilities— over onethird more than its average annual spending for such purposes in the 1955-63 period. Rev olutionary production processes have been introduced, including the concentration and beneficiation of lower-grade ores, the intro duction of continuous casting, and the con version to oxygen converters. About one-eighth of the industry’s output is now produced in FEDERAL RES ERVE BANK OF S A N F R A N C I S C O oxygen converters (and the proportion is ex pected to approach one-half by 1970), where as hardly any was produced by this efficient process a decade ago. Challenge: foreign But foreign producers, like American pro ducers, have also made rapid technological strides, and the result has been a vast increase in the availability of attractively priced foreign steel in the American market. Between 1955 and 1964, steel imports rose from less than 1 to more than 6 million tons, and then jumped to over 10 million tons in 1965. Since steel exports trended down from 4 to 2V2 million tons over the entire period, almost 11 million tons of steel shifted from American to foreign orderbooks. Imported steel represented only about one percent of the domestic market in 1955, but it began a significant market penetration dur ing the 116-day steel strike of 1959, gaining over 6 percent of the domestic market in that year. By 1964 the import share increased even more, to over 7 percent, and it then jumped to 10 percent in 1965, on the heels of a sub stantial strike-anticipation inventory buildup. Foreign invasion of American market creates substantial export deficit This development has been most striking in the West, where imports increased their penetration to 18 percent in 1964 and ap parently gained an even stronger market share in the following year. In some sectors, imports have now gained a dominant position, ac counting for as much as 40 percent of the District market for pipe and 25 percent of the regional market for sheet and strip steel. This penetration of imports has continued in the face of a 1962 action designed to help the Western industry combat steel imports. In earlier years, Western producers could charge a higher base price than other domes tic producers because of the high freight charges on steel shipped in from the East, but in doing so they made the West an uncom monly attractive market for foreign producers. Consequently, in late 1962, regional mills re duced their base price an average of $12 a ton in order to improve their competitve situation vis-a-vis imports. Nonetheless, the import flood continued and, if anything, gathered more strength in subsequent years. Price increases announced by regional and other mills early in January certainly will not help the industry’s import problems. Domes tic producers increased structural-steel prices by $2.75 a ton at that time, even though im ported structurals already were selling $ 1025 a ton below American prices. Millions of Toni 12 i— S T E E L IMPORTS St«st Exports Enporl Surplus 1955 i960 Source: American Iron and Steel Institute 1965 Challenge: domestic But foreign competition remains only one of the industry’s competitive problems. Even when imported steel is included, total steel shipments nationwide have lagged behind the rise in output of steel-consuming industries. Between 1955 and 1965, total shipments (domestic plus imports) increased 21 percent, but output in construction and durable goods industries increased 31 percent in the same period. This difference is attributable in large part to the market penetration of substitute materials. MONTHLY REVIEW January 1966 M arket penetration by steel's major competitors helped along by their more successful price performance P«rc«nt Chongt in Output, 1955-65 1955 =100 140 r_ Averagt Price STEEL Aluminum Aluminum 1955 i960 1965 Source: U. S. Department of Labor; Federal Reserve Board Over the past decade, shipments of alterna tive materials have risen substantially— ce ment by 27 percent, aluminum by 80 percent, and plastics by over 350 percent. These in dustries have not expanded simply through displacement of steel; in many applications, such as aluminum foil, they are noncompeti tive with that metal. But in many other mar kets they have clashed head-on with steel. Thus, the construction, transportation, and container industries, which account for more than half of the total steel market, also ac count for more than half of the total aluminum market. (In tonnage terms, steel remains a giant among its competitors—with aluminum shipments, for example, amounting to only about 5 percent by weight of total steel ship ments.) Substitution has been stimulated by both the versatility and the price behavior of these alternative materials. The average price of steel-mill products today is about 26 percent higher than a decade ago, primarily as a con sequence of a strong upsurge in the 19551959 period. But over the same period, ce ment prices have increased just 15 percent, and aluminum prices 12 percent, while plas tic-materials prices have actually declined 25 percent. And even where price factors con tinue to favor steel, substitutes are often chosen because of advantages in appearance, ease of fabrication, or cost of maintenance and transportation. Consider construction . . . Steel shipments to the nonresidential and heavy construction industry were very sub stantial during the 1955-1957 boom, but steel usage has declined relatively since that time. This industry takes 18 percent of steel ship ments nationwide but it is by far the dominant steel-user in the regional economy, account ing for some 56 percent of Western steel usage. In construction, steel has faced a broad range of competitive materials, but concrete has made the heaviest inroads. Reinforced concrete requires only one-third to one-half of the amount of steel needed for a similar allsteel structure. Pre-stressed concrete— rein forced concrete in which steel is tensioned by controlled stretching — requires only onefourth as much steel or one-half as much con crete as is needed for ordinary reinforced con crete, and it also offers large savings in con FEDERAL RES ERVE BANK OF S A N F R A N C I S C O struction time and increased flexibility of de sign, Pre-stressed concrete first became a major factor in the bridge-construction field, and it has come to be highly favored through out the building field since major buildingcode revisions were instituted in 1963. Aluminum has also invaded the construc tion market, doubling its shipments to this industry within a decade. About one-fourth of aluminum’s total market is now in construc tion, where it has replaced both wood and steel in windows, siding, and sash, and where it has gained a foothold in larger structures through the development of curtain-wall de sign by modern architects. Price increases averaging $2.75 a ton over the full range of structural steel products, announced by the industry in January of this year, could help to accentuate the trend toward the use of sub stitute materials in construction. for 22 percent of total steel shipments na tionwide, steel output has moved fairly close ly with auto production, sharing in both the industry’s earlier decline and its recent come back. But steel has not shared completely in the auto boom, especially because of the growing consumer preference for cars which require less steel than the mammoths of yesteryear. (In the 1961-1965 period alone, compact and intermediate cars increased their market share from 24 to 41 percent.) Aluminum, moreover, has made a specta cular penetration into the auto market. The average 1965 model contained about 69 pounds of aluminum-—triple the usage of a decade ago— and the 1966 models may con tain even more of the light metal. Aluminum also has taken an increasing role in the pro duction of heavy-duty trucks, as well as trailer containers for rail piggy-back service. In the railroad-equipment field, which ac counts for about 4 percent of the national steel market, usage has been drifting down for a . . . and transportation In the automotive industry, which accounts Steel output lag s behind output of major consuming industries, partly because of technology gains and partly because of market losses 1955 = 100 140 - CONSTRUCTION AUTOM O TIVE M A C H IN E R Y AND 40 1955 EQUIPMENT I960 M ET A L CANS RAILROAD 1965 1955 I960 A P P L IA N C E S EQUIPMENT 1965 1955 Source: U, S. Department of Commerce; Federal Reserve Board; American Iron and Steel Institute I960 January 1966 MONTHLY REVIEW decade. Production of railroad equipment is now back to decade-ago levels, but steel ship ments to that industry are off by about 20 percent. Technological improvements have helped to account for the lower steel-use per unit. In contrast to the prewar period, when increases in locomotive pulling power required expan sion of engine size and weight, present-day technology through dieselization permits in creases in pulling power with less weight than was required heretofore. Aluminum has made inroads in the railequipment business since about 1960, when the railroad industry placed orders for 1200 aluminum gondola and hopper cars. Despite its higher sales price, aluminum can compete in this field because of its light weight and low maintenance cost, which is far below the $300-a-car annual maintenance cost of steel railroad cars. . . , and packaging Steel has also had competitive problems in the container and packaging market, which accounts for 8 percent of total steel shipments nationwide and for 18 percent of the Western steel market. Technological improvements have helped account for the relative decline in steel usage in canning, primarily because of the trend to thinner gauges of steel, but alu minum’s inroads have also been a major fac tor. Other substitute materials have found in creasing usage in plastic bottles and bottle caps and in composite aluminum-paperboard oil cans. Since 1960, when aluminum moved into this field, it has come to dominate the frozen citrus market and has made progress in the 10-billion-a-year beer-can market. The indus try developed in turn the soft top, the pull top, and, finally, the seamless all-aluminum can. But steel fought back recently by introducing the unsoldered tin-free can, and then by ad justing price schedules in order to make these new cans cheaper than ordinary tinplate cans. Meeting the challenge From an earlier situation of complacency, steel in recent years has moved increasingly to meet the competitive threats of imports and substitute materials. While its research and development budget is still lower than that of any other heavy industry, it is now almost double the expenditure of the late 1950’s. The industry also has attempted to develop new markets, to anticipate customer needs, to im prove sales techniques— and, as always, to produce at lower costs. A key change is the industry’s growing recognition that it is participating in a dollar and not a tonnage business. It is not simply turning out tonnage and forcing the customer to decide how to use its products; rather, it is determining the needs of its potential cus tomers and then moving to meet those require ments. One result has been a substantial im provement in the industry’s profit perform ance— net income, which had declined by half between 1957 and 1962, recovered sharply thereafter and reached a new high in the first three quarters of 1965. The industry may be producing relatively fewer tons of steel than a decade ago, but each ton of metal is now doing a far better job than before. — Yvonne Levy Publication Staff: R. Mansfield, Chartist; Phyllis Taylor, Editorial Assistant. Single and group subscriptions to the M o n th ly R eview are available on request from the Adm in istrative Service Departm ent, Federal Reserve Bank o f San Francisco, 400 Sansome Street, San Francisco, California 94120. FEDERAL R E S E RV E B ANK OF S A N F R A N C I S C O W estern Digest Banking Developments Twelfth District weekly reporting banks increased their total credit by $166 million in December. The increase was only half as great as a year earlier, since the loan expansion was smaller and security holdings were actually reduced. But this December’s loan expansion exceeded the year-ago gain after adjustment was made for the security-loan and loan-to-domestic-bank categories.. . . Business-loan demand was especially strong—up $227 million—with heavy borrowing over the tax date followed by further increases in the following two weeks. Other loans (mainly consumer) rose $100 million during the month, and real-estate loans also recorded a year-end spurt, rising by $48 million.. . . December’s reduction in demand deposits adjusted was larger than a year earlier. However, the gain in total time and savings deposits was greater than in the year-ago period, mostly because of larger deposits by states and political subdivisions as well as a small increase in negotiable certificates of deposit. In early January, rates offered by banks on CD’s were in the process of further upward adjustment to remain competitive with other market instruments. Employment and Unemployment Twelfth District nonfarm employment rose substantially in November, with man ufacturing showing an especially strong (0.9-percent) gain.. .. The aerospace sector continued to recover from its earlier slump. District aerospace employment in No vember was 7 percent above the March-1965 level; however, the rest of the national industry boasted an even stronger recovery. . . . The District unemployment rate dropped from 5.4 to 5.3 percent in November. In the nation, the jobless rate dropped a comparable amount to 4.2 percent— and it continued declining to 4.1 percent in December. Production Developments District construction awards rose sharply in November, and consequently the 11-month total almost matched the corresponding 1964 total. But this comparison masked sharply divergent movements in the different sectors of the industry. For the January-November period as a whole, residential construction ran 16 percent behind the year-ago pace, while nonresidential building and heavy construction together recorded an offsetting increase. . . . Lumber orders held above year-ago levels in early December, as extremely favorable building weather in other sections of the country spurred the need for retail replacement buying. The heavy flow of orders resulted in price increases ranging from $1 to $2 per thousand board feet. . . . The Western steel industry ended the year on a strong note. Production increased 4 percent between early and late December— an even stronger gain than that recorded in the rest of the booming national industry. 20
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