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F E D E R A L R E S E R V E BANK OF SAN FRANCISCC MONTHLY REVIEW AUG 1 0 1964 8ANK OP PHILADELPHIA I N T H I S I S S UE Aluminum Canoes Again? . . . . 139 How the West Grows . . . . . . 148 The High Cost of People . . . . . 151 JULY 1964 1914 FIFTIETH ANNIVERSARY 19 6 4 Alum inum Canoes A g a in ? . . . the Pentagon sneezes and the West sniffles, but the resource base that supported the defense boom remains intact. How the West Grow s . . . the record shows a mixture of fast- and slow-growing industries, but a strong emphasis on rapid growth. The H igh Cost of People . . . rising costs and rising population cause a 60-percent rise in District state-local spending within a half-decade. July 1964 M ONTHLY REVIEW Aluminum Canoes Again? late 1943 and late 1945— but especially in the otherwise joyous period following V -J Day— W estern defense plants laid off some 600,000 workers. Housewives returned to their kitchens, farmers returned to their fields, and the unemployed queued up for jobless benefits, but most of the displaced workers soon found ample scope for their talents in the nation’s postw ar reconversion effort. Displaced defense contractors m ean while transferred their technological capabili ties to commercial m arkets, and in the process found themselves in such diverse lines as canoes, com puters, and coffins. e t w e e n B Alum inum canoe ventures and other proj ects of that type had difficulty staying afloat, so most defense contractors eventually de cided to adjust their operations to the trun cated military m arket. T hat m arket, however, did not remain truncated for long; K orea and the Cold W ar soon generated dem ands that caused a tripling of defense-related employ ment in Twelfth D istrict states between 1950 and 1962. Yet, between late 1962 and m id-1964, in a period when military (plus space) spending was still rising, W estern defense plants laid off about one-tenth of their workforce (60,000 w orkers). The cutbacks, of course, were hardly com parable with the severe declines that characterized the post-V -J period, but they am ounted to the deepest and most pro longed reduction of em ployment of the entire postw ar era. Big-spending customer There are now about 600,000 District workers in defense-related activities (aircraft, electrical m achinery, ordnance, instruments, and shipbuilding), and their products are tailored predom inantly for the single-— and sometimes changeable— custom er in Wash ington, D. C. Some firms, of course, obtain valuable business from the domestic and for eign airlines, and hundreds of other firms deal only with the prime aerospace contractors, but in the vast m ajority of cases the ultimate custom er is the Federal G overnm ent. Price is not so im portant to that big-spending custom er as it is to most ordinary con sumers. The Pentagon has gone to great lengths recently to disprove that dictum— as any contractor could show— but the fact re mains that the custom er’s main concern is to purchase only the products that are greatly superior in quality. Since the significant com petition for new weapons and space systems occurs before the final products are designed, estimates of total cost are necessarily tenta tive and of limited reliability. One thing is essential to a successful sales record, however, and that is the capability for scientific innovation. Frequently, the indus try’s m ajor custom er will contract for a sup plier to undertake a program of research and development that includes the delivery of the product resulting from this R&D function. In any case, the intensity of the military cus tom er’s dem and depends prim arily on the quality of the systems available to him through 139 FEDERAL RESERVE BANK technological breakthroughs — and on the quality of systems available to potential op ponents as well. If a producer has a likely looking product on his drawing board, the custom er will nego tiate a price directly with him; the alternative, sealed bidding, usually is not feasible because of the extreme differentiation among the products offered by competing companies. Com petition among prospective suppliers fre quently is very keen, but it will center on the capability of alternative systems for perform ing a given military mission or meeting a stated military specification. E ntry into this m arket is relatively easy, provided that the entrant possesses scientific skills that are strong enough to attract gov ernm ent backing. Once inside the industry, however, the new firm may find that its skills are incapable of producing the special type of product dem anded by its sole customer, or that the m arket is being invaded by another new entrant backed by that same custom er— and at the same time the firm may find itself forced by problem s of excess capacity to bid unrealistically for available work. These prob lems are com pounded by the very long leadtimes required between initial product plan ning and final delivery — and com pounded even more by the rapid technological obso lescence that affects most defense products. The customer’s changing tastes ]4 0 F o r all these reasons, the firms in this in dustry pay a great deal of attention to the details of their custom er’s budget— a budget which, in the past decade alone, has exhibited massive structural shifts as well as significant ups and downs. These changes can best be discerned by analyzing the m ajor components of the D epartm ent of Defense budget— mili tary personnel, operations and m aintenance (including civilian payrolls), procurem ent (including aircraft, missiles-electronics, and other equipm ent), and research-developm enttest-evaluation (that is, the R&D category) — OF SAN FRANCISCO along with the budget of the N ational A ero nautics and Space A dm inistration. Outlays on m ilitary functions of the D e partm ent of Defense (D O D ) reached a K o rean W ar peak of $43.6 billion in fiscal 1953. D O D spending later dropped sharply, but re gained the 1953 level in fiscal 1961— and then jum ped to $48.3 billion in fiscal 1963. Over the same decade, NASA (space) spend ing increased from an insignificant am ount to $2.6 billion. The housekeeping com ponents of this package (personnel, operations, and m aintenance) rose by one-tenth over the dec ade. The other com ponents, centered in procurem ent and R&D, increased by almost one-fourth— and in the process provided a sharp stimulus to W estern growth. The breakdow n of the total shows the suc cessive shifts in emphasis from operations to procurem ent of increasingly expensive w eap ons and from this to research and develop ment. It shows also the successive shifts in the procurem ent-R& D category from surface weapons to m anned aircraft to missile and space systems, along with the shift in weap ons m anufacturing from fabrication to elec tronics and other complex subsystems. A t the height of the K orean W ar, procure m ent officers concentrated their purchases on conventional land and sea weapons, such as com bat vehicles, artillery, rifles, ammunition, and surface ships. L ater, in 1955, they spent almost 70 percent of their procurem ent dol lars on aircraft, but in 1963 they spent less than 40 percent on that product as a result of a growing preference for missile and space program s. This changing pattern of procurem ent m eant that purchases from private industry shifted from airframes and other fabricated structures to electronics, propulsion systems, and other advanced gear. It m eant also that contracts and job opportunities shifted from the companies and the workers who could make land or sea vehicles to those who could M O NTHLY REVIEW July 19 6 4 H ard w are, R&D due to drop this new fiscal year. Space agency spending, at about $5.0 billion in fiscal 1965, will be almost double the 1963 total. But other cate gories will be down. R esearch and develop ment, after rising from $6.4 billion to $6.9 billion between 1963 and 1964, will lose most of that gain in 1965. A ircraft procurem ent, which also rose somewhat in 1964, will drop from $ 6 . 6 billion to $5.7 billion in 1965. A nd missile-electronics spending, which peaked at $5.2 billion in 1963, will drop to $4.5 billion in the current fiscal year. in 1965, while other sectors rise B illio n s of D o llars 1951 1953 1955 1957 1959 1961 1963 1965 N ote: Chart shows fiscal-year expenditures for major D efense D epartm ent categories and for National Aeronautics and Space Administration. Source: U . S. Bureau of the Budget. produce airborne craft, and finally to those who could turn out the sophisticated systems that soar through outer space. The firms that were unable to make the transition either dis appeared or shifted to the more tranquil ci vilian m arket. The No. 1 military contractor in 1950, for example, was in twentieth place in the 1960 fiscal year. Major shifts, declining totals Substantial shifts in the defense-space m ar ket basket can be m anaged when the cus tom er’s total purchases are growing rapidly, as in the early 1960’s. Problem s can arise, however, when the total is declining, as in the mid-’50’s— and perhaps again in the mid’60’s. That, at any rate, was the thought that occurred to many observers when defensespace spending, following a 25-percent jump in the 1961-64 period, was budgeted for a decline in fiscal 1965. The m ajor categories, as usual, will show quite diverse movements. T he housekeeping functions (personnel, operations, and main tenance), after rising to $24.9 billion in fiscal 1963 and even higher in 1964, are now sched uled to increase further, to $26.9 billion, in These budget figures to some extent reflect the A dm inistration’s economy drive. One result is the D O D cost-reduction program , which led to savings of $2.5 billion in fiscal 1964 and is expected ultimately to yield $4 billion in annual savings. Secretary M cN a m ara’s five-year program comes under three headings: 1 ) “buying only what we need” by eliminating “ gold-plating” and by refining calculations of equipm ent requirements; 2 ) “ buying at the lowest sound price” by shift ing procurem ent from a noncompetitive to a competitive basis (w herever possible) and by shifting contracts from a cost-plus-fixed-fee to an incentive basis; and 3 ) “reducing oper ating costs” through consolidation, standardi zation, and greater operating efficiency. Aside from the economy drive, the budget cuts reflect a sharp decline in the rate of accu m ulation of strategic weapons, because of the large and growing inventory presently in ex istence. Since strategic retaliatory forces are now reaching desired strength, future expendi tures will be required mainly for replacement and upgrading. No one knows, of course, what the optimum level is for inventories of these products— but with 800 Atlas, Titan, and Polaris missiles stored away in silos and sub marines, and with a scheduled production run of 1,200 M inutemen, m ost experts seem rea sonably content. W hatever the reasons, the squeeze is on, and the consequences are felt wherever de- FEDERAL RESERVE BANK OF SAN FRANCISCO Percent W est boasts higher contract volume as share increases . . . jobs decline, especially in production IF O R N IA Other D istrict North Cast WORLD WAR II Thousands of Persons B illio n s of D o llars 10 K O REA 1960’s R E G IO N A L SH A R E OF D E F E N S E CO N T R A C TS o Percent 10 20 30 40 N o te: Chart show s T w elfth D istrict data for contract awards and defense-related em ploym ent, and California data for productionworker share of em ploym ent. Sources: D epartm ent of D efense; National Aeronautics and Space A dm inistration; Departm ents of E m ploym ent (various sta tes); Federal Reserve Bank of San Francisco. fcnse spending is a m ajor bulwark of the regional economy— as is particularly the case in California and the other W estern states. This developm ent suggests to some pessimis tic observers that the shift which contributed so much to the past growth of the District is now turning against this region. Thus, al though budget totals are still rising in one field — the housekeeping sector— where District states account for almost one-fourth of total payrolls, spending declines are concentrated in another field— the procurement-R&D sec t o r — where those states account for more than one-third of total payrolls. One-third of the market 142 The cutbacks have already had some ef fect, as was indicated at the outset, but they m ust be placed within the context of a decadelong record of W estern achievement. During that period the procurem ent situation has shifted drastically in favor of the West, to the detrim ent of the N ortheast and (especially) the N orth Central regions. Between W orld W ar II and K orea, the Twelfth District share of military prime contract awards rose from 13 to 18 percent but then jum ped to more than 30 percent of the national total in the 1961-63 period. (By way of contrast, the N ortheast share dropped from 33 to 29 per cent over the past decade, while the N orth C entral share slumped from 34 to 19 p er cent.) To cap the climax, District states ac counted for about one-half of N A SA spend ing during the space agency’s first several years of large-scale operation. California, to cite the obvious example, has been unique in the variety as well as the ex tent of its procurem ent effort. In one recent year (1 9 6 2 ), California contractors ranked first in missiles, aircraft, am m unition, miscel laneous hard goods, subsistence, services and construction program s; second in electronics, com bat vehicles, and petroleum and fuels; third in weapons; and fourth in ship program contracts. July 196 4 M O NTHLY REVIEW Why such a predom inance? Admittedly, the West gained a head start during and after W orld W ar II, as military dem and trans formed a num ber of small aircraft fabricators and suppliers into giant enterprises capable of turning out tens of thousands of military air craft. During this period, while missile tech nology was in its infancy, the G overnment encouraged these firms to utilize their plant facilities and technical skills in creating new types of weapons. As a result, many of the aircraft firms developed new capabilities in the missile field and retained their positions as m ajor defense contractors. B ut this ex plains only the head start; it fails to explain the dominance achieved by the West within the span of a single decade. The changing structure of the D O D -N A SA m arket basket helps to account for the widening lead; the major factor, however, is R&D. How to achieve dominance The firm with a successful sales record in the defense-space m arket is the firm with the capability for scientific innovation — which means the firm with a superior R&D perform ance. The company which conducts or m an ages the research, design, development, and testwork on a new weapon system— and has assembled the engineering talent and experi ence for this purpose -— is in a very strong position to compete for the follow-on produc tion contracts and for new developmental contracts as well. Thus, since District states have accounted for one-half of total R&D spending in recent years, they have been in an extremely good position to m aintain and even expand their share of total defense-space spending. A DOD study of the defense m arket neatly summarizes the situation: “Successful re search and design, or development and testing effort, often leads to follow-on production contracts; and, in turn, engineering work on highly complex new weapons systems creates new R&D capability. The process is circular; and it regenerates itself.” The crucial element is a favorable R&D climate, which includes the availability of highly specialized scientific, engineering, and technical m anpower, spe cialized facilities, labor skills, and production experience— all of which the West possesses to an abundant degree. The “footloose” R&D industries depend on footloose scientists who prefer W estern edu cational and working conditions. With some of the w orld’s leading graduate schools, the West produces a m ore-than-proportionate share of the nation’s scientists; California alone has accounted for about 15 percent of the total national production of physicists over the past four decades. A nd what the West fails to grow, it can easily import; in the late 1950’s, for example, more than 23 per cent of the new crop of physicists went to work in the West after receiving their Ph.D .’s, even though only 1 0 percent of the group came originally from this region. On the basis of their strong concentration of outstanding scientists and technicians, Western universities and their satellite re search centers manage to attract a very large share of Federal R&D contracts. On the basis of the scientifically interesting (and profit able) projects created by those contracts, R&D spending in turn manages to attract into the Western orbit a m ore-than-proportionate share of the scientific com m unity’s outstand ing men. Again, the process is circular, and it regenerates itself. Rising contracts, declining jobs The supply side of the defense-space m ar ket thus has come to be dom inated by the West, with its strongly favorable climate for R&D. But the dem and side, which in recent years had been geared increasingly to the unique Western product line, has now shown some signs of a shift. Actually, the trend of contracts to District defense firms is still 143 FEDERAL RESERVE BANK uncertain — it continued to point upw ard throughout 1963— but the em ploym ent trend has been down since late 1962. Em ploym ent peaked at 658,000 in D ecem ber 1962, and then began a steady slide; about 25,000 de fense-related jobs disappeared by the end of 1963, and about 35,000 m ore by m id-1964. The D O D cost-reduction program is an im portant factor in the employment squeeze. M any District firms, expecting an extensive expansion of new defense business, apparent ly built up a cushion of scarce technical talent over the years, only to find little use for that talent when new contracts failed to m aterial ize. W hat with the recent shift in emphasis from cost-plus-fixed-fee to fixed-price or in centive contracts, the cost-reduction program makes such hoarding of talent unprofitable, since it eliminates the opportunity to charge the cost of “ excess” technical talent to the cost of each project. The process is helped along by the D O D requirem ent that defense contractors m ake periodic reports on the steps taken to reduce employment on govern ment contracts. OF SAN FRANCISCO Nonetheless, the m ajor structural shift that has occurred in the procurem ent-R& D cate gory is probably an even greater factor in the em ploym ent decline. In contrast to the situa tion a decade or two ago, the leading products of the defense industry today are generally expensive, handcrafted items that require the efforts of only a relative handful of scientists, engineers, and skilled craftsm en. The trend becomes evident from a glance at California industry statistics. In that State, nondefense industries require m ore than seven out of every ten workers on the production line— almost as high a proportion as in 1950. But aircraft and electrical machinery, although they formerly required roughly the same p ro portion of production workers, now have no m ore than one-half of their workers on the production line — and ordnance has even a sm aller proportion. Impact areas The em ployment decline (w hatever the factors involved) has been quite significant, and its effects have been widely felt in those Slow dow n in defense sector creates drag on total employment and leads to higher jobless rates in major Western areas EMPLOYMENT UNEMPLOYMENT RATES D EFEN SE-RELATED TO TAL \ \ 0 LOS ANGELES SAN FRANCISCO SEA TT LE S A N D IEG O 20 30 40 60 Thousands of Parsons 80 100 (R ati o Se al* ) 200 300 400 600 8 0 0 1000 2000 3 0 00 O 2 P»rc#n1 N ote: Chart shows annual averages for 1953 and 1959, and M ay data for 1964. Sources: D epartm ents of Em ploym ent and Departm ents of Industrial Relations (various sta tes); Federal Reserve Bank of San Francisco. July 196 4 M O NTHLY REVIEW communities whose recent growth has been built in large part on a defense foundation— Los Angeles, the San Francisco Bay Area, Seattle, and San Diego. Just as those areas benefitted most from the past expansion of procurem ent, R&D, and space spending, they now tend to suffer m ost from the failure of defense spending to m aintain its past rate of expansion. Between 1953 and 1959— two generally expansionary years— a strong increase in defense-related employment in each of those areas was associated with a com parable in crease in total employment, along with a rela tively slow rise in the unemployment rate. But between 1959 and m id-1964, a declining rate of growth of defense-related employment (o r even an actual decline) was associated with a declining rate of growth in total em ployment, along with a noticeable increase in the jobless rate. O ther indexes of business activity, such as retail sales and housing starts, have shown the same type of response to shifts in defense jobs. Since the Los Angeles m etropolitan area accounts for the vast bulk— 60 percent— of District defense-space employment, that area has suffered the largest num erical drop during the decline of the past eighteen months. D e fense jobs in that area now num ber about 355,000, or about 5 percent below the D e cem ber-1962 peak. O ther industries in that vast m etropolitan m arket have helped take up the job slack; three industries (trade, serv ices, and governm ent) have each grown by as much as the entire decline in defense m anu facturing. Nonetheless, the decline in the de fense sector (which accounts for more than two out of five jobs in m anufacturing) has helped raise the jobless rate by now to almost 6 percent. The San Francisco Bay A rea (including San Jose) has suffered a smaller percentage decline and a m uch smaller drop in the actual num ber of jobs, to about 72,000 today. This Business in d exe s reflect shifts in defense-related employment N ote: C hart shows biennial percentage changes for all series. Sources: D epartm ents of Industrial Relations and Boards of Equalization (California and W ashington); U. S. D epartm ent of Commerce. fact, plus the more diversified nature of the Bay A rea’s economy, which has only one out of four m anufacturing jobs concentrated in defense-related activities, accounts for the smaller relative im pact of the cutbacks on the area. Here as in Los Angeles, several in dustries have each shown the ability to offset the entire decline in the defense sector. The story is somewhat different in the oneindustry towns such as Seattle and San Diego. (D efense-related activities account for almost six out of every ten m anufacturing jobs in Seattle, and for more than seven out of every ten factory jobs in San Diego.) In both areas, defense cutbacks have been both steeper and more prolonged than in the larger com m uni ties. San Diego has recorded almost a 20- 145 FEDERAL RESERVE BANK percent decline, and Seattle, almost a 25-per cent decline, during recent cutbacks; in addi tion, both areas have suffered from a declinine trend in defense jobs since the late 1950’s, although Seattle reached a secondary peak again in m id-1962. As a result, unemployment has become something of a chronic problem in both communities. O ther areas in the District have recorded smaller numerical reductions in defense-re lated jobs, but in percentage terms the impact has been just as great as in San Diego or Se attle. F or example, U tah now has about 13,000, and Arizona about 8,500, in such activities— but in each case the defense job total is at least 2 0 percent below what it was a year or two ago. These sm aller areas, there fore, have proved to be just as vulnerable to defense budget shifts as have the larger labor m arket areas. What the models say This was the situation in m id-1964, as the defense-space budget headed for a modest decline in fiscal 1965. But what if that budget should continue downwards, as economy drives accentuate and weapons system m a ture? Obviously, offsets would be necessary. So, arm ed with input-output tables, lagged regression models, and ample com puter time, a num ber of economists are now attempting to quantify the effects of the medicines that have been prescribed for the withdrawal symptoms arising from defense cutbacks. 145 This approach is typified by a report pre pared for the Senate L abor Committee by two University of Pennsylvania economists, W al ter Isard and Eugene Schooler. (This and several similar studies are found in the com pendium, “Convertibility of Space and De fense Resources to Civilian N eeds” .) Isard and Schooler examine the possible conse quences for the California economy, indus try by industry, of a 1 0 -percent reduction in national defense expenditures offset by an OF SAN FRANCISCO equivalent increase in spending elsewhere in the economy. Given the structure of the Cali fornia economy, they argue that a 1 0 -percent cut in defense spending could destroy more than 75,000 jobs, prim arily in the defensemanufacturing and governm ent sectors. Yet, an equivalent increase in dollar spending, al located in different ways to different sectors, could offset most of the job loss; in fact, a certain mix of consum er tax cuts and in creased business and governm ent investm ent could generate more than 90,000 new jobs. The State’s new em ploym ent structure would be somewhat different from the old. however, since construction would account for almost half of the total job increase, while defensem anufacturing would suffer a substantial net decline. (Incidentally, the figures cited in this illustration are based on 1960 budget totals; a proportionate decline today would lead to larger but still com parable results.) Some observers would argue that studies and plans of this sort are unnecessary, since defense and space spending will rebound after the current lull and lead the W estern econ omy to even greater heights. This argument has the logic of history on its side; during the past decade alone, the W est has experienced, several sharp fluctuations— but fluctuations around a rising trend— as a result of the vari ous shifts in international tensions and the frequent replacement of m aturing weapon systems with ever-more-expensive systems. Today, of course, planning for the next gen eration of weapons is proceeding apace, and it is being supplem ented by planning for the further (and increasingly expensive) explor ation of space. As a m atter of fact, Space A dm inistrator W ebb recently furnished to the Senate Space Committee an imposing list of future projects, including everything but intergalactic travel, that bore no price tag but seemed quite capable of carrying N A SA ex penditures far into the stratosphere. July 1964 M O NTHLY REVIEW Of change and diversity Spending in the defense-space sector may well bound upw ard again, but many govern m ental and business leaders— prudently re alizing that that sector cannot be a perpetual source of rapid growth— have begun to study the econom ists’ models with an eye to de veloping practical offsets to defense cut backs. As a result, committees have prolif erated throughout the land to examine the problem along with a host of possible solu tions. To date, much of the discussion has centered around the familiarity of both the problem and its solutions, since (the argu ment runs) the same types of effects flow from a shift in taste in this m arket and from the shifts in taste that occur daily in all other markets. In this vein, C alifornia’s Governor Brown recently told his Advisory Panel on A ero space and Electronics Industries, “We must take seriously the word ‘diversification’.” The chairm an of the President’s Committee on the Econom ic Im pact of Defense and Dis arm am ent, G ardner Ackley, implied the same solution when he testified at Senate hearings on a N ational Economic Conversion Act: “ Changes in technology, in consumer tastes and incomes, in foreign com peti tion, in the quantity and quality of our labor supply — all these radically and continuously affect the level and com position of dem and or the way in which dem and is satisfied. In the aggregate these other changes are surely much more significant and impose even greater re quirements for adaptation and adjust ment than do the kinds and magnitudes of defense changes we are likely to ex perience.” The constancy of change and the need for diversification thus are likely to be the watchwords in the struggle to overcome the current and future problems of the W estern defense industry. Ackley undoubtedly would argue that the same types of program s that suffice to offset m ajor shifts in other m arkets would also serve to offset cutbacks in the defense m arket— and this is no doubt true, provided that allowances are made for the special occupational and regional character istics of the industry, and particularly for the unique W estern capability for R&D work. The possible fields for expansion include space platform s, supersonic transports, and (closer to earth ) rapid-transit vehicles and new types of building materials and tech niques. Provided, again, that the W estern ca pability in the R&D field is given free rein, profit and job opportunities will develop in these fields and in fields as yet unknown. C er tainly, if the right choices are made, there should be no need to return to the m anufac ture of aluminum canoes. 147 FEDERAL RESERVE BANK OF SAN FRANCISCO How the West Crows observers have failed to note the fact D iverse W estern regions that the W est has won an ever-larger display diverse growth patterns place in the sun during the postw ar period. B illio n s of Dollars California, with $52.4 billion in personal in 50 come, has increased its share of total U. S. . 0th«r Growth income from 814 percent in 1948 to II V 2 Induifry-Mix 40 percent in 1963. The other eight states in the Ragional-Shara Twelfth District, with $22.6 billion in per 30 sonal income, have raised their share of the -National Growth U. S. total from AV2 to almost 5 percent in 20 the same period. 1948 Income Until recently, m ost observers have found 10 it difficult to quantify the factors that created this dram atic record of growth. B ut now, + A through the use of a new statistical approach u — developed principally by the economists Mountain C a lifo rn ia N o r t h W«st Edgar S. D unn and R. E. G raham , Jr., and Source: U. S. D epartm ent of Commerce. applied by G raham in his article in the April issue of the Survey o f Current Business— the other two com ponents— the elements which industrial sources of W estern growth can be make for a difference in the growth rate of precisely identified. the W est and the nation— come under the In this approach, total personal income is heading of “ industry-m ix” and “ regionalbroken into two categories: income re share” effects. ceived by workers and proprietors for their The industry-m ix effect stems from differ participation in current production (partic ences in income structure of the W est and the ipation incom e), and non-production income nation. The effect is m easured by applying to received by persons from investments or from each W estern industry in the base year social security and other transfer payments. (1 9 4 8 ) the difference between the national The analysis concentrates on participation in growth rate in that industry and the national come, which not only accounts for the vast all-industry growth rate. W here the form er bulk of total income but also can be studied is larger, the industry obviously is a rapidon an industry-by-industry basis. growth industry, and it gives a special boost F ew HH Three components of growth 148 To analyze the factors making for the W est’s growing share of participation income, the total growth increm ent is dissected into three com ponent parts. The first com ponent is due to the overall growth of the national economy; it is com puted on the assumption th at the lack of differences in regional char acteristics would cause each area to grow at the same rate, so that each area’s share of the national total would rem ain unchanged. The to area growth, with the size of the increm ent determ ined by the am ount of the industry lo cated in the area. Thus, since the D istrict specializes in this type of rapid-growth indus try— with some notable exceptions such as agriculture— it has increased its share of the U. S. income total during the postw ar period. The regional-share effect stems from re gional shifts within individual industries. The effect is calculated by applying to each area industry in the base year (1 9 4 8 ) the differ M O NTHLY REVIEW July 1 9 6 4 ence between the percentage change in that industry in the area and the percentage change in the same industry nationally. Thus, since District industries generally have grown fast er than their national counterparts, they have added to the D istrict’s overall growth during the postwar years. Mix plus share equals growth In the W est as in the rest of the nation, regional-share effects played the dom inant role in determining net changes in the geographic distribution of participation income between 1948 and 1962 (the last year for which de tailed data are available). But, unlike the rest of the nation, the D istrict benefited from both factors; the region’s favorable industry mix added $1.5 billion to its relative growth dur ing the period, while its superior competitive position added a massive $9.5 billion through the regional-share component. In practically all other regions, the two components of change moved in opposite di rections. In the industrial centers of the N orth east and G reat Lakes regions, a favorable industry mix brought about substantial rela tive gains, but these were far outbalanced by a deteriorating competitive position vis-a-vis the rest of the nation. Conversely, in the lessdeveloped South and Southwest, an unfavor able industry mix (based on a declining agri cultural sector) brought about substantial relative losses, but these were countered by strong gains incurred through the regionalshare effect. Only the W est exhibited the type of strong and balanced growth which perm it ted income gains through both effects. Not unexpectedly, however, the dissimilar District states recorded somewhat dissimilar perform ances over the postw ar period. C al ifornia’s relative gain through its favorable industry mix was bettered only by one state (New Y o rk ), and its increasing competitive strength gave it a regional-share gain far sur passing that of any single region in the entire country— even the rapidly growing Southeast. O n the other hand, the Pacific Northwest (W ashington and O regon) suffered relative declines through both effects, while the M oun tain states (A rizona, Utah, Idaho, and N e vada) scored strongly through an increasing regional share but lost slightly through an un favorable industry mix. (D etailed data are unavailable for A laska and H awaii.) District contains m ixtu re of fast- and slow-growing industries, but most regional industries grow faster than national counterparts REGIONAL-SHARE EFFECT IN D U S T R Y - M I X EFFECT -3.0 -2 .5 -2.0 Btl lion s of D ollars -.5 0 .5 "T“ B illio n s of D o llars -.5 0 .5 I.' 1.0 1.5 Agriculture Mining Construction E le c tric a l Machinery Metals; Ordnance A ircraft Other Manufacturing Trade Finance Services Transport; Utilities S ta le -L o c a l Government Federal Government N ote: Asterisk denotes $10 million relative decline for California mining. Source: U . S. D epartm ent of Commerce. 149 FEDERAL RESERVE BANK Taking all these factors into account, total participation income from current production increased almost 1 0 0 percent in the rest of the country in the 1948-62 period. The N orth west just about equaled that overall gain, but California and the M ountain states both out matched it with overall gains of about 175 percent. (Incidentally, the same general p at tern was visible in other types of income. O ut side the D istrict, property income increased by almost 150 percent and transfer income by almost 200 percent; the Northwest record ed quite similar increases, but California and the M ountain states experienced far more substantial gains.) Pinpointing the sectors 150 These sum m ary figures, however, fail to pinpoint the specific sectors which have brought about the differential growth of the District. To do this, it is necessary to identify those fast- or slow-growing industries that are concentrated in the D istrict (the industry-mix effect), and to identify those industries that are growing faster or slower here than they are elsewhere in the nation (the regional-share effect). In G raham ’s analysis, 34 industries are analyzed in this m anner, but they can be regrouped into 13 m ajor categories. Each of the D istrict’s regions showed a similar industry-m ix effect; five slow-growing sectors adversely affected area growth, while eight fast-growing sectors contributed to a favorable effect. Agriculture was the dom i nant negative factor, partly because its rapid productivity growth contributed to its slow income growth, but the concentration in the District of several other industries with belowaverage growth rates also contributed to the spotty industry-m ix perform ance. Trade, transportation, mining, and non-defense m an ufacturing (prim arily lumber, food, and oil refining)— sectors which, despite their abso lute growth, have lagged in relation to other sectors— provided a drag on California’s dif ferential growth and actually created a neg OF SAN FRANCISCO ative industry-mix effect for the N orthw est and M ountain states. The postw ar expansion of state, local, and Federal government activities— traditionally strong contributors to D istrict growth— m ean while created a strong positive industry-mix effect. The same was true, to almost the same extent, of finance, services, and construction. A significant relative gain was created also by the D istrict’s im portant defense-manufacturing sector, as a result of the defense-procurem ent shift in favor of W estern specialties such as aircraft and missiles. Striking regional-share gains As for the regional-share effect, California and the M ountain states showed striking post war gains, while the N orthw est suffered a small relative decline. C alifornia’s gain from that effect am ounted to m ore than half of its participation income in 1948, while the M ountain states’ regional share increased by almost as m uch as their entire participation income in that base year. The M ountain states increased their share of every m ajor industry— especially in con struction, trade, and services. By way of con trast, the N orthw est states experienced rela tive declines in those categories, and in lum ber m anufacturing and Federal G overnm ent payrolls as well. W ashington’s aircraft indus try was the only N orthw est industry to record a substantial increase in regional share dur ing the postwar period. California, as already noted, increased its regional share more than any single region in the entire nation. It failed to increase its share of Federal payrolls, and it even lost a small am ount of its share of the petroleum industry; in all other categories, however, the State’s relative gains were quite substantial. A bout half of its total gain came in m anufacturing— prim arily defense-related m anufacturing— again because of the strong postw ar trend in defense procurem ent in favor of California products. The State’s relative gains in trade, M ONTHLY REVIEW July 19 6 4 services, and state-local government also were very large. This, then, was the W est’s postw ar growth profile— a spotty mixture of both fast- and slow-growing industries, but a strong group ing of industries that far outpaced their na tional counterparts. The N orthwest, of course, was an exception; its industrial structure tended to be concentrated in slow-growing fields, and most of its industries also grew m ore slowly than their counterparts else where. The M ountain states’ structure was concentrated even more in slow-growing fields, but this unfavorable industry mix was more than offset by the region’s ability to increase its regional share of every single m a jor industry. California’s record, meanwhile, was almost unique. Despite the state’s con centration in several slow-growing sectors (notably agriculture), it still obtained a fa vorable industry mix, and at the same time it increased its regional share of m ajor indus tries to a surpassing degree. The High Cost of People State-local payrolls grow faster party— complete with horns, hats, balloons, and other regalia— in West than in rest of nation was held in Sacramento on June 30, as State Bi llio n s of Dollars officials fittingly celebrated the advent of a new fiscal year and a record-shattering C al ifornia State budget. The press failed to record any wholesale participation by taxpayers in the festivities, but the event served as a useful rem inder of the continued strength of the forces that have generated the rapid increases in state and local governm ent spending throughout the W est during the postw ar pe riod. But where have the m ajor increases oc curred? M ore im portant, will expenditures continue to rise at the same rapid pace dur ing the future as well? A n ew y e a r ’s eve Source: U . S. Departm ent of Commerce. The state and local government sector has been a m ajor contributor to growth, as well as a m ajor cost of growth, throughout the postw ar period. F or example, state-local payrolls in Twelfth District states amounted to $ 6 billion in 1963— roughly one-twelfth of total personal income in that year. But pay rolls and other expenses have persistently ex hibited a rapid growth rate; in one typical five-year period (1 9 5 7 -1 9 6 2 ), D istrict statelocal spending jum ped 61 percent, from $6.7 to $ 1 0 . 8 billion. People cost 60 percent more The high cost of people— the cost of pro viding an expanding package of public serv ices for constantly rising num bers of people— is the basic cause of the rapid expansion of payrolls and public facilities. The cost is met by 8,900 governmental units in the District — nine state governments, 1,373 cities, 234 counties, 6 6 townships, 2,897 school districts, and 4,320 special districts. A good indication of the purposes for which they spend their 151 FEDERAL R ESERVE BANK money (and the taxpayer’s) can be had from a functional analysis of expenditures for 1962, the last year for which data are available. The nine state governments in the Twelfth District raised $4.3 billion from taxes and fees in fiscal year 1962, and from the Federal G ov ernm ent they received grants totaling $1.5 billion. The states passed on $2.3 billion to their subordinate local governments, and this left them with $3.5 billion for their statewide responsibilities. 152 The local governments raised about $4.7 billion from their own sources— relying heavi ly, like local governments everywhere, on property taxes. From the Federal and state governments (predom inantly from the latter) they received $2.4 billion in grants, but they also transferred a small am ount of funds back to the state governments. A fter these ex changes, the D istrict’s local governments had about $7.0 billion at their disposal— half again as m uch as they raised on their own initiative. In addition to these sums, both types of jurisdictions obtained funds from the m arket ing of new bond issues and from other sources. Taking into account these additional funds and certain statistical discrepancies, the total am ounts expended in the District in fiscal 1962 were almost $3.7 billion for state gov ernm ents and about $7.1 billion for local gov ernm ents. (These figures represent “ direct general expenditure” and exclude the expend itures of state-operated public utilities, in surance trusts, and liquor stores.) B oth totals were strikingly larger than they were just a half-decade before. State governments have concentrated their direct spending in the fields of education and highways. Even so, the local governments have been pouring three times as much money into education as the states; in addition, they have shouldered m ajor burdens in the fields of public welfare, streets and highways, health, and general administration. Both state OF SAN FRANCISCO and local governments pay for a host of other functions, and in addition allocate about 2-3 percent of their income for interest on gen eral debt. The cost of children Education is the m ajor cost item, account ing for almost 40 percent of total state-local spending in the D istrict in fiscal 1962. M ore im portant, the total increased almost 70 p er cent, to $4.2 billion, in the 1957-62 period alone. D istrict leaders obviously are well aware of the crucial im portance of education to economic grow th; in fact, the District pays 19 percent of the nation’s total public educa tional bill, even though it accounts for only 14 percent of the U. S. population. O n a per capita basis, it paid $161 in 1962 as against a national average of $ 1 1 B. The high level of school spending results in part from the fact that the D istrict contains relatively more children of school age than the rest of the nation; in 1962, District school enrollment am ounted to 22.5 percent of the total population, com pared with 20.9 percent elsewhere. But the D istrict also spends more on each pupil than does the rest of the nation; outlays in 1962 averaged $412 per student here as against $364 elsewhere. The requirements in each state depend in part on population density. G enerally speak ing, per pupil costs are higher in sparsely populated regions than in other areas— and the District contains some of the most sparse ly populated states in the country. O f its nine states, only California and Hawaii are above the national average in population den sity; W ashington is slightly below the average, and the other states have less than half the density of the nation as a whole. A laska has about two squares miles of land for every per son living in the State, and A laska thus ranks second only to W yoming in the am ount of money required per student. Extensiveness of educational facilities is M O NTHLY REVIEW July 1964 Schools and high w ays dominate state-local government budgets P«rc«nt Of TOSOI 0 10 20 30 40 an even greater determ inant of school costs— as is evidenced in the case of California. T hat State, with its large population and broad educational program , spends more on public education (at all levels ) than any other state in the nation. It has well over half of all the D istrict’s school children, and it accounts for nearly two-thirds of the D istrict’s total out lays for local schools. The network of state colleges and universities also adds substan tially to California’s educational expenses: at least one-fourth of those expenses are allo cated to higher education. The cost of cars Construction and m aintenance of high ways, roads, and streets is the second largest cost item; it accounted for about 15 percent of total state-local spending in the District in fiscal 1962. Between 1957 and 1962, spend ing in this category rose 44 percent, to $1.6 billion. The growing population of cars and trucks is of course a m ajor cause of the grow ing cost of roads; the total num ber of motor vehicles has been rising about AVz percent annually in the District, but only about 3 p er cent elsewhere. The annual count in mid1963 showed the D istrict with 12 million of the country’s 75 million vehicles. Twelfth District states allocate substantially more for highways, on a per capita basis, than do other states. (T he comparative figures for 1962 were $60 and $55, respectively.) Cali fornia naturally spends more on its highways than do the other parts of the region. But on a per capita basis, the greatest costs are in curred by the states with the greatest distances to be covered between communities— Idaho, Nevada, and, above all, Alaska. Highway financing depends chiefly on motor-fuel tax revenues, which are specifi cally reserved (generally by constitutional am endm ent) for highway construction and m aintenance. To keep pace with the growing volume of expenditures, fuel tax rates have been raised during recent years. W ashington increased its tax rate from 6.5 to 7.5 cents per gallon in 1961. A laska and Hawaii both intro duced m otor fuel taxes for the first time in 1959, and A laska later raised its rate from 5 to 8 cents per gallon. In 1963 A rizona raised its rate from 5 to 6 cents per gallon, and Cali fornia went from 6 to 7 cents. District states also have been receiving about one-sixth of the grants-in-aid provided by the Federal G overnm ent for highway con struction, The bulk of the grants have been made for the Interstate Highway System, for which the Federal G overnm ent pays 90 per cent of the cost. (F o r other roads, it gener ally pays half the cost, but it assumes a larger share when roads are built in states where public lands make up more than 5 percent of the total state area.) T he D istrict’s share of the Federal grants corresponds roughly to the proportion of the Interstate Highway System that will lie within the D istrict’s borders— which will be about 7,000 of the total mileage of 41,000. The cost of community Public welfare expenditures and health and hospital expenditures are the next largest cost items, after education and highways; these 153 FEDERAL RESERVE BANK items accounted for roughly 8 and 6 percent, respectively, of total District spending in 1962. Over the preceding five-year period their cost rose 46 percent, to $1.6 billion; thus, these items together grew just as rapidly as highway spending. OF SAN FRANCISCO Per capita spending ranges from $311 to $551 in District states EXPENDITURES Dotlars 400 200 UNITS 0 P er capita welfare payments averaged $34 in the District in 1962. Several states spent less than the national average of $27, but high rates of spending by the Pacific Coast States raised the D istrict average far above the na tional per capita figure. California spent more than $38 per capita— a level exceeded only by four other states. The Federal Governm ent provided about 43 percent of the total welfare bill, although it does not participate in the adm inistration of m ost welfare programs. In the District, as elsewhere, adm inistration of most local pro grams has been handled by counties, with the state governments controlling the size of the payments to recipients and the requirements for eligibility. H ere, as elsewhere, high-income states generally have paid higher aver age benefits, while less-prosperous states have paid smaller individual payments but have been faced with relatively more families re quiring assistance. In the health field, most D istrict expendi tures in 1962 were used for the construction, operation, and m aintenance of public hos pitals. Per capita payments varied widely from the $26 D istrict norm, with Alaska spending almost twice as much as the national per capita figure of $23. Incidentally, this pro gram is financed somewhat differently from the welfare program ; the Federal Governm ent spends nearly $ 2 billion annually for direct support of public hospitals and other related activities, and the states then raise other funds for additional health and hospital financing. 154 In addition to the m ajor categories listed above, D istrict states and their subdivisions spent about $130 per capita in 1962 for other activities. (T he national figure was $97.) A t N ote: Chart shows numbers of u n its of local governm ent and per capita expenditures of state-local governm ents, by state. Source: U. S. Bureau of the Census. both state and local levels, expenditures were incurred for the operation of the judicial, leg islative, and executive branches of govern ment, and the local governments also devoted a considerable part of their budgets to police and fire protection, sanitation, and local park and recreation programs. Finally, more than $ 1 1 per capita went to pay the interest on debts which these governments have accum u lated over the years. How large a package? The total D istrict bill for education, high ways, welfare, health, and other state-local services in 1962 was $10.8 billion— 61 p er cent more than it had been just five short years before. Will spending necessarily rise that rapidly in the future as well? Pondering that question recently, economist C. Lowell H arriss discerned a group of factors that would tend to increase spending, but he also found several others that would tend to limit further increases, both here and in the nation as a whole. (His comments are found in the Jan u ary Tax R eview .) Among the hopeful signs for taxpayers, Professor Harriss foresees a slowdown in the July 196 4 M ONTHLY REVIEW price increases that have characterized the postw ar period— a period in which prices of state-local purchases have increased twice as rapidly as prices of other items in the national economy. These price increases, among other things, have raised the state-local salary level to the level of private industry, and for that reason the earlier pressure to catch up is now somewhat lacking. A second restraining factor probably will be revenue stringency. F o r one thing, law makers may decide that the task of attracting new business precludes the imposition of tax burdens higher than those effective elsewhere. F o r another thing, state and local govern ments may find that the Federal program of reduced taxes and stable spending precludes the continued rapid expansion of grant-in-aid programs. (F o r the nation as a whole, Fed eral grants jum ped from $4.1 billion in 1957 to $7.7 billion in 1962.) Against these and other restraining factors — such as the continuing search for greater operating efficiency— a num ber of factors can be cited which are likely to expand state and local spending, in the District and in the rest of the nation as well. Necessary improvements in education, highway, welfare, police pro tection, and the like will lead to increased costs in practically every jurisdiction. So, too, will the pressure generated by the public and by public adm inistrators for expanded serv ices. Built-in expenditure increases — as in debt service, pension commitments, and auto matic salary increases— are another expan sionary force, and so also is the necessity to replace facilities at much higher cost levels than those at which they were first built. M oreover, per capita expenditures may con tinue to rise, as they have in the past, in tan dem with the increasing urbanization of the Western population. (O n the other hand, Alaska and other thinly-populated areas may realize some economies through increased population density.) These expansionary factors will now be strengthened, according to many legislative observers, by the greater voice given to the urban population by the Supreme C ourt’s re cent ruling that state legislatures must be apportioned on the basis of equal population. Over the long run. the ruling may well lead to stronger dem ands for expensive urbanoriented program s in the fields of education, welfare, and rapid transit. The restraints on increased spending will be strong, as Harriss notes, but (if recent history is any guide) the taxpayer will continue to pay more for the expanding package of public services which he demands. 155 FEDERAL RESERVE BANK OF SAN FRANCISCO Western Digest Banking Developments In June, total bank credit at weekly reporting m em ber banks in the Twelfth D istrict rose $433 million. This com pares with a June-1963 gain of $560 million. . . . Loan expansion accounted for two-thirds of the June increase and purchases of municipals and Federal Agency securities made up the rest of the gain. Loan demand was strongest from business, nonbank financial institutions, consum ers, and governm ent securities dealers. . . . Business borrowing over the corporate tax date was greater than a year ago— but it was less for the m onth as a whole— while the expansion in mortgage holdings was almost two-thirds sm aller than in June 1963. Employment and Unemployment Em ploym ent declined during June in the nation as a whole, but trends were mixed in m ajor District states (seasonally adjusted basis). Largely because of a drop in farm jobs, C alifornia’s total job count rem ained steady and W ashington’s declined. . . . C alifornia’s unemployment rate edged up to 6.0 percent in June; it had already risen, from 5.7 to 5.9 percent, between A pril and May. W ashington followed a similar trend, with the jobless rate rising from A pril’s 6.4 percent to 6.7 percent in June. The national rate, which had dropped from 5.4 to 5.1 percent between April and M ay, rose again to 5.3 percent in June. (All rates seasonally adjusted.) . . . C alifornia’s total employment held steady at about 6 . 6 million, with a small increase in nonagricultural employment being largely offset by a decline in farm employment. Total em ployment in W ashington dipped during June— from 1.06 to 1.05 million— again as a result of relative weakness in agricultural employment. . . . The declining trend of employment in defense-related industries continued in C al ifornia, with a drop from 511,000 to 507,000. In W ashington, employment in this sector levelled off, at least tem porarily, at 60,000. Production and Trade Receipts from District farm marketings in M ay dropped 2.6 percent below the year-ago total, with both crop and livestock sales contributing to the decline. In the three preceding m onths, returns exceeded 1963 levels— but the im provem ent in receipts came about only because of heavier marketings, since m ost prices were below year-ago levels. In M ay, however, the volume of m arketings was not sufficient to offset the price decline. . . . D istrict crop prospects are mixed. M ost dry land crops reflect the lack of moisture early in the growing season. F o r example, indi cated wheat yields are considerably lower than last year in all m ajor w heat-producing states of the D istrict except W ashington. However, the output of irrigated crops, such as fruits, is expected to be larger than in 1963 despite freeze dam age to the apple and grape crops. . . . During the four weeks ending June 20, D istrict depart ment store sales were 7 percent higher than during the corresponding period a year ago. F or the nation, they were 6 percent higher. 156
@FedFRASER