Innovation in Electric Power?

Electric power is often considered the most transformative technology of the past 100 years. Its near universal adoption in our homes and workplaces (e.g., to power appliances, communications, and computers) is indeed remarkable. As a result, the electric industry today boasts $600 billion in assets in the U.S., as well as yearly sales of $260 billion (double that of the telecom industry). However, many believe that the business model by which the U.S. and Midwest produces and delivers electric power is outmoded and subpar. Movement toward a more competitive framework can be expected to produce innovations that would achieve significant cost reductions, greater reliability, and a cleaner environment.

The executive director of the Northeast-Midwest Institute, Dick Munson, has recently written a book entitled From Edison to Enron, which recounts the history of electricity and suggests an innovation-based vision for the future of the power industry.

In it, Munson describes major shifts in the electric power industry since its inception. At the dawn of the twentieth century, Chicago mogul Samuel Insull combined many small neighboring electric generation facilities, which achieved economies of scale and balanced loads throughout the day. In doing so, Insull was able to lower prices and increase reliability, thereby expanding the market and use of the product. At the time of his company’s peak in the 1920s, it served 4 million customers in 32 states.

Insull’s innovations transcended the physical production process. Tired of dealing with (and compensating) many local governments for the rights to serve fragmented local markets, Insull successfully pushed for state level regulation of electric power. And so, the state-regulated monopoly model eventually became the national norm. This bargain provided reliable power at regulated prices to consumers in return for state-sanctioned rates of return on investment for utility owners.

Though this model remained intact for most of the twentieth century, Insull’s business empire eventually collapsed amidst charges of corrupt business practices. Munson draws a thoughtful parallel between Samuel Insull’s business and Kenneth Lay’s Enron Corporation. Laying aside the later collapse of Enron, its futuristic business model for electric power production and delivery, trading across the broad geography of the United States, continues to shape the industry today. It is a model of competitive power production and, in some instances, competitive delivery, in which individual power producers have the incentive to innovate because they have a broad market in which to sell their product.

What are the possible gains (i.e., possible innovations) in following this new business model? According to Munson, the costs to businesses of power interruptions are on the order of $120 billion per year under the existing state-regulated monopoly model. Yet, under this older model, almost no research and development (R&D) takes place by the industry. At a recent book chat at the Chicago Fed, Munson said, “Last year, R&D expenditures by the dog food industry exceeded those of public utilities.”

Munson believes that we are on the verge of a vast array of innovations, if only they are not blocked by existing legislation and the old business model. In particular, progressive techniques for co-generation and other recycling of energy and waste energy are capable of producing remarkable efficiency gains. For instance, Scandanavian countries such as Finland are leading the way in co-generation, achieving upwards of 80% energy efficiency in electric power–heat production. And from an environmental perspective, efficiency gains from such techniques are every bit as “clean” as those touted from alternative fuels.

The Great Lakes region could become a leader in reforming its power industry if it chose to do so. However, if the region is to acheve a workable model of competition, a large and well-managed infrastructure must be put into place which would allow buyers and sellers to readily trade electric power (link).

In the meantime, the monumental price-spike disaster in California five years ago, following its experiment to decouple power production from the distribution of electric power, continues to give policymakers great pause. For instance, Illinois passed the Restructuring Act of 1997 that began to decouple power generation businesses from the power delivery and service businesses. In northern Illinois, very large customers (e.g., big corporations) began to negotiate their own purchases of electric power, while their local utility company typically maintained the responsibility for delivering it. For smaller customers, particularly residential customers, decoupling was deferred until 2007, and rates were frozen (actually lowered 20 percent) until that time. In the meantime, independent power producers were encouraged to get on to the delivery network. After 2006, the utility company, Commonwealth Edison (CE), will act as a purchasing agent for residential customers, buying power from independent producers through an auction process and passing along both distribution charges and power costs to consumers.

After the rate freeze expires, CE will require a rate increase to pay for its infrastructure investments in the distribution system since 1997. In 2005, some critics feared that the particular process by which CE would bid for power would raise customer rates unduly. And so, the prospect of a price spike for residential customers when the price freeze expires contributed to an outcry over CE’s plans to move to the auction process in 2007. Nonetheless, plans for this next phase of deregulation were approved by the state’s regulatory authority.

Much like residential and small customers in most of the nation, those in Illinois have enjoyed a long period of stable or declining prices. From 1995 to 2005, the real or inflation adjusted price of electric power has declined by an annual average of 4.4 percent. Of course, electric bills have climbed along with the increasing consumption of electricity in powering home electronics and electrical appliances.

The chart below displays average electric revenues (so-called average prices) for providing electric power to residential customers in the Seventh District states. Price rises since have been tame or have declined in real terms.

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Foreign Direct Investment in the Midwest

Recently, companies from China have begun to explore direct investments in the Midwest and elsewhere around the world(link). Direct investment differs from portfolio investment, such as investment in U.S. Treasuries, in that direct investors have an equity interest that allows them to have some hand in the operation of the enterprise and its assets. Though direct investment from China is miniscule so far, past experiences with other emerging nations, such as Japan, suggest that the growth prospects may be large. Beginning in the 1980s, Japanese companies began to heavily invest in the Midwest, especially in automotive assembly and parts operations. Many of these ventures brought new capital and new ideas to the region’s economy, thereby easing the region’s adjustment to competitive decline and import competition. Such investments continue today as in the case of Toyota, which is scouring the nation—including Michigan—in siting a planned engine production facility. Can investors and partners from China and other emerging countries play a similar role in the Midwest in the years ahead?

Part of the globalization phenomenon has occurred through the integration of capital markets, including direct ownership of companies by overseas parents. Data from the U.S. Bureau of Economic Analysis records foreign direct investment (FDI) transactions, along with characteristics by location of foreign-owned companies and their affiliated establishments in the United States. As a result, FDI in the U.S. may be either an acquisition of existing operations or a new investment, such as the building of a new manufacturing plant. The figure below displays wage and salary employment of FDI affiliates as a share of total employment in both the Midwest and in the rest of the U.S. It is telling us that this share has doubled in both the Midwest and the U.S. over the past 25 years.

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By this measure, the Midwest has kept pace with the U.S. In one respect, this is surprising since the Midwest is far way from the coastal economies, where one might think that access to and linkage with global companies would be more intensive. On the other hand, most FDI takes place in the manufacturing sector, which is more concentrated in the Midwest relative to the rest of the U.S.

From which countries does our FDI originate? Inbound FDI has been taking place for a long, long time, back to our country’s founding when you stop to think about it. For this reason, it may not be surprising that most of our FDI is today domiciled in Europe (table below). As of 2000, Europe made up two-thirds of FDI employment at foreign-affiliated establishments in the Midwest, with over one-half of these domiciled in Germany or in the United Kingdom. The remaining one-third of FDI employment is equally split between Asia and the Americas. Almost all of the Americas’ FDI originates with Canadian companies, while almost all of Asia’s FDI originates with Japanese companies.

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Rural Economic Development

Necessity is the mother of invention, and if ever invention was needed, it is in today’s rural America. This is especially true in the portion of the Midwest stretching from central Illinois westward to Kansas and Nebraska and, from there, north and south from the Dakotas in the north to west Texas in the south. There, declining population, disappearing towns, and falling incomes plague many communities. In such places, farming and farmland have traditionally been the way of life. But rising productivity in farming has almost eliminated the need for farmers to live on and work the land, with barely 1 percent of American’s population living on farms according to the 2000 Census. As jobs and population shrink, derivative businesses such as banks, schools, and hospitals are consolidating and re-shaping vigorously in order to survive and prosper.

Many rural communities continue to fight back. The Chicago Fed’s Community Affairs program and its partners gathered in Des Moines this past November to assess the “invention” taking place in rural America (link). Bankers, economic development officials, and business and community leaders met to explore avenues to economic development in the rural Midwest; they met to share best practices and approaches.

The entire Des Moines conference will be summarized for an upcoming issue of the Chicago Fed publication Profitwise News and Views (link). But for those of us, like myself, who’d rather not wait, many fine presentations from this event are already available online (link).

Many communities have turned to manufacturing and distribution activities as sources of income and jobs. The same roads and rail that are useful for farm products are readily adaptable for hauling processed and finished goods. Today, according to the analysts at the USDA’s Economic Research Service (link), more rural counties count manufacturing as their dominant economic base than they do farming. Those same roads are also often a convenient vehicle to convey skilled workers many miles to jobs at factories and distribution centers. The further processing of farm products continues to boost manufacturing, especially food processing and, more recently, the processing of farm product into bio-fuels (link). A downside has been that rural production wages have not fared well, on average.

Advances in telecommunications hold the promise that service jobs can develop or can be outsourced to rural counties, much as some are decentralizing overseas. Broadband and other high-speed high-capacity infrastructure services have been expanding in rural areas, though this growth lags that of urban areas where proximity makes the up-front costs of connection less prohibitive.

A further impediment to locating many information jobs in rural areas is that information exchange via telecom is not an easy substitute for some types of human discourse, especially where face-to-face communication is needed to evaluate information or where the information is otherwise ambiguous or interpretive in nature. Nonetheless, for those workers who prefer rural living or quality of life, telecom infrastructure at least makes rural location possible.

Many rural communities are on the forefront in making the most of their abundant land resources to enhance rural quality of life. Traditional outdoors amenities such as hiking, birding, and hunting are being augmented with new initiatives like agricultural tourism, including harvest fairs and winery-related tours, retail, and lodging. At the same time, small towns are using available economic development financing tools to redevelop their towns and to help new generations discover the sense of place and social fabric of rural America.

Midwest payroll job growth—Turning but weak

Sample-based estimates of payroll employment are among the most prominent and timely indicators of regional economic performance. Recent trends in reported payroll data indicate lagging economic performance in the Seventh Federal Reserve District, which comprises all of Iowa and major parts of Illinois, Indiana, Michigan , and Wisconsin . Payroll job growth over the past year varies among these states, with losses in Michigan pulling down the District’s job growth average.

The District’s payroll job performance during the period following the 1990 national recession compared much more favorably to that of recent times. Have the region’s fortunes temporarily turned for the worse? Or is this lagging performance an indication of a structural worsening in the region’s growth path?

Payroll job estimates for December 2005 were released by the Bureau of Labor Statistics on January 24, 2006. While these figures seemingly complete the calendar year 2005, they have not been finalized yet. When the January figures are released (every March), monthly data are revised back for the previous 18 months. Because current data are based on reports from a sample of establishments, the data are later revised or benchmarked to a so-called universe of establishments that report their employment covered by the Unemployment Insurance tax system. The revisions can sometimes be significant and we will examine them during the week of March 6.

Over the past year, this preliminary data suggest that payroll job growth is trending up in all District states except Michigan. However, job growth continues to lag the nation in all District states except Iowa.

Looking back over the past five years to one quarter prior to the onset of the last national recession, there have also been steep job losses. The table below indicates that Michigan’s monthly average payroll jobs declined 6.7% from the fourth quarter of 2000 (prior to the onset of the national recession) to the fourth quarter of 2005. Reviewing payroll jobs data over this same five-year period for other Distict states and the rest of the nation, we can see that there was a 2.8% loss in jobs for the average of all five District states and a 2.2% gain for the remainder of the U.S.

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Looming Crisis or Tempest in a Tea Pot? State and Local Government Pensions

State and local government pension obligations have been growing at a rapid rate. Payouts from major public pensions rose by 50% from 2000 to 2004 to $118 billion according to the U.S. Census Bureau . While this payout only represented a little less than 2.5% of total 2003 state and local government spending, the picture may worsen as aging government work forces reach retirement age in greater numbers.

There are nearly 14 million state and local government workers and six million current retirees who are owed more than $2.3 trillion dollars in eventual pension payouts by more than 2,000 different governments. Strains to make these payouts will be especially acute for those governments that have not kept their contributions current in funding obligations and where economic growth is lagging, such as parts of the Midwest. In such regions, government cannot outgrow its obligations through economic and population growth, but must rather dig deeply into current spending on public services or raise taxes to meet the pension obligations of the past. Not a promising recipe for a revival of growth and development in lagging regions.

How this pension crisis occurred and what can be done about it will be the focus of a half-day program organized by Rick Mattoon to be held at the Chicago Fed on February 28, 2006 (conference announcement and agenda)and cosponsored by the Civic Federation and the National Tax Association. At this event, pension experts will describe the current condition of state and local public pensions and offer some solutions for returning fiscal balance. Issues that will receive particular scrutiny will include:

  • To what extent are today’s pension systems funded, especially in the Midwest? What are the demographics of the state and local government work force and the attendant size of the potential pension funding stress? What are the resulting implications for general fiscal stress and strain?
  • How do public pension systems compare with private pensions and Social Security? Can and should they be structured differently? Most public pensions are still “defined benefit” plans where payouts are guaranteed over the retiree’s lifetime regardless of contributions. Should pension benefits for future retirees be changed to reflect their actual contributions?
  • What will be the likely financial impact of new accounting regulations that will require governments to recognize non-pension retiree expenses such as health care costs as future liabilities?

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China and Midwest Biotech

Many Midwest businesses are scrambling to adapt to the rise of China’s economy in world trade and financial markets. Import competition is especially keen. Some Midwest automotive parts suppliers are watching with concern as China has climbed to the number four exporter to the U.S. behind Japan, Mexico, and Canada (CFL).

How can U.S. businesses successfully adapt to the expansion of the dynamic Chinese economy with its low labor costs and less stringent environmental regulations? One way is to shift some operations overseas, investing in China for export back to the states and/or for sales to the growing Chinese market. So far, China has grown at a spectacular rate by inviting foreign companies to set up shop there. While many U.S. multinationals such as GM, Tenneco, and Motorola have done so, so have smaller producers such as Wahl Clipper (hair grooming products) out of Sterling, Illinois, and Atlantic Tool and Die Co. of Strongsville, Ohio.

Another avenue to survival and adaptation is to partner with Chinese companies on investment inside the U.S. So far, foreign direct investment (FDI) by Chinese companies in the U.S. has been miniscule. A few prominent examples of late may make Chinese FDI seem larger than it is, such as Legend’s purchase of IBM’s personal computer business and CNOOC’s failed attempt to purchase Unocal (petroleum). Over time, it is natural to expect that as Chinese companies grow and mature, they will sometimes find it advantageous to invest overseas. Likewise, foreign investment flows into the U.S. can mean new technologies and new portals to global markets for U.S. products, which often keep American workers productive and well-compensated.

This week I am speaking about biotech in the Midwest to the Midwest China Association (MWCA). The MWCA’s mission is to attract inbound Chinese investment into the greater Midwest. They do so by educating the Chinese business community about the benefits of the Midwest, as well as educating our region about overseas opportunities. The MWCA sees Midwest biotech as one of the future cornerstones of the Midwest economy and aims to gather a portfolio of information that can be used to characterize and market the region to potential Chinese investors and partners.

Where can the MWCA and foreign investors learn about biotech activity and opportunities in the Midwest? Currently, there is no Midwest biotech association that compiles information and markets the region’s industry assets. However, journalist and seasoned industry veteran Michael S. Rosen is a virtual encyclopedia of information on the Midwest biotech business scene (link). And for a more active way of gathering information, the nation’s premier biotech meeting, BIO2006, will be held in Chicago this coming April. Due to its nearby location and Illinois sponsorship, Midwest states will be heavily represented.

As we learned at the December Chicago Technology Forum, past “BIO” meetings have galvanized the host regions, if not spurring them to significant cooperative efforts and partnerships, then at least delivering a more comprehensive and cohesive image and understanding of biotech activity and opportunities in the host region. Past meeting have been held in Philadelphia (2005), San Francisco (2004), Washington, DC (2003), Toronto (2002), San Diego (2001), and Seattle (1999).

How will I characterize the Midwest biotech landscape when I speak to the MWCA? For one, the Midwest is long on research and short on commercialization (CFL). A familiar refrain among biotech wannabe locales across the U.S. is their inability to attract venture capital investment flow and to originate startup companies, which is also true of most locales in the Midwest. However, less common among U.S. biotech wannabe locations are the host of potential assets for commercialization that can be found here in the Midwest.

Our region’s universities and federal labs boast prodigious R&D funding and activity (see figure below). One prominent ranking of world universities’ science capacity reports that the states of Iowa, Minnesota, Missouri, Wisconsin, Illinois, Indiana, Michigan, and Ohio are the domicile of 7 of the top 50 and 12 of the top 100 institutions. Overall academic R&D funding in Midwest states tends to be above the U.S. average, with Ohio, Illinois, Michigan, Missouri, and Minnesota ranking 9th, 10th, 11th, 12th, and 14th nationally in 2004. Licensing revenue from the region’s universities amounted to $197 million for FY2003, with 47 new startup companies created, many of which are biotech in orientation. A young organization, the Midwest Research Universities Network (MRUN), is a collaboration that promises to raise the number of startups emerging from the regions universities and labs.

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Bullish on the Chicago Metropolitan Economy

So far this decade, the Chicago metropolitan area’s economic performance has been disappointing. As in the surrounding Midwest, job declines during the recent recession were worse here than in the nation as a whole, and this area’s job growth during the expansion has since been lagging. With this lackluster performance, there has been a special disappointment for Chicagoans; the metropolitan region’s economy led the nation and most of the surrounding Midwest during the 1990s. During that time, there was a sense that Chicago’s economy had evolved beyond its role as regional business capital into one as national and global business center.

What is Chicago’s outlook for 2006? I am optimistic, although there are some defensible reasons for caution. For one, goods producing industries in the surrounding region may continue to pull down Chicago’s service sectors. Chicago’s outsized business and professional service sector continues to serve the Midwest, as do its travel, distribution, and business meeting services. But looking ahead, the Midwest economic outlook is clouded by the prospects for its automotive industry. Nationally, automotive sales growth is not expected to be robust this coming year, especially for the Big Three automakers and their suppliers that populate the eastern part of the Midwest region as well as northern Illinois and southern Wisconsin. Accordingly, this segment of the Midwest cannot be expected to propel Chicago’s service economy in 2006.

There is a second reason to be cautious: National economic growth is expected to moderate modestly in 2006 (link). Since Chicago and the Midwest generally follow national trends—perhaps even follow them in a magnified fashion—there is some doubt that the metropolitan economy’s performance will gain momentum as the national economy moderates.

Still, despite these trends, and with a great deal of uncertainty, I offer some reasons for optimism for those of us who are inclined to be bullish about Chicago.

Not all of the surrounding Midwest manufacturing activity is moribund. The region’s capital goods industries, such as the machinery and equipment industry, are expanding. Looking forward, as national and global economic growth continues, U.S. and world demand for “new tools” and added production capacity tend to lift capital goods sectors. In turn, employment in manufacturing sectors, along with physical expansion of factories, tend to take place with a lag as excess capacity becomes squeezed.

More generally, recently reported data indicate that improvement in Chicago’s labor markets is already underway. During the autumn, Chicago’s year-over-year payroll job growth exceeded 1 percent for the first time since the year 2000, while the unemployment rates were down in the fourth quarter (according to preliminary reports).

Chicago’s vaunted business and professional services industry is once more reporting strong employment growth. Though it has much catching up to do from its poor performance in recent years, Chicago’s year-over-year job growth in this sector is exceeding the nation’s.

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Midwest and the Global Economy Part I

From the slow progress being made on the Doha round of global trade liberalization, it would seem that globalization is slowing down. Yet, this is not the case at all. As the 2002 Economic Report of the President articulated, globalization continues to be enhanced by ever-falling costs and technical advancements in communication and transportation. Such developments are magnifying trade flows of merchandise and commodities and, more recently, services such as software, R&D, call services, and data processing. Springing from these developments in information technology and communication, global capital markets are deepening, which in turn further heightens trade in goods and services.

Regional economies, especially that of the Midwest, are being affected by globalization. Tradable goods such as manufacturing and agriculture products play a significant role in the upheavals of globalization. And so, Midwestern households and business would benefit from timely and appropriate adaptation to the globally induced upheavals taking place in industries, companies, and occupations in the region.

Since households continue to learn about globalization from the print media, The Global Chicago Center of the Chicago Council on Foreign Relations and the Ford Foundation are fashioning a project called the Midwest Media Project. The project intends to assist journalists throughout the region to help put local interests in the broader context of global economic developments and events. In this way, Midwesterners can become more attuned to globalization, especially as it relates to the region.

At the first meeting of the project on January 10, researchers and policy leaders are being asked to present globalization topics and information to the attending journalists. In turn, several senior journalists will lead discussions on ways in which global events and trends can be linked to local stories in engaging ways.

I was asked to deliver the overview on the Midwest economy, highlighting the linkages between our region and the world economy. And when I stop to think of the linkages, there are many. For one, given our sharp manufacturing concentration, the Midwest economy is about on par with the nation in terms of exports, and our region’s exports to the world are large and growing. Not surprisingly, it is our “capital goods” that stand out as prominent exports—construction and farm machinery, medical equipment, engines, and electrical equipment. Automotive exports are also prominent, with most of them destined for nearby Canada rather than for far-away locales. As Thomas Klier, automotive expert here at the Chicago Fed has said, “the binational region’s auto industry knows no boundaries.” (Chicago Fed Letter on border conference) Close to 40% of the considerable U.S.–Canada merchandise trade crosses the border in Michigan through the Detroit–Windsor corridor or over the bridge at nearby Huron-Sarnia, much of it being automotive parts and finished vehicles.

Partly owing to this tight automotive production integration, Great Lakes exports to Canada represent 50.4% of the region’s exports versus only 18.2% for the overall U.S. If we were to deduct U.S. exports to Canada from both the Great Lakes region and the U.S., the pattern of export destination by country would be nearly identical for both the region and the overall U.S., with a slight tilt of Midwestern exports to Europe rather than toward Asia.

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Great Lakes: Economy and water

The Council of Great Lakes Governors convenes December 13, 2005, in Milwaukee. At that time, the governors will discuss progress on region-wide procedures to regulate, protect, and control diversions of the waters of the Great Lakes basin, the largest single body of surface water in the world. Such actions are laudable for their foresight in sustaining the health of the Lakes ecosystem. Interstate cooperation in fashioning public policy is difficult and rare. Inspired by such achievements in the environmental arena, should the region’s leaders aspire to broader cooperation to spur economic growth and development?

The Council of Great Lakes Governors, formed in 1983, is a non-partisan partnership of the eight states that border the Lakes—Illinois, Indiana, Michigan, Minnesota, New York, Ohio, Pennsylvania, and Wisconsin—along with the Premiers of Ontario and Quebec. The council’s goals are both environmental and economic.

Next week’s agreements to address water diversions are but one of several initiatives that the governors are engaged in to improve the health of the Great Lakes ecosystem. Through the Great Lakes Governors’ Priorities Initiative, the council has established a list of nine priorities to guide the restoration and protection of the largest single source of freshwater in the world, the Great Lakes. Most of these priorities are being addressed more broadly in the U.S. by the Great Lakes Regional Collaboration, which was created by executive order in 2004. The collaboration includes the EPA-led federal agency task force, the Great Lakes states, local communities, Native American tribes, non-governmental organizations and other interests in the Great Lakes region. The first goal of the Collaboration is to create a workable strategy to restore and protect the Great Lakes ecosystem. Past abuses of the Lakes include the introduction of invasive species, destruction of sensitive shoreline habitat, and the introduction of persistent toxins and pollutants. Today’s threats include increased demands for consumptive uses of Great Lakes water; pollutants from land, sea, and air; erosion of coastal habitat through onshore development; and imminent introduction of invasive species such as the Asian carp.

Should similar interstate cooperative efforts be marshalled for economic growth and development? Some limited efforts are being taken already. Through the Council of Great Lakes Governors, a group of five of the Great Lakes states maintain a non-competitive partnership in international trade initiatives. Five states share overseas trade offices that offer responsive and comprehensive services to small and medium sized companies seeking to expand product and service sales.

In addition, one might argue that proper stewardship of the watershed itself is highly important to the economy. Regionwide organizations such as the Great Lakes Commission address the use of the waters for maritime transportation and tourism-related activities. A Council of Great Lakes Industries tries to preserve the region’s industrial activity and balance the needs of industry with those of the environment.

The Lakes ecosystem is also important to what the region’s economy is becoming. Quality of life, especially human health and outdoor recreational amenities, are increasingly important in attracting the highly skilled and highly mobile knowledge workers of “the information economy.” As family income and educational attainment grow in the U.S., demands for environmental quality grow more than proportionately. Primary residences adjacent to scenery and open waters are in ever greater demand. More people are buying second and even third homes for vacation and retirement. A small but growing subset of households follows the seasons residence by residence suggesting that, over time, the Great Lakes attractiveness as a site of seasonal homes is likely to expand.

Still, as we stand at mid-decade, the Great Lakes economy appears to have lost some steam from ten years ago (chart and table below). At that time, the region was celebrating a return to prosperity from the tougher times of the 1980s (see Assessing the Midwest Economy project of Fed). Labor markets in the mid-1990s were tighter in the region than the nation, with concerns of work force shortages about to emerge.

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Driving Indiana’s and Michigan’s Economic Performance

The Midwest economy is lagging the U.S., but some states are doing better than others. These differences may help us understand the reasons for the region’s lagging economy.

Last week in Indiana, I presented some evidence that the entire region is growing more slowly than the nation. Payroll job growth in our Seventh Federal Reserve District is up only 0.6% for September from one year earlier, versus 1.6% in the nation. In some respects, this performance is not surprising since, nationally, manufacturing jobs are still declining (down 1% year over year through September), and the Midwest’s economy is steeped in manufacturing. In addition, the region’s economy is bogged down by the structural change taking place in the automotive industry. Foreign nameplates continue to gain market share from the domestic automakers (previous blog). Since the foreign nameplate companies and their parts suppliers tend to locate in the South, jobs and income are seeping away from the Midwest.

In this regard, comparing the performance between Indiana and Michigan is telling. Though both states rank among the top 3 nationally in manufacturing concentration, the unemployment rate in Michigan stands at 6.1% in Michigan (Oct.) versus 5.4% in Indiana. Year over year, manufacturing payroll job growth is virtually flat in Indiana, but down over 3% in Michigan.

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The economies of both states are automotive intensive, but Michigan to an even greater degree. Indiana’s automotive share dominates manufacturing inside the state, at 16%. But Michigan’s automotive sector accounts for 35% of its manufacturing employment. A weakening automotive sector, then, would be felt more sharply in Michigan.

On top this, the auto sector’s performance in Michigan has been worse. From 2001 to date, automotive jobs have fallen 24% in Michigan, compared to 8% in Indiana.

Indiana’s automotive performance is buffered by having a larger share of foreign auto parts and auto assembly plants than Michigan. According to senior economist Thomas Klier, 29% of automotive parts plants in Indiana are foreign owned, as are 2 of its 3 auto assembly plants.

Auto parts makers tend to locate close to their customers. In Indiana, the foreign-owned parts plants are more likely to supply parts to those automakers who are gaining market share—the foreign nameplates.

Michigan’s automakers are only 17% foreign owned; its only foreign owned assembly plant is the Mazda plant, versus its 15 domestic auto assembly plants.

If the current shifts in market share among automakers continue, it will be imperative for Michigan’s economy to attract investments from the successful auto suppliers and auto assembly companies.

Other performance differences between Indiana and Michigan are intriguing, though one cannot draw any hard conclusions. The chart below illustrates the population growth of the largest metropolitan areas in each state—Indianapolis and the Detroit MSA. Indianapolis’ population growth has exceeded the surrounding areas, and far exceeded that of the Detroit metro area.

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In searching for explanations, manufacturing concentration again comes to mind. As recently as 1969, only 26% of Indianapolis’ overall employment was manufacturing, versus Detroit’s 35%. Generally speaking, “factory towns” have had the roughest road in restructuring. As manufacturing employment shrinks, such cities must re-employ larger shares of their work force in new industries and activities. Otherwise, workers move from the area and create a different set of challenges to the town governments. That is, how to efficiently use and maintain their current roads and buildings for a less populous (and sometimes less wealthy) population.

Governance structures may also explain some of the challenges. Central city Detroit has been buffeted by job, population, and income flight, with concentrated poverty left in the wake. Detroit city leaders have been unable or unwilling to climb above the city’s fiscal problems to re-build its economy. To what extent has this failure come about because the central city was isolated from the rest of the metropolitan area (and state), and left to solve profound problems with its own (meager) resources?

Indianapolis and other cities have taken some modest steps in consolidating local governance to a closer fit with their metropolitan-wide economies. In the late 1960s, Indianapolis moved toward a “Unigov” structure. As Rick Mattoon discusses (working paper), the city’s boundary was expanded from 82 square miles to 402 square miles, with a legislative body responsible for governing the city. Though there remain many independent governments, taxing authorities, and school districts within the city, the consolidated city has six administrative departments below the mayor’s office.

Other Midwest cities with elements of regional governance include Minneapolis–St. Paul, which has a metropolitan sharing of property tax base. Columbus, Ohio, has not consolidated, yet its central city government has been aggressive in annexing land outward toward its interstate beltway. Both metropolitan economies have outgrown the broader Midwest.



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