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The Regional Economist January 2003
■

www.stlouisfed.org

President’s
Message
On a light-rail tour of
the East St. Louis area,
President William Poole
asks the guide a question
about redevelopment
along the train’s route.

The Fed Lends a Helping Hand—and Sometimes a Push
f you were to poll the citizenry about what the Fed does, most would probably say something about
setting interest rates. Others might be familiar with our role in supervising banks. A smaller minority
might have heard about our third main responsibility, that of providing financial institutions with check
processing, electronic funds transfers and similar services—just like the “real” big banks do. I’m betting,
however, that few would venture to say that the Fed is involved in revitalizing our inner cities.

But that was the goal of the St. Louis
Fed in organizing a conference on this
topic last fall in East St. Louis, Ill., long
the poster child for cities in distress.
More than 150 people from around the
country gathered to talk about housing,
jobs, financial education, reuse of
abandoned industrial sites and similar
needs in East St. Louis and other distressed urban areas. Similar efforts
have been undertaken by other Federal
Reserve banks, with the focus just as
often being on the needs of rural areas.
When people find out that the Fed
does such things as organize community investment fairs and research the
credit needs of the Mississippi Delta,
they sometimes ask why we don’t flex
our muscle more where help is needed
the most. Why don’t we create money
just for cases like East St. Louis? Why
don’t we lower interest rates for those
willing to invest in such areas? But
such approaches don’t work, as other
central banks have learned. Relying on
national monetary policy, we couldn’t
stimulate the economy in East St. Louis
without overheating it in surrounding

areas that are already better off. Even
if the Fed pumped reserves into the
banking system in the East St. Louis
area to lower rates there, that money
would quickly be gobbled up by
bankers and brokers elsewhere, who
would take advantage of the rate differential to make a profit. Rather than
try such tactics, the Fed believes that if
it sticks to its main goal—of keeping
inflation low and stable—everybody’s
boat will have a better chance of floating a bit higher.
This limited role doesn’t mean the
Fed has little interest in community
development. As the recent conference
demonstrates, the Fed brings lenders
and investors together with neighborhood activists, foundations, government agencies and others to try to find
ways to get needed projects off the
ground. For leverage, the Fed has the
Community Reinvestment Act of 1977.
This law tells federally regulated financial institutions that if they want
approval to buy, sell or expand, they
must have a track record of providing
credit access to all parts of their com[3]

munity, including low- and moderateincome areas. CRA doesn’t force banks
to throw away money on such projects,
but to find a way to make them profitable. It can be done — even in East
St. Louis, as can be seen in the recent
construction of a hotel, community
center, strip shopping center and several
hundred townhomes.
Through its Community Affairs
Offices, the Fed provides a host of
other assistance in this vein: from
workshops on building wealth, to
“how-to”manuals for community
developers, to research by economists
on what works and what doesn’t.
If you’ve got other ideas on how we
can help foster development in your
community, please contact us at communityaffairs@stls.frb.org.

William Poole, President and CEO,
The Federal Reserve Bank of St. Louis

The Regional Economist January 2003
■

www.stlouisfed.org

BY KEVIN L. KLIESEN

he 20th century saw a significant increase in the size and scope of government. Important factors behind this increase included two world wars, an
economic depression in the 1930s, a significant expansion of the welfare
state in the early 1960s and an upsurge in environmental regulation in the
1970s. But with the federal government in a deregulatory mode since the early
1980s and with the end of the Cold War in 1989, growth of government spending and of regulatory intervention was rolled back during the 1990s. This development, combined with stronger-than-expected economic growth, helped
to produce relatively large budget surpluses from 1998 to 2001 and even larger
projected budget surpluses for future years.
These surpluses gave policy-makers the impetus to boost spending in areas
outside defense and entitlement programs. Then, in the aftermath of events of
Sept. 11, 2001, spending on defense also jumped. But
government is not just spending more, it is also regulating
more—partly in response to corporate accounting
scandals; partly because of the drubbing in the
stock market, which sharply reduced the value
of 401(k)s and household wealth; and partly
in response to the war on terrorism.
Is big government staging a comeback?

[5]

The Regional Economist January 2003
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www.stlouisfed.org

BY KEVIN L. KLIESEN

[5]

The Regional Economist January 2003
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www.stlouisfed.org

Rise of the Welfare State

Before the 20th century, government
at all levels (federal, state and local)
extracted a relatively small slice of
national income, chiefly through taxes
on economic activity that affected a
small percentage of the population.
These included taxes on imported goods
(tariffs), excise taxes and property taxes.
U.S. fiscal policy began to change during
World War I and, especially, the Great
Depression, when a significant expansion
of the U.S. government occurred. Indeed,
the foundation of the modern welfare
state was laid during the 1930s, which
saw social upheaval caused by financial
market calamity and by a significant
migration of the population from rural
to urban areas.
With the unemployment rate rising to
about 25 percent in 1933, and with more
than 9,000 bank failures between the
stock market crash in October 1929 and
March 1933, the public sector began to
regulate the private sector as never
before. Industries that fell under closer
government scrutiny, not surprisingly,
included banking and finance. At the
same time, individuals, families, retirees
and small farmers were provided a measure of income security not seen heretofore. This activism, accordingly, required
a considerable amount of resources.
Rise of the Regulatory State

The government’s expanding role
in the economy can be measured in a
couple of different ways. One way is to
look at the level of regulation.
The transformation of the
U.S. government from
a largely laissez faire
entity to one more
actively engaged in the
regulation of private commerce began, to a large extent,
in response to the rise of the
industrial and financial barons
in the 19th century. For
example, many of the
large firms headed
by these barons—
firms like
Carnegie Steel and
Standard Oil—were
essentially monopolies and
able to exert control on production and market prices.
The first permanent regulatory agency to combat these
forces was the Interstate Commerce Commission, created in
1887 to foster competition in
the railroad industry.
Roughly 20 years
later, the food
and medicine
[6]

industry began to get closer scrutiny with
the Pure Food and Drug Act of 1906 and
the Meat Inspection Act of 1907. The
Federal Trade Commission was created in
1914. A series of financial calamities and
bank runs in the late 19th and early 20th
centuries finally induced Congress and
President Woodrow Wilson to create the
Federal Reserve System in 1913, the same
year that the modern personal income
tax was permanently instituted.
The regulatory powers of the federal
government were expanded further during the Depression, when segments of
the public clamored for greater oversight
of the nation’s financial system following
the stock market crash in 1929 and the
numerous failures of banks that followed.
Regulatory agencies that had their beginnings during the Roosevelt administration
included the Federal Deposit Insurance
Corp. and the Securities and Exchange
Commission, both in 1934, and the
National Labor Relations Board in 1935.
The next big push in government regulation at the federal level occurred during
the 1960s and 1970s. The Equal Employment Opportunity Commission (1965),
the Environmental Protection Agency
(1970) and the Occupational Safety and
Health Administration (1970) were
among the new agencies established to
regulate private business activity. The
implementation of temporary wage and
price controls by the Nixon administration in 1973 represented an even more
onerous level of regulation.
By the end of the 1970s, something
was clearly awry. Ominously, productivity growth, which determines how fast
the nation’s living standard increases,
had decelerated sharply. After growing
by an average of 3 percent per year during the 1950s, living standards (real Gross
Domestic Product per capita) grew by
only 2.2 percent a year during the 1960s.
The economy’s performance deteriorated
further between 1969 and 1982: After
four recessions, a debilitating war and
two major oil price shocks, growth of U.S.
living standards slipped to a 1.4 percent
annual rate.
Some economists and policy-makers
came to believe that one additional factor
sapping the nation’s growth was the
rapidly rising estimate of the cost of
complying with new government regulations. According to one study, the cost of
regulatory compliance totaled $623 billion in 1979 (1995 dollars), roughly 13
percent of real GDP. 1 But those direct
costs tell only part of the story: These
costs do not account for the output lost
by the disincentives that they impose on
businesses and consumers.
In response, the pendulum began to
swing modestly back toward less government intervention and freer markets in

the late 1970s. Sectors that saw active
deregulatory efforts included the energy
and transportation industries and the
financial sector. This trend continued
into the 1980s, as estimated real regulatory compliance costs fell about 10 percent, while real GDP rose a little more
than 30 percent. By 2001, estimated real
compliance costs totaled $854 billion, or
a little more than 9 percent of real GDP. 2

Figure 1

Government Receipts as a Share of GNP/GDP
Percent
35
30
Total Government

25
20

Trends in Government Taxation

The second way to measure the
expanding size of the public sector in the
20th century is by the amount of privatesector resources that are claimed by all
levels of government. Figure 1 shows that
prior to World War I, federal government
receipts as a share of GNP/GDP were
steadily declining, from about 3 percent
in 1900 to a little more than 1.5 percent
by 1916. Over this period, receipts
claimed by state and local governments
were larger so that total government
receipts remained roughly constant at
about 7.5 percent of GNP from 1900 to
1913. (Only partial data exists for receipts
for state and local governments and,
hence, total government receipts, before
1929. Before then, we used Gross
National Product.) The surge in federal
government receipts associated with
financing World War I was brief, as this
share subsequently fell back to about
2.5 percent by 1931. Still, total government receipts remained near their postWorld War I peak of nearly 13 percent
because taxes collected by state and local
governments remained high.
Two key developments occurred during
the 1930s. First, the size and scope of the
federal government began to rise rapidly,
which displaced many of the activities that
state and local governments were accustomed to providing. Accordingly, federal
receipts as a share of GDP jumped
roughly three-fold between 1931 and
1940, while the share of state and local
receipts fell back to just over 8 percent by
1940. The second key development was
the financing of World War II. Although
the government largely financed the war
through the issuance of debt, federal
receipts as a share of GDP nonetheless
rose to an all-time high (up to that point)
of almost 20 percent by 1943. The rising
share of federal receipts displaced state
and local governments’receipts further.
By the end of the 20th century, state and
local governments’take of private-sector
income was about the same as it was at
the beginning of the Great Depression,
but rising federal receipts caused total
government receipts to reach an all-time
high in 2000.
The direct manifestation of government taxation is government spending.

15
Federal

State and Local

5
0
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Figure 2

Government Expenditures as a Share of GDP
Percent
40
35
Total Government

30
25
20

Federal

15
10

State and Local

5
0

1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001

As seen in Figure 2, government spending
at all levels trended steadily higher, reaching a little more than 32 percent of GDP
by 1992. A goodly part of this increase
was at the state and local level, as expenditures on Medicaid and education began
to rise sharply. Since then, government
expenditures have drifted lower, paced by
reductions at the federal level.
Bigger and More Activist?

The latter half of the 1990s saw a
tremendous change in the federal government’s budget outlook. Specifically,
large 10-year deficit projections were
replaced by large prospective surpluses.3
After running deficits that averaged
almost $200 billion a year from 1989 to
1997, the federal government recorded a
budget surplus of $69.2 billion in fiscal
year 1998. This was the first surplus in
more than 25 years. Over the next two
years, as the economy strengthened, the
federal surplus nearly quadrupled, rising
to just under $240 billion in fiscal year
2000, or 2.4 percent of GDP. Given reasonable assumptions about the underlying strength of the economy and
[7]

FIGURE 1 NOTE: Prior to 1929, series
represented as shares of GNP. Receipts
for state and local governments are
incomplete between 1900 and 1929.
SOURCE FOR BOTH FIGURES: U.S.
Department of Commerce, Bureau of
Economic Analysis. Data prior to 1929
are from the U.S. Department of the
Census (1975).

The Regional Economist January 2003
■

www.stlouisfed.org

Rise of the Welfare State

Figure 1

Government Receipts as a Share of GNP/GDP
Percent
35
30
Total Government

25
20

Trends in Government Taxation

15
Federal

State and Local

5
0
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Figure 2

Government Expenditures as a Share of GDP
Percent
40
35
Total Government

30
25
20

Federal

15
10

State and Local

5
0

1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001

The Regional Economist January 2003
■

www.stlouisfed.org

prospective trends in government expenditures, the Congressional Budget Office
(CBO) projected in May 2001 that federal
surpluses would total just over $5.6 trillion between fiscal years 2002 and 2011.
Table 1

Changes in Budget Projections
Percent of Nominal GDP
Revenues
Individual Income
Corporate Income
Social Insurance
Other
Total

1999

2000

2001

Jan. 2002

Aug. 2002

9.6
2.1
6.9
1.6
20.2

9.8
1.7
6.8
1.6
19.8

10.2
1.9
6.6
1.5
20.3

9.2
1.8
6.8
1.3
19.1

8.9
1.7
6.8
1.3
18.8

Outlays
Discretionary Spending
Mandatory Spending
Net Interest
Total

5.3
12.1
1.2
17.7

5.7
11.2
1.1
17.2

5.8
10.9
0.8
16.5

6.4
11.3
1.4
18.2

6.7
10.6
1.6
18.9

Deficit (–) or Surplus

2.5

2.6

3.8

0.9

–0.1

SOURCE: Congressional Budget Office (various years).

Each column shows the baseline projection made by the Congressional Budget
Office in that year for the period 200309. The numbers in each column represent that category as a percent of
nominal GDP.

The shift from deficits to surpluses
arose for many reasons, but three stand
out. First, with the end of the Cold War,
government expenditures on defense
were trimmed sharply. Second, the
Budget Enforcement Act of 1990 restricted
spending by instituting—among other
budgetary rules—caps on discretionary
spending and pay-as-you-go budget
rules, which required that changes in
mandatory spending or revenues be
budget-neutral.4 These two developments helped to slow the growth of total
government expenditures appreciably.
Finally, on the revenue side, the combination of above-trend economic growth
beginning in 1997 and an exuberant
stock market led to sharply higher government receipts. By 2000, total government receipts as a share of GDP
measured 30.5 percent, an all-time
high. (See Figure 1.)
The pendulum has now swung modestly in the opposite direction. In its
August 2002 report, the CBO projected
a cumulative budget surplus of just over
$1 trillion for fiscal years 2003-12, about
$1.4 trillion less than the March 2002
projection and several trillion less than
the May 2001 projection.5 The change
in the budget outlook suggests that the
three positive budgetary developments
mentioned earlier were temporary aberrations.6 If so, the debate over when, or
whether, the federal government will ever
post another unified budget surplus may
be moot. That is, there is significant
probability that the size and scope of the
federal government are poised to expand.
[8]

Post-Sept. 11 Fiscal Policy

Gauging the future size of government is difficult during a period when the
government is actively trying to jumpstart the economy. In particular, the
levers of both monetary and fiscal policy
were engaged quite strongly during the
2001 recession—both before and after
Sept. 11. Moreover, because the recovery
was not proceeding at the vigorous pace
that typically occurs following a recession, policy-makers undertook additional
stimulative monetary and fiscal actions in
2002. But with the myriad of new challenges faced by public policy-makers and
private businesses in the post-Sept. 11
environment, there is concern that the
period of minimalist government and of
freer markets that has prevailed over the
past 20 years or so may be ending. This
view is by no means universal, though.
According to a recent survey of business
economists conducted by the National
Association for Business Economics,
roughly three out of four disagreed with
the assertion that the United States had
“entered an activist policy regime.” 7
If, however, we have entered a more
activist policy regime, there is some evidence that the public is more amenable
to such a development than in years past.
According to a recent Gallup Poll, the
public’s confidence in the executive and
legislative branches of government has
been on the upswing over the past five
years and, in the case of the executive
branch, rivals the confidence levels seen
in 1972 (pre-Watergate).8 In this regard,
probably the single-most important event
that has galvanized the public’s confidence
in government was the public policy
response to the Sept. 11 terrorist attacks.
According to the Office of Management and Budget (OMB), the federal
government has implemented 41“significant”federal regulations in the six months
following the Sept. 11 attacks.9 These
included rules pertaining to domestic
security, immigration control, airline safety, financial disclosures and economic
assistance to businesses harmed by the
direct effects of the attacks.
In light of the government’s response
to Sept. 11, the public might also be more
inclined to look for activist policy actions
in other areas. Financial and corporate
accounting scandals over the past year,
and the stock market meltdown, put
emphasis on renewed regulation in private
pensions and corporate governance. In
response, Congress passed and President
Bush signed the Sarbanes-Oxley Act,
which may be the most encompassing
overhaul of federal securities regulation
since the SEC Act of 1934. Among other
things, the Sarbanes-Oxley Act establishes
a Public Company Accounting Oversight

Board and a new set of mandates for
CEOs and CFOs that potentially exposes
them to increased liability for corporate
financial misconduct.10
But even before Sept. 11, 2001, federal
regulatory spending was on the upswing.
According to a recent study, real federal
spending on regulatory activity posted
average annual increases of about 2 percent per year during the 1980s and the
first half of the 1990s and then a bit less
than 4 percent per year from 1995 to 2000.
Then, real federal regulatory expenditures
jumped 8 percent in 2001; they are estimated to have surged 14.5 percent in
2002.11 Although they are only over two
years, these increases rival the roughly
9 percent rates of growth seen during
the 1960s and 1970s.
Increased spending on new regulations
is one reason why government outlays are
on the rise. Another reason is that policymakers viewed the large budget surpluses
that were being projected in 2001 as an
opportunity to ramp up the path of federal spending. This can be seen in Table 1,
which depicts, as a percent of nominal
GDP, projected cumulative total federal
outlays, discretionary and mandatory outlays, net interest payments and the unified budget deficit for fiscal years 2003 to
2009. For example, in 1999, CBO projected that cumulative—that is, the sum for
each of the years—federal government
outlays for the years 2003 through 2009
would average 17.7 percent of GDP. At
the same time, projected revenues were
expected to average 20.2 percent of GDP
from 2003-09. The projected path of revenues and outlays was thus expected to
produce a surplus that averaged 2.5 percent of GDP. By the time the CBO’s 2001
report was published, the agency was
projecting that this average surplus (for
years 2003-09) would increase to about
3.8 percent of GDP.
But as the latest projections (August
2002) show, the CBO now estimates that
the federal government will spend an
amount over the 2003-09 period totaling
almost 19 percent. All of this upsurge
in future spending is with discretionary
spending, such as defense, the 2002
Farm Security and Rural Investment Act
(Farm Bill) and net interest. But yet
another reason why spending is on the
upswing is the war on terrorism, something policy-makers and CBO forecasters could not have predicted in 1999
or 2001.
Although the CBO tends to use conservative economic assumptions when
making its projections, the inability of
forecasters to predict unforeseen events
is one reason why this assessment might
be understated. This helps to explain, as
Kliesen and Thornton (2001) showed, why
errors in projecting federal government

outlays five years into the future averaged
roughly 2.25 percent of GDP from 1976
to 1999. But there are other reasons why
the August 2002 projections for outlays
for 2003-09 are probably understated.
First, the CBO is required to assume a
permanent renewal of the Budget
Enforcement Act of 1990, which has
helped to restrain expenditures. Second,
the Balanced Budget and Emergency
Deficit Control Act of 1985 requires the
CBO to project annual increases in discretionary spending at the rate of inflation, roughly 3 percent per year from
2003 to 2012. But if discretionary spending grew at an average annual rate of
8.5 percent, which was the actual rate of
growth from 1998 through 2002, then
cumulative total outlays (discretionary
spending plus net interest) from 2003 to
2009 would be nearly $1.3 trillion higher,
or about 1.5 percent of GDP.
Finally, the CBO’s projections do not
incorporate commitments that the federal
government seems poised to make. These
include outlays for future war-like hostilities (and subsequent rebuilding efforts),
the homeland security legislation (passed
in November 2002) and a Medicare prescription drug program, which CBO estimates would add another $341 billion
in outlays over the 2003-12 projection
period. The latter is potentially very
important since the retirement of the
baby boom generation, by itself, will
exert a huge drag on the resources of
future workers (i.e., higher future taxes
and government spending). Hence, we
should not be so sanguine that, as projected, federal legislators will be slowing
the growth of government discretionary
spending after 2003.
A Cautionary Note

Entering the 21st century, the U.S.
economy is the strongest in the world,
with fairly strong productivity growth and
very low and stable inflation. Despite
one of the mildest recessions on record,
monetary and fiscal policy has been
extremely expansionary over the past
year. Few economists expect Federal
Reserve policy-makers to allow inflation
to become the problem that it was in the
1970s. On the fiscal side, however, the
upswing in government spending, buttressed by a more activist regulatory policy, suggests public policy-makers want
to rely less on market forces. If so, policymakers should be wary about repeating
past mistakes.
Kevin L. Kliesen is an economist at the Federal
Reserve Bank of St. Louis. Thomas A. Pollmann
provided research assistance.

[9]

ENDNOTES
1

See Hopkins (1996).

Measured in 2000 dollars.
See Crews (2002).

See Kliesen and Thornton (2001).

See Crippen (2001).

The CBO’s projections place the cause
of the decline in the surplus roughly
equally split between falling revenue
and rising expenditures. See
Congressional Budget Office (2002).

The CBO could not have foreseen the
events of Sept. 11, the subsequent war
on terrorism, the 2001 recession and
the plunge in equity values.

See NABE (2002).

http://www.gallup.com/poll/
releases/pr020902.

See Executive Office
of the President (2002).

See Blumenstein, Clowes, Holt
Frankle and Stanton (2002).

See Dudley and Warren (2002).

REFERENCES
Blumenstein, Paul; Clowes, J. Howard;
Holt Frankle, Diane; and Stanton,
Scott. “President Signs SarbanesOxley Act of 2002,”GrayCary law firm.
http://www.gcwf.com/articles/interest/
interest_55.html
Congressional Budget Office. “The
Budget and Economic Outlook: An
Update.”Report to the Senate and
House Committees on the Budget.
Washington, D.C., August 2002.
Crews, Clyde Wayne, Jr. “Ten Thousand
Commandments: An Annual Snapshot
of the Federal Regulatory State,”Cato
Institute. Washington, D.C., 2002.
Crippen, Dan L. “Extending the Budget
Enforcement Act.” Statement before the
Committee on the Budget, U.S. House
of Representatives, June 27, 2001.
Dudley, Susan and Warren, Melinda.
“Regulatory Response: An Analysis
of the Shifting Priorities of the U.S.
Budget for Fiscal Years 2002 and
2003,”2002-2003 Annual Report,
Regulatory Budget Report No. 24,
June 2002. Weidenbaum Center on
the Economy, Government, and
Public Policy at Washington University
in St. Louis; and the Mercatus Center
at George Mason University in
Arlington,Va.
Executive Office of the President. “Draft
Report to Congress on the Costs and
Benefits of Federal Regulations,”
Office of Management and Budget,
March 28, 2002. http://www.whitehouse.gov/omb/inforeg/cbreport.pdf.
Hopkins, Thomas D. “Regulatory Costs
in Profile,”Center for the Study of
American Business at Washington
University in St. Louis, Policy Study
No. 132, August 1996.
Kliesen, Kevin L. and Thornton, Daniel L.
“The Expected Federal Budget
Surplus: How Much Confidence
Should the Public and Policymakers
Place in the Projections?” Federal
Reserve Bank of St. Louis Review,
March/April 2001,Vol. 83, No. 2,
pp. 11-24.
National Association for Business
Economics News, NABE Panel Gives
Monetary Policy Rave Reviews But
Fiscal Policy Mixed; Double-Dip
Recession Unlikely. March/April 2002.
No. 150, p. 8.

The Regional Economist January 2003
■

www.stlouisfed.org

Changes in Budget Projections
Percent of Nominal GDP
Revenues
Individual Income
Corporate Income
Social Insurance
Other
Total

1999

2000

2001

Jan. 2002

Aug. 2002

9.6
2.1
6.9
1.6
20.2

9.8
1.7
6.8
1.6
19.8

10.2
1.9
6.6
1.5
20.3

9.2
1.8
6.8
1.3
19.1

8.9
1.7
6.8
1.3
18.8

Outlays
Discretionary Spending
Mandatory Spending
Net Interest
Total

5.3
12.1
1.2
17.7

5.7
11.2
1.1
17.2

5.8
10.9
0.8
16.5

6.4
11.3
1.4
18.2

6.7
10.6
1.6
18.9

Deficit (–) or Surplus

2.5

2.6

3.8

0.9

–0.1

SOURCE: Congressional Budget Office (various years).

Each column shows the baseline projection made by the Congressional Budget
Office in that year for the period 200309. The numbers in each column represent that category as a percent of
nominal GDP.

Post-Sept. 11 Fiscal Policy

[9]

ENDNOTES
1

See Hopkins (1996).

Measured in 2000 dollars.
See Crews (2002).

See Kliesen and Thornton (2001).

See Crippen (2001).

The CBO’s projections place the cause
of the decline in the surplus roughly
equally split between falling revenue
and rising expenditures. See
Congressional Budget Office (2002).

The CBO could not have foreseen the
events of Sept. 11, the subsequent war
on terrorism, the 2001 recession and
the plunge in equity values.

See NABE (2002).

http://www.gallup.com/poll/
releases/pr020902.

See Executive Office
of the President (2002).

See Blumenstein, Clowes, Holt
Frankle and Stanton (2002).

See Dudley and Warren (2002).

work, policy responses must follow
a pre-specified plan. The plan can
be non-activist in nature—the rule
may force policy-makers to pursue
the same course of action in all circumstances. Or the plan can be
activist in nature—the rule may
direct policy-makers to respond
to different circumstances in
different pre-determined ways.
The common denominator is
that rules are supposed to constrain policy-makers’actions in
advance. In the flooding example, a non-activist rule might
say: “no flood relief, period.”
An activist rule might limit
flood relief per victim to 10 percent of the pre-flood value of
damaged property—no matter
where it is located (floodplain or
no floodplain). This rule allows a
policy response to the flood, thereby
making it activist in nature, but that
By Jason J. Buol and Mark D. Vaughan
response is pre-defined.
In a discretionary framework, policymakers have wide latitude to design
Policy-makers do not want people to build homes in the best policy response for the given
floodplains. To discourage such building, they circumstances. In the flooding examannounce that anyone suffering flood damage is on ple, discretion means that policy-makers are free to craft disaster-relief policy
his own—no disaster relief will be forthcoming. anew in each period. Today, before
People ignore these warnings and build anyway. Then, flooding has occurred, they can try to
discourage floodplain construction by
the rain comes, the water rises and the homes flood.
forswearing disaster relief. Tomorrow,
if flooding occurs, they can renege and
The media carry heart-wrenching
today are time-inconsistent—they
provide generous compensation for
footage of rooftops poking out of
implicitly encourage floodplain condamages. Proponents of discretionary
roiling currents. Following a public
struction—because people learn to
policy note that such flexibility allows
clamor, policy-makers announce a
watch what policy-makers do (bail out policy-makers to respond to unforebailout—100 percent compensation
victims) and ignore what policy-mak- seen scenarios. Suppose, for example,
for flood-related damage. This result
ers say (build at your own risk). If,
a river that seldom floods rises above
offers the worst of both worlds—
somehow, threats of no relief could be its banks and sweeps away homes.
homes are destroyed by floodwater,
made credible, people would think
Under a discretionary regime, policyand victims who ignored warnings
twice before tempting Mother Nature. makers would have the flexibility to
are indemnified with taxpayer funds.
And no floodplain construction today bail out innocent victims. Under a
After the floodwater has receded and means no need for flood relief tomor- “no bailout, period” rule, all flood
the disaster checks have gone out,
row—a time-consistent outcome.
victims would be on their own.
the cycle starts all over again. How
Kydland and Prescott emphasized
can policy-makers avoid this trap?
the importance of pondering not only
Why Does a Rule Matter?
Economists Finn Kydland and
the desirable policy for a given set of
Edward Prescott were the first to offer
circumstances but also the framework
Rules are valuable, Kydland and
a way out.1 In a classic 1977 article,
likely to produce the best policy over
Prescott noted, because the public
they introduced a distinction between time. They went on to argue that
observes policy-makers and forms
time-inconsistent and time-consistent
rules produce time-consistent outexpectations of their likely actions.
policy. A time-inconsistent policy
comes because they make policyPolicy-makers with discretion can
may make the public happy in the
makers’pronouncements credible.
renege on today’s pronouncements
short run but will ultimately fail to
Kydland and Prescott’s emphasis on
tomorrow; so, the public may come to
produce the long-run policy goal. A
the importance of the framework—
discount such pronouncements as
time-consistent policy, in contrast,
and the value of credible rules—has
cheap talk. In the flood example, bailnails the long-run policy goal but
profoundly influenced the way other
ing out victims is desirable once the
does not make people unhappy in the economists think about policy.
water has receded. The public knows
short run. For example, the long-run
Indeed, even economists who dislike
this from studying the past behavior of
goal of flood policy is to prevent
rules couch their arguments in the
policy-makers. As a consequence,
building in floodplains. In the short
Kydland-Prescott framework.
promises that this time will be differrun, however, compassion dictates
Economists broadly categorize
ent—that this time no bailouts will be
bailing out victims—even those who
policy-making frameworks as either
forthcoming—may not be credible.
failed to heed warnings. Bailouts
rules or discretion. In a rules frameOnly a binding rule that keeps policy-

Rules
vs.
Discretion
The Wrong Choice Could Open the Floodgates

[10]

The Regional Economist January 2003
■

www.stlouisfed.org

makers from reneging will convince the
public that homes are at genuine risk
and, thereby, discourage floodplain
construction. Such a rule could be
made binding—and therefore credible—in a number of ways, say, by passing a constitutional amendment against
flood relief.
Kydland and Prescott were not the
first to comment on the value of policy
rules. Indeed, economists debated the
value of rules in monetary policy for most
of the 20th century. In the 1930s, Henry
Simons argued that monetary rules
reduce uncertainty about the price level
and, thereby, facilitate private-sector
planning.2 Later, Milton Friedman
extended the argument, noting that realworld policy-makers have imperfect
information and imperfect tools; so, even
the best-intentioned attempts to combat
fluctuations could end up destabilizing
the economy. A rule permitting the
money supply to grow at k-percent, he
reasoned, would at least keep monetary
policy from doing economic harm.3
More recently, Geoffrey Brennan and
James Buchanan have justified monetary
rules on political grounds—discretion,
they contend, permits the central bank to
generate a higher-than-socially-optimal
inflation rate so that it can enjoy the revenue from money creation.4 Kydland and
Prescott’s contribution to the rules vs.
discretion debate was to show that discretionary policy can produce undesirable
long-run outcomes—in the monetarypolicy case, higher inflation with no
reduction in unemployment— even in a
world with little uncertainty, good policy
tools and public-spirited policy-makers.5
Must It Be a Rule?

This is not to say that discretionary
policy is never desirable, even in the
Kydland-Prescott framework. As noted,
discretion allows policy-makers to
respond innovatively to unforeseen problems. This latitude is particularly valuable
in an uncertain environment—say when
policy-makers don’t have a clue about
the volume of rain likely to fall or about
the rivers likely to flood. And discretion
can yield time-consistent outcomes
under certain circumstances. If policymakers are relatively independent from
the political process, then they can resist
pressure from undeserving flood victims
—those who ignored warnings—to
renege on threats of no relief. A reputation for following through on commitments might further persuade the public
to take such threats seriously. If the
director of flood policy is perceived as a
person of his word, for example, he could
renege on pronouncements of no relief
following once-every-millennium floods

without unleashing a torrent of floodplain construction.6
The rules vs. discretion framework is
valuable for analyzing a host of problems, not just flood-relief policy. For
example, should bank supervisors be
given absolute discretion over bank closings? Supervisors have traditionally
closed banks whenever the owners’stake
(capital) got dangerously low. If given
absolute discretion, supervisors might
announce an informal policy of closing
banks whenever capital-to-asset ratios
fall below, say, 5 percent. But when a
ratio does fall below that threshold,
supervisors—if they had absolute discretion—could allow the bank to remain
open to avoid the costs of liquidating the
institution. If bankers believed that closure rules would be loosely enforced,
they would be more likely to allow capital
ratios to fall in the first place—leading to
lower overall capital ratios and higher
closure costs. A trigger mechanism forcing supervisors to act whenever capital
ratios dipped below 5 percent would spur
bankers to maintain high ratios. On the
other hand, if the banking environment
were volatile, and the informal closure
policy were credible—perhaps because
supervisory agencies were well-funded
and insulated from politics—supervisors
might be able to deal with troubled
banks on a case-by-case basis without
undermining the overall incentive to
keep capital ratios high.7

ENDNOTES
1

They also used a floodplain example.
See page 477 of Kydland and Prescott
(1977).

See Simons (1936).

See Friedman (1960). He argued
specifically for a rule restricting growth
of the M2 measure of the money
supply to 3 to 5 percent per year.
Friedman did concede, however, that
constraints on policy were more
important than the numerical target
range; so, this policy prescription is
often characterized as a k-percent rule.

See Brennan and Buchanan (1981).

They noted that central banks with
discretion have an incentive to renege
on commitments to price stability.
After the public has formed expectations of inflation, the central bank can
increase monetary growth to reduce
unemployment. The public will anticipate this possibility; so, in the end,
inflation will be higher but unemployment will be no lower. Only a binding
rule, Kydland and Prescott reasoned,
can make the central bank’s commitment to price stability credible.

See Blinder (1998) for a discussion of
the value of discretionary monetary
policy expressed in the KydlandPrescott framework.

Before the Federal Deposit Insurance
Corp. Improvement Act of 1991 (FDICIA), bank supervisors had almost
complete discretion over bank closings. Currently, supervisors have discretion over closings as long as capital
ratios are above the prompt-correction-action thresholds set by FDICIA.
When capital ratios fall below these
thresholds, however, explicit supervisory responses are required. See Hall,
King, Meyer and Vaughan (2002) for
more details.

REFERENCES

Conclusion

Policy can be conducted by rules or
discretion. Rules offer time consistency—
the outcome demanded by the public in
the short run is consistent with the outcome desired in the long run. Discretion
may better serve the public interest when
the environment is uncertain and policymaker pronouncements are believable.
Modern research on rules and discretion
has helped illuminate the tradeoffs inherent in a range of policy questions. The
legacy of the Kydland-Prescott work is the
recognition that policy-makers must face
up to these tradeoffs. Put another way,
wise policy-makers must think through
the public’s likely responses to their
responses—just as the public is playing
the same game with policy-makers. Only
this type of analysis can produce consistently sound policy.
Jason J. Buol is a graduate student in economics at
the University of Missouri at St. Louis. Mark D.
Vaughan is the supervisory policy officer in the
Banking Supervision and Regulation Department
of the Federal Reserve Bank of St. Louis. The
authors would like to thank John Block, Jim
Bullard, Bill Emmons, Tom King, Julie Stackhouse
and Tim Yeager for helpful comments.

[11]

Blinder, Alan S. Central Banking in
Theory and Practice. Cambridge,
Mass.: The MIT Press, 1998.
Brennan, H. Geoffrey and Buchanan,
James M. Monopoly in Money and
Inflation. London: Institute for
International Affairs, 1981.
Friedman, Milton. A Program for
Monetary Stability. New York:
Fordham University Press, 1960.
Hall, John R.; King, Thomas B.; Meyer,
Andrew P.; and Vaughan, Mark D.
“Jumbo CDs Play Tiny Role in Policing
Risky Banks—So Far.” Federal
Reserve Bank of St. Louis The Regional
Economist, July 2002, pp.12-13.
Kydland, Finn E. and Prescott, Edward C.
“Rules Rather than Discretion: The
Inconsistency of Optimal Plans.”
Journal of Political Economy,Vol. 85,
1977, pp. 473-91.
Simons, Henry C. “Rules versus
Authorities in Monetary Policy.”
Journal of Political Economy, Vol. 44,
1936, pp. 1-30.

The Whole
Country Gets
the Same
Treatment, but
Results Vary
By Abbigail J. Chiodo and Michael T. Owyang

very six weeks or so, the Federal
Open Market Committee
(FOMC) meets to set the federal
funds rate target, the Fed’s most commonly used monetary policy instrument. The federal funds rate is the
overnight interest rate at which banks
borrow from one another to cover
shortfalls in reserves. Although the
funds rate is a short-term rate, it is
thought to affect longer rates such as
mortgage rates and lines of credit used
by firms to invest in plants and
machinery. By adjusting the federal
funds target and affecting these interest rates, the Fed tries to smooth the
bumps in the economy.
For the most part, when analysts
inside and outside the Fed consider
the effects of changes in the federal
funds rate, they look only at the aggregate national economy. But should
the effects of changes in interest rates
be considered regionally rather than
nationally? Recent studies show that
the impact of monetary policy varies
across states. In other words, a single
change in the federal funds rate affects
individual states differently.
What causes the effect of monetary
policy actions to vary across states?
One possibility suggested and examined in a pair of studies by economists
Gerald Carlino and Robert DeFina is
that regional variation exists because
states differ in their shares of interestsensitive industries.
Which Industries Are Sensitive?

Some sectors of the economy, such
as construction and manufacturing,
are much more sensitive to changes

in the interest rate than other sectors,
such as services and retail. To understand why, ask yourself what you
think of first when you hear that
interest rates have fallen. Buying a
house? A car? Why? Because the
cost of the loan falls. The same is true
for manufacturing firms. With lower
interest rates, firms will initiate big
projects (such as building or buying
factories and equipment or purchasing
land) that they had been considering;
lower rates reduce the cost associated
with undertaking projects and, thereby, increase overall investment in capital. This is not true for the retail and
services sectors because these industries typically do not undertake the
kind of long-term projects that are
sensitive to interest rate changes.
(However, interest rates can affect
inventory decisions.) Although a
change in policy does affect these
less-sensitive sectors, the effect on
these sectors tends to be slower and
less pronounced than in construction
and manufacturing.
Another reason sectors such as
construction and manufacturing are
more sensitive to interest rate changes
is because the demand for their products depends more on consumers’borrowing to buy them. The cost of a car
loan or a house loan, for example, goes
down when interest rates fall, causing
an increase in the number of such
loans. If more people are buying cars,
automobile manufacturers will experience an increase in orders and production. On the other hand, interest rates
do not dramatically alter the demand
for services and for most products sold
in the retail sector—for example, the
[12]

cost of a shirt or a lamp is usually unaffected by a change in interest rates. The
end result is that adjustments to interest rates have a relatively bigger impact
in certain sectors.
Industry composition varies quite
a bit from state to state. In 2000, for
example, manufacturing accounted for
approximately 28 percent of real gross
state product (GSP) in Michigan, compared to about 7 percent in Wyoming.
Overall, the state average for manufacturing share of GSP was about 18 percent for the 48 contiguous states.
Each state’s contribution of retail
and service firms also varies, as one
might expect. Several states in the
Southwest and Rocky Mountain
regions had a higher contribution
of retail and service to GSP in 2000
than the U.S. average, which was
28.7 percent.
Monetary Policy and the U.S.

Carlino and DeFina use real personal income to measure state-level
and region-level economic activity
and test the effect of a hypothetical
change in monetary policy.1 Their
goal was to determine to what extent
real personal income reacts to contractionary monetary policy—in this
case, an increase of one percentage
point in the federal funds rate—with
all other things being held equal.
On average, they find that, after a
small initial rise, the level of real personal income declines substantially,
reaching its maximum response
approximately two years after an
increase in the funds rate. For the
most part, each of the 48 contiguous

The Regional Economist January 2003
■

www.stlouisfed.org

states follows this pattern. However, the
magnitude of the decline in income and
the speed of the adjustment varies across
states. This indicates that the transmission of monetary policy may depend on
individual state characteristics, especially
industry composition.
For example, Michigan appears to be
the state that is most sensitive to monetary policy. This makes sense, of course,
because such a large percentage, relatively,
of Michigan’s GSP is made up by manufacturing. Similarly, Wyoming’s response
is smaller than the national average.
Overall, Carlino and DeFina find that
the contractionary monetary policy has
the greatest effect on the Great Lakes
region, a region that is dependent on
the manufacturing sector of its economy.
The regions that are least sensitive to an

reaction almost identical to that of
the United States, as does Kentucky.
Arkansas, Mississippi, Missouri and
Tennessee, however, are slightly more
sensitive to monetary policy than the
national average, while Indiana appears
to react the most.

U.S.

The effects of monetary policy in
the United States are typically thought
of only at the national level. Recent studies suggest, however, that some states,
especially those for which manufacturing
represents a large portion of the economy,
are more sensitive to changes in interest
rates than the country as a whole. Because
there are large differences across states
and regions in the relative importance

–0.5
–1.0
–1.5
–2.0
An increase of one percentage point in the federal funds rate affects real personal income in each of the District’s states
differently over a two-year period. While Illinois and Kentucky react similarly to the United States, Arkansas, Mississippi,
Missouri and Tennessee are slightly more sensitive than the national average. Indiana has the most dramatic reaction.
SOURCE: Carlino and DeFina (1999).

The Eighth District States

The percent of GSP accounted for
by manufacturing in the Eighth Federal
Reserve District states in 2000 ranged
from 17 percent in Illinois to 33 percent
in Indiana.2 The District states’average
ratio of manufacturing to GSP was about
23 percent in 2000, slightly higher than
the national average of 18 percent. It follows, then, that responses to monetary
policy shifts in the Eighth District were
more dramatic than the national average.
Individually, the states that make up the
Eighth District vary in their own right.3
The accompanying chart illustrates the
effect of a hypothetical tightening of
monetary policy across the states in the
District. One can see that Illinois has a

Regions are defined by the Bureau of
Economic Analysis (BEA). There are
eight BEA regions: New England,
Mideast, Great Lakes, Plains,
Southeast, Southwest, Rocky
Mountains and Far West.

The percent of manufacturing for the
remaining District states in 2000 were:
Arkansas, 23 percent; Kentucky, 26
percent; Mississippi, 21 percent;
Missouri, 19 percent; and Tennessee,
22 percent.

Note that the Eighth District is made
up of a portion of most of these states,
not the entire state. See the back
cover of this publication for a map of
the Eighth District.

of interest-sensitive industries, our
understanding of the effects of monetary
policy can be improved by considering
state and regional data. For example,
several economists have argued that the
most recent recession was concentrated
in the manufacturing sector. If so, it may
be useful for monetary policy-makers to
observe the response to changes in the
fed funds target in states like Michigan
and Indiana to get a better idea of
whether or not monetary policy is
having its desired effects.
Abbigail J. Chiodo is a senior research associate,
and Michael T. Owyang is an economist, both at
the Federal Reserve Bank of St. Louis.

[13]

REFERENCES
Carlino, Gerald and DeFina, Robert.
“The Differential Regional Effects of
Monetary Policy: Evidence from the
U.S. States,”Journal of Regional Science,
May 1999,Vol. 39, No. 2, pp. 339-58.
_______ and _______. “The Differential
Regional Effects of Monetary Policy,”
The Review of Economics and Statistics,
November 1998,Vol. 80, No. 4,
pp. 572-87.

increase in interest rates are the Southwest
and Rocky Mountain regions, which have
a more diverse combination of industries.
The other five regions respond more
closely to the U.S. average.

Conclusion

Responses to Monetary Policy Shocks
%

ENDNOTES

Community Profile
By Stephen Greene

Marion’s landmark clock tower graces the
center of downtown.

Inmates at Marion have committed serious
crimes. They are sent here after exhibiting destructive
behavior at other federal institutions. Prisoners are
confined to their solitary cells for more than 20 hours
each day and spend an average of three to five years
in Marion. Before being allowed to transfer to another
prison, they must display a pattern of good behavior.
As part of the $21 million expansion, 252 cells are
under construction. Murphy says the new hires will add
$3 million in payroll to the existing $25 million in
staff salaries.
While studying the topic of prisons’ effects on communities, one local labor market economist learned that
many small towns in southern Illinois have lobbied hard
to attract state correctional facilities in recent years.
Mike Vessell of the Illinois Department of Employment

In addition, we make a concerted effort to do most
of our purchasing for day-to-day operations from
local businesses.”
If there are any drawbacks to having some of
society’s most hardened criminals living in Marion,
you won’t hear about them from the town’s longtime
mayor, Robert L. Butler, who took office the year
before the prison opened.
“I tell people that we’ve never had any negative
aspects, even when we had John Gotti here,” Butler
says. “People would call me and ask, ‘What do you
think of having the Godfather there in your city?’
I’d tell them, ‘Look, he’s in a maximum-security
operation. He’s not going anywhere.’”
Lucky 13

It’s not difficult to notice where the lion’s share
of Marion’s growth is occurring—it’s along Route 13,

BREAKING

sually when people hear about Marion,
Ill., it has less to do with good news
and more to do with bad dudes. This town
is, after all, home turf of the federal penitentiary that in 1963 replaced the notorious Alcatraz prison. Today, the Marion
prison remains one of two super maximum
facilities in the federal system.

But beyond the forbidding—and expanding—
walls of the prison is a community that, thanks to several recent successes, is flush with confidence in what it
can achieve. The town has carved out its own economic identity and become more than just the exit off
Interstate 57 that Southern Illinois University students
take on their way to Carbondale. If the new collaborative approach that area officials have taken continues to
bear fruit, outsiders may have little reason to ask the kind
of question once posed by a Canadian financier, who on a
business trip here turned to a local developer and asked,
“Could you please tell me where in the hell I am?”
“A Growth Industry”

The Marion penitentiary houses 484 inmates, with
an additional 330 serving time at a minimum-security
camp elsewhere on the grounds. More than 350
employees work at the prison, with an additional
70 expected to be hired by July, when an expansion
to the maximum-security area is completed.
“It’s unfortunate, but this is a growth industry,”
says Kevin Murphy, executive assistant at the prison.
“It’s a sad commentary, but it’s a fact of life.”

Marion’s Success

The federal penitentiary in Marion is undergoing
a $21 million expansion (right) that will add
252 cells by July.

Security says that in counties south of Interstate 70,
employment at prisons has increased by more than
2,200 over the past decade as civic leaders try to fill
the gap caused by manufacturing slowdowns.
“The virtue of a prison or a university or a seat of
government is that it generates employment with very
little unemployment,” Vessell says. “Not many politicians get laid off, and not many prison guards get laid
off. So what you have is a very stable workforce and
a solid floor underneath your economy.”
Vessell adds that the jobs at prisons generally pay
well and offer good benefit and retirement plans.
E.A. Stepp, warden at the Marion prison, says:
“I think our economic impact to the community is huge.
[14]

particularly the stretch west of I-57 that ultimately
connects to Carbondale 15 miles down the road.
“Virtually all of the significant expansion has
been along this corridor because it really is the umbilical cord for the area,” says Dutch Doelitzsch, chairman and CEO of the Regional Economic Development
Corp. (REDCO).
A drive down this main artery reveals the
following:
• a new hospital, Heartland Regional Medical Center,
which opened its doors in December;

The Regional Economist January 2003
■

www.stlouisfed.org

• the Robert L. Butler Industrial Park, home of a 20-acre

Circuit City distribution center, as well as two medical
insurance processing centers, including a new Blue
Cross/Blue Shield office that will open in March and
employ about 500;
• the new REDCO Industrial Park, whose first tenant—
Aisin, a Japanese auto parts supplier—opened in July
and employs 200;
• the Williamson County airport, which is currently undergoing a runway expansion;
• the 900,000 square-foot Illinois Centre Mall, built in the
early 1990s; and
• a new Home Depot, just opened in November.
Thomas Wimberly, executive director of REDCO, says
the area’s ability to land Circuit City nearly two years ago
was crucial: “It all started with Circuit City. When they
plopped down a $34 million, 1 million square-foot facility

OUT

ment department, reports that the number of coal miners in the county peaked at around 800 in the early
1980s. Today, that figure is down to about 50. And
the number of coal mines operating in or near Marion
has dropped from four to one small active strip mine.
Coal is plentiful throughout southern Illinois, but the
area’s supply is high in sulfur, which is associated with
acid rain. The high cost of removing sulfur in order to
comply with environmental regulations has lowered
demand. But a $103 million project by the Southern
Illinois Power Cooperative (SIPC) at its Marion generatTo Mt. Vernon
ing station will provide a boost to the state’s coal producers while also burning coal more cleanly.
Williamson
County Airport
SIPC, which supplies power to six other rural
cooperatives for a total of 80,000 accounts, is
Robert L. Butler
Industrial Park
in the final stages of completing a new fluidized To Carbondale
13
bed boiler that will use the latest coal-cleaning
crab orchard lake
technologies. The new boiler, which will be
148
in operation by mid-year, will replace three
U.S.
Federal
Prison
older boilers at the plant.
The cooperative buys nearly all of its coal from
mines within 50 miles of its plant. Dick Myott,
Planning and Environmental Department manager at
the plant, says the new boiler will increase SIPC’s con-

Illinois

williamson county
57

REDCO
Industrial Park

Marion
Downtown
13

Southern Illinois
Power Cooperative
(Marion Plant)
37
ILLINOIS
INDIANA

MISSOURI
KENTUCKY

EIGHTH FEDERAL

RESERVE DISTRICT
TENNESSEE

ARKANSAS
MISSISSIPPI

s Not Confined to Prison
in a southern Illinois cornfield, it gained a lot of attention.”
Formed nearly four years ago, REDCO represents all of
Williamson County, which also includes the city of Herrin.
Doelitzsch credits REDCO for channeling the interests of
disparate groups into one united approach.
“We have a number of communities that for years competed with each other,” he says. “We have been able to put
that aside and look at things with a broader focus. When we
deal with an incoming industry considering us as a potential
site, it comes across early and clearly that this is not a singlecommunity effort; it’s a multi-community effort.”
Wimberly says: “Once you start the momentum in
industrial growth, it feeds on itself. The minute you complete one project, you’ve got to start on another. You have
to keep the momentum going or it will die on its feet.”
While some of the construction around here results
from companies like Circuit City and Aisin coming to town,
other structures, like the new hospital and Blue Cross building, provide homes for employers already part of Marion’s
business landscape. Effort will be required to fill the
vacancies at their old locations. The city owns the old
hospital property near downtown, and Mayor Butler says
he is exploring redevelopment opportunities.
Digging Up Coal

There was a time when Williamson County residents
were less concerned with what was on top of the ground
than underneath it: coal. Vessell, of the Illinois employ-

Marion, Illinois
By the Numbers
Population

16,035

Labor Force

28,839

Unemployment Rate

4.3%

Per Capita Personal Income $22,641
Top Five Employers:
School District........................................750
U.S. Veterans Administration................583
Marion Pepsi-Cola Bottling...................450
General Dynamics.................................420
Verizon North.........................................400

When completed in mid-2003, the Southern
Illinois Power Cooperative’s new bed boiler
will enable the co-op to increase its consumption of Illinois coal by as much as 50 percent.

sumption of Illinois coal by as much as 50 percent
to 1.2 million tons annually.
“The biggest benefit,” Myott says, “is that
we’re going to continue to have reliable, low-cost
power for our members in the future. That allows
industries to come in because they know that
energy is going to be available.”
Stephen Greene is a senior editor at the Federal Reserve
Bank of St. Louis.

[15]

NOTES: Statistics for labor force, unemployment
rate and per capita personal income include all of
Williamson County. Labor force is from 2001.
Unemployment rate is from October 2002.
Per capita personal income is from 2000.

National and District Data

Selected indicators of the national economy
and banking, agricultural and business conditions in the Eighth Federal Reserve District

Commercial Bank Performance Ratios
first quarter 2003

U.S. Banks
by Asset Size

ALL

$100
million$300
million

Return on Average Assets*

1.39

1.23

1.16

1.32

1.23

1.34

1.28

1.44

Net Interest Margin*

3.98

4.49

4.50

4.35

4.44

4.11

4.27

3.84

Nonperforming Loan Ratio

1.41

1.01

1.09

0.98

1.04

1.09

1.07

1.58

Loan Loss Reserve Ratio

1.86

1.41

1.43

1.48

1.45

1.78

1.61

1.98

less than
$300
million

$300
million$1 billion

less
than
$1 billion

$1billion$15
billion

Return on Average Assets *

Net Interest Margin *

1.32
1.25
1.21
1.16
1.11
1.13

.75

3.52

Kentucky

0.97
1.44

3.45

4.38
4.53
4.20
4.00
4.10

Missouri
1.77

1.25

1.50

1.75

Tennessee

percent 3

Nonperforming Loan Ratio

1.77

0.84
1.19
1.22

1.56

Illinois

1.34
1.32

Indiana

1.33

1.33
1.41

1.40

1.47
1.47
1.46

1.26

Tennessee

1.75

percent 1

1.25

1.38

1.5

First Quarter 2002

First Quarter 2003
NOTE: Data include only that portion of the state within Eighth District boundaries.
SOURCE: FFIEC Reports of Condition and Income for all Insured U.S. Commercial Banks
*Annualized data

[16]

1.63

1.59
1.58

Missouri

1.5

5.5

1.45

Kentucky

0.95

1.25

1.42
1.45

Mississippi

4.5

Arkansas

1.18
1.15

.75

Eighth District
1.54
1.50

3.5

4.49

Loan Loss Reserve Ratio

1.22
1.21

0.76
0.78
0.83

3.73
3.90

Mississippi

1.55

.50

3.87
3.93

Illinois

1.11
1.11

.25

4.47
4.40

Arkansas

Indiana

1.26

4.11
4.14

Eighth District

0.97
1.07
0.81

More
less
than
than
$15 billion $15 billion

For additional banking and regional data, visit our web site at:
www.research.stlouisfed.org/fred/data/regional.html.

1.75

The Regional Economist July 2003
■

www.stlouisfed.org

Regional Economic Indicators
Nonfarm Employment Growth*

year-over-year percent change

first quarter 2003
united
states

Total Nonagricultural

eighth
district

–0.2%
–4.4
–0.7
–3.8
–0.9
–4.6
1.1
–0.1
2.5
1.0
–0.4
0.7

Natural Resources/Mining
Construction
Manufacturing
Trade/Transportation/Utilities
Information
Financial Activities
Professional & Business Services
Educational & Health Services
Leisure & Hospitality
Other Services
Government

arkansas

–0.3%
–3.8
–2.2
–2.5
–0.4
–3.1
0.4
0.1
2.1
1.0
1.0
–0.2

illinois

indiana

–0.1%
–3.1
1.4
–3.1
–0.3
–1.7
0.7
1.4
1.6
0.9
0.5
–0.8

–0.2%
–1.0
–6.8
–0.2
–0.6
–2.8
0.4
–3.0
1.8
–0.7
3.2
1.7

0.5%
1.0
0.6
–2.0
0.8
–3.4
0.5
1.5
3.1
2.3
–0.5
0.3

kentucky

mississippi

0.0%
–7.0
0.2
–2.3
–1.6
–1.7
1.6
0.9
4.0
3.1
–0.7
–0.3

missouri

tennessee

0.4% –2.2%
1.9
–12.6
–1.1
–5.2
–4.5
–3.9
2.0
–0.5
–3.0
–6.4
1.2
–0.9
0.6
–5.4
0.3
0.0
0.6
0.8
4.1
0.7
2.5
–3.9

0.4%
–4.5
–4.3
–3.1
–0.9
–3.7
0.2
4.3
4.7
1.5
1.3
1.1

*NOTE: Nonfarm payroll employment series have been converted from the 1987 Standard Classification (SIC) system basis to a 2002 North American Industry Classification (NAICS) basis.

Unemployment Rates

Exports

percent

year-over-year percent change
–5.2
–6.3
–3.7

United States
I/2003

IV/2002

5.8%
4.9
6.5
4.8
5.6
6.2
4.9
4.8

United States
Arkansas
Illinois
Indiana
Kentucky
Mississippi
Missouri
Tennessee

5.9%
5.4
6.7
5.0
5.5
7.0
5.5
4.9

I/2002

Arkansas

5.6%
5.4
6.2
5.3
5.7
6.6
5.4
5.4

–15.6

Illinois

12.0

–3.2
3.9

Indiana

–6.6

Kentucky

–5.9

17.2

–14.0

Mississippi

30.5

Missouri

10.0

–5.0

Tennessee

2.7

–2.3

–25 –20 –15 –10 –5

10 15 20 25 30 35 40

2002

first quarter

fourth quarter

Housing Permits

Real Personal Income *

year-over-year percent change
in year-to-date levels

year-over-year percent change

3.9
0.8

United States

–9.2

34.3
–5.0

–11.8

2001

1.1

–1.0

Indiana

–4.1
3.1
–3.2

15.9

1.3

Kentucky

2003

2.8

0.4

Missouri

0.7

Tennessee

–1

3.1

2002

All data are seasonally adjusted unless otherwise noted.

2.5
2.2
2.0

0.2

10 15 20 25 30 35 40 percent – 2

2002

3.1

0.7

Mississippi

8.9

–3.7
–3.0
–6.8

– 20 – 15 – 10 – 5

2.5
2.4

Arkansas
Illinois

4.4

2.1

0.0

2001

* NOTE: Real personal income is personal income divided by the PCE chained price index.

[17]

Major Macroeconomic Indicators
Real GDP Growth

Consumer Price Inflation

percent

8
7
6
5
4
3
2
1
0
–1
–2
1998

4.0

all items

3.5
3.0
2.5
2.0
1.5

all items, less
food and energy

1.0

Apr.

0.5
1998

NOTE: Each bar is a one-quarter growth rate (annualized); the green line is the
10-year growth rate.

Civilian Unemployment Rate

Interest Rates

percent

percent
8
7

6.5
6.0
5.5

4.5
May

three-month
t-bill

2
1

4.0
00

fed funds
target

t-bond

5
4
3

5.0

10-year

3.5
1998

NOTE: Percent change from a year earlier

May

0
1998

NOTE: Beginning in January 2003, household data reflect revised population
controls used in the Current Population Survey.

NOTE: Except for the fed funds target, which is end-of-period, data are
monthly averages of daily data.

Farm Sector Indicators
U.S. Agricultural Trade

Farming Cash Receipts

billions of dollars

billions of dollars
115

exports

110

crops

105

imports

livestock

100

trade balance

5
0
1998

90
Mar.

Feb.

85
1998

NOTE: Data are aggregated over the past 12 months. Beginning with December
1999 data, series are based on the new NAICS product codes.

NOTE: Data are aggregated over the past 12 months.

U.S. Crop and Livestock Prices
index 1990-92=100
145
135

crops

125
115
105
95

livestock

85
75
1989

May

[18]

The Regional Economist January 2003
■

www.stlouisfed.org

National and District Overview
he 2002 recovery has been one
of the weakest in the postWorld War II period. Indeed,
the employment gains coming out of
the 2001 recession have been unusually tepid, roughly parallel to the socalled jobless recovery in 1991-92.
At the same time, inflation and inflation expectations have been mostly
contained, affording Federal Reserve
policy-makers the luxury of pushing
their interest-rate target down to a
level not seen since 1961. Why has
the recovery been so weak?

Feet Don’t Fail Me Now

According to the preliminary
estimate, real GDP grew at a 4 percent annual rate during the third
quarter of 2002, measurably stronger than the 1.3 percent growth
seen in the second quarter. Faster
growth during the third quarter
stemmed from another healthy

RECOVERY HAS A CASE OF THE SLOWS
increase in consumer purchases of new
motor vehicles, continued improvement in the growth of business expenditures on equipment and software,
and modest increases in residential
fixed investment, exports and government expenditures. Still, business
investment in structures and buildings
remained exceptionally weak, falling
at a double-digit rate (20.6 percent)
for the fourth consecutive quarter.
Through the first three quarters
of 2002, real GDP grew at about a
3.5 percent annual rate. Although
respectable, it is significantly weaker
than the pace of growth typically
seen when the economy is in transition from recession to expansion.
Assuming that the 2001 recession
ended in December 2001, the pace
of growth during this recovery is less
than half that seen during the first
four quarters of the average recovery
(7.4 percent). According to the Philadelphia Fed’s Survey of Professional
Forecasters, the economy was not
expected to improve much during
the fourth quarter: Real GDP growth
was expected to slow to about
1.25 percent. Monthly data during
October and November were generally consistent with this forecast,
although the November employment
report was clearly weaker than
expected. The weaker tone of fourthquarter data helped spur Federal

By Kevin L. Kliesen
Reserve policy-makers to trim their
federal funds interest target 50 basis
points to 1.25 percent at their Nov. 6
meeting. The Fed’s interest rate target has not been this low since 1961.
A look at three of the key drivers of
economic growth in an average postWorld War II recovery indicates why
the 2002 recovery has been unusually
weak. Through the first three quarters
of 2002, growth of real consumer
expenditures on durable goods was
5.5 percent; for real business fixed
investment, it was –3.0 percent; and
for residential fixed investment, it was
6.2 percent. During the first four
quarters of the average post-war
recovery, these annualized gains
have been, respectively, 16 percent,
8.1 percent and 25.8 percent.
Slower growth of consumer spending and declines in business fixed
investment during the 2002 recovery
may partly reflect the sharp declines
in equity prices: Through the first
11 months of 2002, the S&P 500 was
down by about 18.5 percent, whereas
during the typical four-quarter recovery period the S&P 500 rises by about
19.75 percent. All else equal, rising
stock prices increase consumer wealth,
perhaps leading consumers to increase
their purchases by more than planned.
[19]

For businesses, rising stock prices spur
them to issue equity, which is used to
finance investment in plant and equipment. Hence, when equity prices fall,
the opposite effects arise. Another reason for the weak business investment
performance in 2002 may have been
some excess capital investment in hightech equipment during the latter part
of the 1991-2001 business expansion.
Inflation Remains Low

One heartening aspect of U.S. economic performance in recent years has
been the relatively low rate of inflation.
After averaging about 4 percent per
year from 1980 to 1995, the price index
for personal consumption expenditures
has risen by about 1.75 percent a year
since then. It dipped even lower in
early 2002, growing just 0.9 percent
between the first quarter of 2001 to
the first quarter of 2002. According to
some Fed policy-makers, current inflation is in the “zone of price stability.”
Moreover, after its Nov. 6 meeting, the
FOMC announced that inflation and
inflation expectations “remain wellcontained.” For the most part, forecasters and financial markets expect
this performance to persist into 2003.
Kevin L. Kliesen is an economist at the Federal
Reserve Bank of St. Louis. Thomas A. Pollmann
provided research assistance.

Full text of Regional Economist : A Quarterly Review of Business and Economic Conditions : January 2003

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