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February 21, 2006

Rural Economies and Globalization

Rural economies in the U.S. are on the front lines of the upheavals associated with globalization. Many rural economic engines are based on commodity production and traded goods—namely, routinized manufactured products and production agriculture. Such industries are coming under competitive pressure from overseas economies that often enjoy significant cost advantages. These are also the types of production activities that regularly experience sharp productivity gains—and attendant labor efficiencies—as a result of technical progress. As a result, many rural work forces are shrinking; rural economies are, on average, underperforming metropolitan area economies. In response, rural areas are searching for ways to become innovative in nature rather than commodity-based as a way to stay vibrant.

The Global Chicago Center of the Chicago Council on Foreign Relations recently convened its second in a series of meetings intended to assist print journalists connect global events with their readerships. The Global Chicago Center has fashioned a web-based guide for media so that local experts on global affairs can be readily sourced by local journalists. This particular meeting in Chicago focused on newspaper journalists in rural regions of the Midwest. Experts and analysts of rural regions met with the journalists to discuss the ways in which globalization is affecting rural economies and what, if anything, can be done about it. For some rural regions, the answer to the latter question is not much.

Due to high productivity on farms, which has helped give Americans the world’s highest standard of living, production agriculture employs relatively few people. Indeed, farmers account for only 2 percent of the U.S. work force and only 11 percent of rural population.

Manufacturing now dominates many more rural counties than does agriculture, but the type of manufacturing activity there is vulnerable to global competition and displacement. Over the past 50 years, manufacturing plants locating in rural areas have been seeking a low-cost environment and high-quality but lower-skilled rural workers. Nonetheless, technological progress and heightened global competition often have an adverse impact on these operations. As the figure below shows, metropolitan economies in the Seventh District are easily outperforming nonmetropolitan areas on average.

Click to enlarge image.

Why are metropolitan areas adapting more successfully to globalization? At least part of the answer is that innovative industries or groups of activities have more frequently emerged or prospered in urban areas. And innovative companies can sometimes stay one step ahead of the competition—even low-cost competition—by spinning out new products and conducting business with new processes and management techniques.

But all is not lost in rural areas, according to Lee Munnich of the Humphrey Institute at the University of Minnesota. Munnich has studied what he calls “rural knowledge clusters” in Minnesota. These clusters are proximate groups of innovative, inter-related firms, workers, entrepreneurs and, sometimes, educational institutions. They have managed to thrive, often building an industry related to local features or activities such as the snowmobile “cluster” of leading firms in northwest Minnesota. Other knowledge clusters in Minnesota identified by Munnich include:

  • Mankato: wireless and radio frequency technology
  • Alexandria: automation/motion control technology
  • Winona: advanced composite materials
  • Northwest Minnesota: recreational transport equipment
  • Southwest Minnesota: precision agricultural equipment

Munnich argues that you cannot build a knowledge cluster from scratch, but you can identify existing clusters and build on them. Building blocks include programs to encourage further entrepreneurship, mentor and provide seed capital for new ventures, and create complementary work force programs at the local colleges.

One who agrees with Munnich’s assessment that rural economies are struggling is Mark Drabenstott, Vice President at the Kansas City Fed and Director of their Center for the Study of Rural America. Drabenstott reports that the top 310 fastest growing counties in the U.S. over the past ten years accounted for three-fourths of total U.S. economic growth and that only eight of these were nonmetropolitan counties. Rural areas must find ways to achieve the critical mass of talent and innovation that are needed to compete in today’s global economy.

According to Drabenstott, finding ways to develop rural economies toward greater scale and innovation is far from simple. For one thing, rural areas vary enormously. So what might be a successful path to redevelopment in one area might be entirely different from what will work in another area.

Another hurdle is that rural areas themselves often lack the local capacity to understand and react to global phenomena. And nationally, few resources are being devoted to assisting rural economies in handling their development challenges. For instance, almost two-thirds of USDA expenditures are earmarked for payments and subsidies for commodity agriculture; only 0.5 percent is going toward rural economic development.

Drabenstott sees a few bright spots in rural America. U.S. agricultural exports have been steadily shifting away from commodities and toward “consumer” food products and other higher value added agriculture. So too, many rural manufacturing firms are adapting to global competition by adopting world class manufacturing processes. Immigrants are also bringing their entrepreneurial enthusiasm to parts of rural America, and foreign companies are also scouring rural economies for investment opportunities.

As the Global Chicago Center sees it, newspaper journalists in rural areas can help their readers and their communities in understanding and reacting to the challenges and opportunities that accompany globalization.

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Posted by Testa at 10:07 AM | Comments (0)

February 14, 2006

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.

Click to enlarge image.

However, residential electric prices will soon be rising, on average, in the Midwest and nationwide. That is because fuel costs, including those for natural gas, coal, and petroleum, have been rising sharply for power generators, much as they have been rising in other end-use sectors (link). Because of lags in the passing through of fuel costs in the quasi-regulated environment, small customers in the residential sector have not yet felt the impact of fuel price rises (which typically make up two-thirds or so of delivered electricity costs for residential consumers). But the pass-through of rising fuel costs is now “in the pipeline.”

The rising prices for electric power are likely to confuse and frustrate many customers who will associate price hikes with the shifting regulatory structure of the industry, especially those who remember the mistaken path to deregulation taken by California. It will be a shame if their confusion and frustration over rising prices stalls the necessary innovations in power production that Dick Munson envisions for the Midwest in the years ahead.

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Posted by Testa at 3:47 PM | Comments (0)

February 7, 2006

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.

Click to enlarge.

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.

Click to enlarge.

Over time, Japan’s FDI has been replacing Europe’s and Canada’s in the Midwest (table below). From 1980 to 2000, FDI employment at Japanese affiliates grew from 14,000 to 190,000 in number, thereby boosting Japan's share of the region's FDI from 3.4% to 15%. With this growth, Japan’s FDI displaced Canada’s for the number three spot behind those of Germany and the United Kingdom.

Click to enlarge.

By now, the origin and legacy of Japanese FDI in the Midwest is well known. Japanese automotive assembly and parts plants in the U.S., such as Denso, Honda, and Toyota, demonstrated that their successful production and distribution technologies were not derived from location or cost advantages abroad. Rather, their affiliates' success proved that the quality and cost efficiencies of their products could be duplicated in the U.S. This lesson was not lost on other manufacturers in the U.S. or worldwide. Japanese methods were copied and often improved across many industries. For many companies based outside of Japan, successful imitation and adaptation, along with investment from Japanese companies themselves, eased the transition to global competition and helped revive local production activity.

The map below displays the location and number of foreign-affiliated automotive parts plants in the eastern United States. Clearly, the Midwest has held its own in attracting these plants, which in turn suggests that the Midwest continues to be a desirable location for manufacturing production.

(courtesy of Thomas Klier)
Click to enlarge.

Can inbound FDI from China serve the same purpose as FDI from Japan? To date, Chinese inbound FDI has been miniscule. As of the most recent tally, only 4,000 payroll workers in the entire U.S. were employees of Chinese affiliates versus almost 6 million from FDI affiliates from all nations combined.

So, too, the source of China’s emergence as a global producer differs greatly from those of Japanese and many European manufacturing companies. Although China is rapidly evolving its economy to integrate more sophisticated technology (link), China’s initial strength is as the low-cost producer for the world, not as the innovator. Unlike Japan, China’s rapid rise owes much to its openness to a huge influx of FDI into China by other Asian nations and the U.S. in search of low cost production there. Accordingly, Chinese companies’ interest in Midwest locales will probably be less focussed on production. Rather, these firms will more likely be interested in activities such as local product research and design for distribution to U.S. markets, with most of the production remaining in low-cost China.

A recent story by journalist Michael Oneal (link) documented one such instance, that of Chinese affiliate Wanxiang, which is headquartered in Elgin, Illinois. Wanxiang’s originator is reported to be scouring the Midwest for troubled manufacturing operations, including auto parts suppliers, to acquire or with which to partner. One such partnership has resulted in Wanxiang taking an equity interest in Rockford Powertrain Inc., a supplier of heavy-duty driveline components to U.S. off-road equipment makers. Thanks partly to the partnership, the operation is now on a sounder financial footing. However, as part of its restructuring, its nonassembly production has been outsourced to China, while the U.S. operation concentrates on design, engineering, customer relations, assembly, and distribution. Overall employment has declined so far, especially in production, although the company is looking to grow.

What are we to make of China’s initial (and thus far miniscule) FDI overtures in the Midwest? First, China’s character as low-cost producer rather than as innovator likely means that the volume of China’s overseas FDI interest will be limited, at least for a while. Second, much like all potential FDI opportunities, partnering with Chinese companies on operations in the U.S. can sometimes be a successful strategy for domestic companies in preserving or expanding jobs and income. However, in China’s instance, the resulting production employment prospects in the Midwest are not likely to be as expansive as they have been from FDI partnerships with Japanese and European companies.

If Midwest manufacturing companies are to succeed, they will need to find their own best pathways. In some instances, success will be achieved by partnering with foreign companies on U.S. soil; in others, it will mean investing abroad to serve emerging market opportunities (link). Above all, innovation will be key to the success of their organizational structure, management, process technology, distribution, and new products.

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Posted by Testa at 4:00 PM | Comments (1)

February 2, 2006

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.

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Posted by Testa at 12:33 PM | Comments (0)