Statement by Silas Keehn, President, Federal Reserve Bank of Chicago, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 10, 1993.

I am pleased to be here today to discuss economic conditions in the Seventh Federal Reserve District and to comment on my views on monetary policy. The Seventh District, which includes all of the State of Iowa and most of the States of Illinois, Indiana, Michigan, and Wisconsin, is an economically large, important, and diverse region, which both reflects and drives a substantial portion of the U.S. economy.

By any measure, the District ranks as a major economic force, and, therefore, conditions in the District directly influence my views regarding monetary policy. And, in turn, monetary policy actions have an important impact on economic activity in our District.

The five District states account for about 14 percent of the nation's GDP and 18 percent of U.S. manufacturing employment. The District produces 45 percent of the nation's automobiles, 30 percent of the trucks, 38 percent of the nation's steel, and more than 40 percent of the country's farm machinery. Farmers in the Seventh District account for nearly one-fifth of the nation's annual sales of farm commodities and half of the corn, soybeans, and pork produced nationwide. The District is the headquarters of some of the largest firms in the United States in manufacturing, retailing, and financial services.

Given its size and diversity, it is not surprising that the District mirrors the economic challenges and opportunities in the U.S. economy as a whole. Consequently the District, as the nation, has been experiencing significant difficulties in maintaining an adequate rate of real growth. District performance has improved, but the pace of improvement continues to be impeded by further financial and industrial restructuring.

Monetary policy requires two things above all, a solid assessment of where we are and a sure sense of where we should be going. Both of these questions require contact with businesses and individuals and cannot be derived solely from statistics and theory. While our Bank follows the publicly released data very carefully, we rely very heavily on information sources and contacts within the District to determine current and prospective conditions so important to the development of the appropriate monetary policy to deal with changing economic circumstances. It was only by maintaining close contact with our District that it has been possible to go beyond the economic statistics to an understanding of what has really been going on in the District's economy and in the nation as a whole.

The Federal Reserve Bank of Chicago is deeply involved in monitoring and analyzing economic developments in the District on an ongoing basis with a variety of fact-finding initiatives. In addition to the very valuable input from our boards of Directors in Chicago and Detroit, we have set up a network of advisory and contact groups. The Reserve Bank assembles regional data to provide a quantitative base for regional analysis, drawing from government sources and business in the District, and we have developed our own measures, such as the Midwest Manufacturing Index, to track District economic activity. Some years ago we formed Small Business and Agricultural Advisory Councils to obtain continuing and very important input from these large sectors of our economy. In addition, the Bank has established a network of Industrial Roundtables to provide information about emerging business conditions. Industrial Roundtables now meet in Chicago, Detroit, Milwaukee, Grand Rapids, and Kalamazoo. The Detroit and Chicago groups include corporate economists from some of the largest companies in the District. The Milwaukee and western Michigan groups include chief financial officers and corporate planners from the diverse and important companies located in these areas. In addition, the roundtables include contacts whose businesses are leading indicators of economic activity throughout the District. These roundtables are a direct link to about 100 companies and trade associations in the District and provide timely insight into current conditions and emerging market trends. By integrating economic data with direct corporate and small business contacts, we are able to make a comprehensive analysis of the economic trends and current conditions in the District and from that develop a factual basis for my recommendations on monetary policy.

In addition to our formal roundtables, the Bank works together with those public sector and quasipublic groups that are struggling to revitalize the region's economy. Collaborations with the Wisconsin Strategic Development Commission, the Iowa Business Council, the Commercial Club of Chicago, and the Council of Great Lakes Industries are examples of organizations working to rebuild the District economy. Such efforts yield a lasting return to us. Through our personal participation, we establish a relationship of trust and open important avenues of communication with other analysts of areas within the region that enhances our knowledge of issues important to our District.

The diversification of our sources of information in the District helps to ensure that we do not overlook any emerging sectors of economic activity and problems that broad national statistics can overlook.

DISTRICT OVERVIEW

The Seventh Federal Reserve District is situated in the heart of the Midwest, straddling the agricultural plains toward the West and encompassing a large part of the nation's heavy manufacturing belt, which begins further to the East. With a population that accounts for 13.6 percent of the nation, our District includes the entire state of Iowa along with the most populous and urbanized portions of Michigan, Illinois, Wisconsin, and Indiana. Accordingly, while we are headquartered in Chicago, we maintain a branch office in Detroit, and regional offices in Des Moines, Indianapolis, and Milwaukee.

Many of the District's large urbanized areas now specialize in the business of providing services--business, personal, financial, and wholesale and retail services. Over all, however, our part of the Midwest currently and historically can be characterized as a producer and mover of goods--both natural resource oriented such as farm goods, as well as manufactured goods. Nearly one-fifth of the nation's $170 billion in annual sales of farm commodities is generated by farmers in District states, mostly because of its dominant positions in corn, soybeans, dairy, and hogs. In manufacturing, the District states account for more than one-sixth of the nation's output. Land-based transportation equipment, electrical equipment, primary metals, machinery, and food processing are the mainstays of the economy.

However useful as an initial characterization, such generalizations belie the very broad diversity of locales and industries in the Seventh District. Today, I would like to share with you the diverse richness of economic activity among subregions and industries within the Seventh District by drawing not only on our own analysis and public data sets but also from a wide network of personal contacts with organizations in the region.

The Seventh District economy emerged from the decade of the 1980s in far better shape than most analysts expected. Its image as part of the nation's collapsing rust belt has been replaced by an emerging image as the center of lean and agile manufacturing. That is not to say that the District's economy has not shared the frustration of a subpar recovery nationally or that it has been immune from the economic hardships of the recession or the corporate restructurings that have swept the nation. General Motor's (GM's) announced plans to close twenty-eight plants over the next three years--roughly half of them in the Seventh District--is a key example; Sears, Ameritech, Dow Chemical, and United Air Lines are among other notable examples of Seventh District corporations undergoing dramatic adjustments in the face of changing markets and competitive pressures.

In addition to upheaval among such corporate entities, there is a striking diversity of conditions among towns and metropolitan areas within our Seventh District. Locations such as Flint, Peoria, Rockford, Detroit, and Chicago continue to search for answers and solutions to disappearing jobs and income, even while national attention focuses on the entire region's turnaround.

In the early 1980s, firms such as Caterpillar, Cummins Engine, and Whirlpool faced formidable challenges. Many companies made the necessary adjustments in the 1980s, while others are still making these adjustments.

But the success stories are far from universal. Well-meaning and well-directed efforts to restructure have been to no avail for many small businesses and family farms and for many large corporations that have gone out of existence. Similarly, there is parallel diversity in locational well-being and revival for those towns that have grown up around large specialized industries. Some can succeed, such as Indianapolis and Des Moines, by redefining and reinventing themselves (for example, Indianapolis as a center of sports-oriented tourism, business services, and retail trade). Others however, despite their best efforts at "diversifying" (for example, Flint) have thus far made less progress confronted by external forces and events. It is an accurate statement that the Seventh District has been through an enormous and very fundamental change. And in this tremendous diversity of experience, not every region or industry has come through intact.

The Seventh District is no stranger to adversity. In particular, the region has long needed to adapt to the cyclical nature of its economy. Moreover, even when its industries are successful in becoming competitive, the process itself leaves significant challenges and opportunities in its wake. Goods-producing industries, including farm and factory, have continually boosted productivity by economizing on the number of jobs. In the United States alone, manufacturing jobs as a share of the total payroll labor force have declined from 30 percent to 17 percent from 1963 to 1992 even while the sector's share of real national output has remained roughly constant. Such labor dislocation is an amplified problem for regions that are concentrated in manufacturing such as the Seventh District. The District's manufacturing share of total payroll jobs declined from 37 percent to 21 percent over the same period. Recent management strategies by firms to improve their competitiveness by labor-saving cost attrition and mass layoffs have added to this problem.

The imbalances in the Seventh District's economic base are also reflected in the response of local institutions--banks and governments. Governments have the task of making the investments in the future of the region--infrastructure and education. However, weakness in the underlying economic base can place a region in a vicious cycle. The vicious cycle of economic shock, followed by inability to fund social services and public reinvestment, is further aggravated. In recent years, weak growth in revenues, coupled with fiscal strains from Medicaid and prison expenditures, have squeezed out budget items such as economic development and higher education in District states. In the Seventh District, responsibilities for service provision fall to a much higher degree at the local level of government. As a result, wide disparities in economic conditions among local communities means that local plant closings, for example, will carry over strongly to the fiscal health of local governments.

Lending institutions share a similar fate. In the early 1980s, the balance sheets of Seventh District banks were weakened by the region's weakening economy. Banks have been restructuring, although problems remain. As in other areas of the country, bank lending slowed sharply in the early 1990s. The safety and soundness of Seventh District banks are being strengthened by the ongoing process of consolidation as earnings, capital ratios, and asset quality issues have all shown important signs of improvement. The impetus is not being undertaken by money center and other larger banks in Chicago, however, but by large regional banks headquartered outside Chicago and, in some cases, outside the District.

THE 1980s--A TIME OF DIFFICULT TRANSITION

Much of the Seventh District was characterized as the "rustbelt" of the nation in the early 1980s. Weak firms either failed or relocated to lower cost regions, and inefficient plants were closed or downsized. Indeed, the District lost nearly 1.5 million jobs during the recessionary period of 1980-82, mostly in its manufacturing sector, while the nation lost about 2 million altogether. To be sure, many of these job losses were from cyclically sensitive industries that were able to recall workers during the vigorous recovery that followed. But, many jobs were also linked to structural changes that had been adversely affecting the District since at least the mid-1960s. Such jobs would never return, creating a large pool of structurally unemployed workers and above-average unemployment rates in many metropolitan areas of the District. The region's standard of living, as reflected by per capita income, declined in relation to the overall U.S. standard during this period.

Why was the District affected so heavily during the 1980s? Why did it need to restructure so profoundly? The problems of the 1980s were to be found in both the District's mix of industries and also its competitive advantage. Unfavorable industry mix presented a formidable challenge to the District during this period. Fortunately, because of changes in the external environment, the District's current industry mix has since become more favorable than many other U.S. regions, as the nation is winding down from its cold war emphasis. The early 1980s favored regions that produced high tech defense and aerospace equipment. At the same time, heavy U.S. investment in newly emerging high tech office equipment such as micro and personal computers contributed to a shifting of demand away from the District's manufacturing sector.

Part of the problem of the 1980s was also the external environment for exports, which was partly due to the dollar's climb of 85 percent between 1980 and 1985. As illustrated by unit labor costs over this period, the value of the dollar had the effect of raising world prices of U.S. exports.

The unfavorable exchange rate environment for exports aggravated an underlying competitive trade problem for District industry. Many District firms were disadvantaged in foreign markets by their use of outmoded technologies. The competitive shocks of the early 1980s jolted many District firms into recognizing the need to reorganize, reinvest in new technologies, and to restructure their operations.

The Auto Industry

The auto industry is perhaps the most vivid example of the combination of cyclical and structural forces that were affecting the District in the early 1980s. Ford and Chrysler were the first to begin the arduous process of downsizing to adjust to changing market forces. In the early 1980s, Chrysler was already in the midst of a government-backed rescue effort. Four Chrysler facilities were closed, all within the Seventh District. Ford closed another five plants, but these facilities were outside the District. In the late 1980s, GM began closing plants in Detroit, Pontiac, and Flint. In all, Big Three auto producers cut assembly plant capacity by about 2.5 million units (roughly 20 percent) between 1985 and 1992. To be sure, offsets occurred with the building of transplants in the District, including Diamond-Star in Bloomington, Illinois, and Mazda's plant in Flat Rock, Michigan. But in Michigan alone, an estimated 70,000jobs were lost as a result of auto plant closings even before the 1990-91 recession (between 1987 and 1990), with another 40,000 to 50,000 job eliminations to be realized as recently announced plant closings take place.

The Agricultural Industry

The downturn of the 1980s began early in the decade for agriculture and ended around 1986. Several developments during the first half of the 1980s caused farm earnings and the income return on farm assets to plummet. The combination of lower earnings, higher long-term interest rates, and shrinking exports of that time period contributed to a sharp decline in farmland values and huge equity losses for owners of farm real estate. Estimates by the U.S. Department of Agriculture show that the peak-to-trough decline in the average per acre value of farmland nationwide was more than one-fourth in nominal dollar terms and nearly 45 percent in real dollar terms. The declines were especially steep in the Seventh Federal Reserve District. Reflecting this, our land value surveys showed the declines in farmland values in Illinois, Indiana, and Iowa ranged from 50 percent to 60 percent in nominal dollar terms and 60 percent to 70 percent in real terms. With farmland accounting for three-fourths of all assets in the farm sector, the weakness in the land market translated into equity losses of 30 percent in the balance sheet of the farm sector nationwide and 50 percent to 60 percent (nominal dollar terms) in Illinois, Indiana, and Iowa.

The combination of low earnings and sinking asset values quickly extended the farm problems of the early-to-mid-1980s to lenders and most of the agribusiness industries that support this nation's vast agricultural production plant. It has been estimated that lenders wrote off some $20 billion in bad farm loans as a result of the experiences of the 1980s. From 1984 to 1987 banks nationwide wrote off $4 billion in non-real-estate farm loans. About $1.1 billion of that write-off was by banks in states comprising the Seventh Federal Reserve District. Further evidence of the spreading problems of the 1980s is reflected in the cutback in capital expenditures by farmers. At the trough in 1986, capital expenditures in the farm sector fell to less than $8.5 billion, down from the speculative excesses that peaked at $20 billion in 1979.

PROFILES IN DIVERSITY

Although the Seventh District can be broadly characterized by its farming and manufacturing, the region hosts a great diversity of industries and local economies. These places and industries are closely tied together. Changing conditions in individual sectors and geographic areas have rippled throughout the Seventh District.

Industrial Diversity

Despite all the stress and strain on the Seventh District's economy in the 1980s, the process of adjustment has been slow. To be sure, the early 1980s were only part of a long-term readjustment of the District's role in the national economy. From 1964 to 1991, the District's share of total U.S. employment declined from 16 percent to 14 percent, while manufacturing employment declined from 20 percent to 16 percent in 1982 before rising to 18 percent by the end of the decade. Still, the District's share--one-sixth of the national economy--represents a sizable influence. And, despite a decline in the role of the District's manufacturing sector in the national economy, its manufacturing sector remains the defining characteristic of the District's economy, accounting for about 25 percent of District employment (down from 30 percent in 1980). The nation on average devotes about 17 percent of its employment to manufacturing (also down from 24 percent in 1980). And within manufacturing, it is the auto-steel-machine-tool nexus that dominates economic activity. In general terms, the District is responsible for producing about 45 percent of the nation's cars, 30 percent of its trucks, and 38 percent of its steel (including the bulk of the higher-quality specialty steels). The Seventh District also supports a thriving service sector primarily focused on the financial and business needs of its manufacturing sector, while Chicago's Board of Trade and Mercantile Exchange serve global commodity and financial markets. However, while the District's economy has been diversifying away from manufacturing, it is likely to remain the core sector of the region's economy for some time into the future.

Still, there is considerable diversity among the different subregions that comprise the Seventh District. For example, Illinois is a major capital goods producer, particularly of farm and off-highway equipment. Deere & Company and Caterpillar are major producers in these markets. Indiana is a center for steel production and auto parts suppliers. Inland Steel and Cummins Engine are world leaders in these markets. Wisconsin is another major supplier of auto parts and particularly a supplier of machine tools for the auto industry. Modine and Giddings & Lewis are examples of these types of firms. Michigan is closely linked to the auto industry and is the headquarters for the Big Three.

Machine tool industry

The machine tool industry in the Seventh District is heavily geared toward the auto industry, either directly for model design retooling of the auto industry or indirectly for the supplier industries. The District contains almost half (43 percent) of all metal cutting machine tool producers and 35 percent of all metal forming machine tool producers in the United States. Michigan alone employs about 15 percent of all workers in the machine tool industry, second only to Ohio (about 20 percent). Illinois employs slightly more than 25 percent of the workers in the metal forming machine tool industry. However, it should be noted that employment in the industry has declined from a peak of 108,000 in 1980 to 73,000 in 1989 and the number of companies has declined, often through consolidation, from more than 1,400 to 624. In terms of market, the District constitutes about 22 percent of all machine tools in use today, with the greater Chicago area accounting for half of that market. In 1989, the United States exported about $1 billion worth of machine tools but imported nearly $2.5 billion (about half of which came from Japan). Imports have risen from about 20 percent of total U.S. machine tool consumption in 1979 to 50 percent of the market today. Finally, between 1968 and 1989, productivity of machine tools has more than doubled (using U.S. average annual output per metal cutting machine tool in constant dollars as the measure), greatly restricting the growth in the market for these machines. After three years of declining shipments, industry forecasts call for an 8 percent increase in 1993, with exports up 5 percent and imports down 7 percent.

Construction machinery

Another key area of capital goods production in the Seventh District is construction machinery. For example, Caterpillar, Deere, and Case (all headquartered in the District) are the dominant producers in the United States, with mainly Hitachi and Komatsu as major competitors. Caterpillar alone accounts for 45 to 50 percent of the sales of crawler loaders and tractors in the U.S. and Deere and Case add another 25 to 30 percent. In terms of markets, the Seventh District represents about 10 to 15 percent of all purchases of construction machinery. U.S. producers were particularly hurt during the early and mid-1980s, when a weak domestic economy was augmented by a strong dollar that severely hampered export sales of domestically produced construction equipment.

Steel industry

The steel industry in the Seventh District is concentrated in northern Indiana (about 25 percent of U.S. production), serving appliance and auto plants in the Midwest. Detroit, with about 8 percent of the nation's production, also produces specialty steels for the auto industry. The District is dominated by integrated mills, with more than one-third of the nation's steel-making capacity but only 15 percent to 20 percent of the nation's minimill capacity. In 1991, total domestic steel shipments were about 79 million tons, rising to 81 million tons in 1992. Some improvement is forecasted for 1993 (with projections ranging between 83 million and 86 million tons), and U.S. firms expect to pick up a bigger share of its total shipments due to restrictions on imports, which currently constitute about 20 percent of the domestic market.

Agriculture

Blessed with an abundance of rainfall and highly productive land, the five states comprising the Seventh Federal Reserve District account for a sizable portion of the nation's agricultural output. Using only one-tenth of the land in farms, District states generate nearly one-fifth of the $170 billion in annual sales of farm commodities. The District's share is concentrated in five major commodities. Anchored by Illinois, Indiana, and Iowa, farmers in District states account for about one-half of the corn, soybeans, and pork produced nationwide. Paced by Wisconsin's top ranking, they also contribute about one-fourth of the milk production. Those commodities, plus cattle account for more than 85 percent of the sales of all farm commodities from District states.

Outside the five major commodities, the District's agricultural plant produces a wide diversity of products. For example, the five-state region has a sizable stake in fruit and vegetable production. Apples and cherries dominate the fruit component, while potatoes and dry beans account for a large share of the District's vegetable production. Within the broad-based fruit and vegetable complex, Michigan has achieved the top ranking in several components, such as tart cherries, navy beans, and blueberries. Similarly, Wisconsin ranks first or second in the production of cranberries and in the acreage devoted to sweet corn, green peas, and snap beans used for processing. The diversity of the District's agricultural production is also apparent in Indiana's top ranking for eggs and in Wisconsin's dominating share for mink pelts. In addition, the agricultural base of the five-state region contains an extensive greenhouse and nursery component and several other commodities, including honey, maple syrup, mint, mushrooms, sugar beets and tobacco.

Services

Service industries have naturally developed in our District in support of its goods producing industries. Increasingly, however, business services are being sold to firms outside the District and the United States.

A strong tendency for producer service firms to favor large metropolitan areas in our District areas is evident. The largest metropolitan areas in the Seventh District--Chicago, Detroit, Indianapolis, Des Moines, and Milwaukee--display a tendency to export services, largely from urban centers to smaller towns and rural locations within the region. However, less populous metropolitan areas specialize in important services as well. For example, although Milwaukee is located only ninety miles from Chicago, a city with more than three times as many people, Milwaukee serves as an independent purveyor and specialist in certain urban services such as advertising, consumer credit reporting, and accounting. Moreover, many small metropolitan areas rank close to or above the larger areas in particular services: Peoria and Cedar Rapids in advertising, Lansing and South Bend in consumer credit reporting, Sheboygan in engineering and architecture, Grand Rapids in accounting, and Battle Creek in management and public relations. Those smaller metropolitan areas hosting major state universities such as Ann Arbor, Madison, and Champaign--Urbana figure prominently as service exporters. Computer programming, engineering, research, and testing labs draw heavily on university skilled labor and institutional capital.

Regional Diversity

From the service sector alone, it is easy to see that a diversity of economic activity also exists within states that can affect individual perceptions of District economic performance. For example, Chicago is a world center for derivative markets and serves as the mid-continental center of business services. While services grew, manufacturing declined. Manufacturing employment in Chicago dropped sharply in the early 1980s. The manufacturing sector lost 179,000 jobs between 1979 and 1983, and Chicago has shown little recovery in its manufacturing sector since that time.

Chicago's service sector employment began to exceed its manufacturing employment in 1979, two years earlier than the rest of the nation. Indianapolis and Des Moines are prime examples of service-sector economies that have thrived on the economic transition from manufacturing to services. For some types of firms and activities, both have provided lower cost locations for financial and business services than either New York or Chicago.

While Michigan is most often identified as the birthplace of the modem auto industry, the northern and western parts of the state are more diversified than the auto-dominated southeastern portion of the state. Office furniture (Steelcase and Herman-Miller), chemicals (Upjohn and Dow), and auto suppliers (Guardsman and Donnelly) have provided the diversity to make cities like Kalamazoo and Grand Rapids among the fastest growing metropolitan areas in the state, while the city of Detroit struggles with a shrinking job base, declining population, and a host of urban problems.

While the recession was not easy for the District economy, employment data seem to suggest that the District has fared far better in the most recent recession than in previous ones--both in comparison to the national experience and to its own past.

Payroll employment data indicate that District employment fell at about the same rate as that for the nation during the recession and has recovered at a slightly faster pace since the beginning of the employment recovery in April 1991. Household employment data show a stronger recovery in Illinois and Michigan, with current levels in both states exceeding previous peaks (while payroll employment data for these states are still well below their previous peak levels). Since unemployment data are derived from the household survey, unemployment rates for the District states have been showing substantial improvement relative to the national experience in recent months. For example, Illinois's unemployment rate of 6.5 percent in January of 1993 marked the longest period of time (six months) that the state had been below the nation's unemployment rate in fourteen years, before jumping up to 7.9 percent in February. Michigan's unemployment rate was 6.8 percent in February of this year.

RESTRUCTURING PROGRESS

Productivity and Competitiveness

Despite the hardships of the recessions in the early 1980s, Seventh District manufacturers maintained a strong commitment to modernization. Indeed, despite a shrinking manufacturing sector, District manufacturers invested on average 5 percent to 10 percent more per production worker annually than the nation since 1984. Investment lagged only during recession years and during the rest of the years of recovery when the high value of the dollar severely depressed export demand for manufactured goods in the Midwest. In the District in the second half of the 1980s the combination of closing inefficient plants and investing in new or existing plants began to show dramatic gains in productivity. For example, estimates based on the relative improvement in District manufacturing output using pre-1985 technology with post-1985 technology suggest efficiency in the District improved about 20 percent more than for the rest of the nation.

Once the exchange value of the dollar began to fall in the mid- to late-1980s, the revitalized manufacturers in the District began to regain market share lost in the 1970s and early 1980s. The 1990-91 recession, in some sense, became a testing ground for the ability of District manufacturers to sustain their competitive edge in an environment that required many to produce well below their most profitable operating rates. Typically, the District economy had been hard hit by national recessions, with employment tending to decline by as much as twice the national rate. If manufacturers in the District were truly becoming more competitive, one would expect that they would weather the recessionary storm more easily than in the past.

While the nation lost more than 2 million jobs in the 1990-91 recession (about the same as in the 1980-82 period), the District lost only about 300,000 jobs. Since the onset of recovery, the nation has recorded an increase of slightly more than 500,000 payroll jobs, an increase of about 0.5 percent from the recession's trough. The District has increased employment about 130,000, or about 0.8 percent from its trough. In other words, the District has fared somewhat better than the nation throughout the recession and recovery period, in marked contrast to its more typical pattern of deep recession and partial recovery.

Real estate activity in the District has been less adversely affected than in much of the rest of the nation. This difference can be explained by the District's relatively stronger economy in recent years than that in other parts of the nation and by the relative lack of speculative excesses in the 1980s. Still, vacancy rates of commercial buildings in the major metropolitan areas of the District have been rising in recent years and in some cases are higher than in the nation as a whole. For example, downtown office vacancy rates in both Detroit and Chicago have generally been below national rates for many years. Chicago's office vacancy rate rose to 17.7 percent in the third quarter of 1992, virtually equal to the nation, but much of that increase was due to recent completion of major office construction projects at a time when the commercial real estate market was weak. Indianapolis has consistently had vacancy rates above the national average, but this may reflect in part the fact that Indianapolis has had a rapidly growing commercial sector. Rapid expansion of office space may have fueled building activity in anticipation of future needs, which may not have been unrealistic given Indianapolis' growth in the 1980s. In contrast, Detroit's low office vacancy rate reflects very little office construction for many years.

Residential real estate activity in the Seventh District has been another strong point in the comparisons with the nation. By almost any measure--housing starts, new home sales, or existing home sales--the District has been outperforming the national housing market in the early 1990s. For example, housing starts for single-family homes in the Midwest portion of the nation rose 25 percent in 1992, compared with 20 percent in the nation as a whole, and the region has returned to previous peak levels of activity in 1986 while the nation is still about 33 percent below 1986 levels. The reasons for this are similar to the relative strength in commercial activity. The District has experienced slow but steady income growth, and housing values have been in line with this growth. As a result, the District has avoided the speculative overbuilding that has been haunting the eastern and western coasts. Indeed, the District generally can be characterized as having some of the most affordable housing in the nation. When the housing market nationally was depressed in 1990 and 1991, District homeowners did not experience the decline in home values that occurred in other regions and in many cases were able to enjoy some of the highest appreciation of housing stock in the nation during the recent economic recovery.

Industrial Restructuring

A close look behind the progress reveals the fact that the challenges facing the District economy remain formidable. The region's firms have begun to restructure in such a way as to be globally competitive. But this process goes hand in hand with massive and geographically concentrated layoffs of the region's residents. For example, in recent years, restructuring announcements in the auto industry are perhaps the most traumatic. Gm's restructuring plans call for closing up to twenty-eight assembly and parts plants, many of which are expected to be in the Midwest, and to reduce its work force by roughly 85,000 white-and blue-collar workers, with most of the white-collar job losses concentrated in Michigan. According to recent estimates, the need for the restructuring can be seen from production cost comparisons between one or more domestic producers with low-cost Japanese producers. The estimates show that cost differentials with low-cost Japanese producers on small cars (assuming full capacity) may have fallen from more than $2,000 in 1982 to less than $500 in 1991.

How have the District's key manufacturing industries fared during this recovery? The auto industry has been improving since mid-1992, leading industrial production both in the nation and the District. If recently announced production plans hold, autos will continue to boost the District economy. Steel is another industry that has been improving recently, even though profitability has been elusive. Recent adjustments in trade restriction are likely to provide a significant boost to District steel production in 1993. Finally, demand for machine tools is being sustained by the need for the auto industry to keep pace with model changes of imports and transplants and by the need for manufacturers to reduce cost and improve quality. Plans for equipment spending appear to be strong and should be a key source of strength in the District's economy in 1993.

Exports have always been an important component of the District's economy, one that has been increasing over time but which was undermined in the mid-1980s, when the dollar's exchange rate was high. Currently, manufactured exports from the District amount to about 12 percent (or $49 billion) of the nation's total. A primary strength in exports has come from capital equipment (particularly industrial and electrical equipment) and scientific instruments. Growth in foreign demand for products of these industries during 1991-92 has helped hold up the District economy in an otherwise sagging export market. In Wisconsin, for example, nonelectrical machinery (mostly machine tools) grew at an average annual rate of nearly 20 percent between 1987 and 1991, before slowing to only 1 percent in 1991 as global markets weakened. Chemical and transportation equipment industries have also been important in the export mix but have been harder hit by the recent slowdown in export growth (in part because of slower economic growth overseas).

Because of the relative importance of this latter group to total District exports, and because of the special role of trade between Canada and Michigan, the District's overall export growth has been held back in recent years. For example, after outpacing the nation in 1990 by a substantial margin, District exports of manufactured goods expanded 8 percent in 1991 and 6 percent in 1992, while nationally exports increased 12 percent and 8 percent. However, if Michigan is excluded (high volume trade occurs between Michigan and Canada and, unless the auto industry is directly involved, Michigan's volume does not respond to changes in overseas demand), the comparisons look a little better, with District exports outpacing the nation in 1992 by roughly 2 percentage points.

External and global swings in the marketplace, such as those influencing current demand for capital machinery and equipment will continue to lie beyond the influence of either local policymakers, or national policymakers for that matter. And because the industries involved are often those who are large employers at individual locations, the local effects will be severe for those regions affected.

Agricultural Restructuring

The late 1980s brought substantial recovery to the farm sector. Farm earnings improved considerably as rebounding exports and altered farm support programs trimmed the burdensome crop supplies of the mid-1980s. The improved returns caused farm asset values to turn upward. The downturn in farm debt that started in 1984 continued through 1990, further strengthening the farm sector balance sheet. Various measures of the quality of farm debt have improved substantially from the distressed levels of the mid-1980s and are more in line with the levels that prevailed before the excesses of the 1970s. Accordingly, the performance of commercial farm lenders has rebounded sharply.

While the financial condition of the farm sector today is vastly improved from that of the mid-1980s, it exhibits a cautious demeanor in spending and continues to go through considerable restructuring to achieve greater production efficiencies. Reflecting the cautious attitudes of farmers, capital expenditures in the farm sector declined for the second consecutive year in 1992 and, at $11.2 billion, were well below the levels of most years over the past two decades. And despite the relatively strong returns to assets in recent years, the bidding in farmland transactions has been lackluster. As a result, the trend in farmland values is only modestly upward in nominal dollar terms and flat to slightly downward in real terms.

The restructuring that still characterizes the farm sector here and elsewhere is reflected in the continuing decline in the number of farms. During the 1950s and the 1960s, farm numbers declined at an annual rate of 3 percent. The rate of decline slowed considerably during the "boom" times of the 1970s and from 1978 to 1981 farm numbers actually stabilized. But the downtrend has resumed since then, with the annual rate of decline over the last eleven years approximating 1.5 percent.

The decline in farm numbers has been especially apparent among pork producers, a commodity of particular importance in states comprising the Seventh Federal Reserve District. The 1987 Census of Agriculture found that the number of farms with hogs was down 45 percent from nine years earlier nationwide and down 37 percent in District states. (During the same time period, the decline in all farm numbers was closer to one-tenth). Updated information shows that the number of operations with hogs has declined an additional 25 percent nationwide since 1987 and about 14 percent in District states.

Several factors are behind the restructuring that continues to result in shrinking farm numbers and a greater degree of commodity specialization among those that remain. But a major factor reflects the need to achieve scale economies to reduce production costs per unit of output. With the increasing globalization of agricultural markets and the likelihood of a further downscaling of federal government farm income and price support programs, the focus on achieving scale economies will no doubt continue in the future. These restructurings that enhance the production efficiency of U.S. agriculture may need to be complemented with redefined rural development and infrastructure investment policies that, among other things, help to retrain displaced farmers and provide better job opportunities for all rural residents. Research on relocation of manufacturing activity shows that a number of nonmetropolitan counties in our District are achieving growth in manufacturing employment. But many of these fortunate counties either border metropolitan areas or enjoy the transportation advantages of an interstate highway. Many other rural counties could benefit from efforts to retrain workers and expand off-farm job opportunities.

The farm sector restructuring has parallel trends among agribusiness firms that process and distribute agricultural commodities or manufacture the inputs used by farmers. Consolidation has been vividly evident in recent years in the number of meat packers and processors. Moreover, the emphasis on specialization has led to a geographical shift of beef processors out of the Midwest into more western states. Reflecting this, the share of cattle processed by packing firms in the five states of the Seventh Federal Reserve District has declined from 23 percent to 14 percent over the past two decades. This loss has been only partially offset by the growing share--from 44 percent to 50 percent--of the nation's hogs that are processed by commercial packers in District states.

Mergers and acquisitions have also been widespread in the fertilizer, pesticide, seed, and farm machinery and equipment industries in recent years. The consolidation of the farm machinery and equipment industry has had a sizable repercussion on the states of the Seventh Federal Reserve District. As purchases of farm machinery and equipment retreated during the "credit crises" of the 1980s, U.S. payroll employment among farm machinery and equipment manufacturers retreated from a peak of 159,000 in 1979 to a low of 65,000 in 1986. The trend since then has been mixed; recovering to about 79,000 in 1990 and then retreating to just over 70,000 last year as the cautious spending patterns of farmers triggered another slump in sales. The consolidation suggested by these employment numbers for farm equipment manufacturers was, no doubt just as extensive in the number of dealerships and the network of suppliers, distributors, and haulers that support the farm equipment industry.

CONFRONTING THE CHALLENGES

After periods of economic shocks, a region's indigenous institutions, including its financial lenders and state and local governments, must take up the challenges of redevelopment and rebuilding. However, during such times, their resources are often stretched thin.

State and Local Government

In the 1990s the District's state and local governments are being forced to make structural changes to their revenue systems and cuts in their service programs rather than relying on the usual temporary budget maneuvers that are typical of cyclical downturns. Despite profound shocks to its economy during the 1980s, Seventh District governments largely avoided structural changes to revenue systems and services. Following the weak 1980-82 period, District governments were able to restore fiscal solvency and repeal the temporary surcharges that they had imposed to shore up deficit positions. Today, however, the tepid pace of economic growth, coupled with overlying pressures from Medicaid and federal mandates, have pushed state and local governments to enact tax hikes and service cuts during the aftermath of the 1990-91 recession. This pressure has left fewer resources to assist the region in reinvestment and redevelopment.

The 1980s

The back-to-back recessions of 1980 and 1981-82 were particularly hard on the Seventh District as illustrated by a nearly 25 percent drop in Seventh District manufacturing employment from the peak in the first quarter of 1980 to the trough of the second recession in the third quarter of 1982. At the same time and for several years thereafter, the agriculture sector was plagued by several droughts, debt carryover from the 1970s, and a rising value of the dollar.

The decline in these two key industry sectors had a strong effect on the District's state and local fiscal health. Still District governments managed to weather the short-lived 1980 recession without having to turn to major tax increases; they did so by drawing down relatively healthy fund balances. The recession of 1981-82 proved harder to absorb. Still, District states managed to forestall major spending cuts and tax hikes, at least up until the second half of fiscal year 1983. At that time, deficits were so severe, and further public service cuts so intolerable, that all of the five states took the unpopular measure of increasing either income or sales tax rates or both. Nonetheless, the income tax changes came primarily in the form of surtaxes that were repealed or expired when recovery set in. For example, the long-awaited snapback in consumer spending lifted the Michigan economy in 1983 and 1984, enabling Michigan to cut a temporary income tax rate hike from 6.35 percent to 5.35 percent by fall 1984. State and local balance sheets were replenished so that fiscal conditions in all five states were fairly strong by the first quarter of 1985.

Relative to East and West Coast states, Seventh District states tended to increase expenditures at a slower rate during this period. Also, District states used this period of improved conditions to bolster their fiscal structure against future downturns. Michigan pioneered the creation of a budget stabilization fund, and other District states began using a series of techniques all designed to put structures in place to cushion government from future economic downturns.

The 1990s

Fiscal prudence has generally allowed the Seventh District states to avoid the high degree of fiscal adjustment that has characterized the New England states and California; however, it has not left the states insulated from the fiscal stresses that now have an estimated twenty-two states running structural deficits.

As both self-initiated programs and federally mandated programs have grown, state revenue growth has been unable to keep up. Mandated prison sentences are swelling corrections expenditures as prisons must be constructed to house the swelling inmate population. Medicaid, which requires states to match federal contributions, has also been exploding in terms of costs as the scope of services covered by Medicaid have been regularly expanded and the eligible population has grown. These costs have shown little prospect of abating.

Meanwhile the potential for huge additional costs to be added through more stringent environmental compliance standards looms in the future. Additionally, unlike the early 1980s, the cyclical strategy of using surtaxes to cover budget problems in downturns may need to be abandoned this time. Illinois, for example, has extended its income tax surcharge through June of 1993 and is now considering making it permanent and dedicating the proceeds to state government or to local education rather than sharing the receipts with municipalities. Michigan voters have recently rejected a proposal for local property tax relief in the belief that the state would not have the resources to make up for the accompanying revenue shortfalls.

State and local governments have also made painful expenditure cuts. The structural nature of the adjustments now under way in District states is also illustrated by the fundamental service programs that have been the target of cuts. Deep cuts have been made in popular programs such as general assistance, higher education, and economic development. For example, among the first programs to fall under the budget axe in Michigan was the state's General Assistance program, where 90,000 "able-bodied" recipients were cut from the rolls. Similarly, state universities throughout the Seventh District have seen only small increases in their budgets. From fiscal year 1991 to fiscal year 1993, the average annual increase in higher education appropriations ranged from a high of 3.5 percent in Wisconsin, to a decline of -0.5 percent in Illinois.

So far this year higher education expenditures in Illinois are down 3 percent through the first half of fiscal year 1993. At the same time, public universities have had to raise tuition so as to limit the magnitude of budget cuts. Similarly, economic development departments in Illinois and Michigan have been drastically cut. The state-funded portion of the Illinois Department of Commerce and Community Affairs had its budget cut nearly 80 percent between fiscal year 1991 and fiscal year 1993. Michigan's Department of Commerce saw a 70 percent budget reduction over the same period.

Because of the uncontrolled growth in Medicaid and corrections spending, these programs have had to absorb greater reductions than would have been the case in previous downturns.

At the present time, state governments have little room to maneuver. Both Illinois and Michigan have exhausted their budget reserves and have exhausted the usual list of fiscal measures tried by the states to avoid making more sweeping structural adjustments to their budgets. Faced with a backlog of bills, both states will still be in difficult shape even with a sustained recovery. For example, in fiscal year 1992 Michigan used $150 million from its budget stabilization fund, leaving a balance of only $22 million. Even so, to balance its books, the state had to accrue certain taxes and delay school aid and revenue sharing payments to municipalities. In the coming year, without a budget reserve and having exhausted other fiscal maneuvers, the state will have to make structural changes in expenditures or revenues to cope with additional fiscal stresses. In Indiana, Iowa, and Wisconsin potential fiscal maneuvers are also becoming limited. To keep fiscally healthy, Indiana has been forced to use more of its budget reserve than it would prefer. Wisconsin, whose relatively strong economy has made it better situated than most states, has still relied on the active use of Governor Thompson's veto and has shifted some responsibilities to the local level. Wisconsin's revenue department has been looking at the expanded use of local sales taxes in the state and the possibility of enabling a local option income tax. In Iowa, two very austere budgets in 1990-91 and 1991-92, accompanied by employee reductions and some limited tax increases, have enabled the state to cobble together a precariously balanced budget, but the state has no real reserves left to meet any unforeseen downturns.

Pressures on state government have spilled over and have been passed along to local governments. Despite the fact that property taxes are among the most unpopular of all state and local revenue sources, the Seventh District tax structure is already more reliant on property taxes than is the case nationally.

All of the District states, except for Indiana, rely on property taxes for a larger share of the state and local revenue mix than is the case nationally. As a result, efforts to mitigate future increases in property taxes have been proposed or enacted including property tax caps in Illinois and Wisconsin. This past autumn, Michigan failed to pass the "cut and cap" proposal on the ballot when voters appeared to believe that it was unrealistic to expect state reimbursement for lost property tax revenues. In fact, voters were probably correct in their assessment; state governments have already passed along their own fiscal pressures to local governments by delaying or trimming school and municipal aid payments. Such efforts to push programs down to municipalities or to reduce state aid to towns will further strain the property tax base and impede efforts to reduce reliance on the property tax base.

Compounding the strain on the property tax base is the slow growth in assessed values. More conservative property revaluations and a lack of new construction are limiting the automatic growth in local revenues, which towns became accustomed to during the latter 1980s. With a distinct possibility that some state responsibilities may be shifted to local governments, proposals will probably emerge to permit towns to impose new types of taxes to diversify their revenue base and to avoid even greater reliance on property taxes.

Rising Medicaid and health care costs will continue to pressure the state and local sector even if the current economic expansion accelerates. These costs have provided the most powerful and persistent fiscal strain on state governments. What in 1980 consumed 6 percent of state budgets is being projected to consume 28 percent by 1995. The growth rate for Medicaid expenditures is running at nearly four times that of revenues. Each year the states have underforecast the rate of growth in this budget area. As states have had to provide supplemental funds to cover unanticipated Medicaid expenses, other budget areas have been squeezed. For example, two District states, Wisconsin and Indiana, had to supplement their fiscal year 1992 Medicaid budgets by $67 million and $42 million respectively. These increases represented supplements of more than 40 percent over the original Medicaid budgets in these states. Some pressure has been eased by the enactment of Medicaid provider taxes in Illinois, Michigan, and Wisconsin. These taxes force providers to pay tax on the proceeds they receive from providing Medicaid services and in most cases have the side effect of increasing the federal contribution to state Medicaid programs. In Illinois, Medicaid expenditures twenty years ago were half of state spending on primary and secondary education. Today it slightly exceeds that spending.

Concerns for the Future

Longer term, there will be continuing pressures for increased expenditures on education, infrastructure, and the environment. These three areas will demand more government resources in the future. In the case of education, the District states' reliance on property taxes to fund elementary and secondary education presents two problems. First, property tax revenues over the near term are unlikely to grow very fast because of a lack of expansion in the property tax base. Unless new efficiencies in providing education are miraculously found and implemented, property tax rates will be pressured upward. Given the taxpayer sentiment against the property tax increases and the popularity of tax caps in states such as Illinois, the ability of this tax source to fund the larger educational expenditures, which will be needed with a growing school population, will be strained. Second, the reliance on the property tax also creates funding inequalities between school districts. District states have so far been able to avoid judicial challenges that would compel an equalization scheme. However, in last fall's election, an Illinois referendum that would have required that the state pay "the majority" of school funding was narrowly defeated despite receiving better than 57 percent of the vote; 60 percent was required. Moreover, court challenges will continue. The success of any of these initiatives would be severe. To make equalization schemes at all acceptable to the public, spending will need to be " leveled up, " thereby sharply raising overall revenue requirements.

Infrastructure investments are also being called for, mostly in the form of repair and replacement of existing structures. For example, one-third of Chicago's sewer system is more than eighty years old. Given that the sewer system was designed to have a total life expectancy averaging ninety years, it is clear that significant outlays will need to be made in the coming years. Other basic infrastructure, such as roads and bridges, are also in need of attention. Because the District states do not carry heavy levels of indebtedness (measures of both bonded debt per capita and per $1,000 of personal income are low in all District states), states would ordinarily be in relatively good shape to issue debt in the form of bonds. However, the weak rates of revenue growth will make it costly to issue additional debt because it is uncertain as to whether future revenues will be sufficient to service the debt.

Environmental concerns have been added to the list of long-run concerns. Both states and municipalities face staggering costs in implementing the environmental standards included in programs such as the Clean Air Act Amendments of 1990. A detailed study by the city of Columbus, Ohio, estimated that the city will need slightly more than $1 billion to comply with twenty-two state and federal environmental mandates over the next ten years. The magnitude of that expenditure is best illustrated by the fact that the total city budget in 1991 was $591 million. Similar compliance costs can be expected at both the state and local level in Seventh District states where the industrial and agricultural heritage of the region will make environmental compliance costs steep. At the state level the combination of Medicaid and health care costs and environmental compliance costs has the potential of consuming the bulk of state budgets. At the local level, education expenditures (when coupled with these environmental compliance costs) will have the same effect--limiting the other program options of government.

There are also concerns that the pension systems Of many public employees may be underfunded. Three of the District's five state employee pension funds are severely underfunded, and this has the potential of making worrisome claims on future revenues. Michigan's state pension fund has contributions equal to 66 percent of future liabilities, while Illinois and Indiana have funding levels of 64 percent and 58 percent respectively. These states can use a "pay as you go" strategy to avoid having to make any drastic short-term adjustments in their levels of contributions. However, such a policy has two negative repercussions. In the near term, states have been increasing their immediate pension liabilities and outlays through early retirement programs aimed at saving overall personnel costs. But this policy puts immediate strains on current operating solvency. Second, state bond ratings can be unfavorably affected by pay-as-you-go pension funding, thereby raising borrowing costs because underfunded pensions are usually viewed by agencies as an indicator of fiscal stress.

Recap

Because of both its own fiscal prudence during the troubled 1980s and to the more favorable regional conditions currently prevailing in many parts of the District, state and local governments have passed through these troubled times in better shape than many other regions. Nonetheless, District governments are as widely diverse as the District's economy. For example, state government in Michigan and many of its local governments, in particular, are susceptible to the upheavals in the economic base that accompany plant closings and mass layoffs in the auto industry. Moreover, District governments in general are far from insulated from the pressures common to the entire state and local sector nationally: rising Medicaid and prison expenditures, federal mandates such as compliance with environmental regulation, and slowly growing revenues. As a result, structural changes and fiscal crisis are evident throughout our District for many governments that have made painful cuts in public services and that have raised tax rates or extended tax surcharges.

Financial Developments in the Seventh Federal Reserve District

Although the Seventh District did not escape unscathed the financial trauma that has afflicted the rest of the nation since the early 1980s, it has suffered less than most other regions. Neither the number of failing banks nor their assets have been as large, relative to District totals, as in most other areas of the country. For the entire Seventh District, only 72, or 2.6 percent, of District banks failed between 1982 and 1992, as opposed to 9.7 percent of the banks for the country as a whole. The annual number of failures in the District peaked at 14 in 1985, well before the 1989 peak of 206 failures for the entire United States. In large part, the difference in timing of the District's banking problems relative to the rest of the country reflected some previously noted characteristics of the behavior of the broader economy. One was the fact, discussed in some detail above, that the District economy was hit extremely hard by the 1981-82 downturn relative to other regions of the country. District banking, in turn, was strongly affected by the collapse in land prices and agricultural loan quality problems that accompanied the disinflationary period that followed. In more recent years, in contrast, the District was largely spared the problems experienced by the Southwest associated with the sharp fall in oil prices beginning in 1986, and the 1990-91 recession was not as severe in the District as elsewhere. However, we also like to think that the lower failure rate in the District over the entire decade had something to do with the diligence, conservative loan evaluations, and prompt supervisory intervention that have characterized our field examiners and supervisors.

District banks continue to show improving earnings and capital. In 1992, the average return on equity for commercial banks in the Seventh District was 11.6 percent, up slightly from 11.3 percent in 1991 but slightly below the national average of 12.1 percent, while the average return on assets was 0.90 percent, up from 0.83 percent in 1991 but also slightly below the national average of 0.91. While the return on assets of District banks with assets of less than $1 billion rose sharply to 1.17 percent in 1992 from 0.98 in 1991, that of District banks with assets of more than $1 billion slipped slightly to 0.66 percent from 0.67 percent in the previous year and remains well below what traditionally have been considered "normal" levels; the same pattern holds for return on equity. The improving health of District banks was further attested by the fact that there has been a 70 percent decline in the number of lower-rated banks in the District since the end of 1986.

Beset by the erosion of capital by loan losses of the past decade and new regulatory pressures to increase capital, District banks strived to increase their capital ratios in several ways. They have added to retained earnings by restricting dividends and have gone to market with new issues of equity and subordinated debt. To some degree they have adjusted to the tighter capital constraints by cutting lending and asset growth. The net effect of these adjustments was that capital ratios rose for nearly all District banks, with the average equity capital-to-assets ratio averaging 7.8 percent as of the end of 1992.

A key factor in the improving condition of banks in the District has been the gradual winding down of their asset quality problems. Nonperforming loans were down from 2.1 percent of total loans in the fourth quarter of 1991 to 1.7 percent of total loans as of the fourth quarter of 1992, reflecting the improving economic conditions and further chargeoffs of the worst loans. An equally encouraging sign was the sharp increase in loan-loss reserve coverage at year-end 1992 to 105 percent of nonperforming loans, up from 96 percent in the preceding quarter and from 88 percent at year-end 1991. In view of the fact that this coverage ratio has averaged just over 100 percent for District banks in the past, its current level suggests that most of the negative effects on bank capital of facing up to probable loan losses are behind us and will no longer constitute a drag on new lending.

The ongoing process of consolidation that has characterized our region over the past two decades has allowed Seventh District banks to become more diversified, in turn, increasing their safety and soundness. This process was given added impetus by the decision of District states to open themselves to regional and nationwide banking. This process is dramatically altering the banking structures of states in the District, which for many decades had some of the most restrictive branching and holding company laws in the nation. Because of the asset quality and earnings problems encountered by some of the money center and other larger banks in the Seventh District's major financial centers in the mid-1980s, those banks have not been in a position to take the initiative in geographical expansion and acquisition activity. Consequently, the vacuum has been filled by large regional banks headquartered outside Chicago and, in some cases, outside the District.

Thrift institutions in the Midwest are also showing improvement but from a much lower base. Because of their institutional design, thrift institutions were, of course, much more vulnerable to the unprecedented increases in interest rates at the beginning of the 1980s than commercial banks. Of the District states, only Illinois had a serious thrift problem, ranking fourth in the number (forty-seven) of thrift institutions resolved by the Resolution Trust Corporation between its establishment in 1989 and year-end 1992 and eighth in terms of the total assets of resolved institutions ($7.7 billion). Although most of the terminally ill thrift institutions in the Midwest have now been placed in receivership, a formidable cleanup operation is still in progress. Only four savings and loan associations in the District remain in the conservatorship program, and there are eight undercapitalized savings and loans rated MACRO 5 that are candidates for conservatorship.

It should not be assumed that the health of depository institutions in the Seventh District has been fully restored or that there is no possibility of further setbacks. There is still general weakness in commercial real estate lending, reflecting the high vacancy rates and reduced building activity that constitute the hangover from the binge of the late 1980s. However, because overbuilding in the 1980s never reached the fever pitch in the District that it did in the Southwest and New England, the correction has so far been much more moderate. But while the vacancy rate in Chicago remained lower throughout the mid-to-late 1980s than in the nation, it has risen sharply over the past three years as more space has come on the market--just as Sears was relocating to the suburbs.

Credit Availability

During the past three years, credit availability remained better in the Midwest than in many other parts of the country. This was largely the result of the relatively healthy condition of the District's banking organizations. This health not only meant that fewer banks were forced to reduce their lending, but it also eased the adjustment for borrowers at banks that were facing capital and asset quality problems. Indeed, several of the better capitalized banks in the Seventh District actively sought to bid away creditworthy customers from the District's weaker banks.

In addition, the few midwestern banks that experienced significant asset quality problems had loans outstanding to borrowers throughout the country. This diversification had two consequences. First, the fate of our troubled banks was generally tied to the prospects for the national economy, not the fortunes of a single region, as was the case in New England. Second, in contrast to New England, the disruptions created by the retrenchment of the troubled banks in our District were spread across the entire country rather than being concentrated on borrowers in the District.

But while the District's banking system remained relatively healthy, midwestern borrowers could not completely escape the changes sweeping through U.S. credit markets. The net effect of these changes has been to make bank lending more profitable, ending a long-standing but unsustainable deterioration in the compensation banks receive for bearing risk. Because the new pricing structure reflects these risks more accurately, the ultimate result will be a safer and more effective financial system. The banking industry's transition toward this new, more realistic pricing structure began to be apparent in spring 1990, accelerated dramatically during late 1990 and early 1991, and was completed by 1992. Several forces, including changes in bank regulation, drove the restructuring. However, the three most important forces pushing the industry down the road to restructuring were the perceived increase in the risk of the industry's loan portfolio, the concomitant increase in industry losses, and the growing realization that lending could not be profitable without substantially wider spreads.

As was the case across the nation, District banks responded to these forces by reducing their exposure to their largest borrowers and tightening the pricing of loans and loan commitments to nearly every type of borrower. Whether poorly capitalized or well-capitalized, large or small, urban or rural, virtually every bank in the Seventh District participated in the shift to a new, more realistic pricing structure for bank loans. The upshot has been a slowdown in the growth of assets held by District banks from 3 percent in 1990 to 1 percent in 1992.

The restructuring of credit markets during 1990 and 1991 was inevitable and, on balance, desirable. Nevertheless, because policymakers did have several tools at their disposal to ease the transition process, the Federal Reserve was continually checking for signs that tight credit was creating significant barriers to the growth of businesses, either in the District or nationally. However, our contacts with District businesses and banks suggested that, outside the real estate sector, District borrowers were still able to obtain credit, albeit at a higher price. Indeed, the primary concern of most of the businesses we contacted was neither the availability nor the price of credit; it was the economy's sluggish performance.

At recent meetings of our Small Business and Agricultural Advisory Councils, we have again carefully reviewed the question of credit availability with the council members. The view continues to be that banks have become much more careful in the loan extension process; credit standards have been raised, documentation requirements have been made more demanding, and as noted above, spreads and fees have risen. However, our council members almost universally felt that adequate credit was generally available.

On the other hand, many council members were concerned that environmental regulations are making certain types of transactions unbankable. Leery of the potential liability, some banks are shying away from a credit whenever an environmental issue is even a remote possibility. Those banks that are willing to proceed are very demanding in their requirements for complete but costly environmental studies. Both our Agricultural and Small Business Advisory Councils feel strongly that this environmental matter is significantly impeding the extension of credit to these key sectors of our District's economy.

From the perspective of the District's banks, the restructuring of credit markets is now largely complete. Credit terms have ceased to tighten, asset quality is on the rebound, and most District banking organizations have now built up a sufficient cushion of excess capital that they can focus more of their attention exclusively on the business of lending. However, this does not mean that District banks will soon again begin growing at 7 percent or 8 percent a year. In all likelihood, District borrowers are still adjusting to this new more realistic pricing structure. As these borrowers find additional ways to economize on bank credit, their borrowing needs will decrease. This process will be accelerated by the fact that many businesses are carrying debt burdens that are inappropriately high for such a competitive and volatile economic environment. Until District businesses have fully adjusted to the new credit market realities, we will continue to see relatively modest rates of growth at District banks.

CURRENT CONDITIONS

Entering 1993--A Current Assessment

The same challenges and opportunities that have transformed the District's economy over the past fifteen to twenty years can be seen shaping its economic performance today. To be sure, the District's economy is still doing better relative to the nation in many sectors, but competitive pressures are continuing to force change. Moreover, the pace of our recovery is lackluster by past standards and concerns of sustainability remain as much an issue for the District as for the nation.

Agriculture

The 1992 crop season was characterized by a record harvest nationwide despite some of the most unusual weather patterns in memory. In our District, record-breaking outcomes in Illinois, Indiana, and Iowa pushed the five-state corn and soybean harvest about 28 percent above the low year-earlier level and 8 percent above the previous high set in 1985. But the overall abundance was countered in many areas of the District--especially in Michigan and Wisconsin--by several problems that resulted in a very difficult harvest. Cool temperatures during the growing season, an early frost, and a rainy fall season led to a late harvest, costly drying charges, and extensive quality discounts on much of the corn harvested in the northern portions of our District.

The price implications of the larger harvest will be only partially cushioned by increased consumption. Domestic consumption of both corn and soybeans will likely register further growth during the current marketing year. But compared with the 20 percent decline in the combined tonnage of corn, soybeans, and soybean meal shipments abroad the past two years, export prospects for the District's crop farmers have improved only marginally this year. This partially reflects the delinquencies that have led to a suspension since late November in new government credit guarantees to finance shipments to Russia. It also reflects the evidence that the crops now growing in the Southern Hemisphere could produce a banner harvest and add further to available world supplies.

It now seems clear that the record 1992 crop harvest will contribute to a large buildup in carryover stocks. As such, prices of major Seventh District crops have hovered at fairly low levels. In particular, corn prices since last September have averaged just over $2 a bushel, down nearly one-fifth from a year ago and the lowest in nearly five years. The lower prices will likely outweigh an increase in government payments and lead to a decline in earnings of District crop farmers this year. This will be particularly true for those hit hardest by the harvesting problems of last fall.

The District's livestock and dairy farmers are also experiencing lower prices from expanding production. The current cyclical upswing among hog farmers has been under way since the fall of 1990. Per capita pork production rose 7 percent last year and reached the highest level since 1981. The latest U.S. Department of Agriculture estimates show hog numbers nationwide are up 4 percent, assuring continued growth in pork production well into this year. The inventory estimates for Iowa-by far the largest pork producing state--show a rise of 8 percent. Among the other District states, hog numbers are little changed from a year ago.

The implications of the expanded production on livestock prices have been partially cushioned by the improving trends in U.S. meat trade. U.S. pork exports have grown rapidly in recent years while pork imports have declined. Nevertheless, hog prices for all of 1992 averaged about 14 percent less than the year before, and further slight declines are expected for this year. Prices for many hog farmers may fall below the cost of production. However, the more efficient producers will likely experience smaller but positive operating returns.

The District's dairy farmers have witnessed quite volatile markets in recent years. Last year, milk production expanded a little more than 2 percent. Although averaging 7 percent higher for all of last year, milk prices weakened considerably during the latter half of 1992. Prices are expected to lag year-earlier levels for much of 1993 until production is pulled into better balance with market needs. Earnings of dairy farmers could turn down this year, reversing some of the gains of last year.

The agricultural sector continues to operate with a vivid awareness of the devastating setbacks suffered by farmers and agribusiness firms as the "agricultural credit crises" of the 1980s washed out the excesses during the "boom" of the 1970s. The subsequent improvement in farm earnings and in the level and quality of farm debt has been substantial, placing the industry on much more solid footings for the 1990s. Yet the actions of farmers and agribusiness firms reveal a mood of uncertainty and caution. This mood is tied, in part, to the painful memories of the 1980s. It also reflects the continuing focus on trimming the federal budget deficit and the implications for the safety net provided in farm income and price support programs. The cautious mood of farmers is also related to concerns about the longer-run prospects for export markets that are vital to U.S. agriculture. These concerns mostly center on the General Agreement on Tariffs and Trade and North American Free Trade Agreement negotiations and the changing economies of Eastern Europe and the former Union of Soviet Socialist Republics.

The near-term prospects for Midwest farmers are somewhat mixed. A record crop harvest last fall and the ongoing expansion among livestock producers will continue to weigh heavily on prices of major Midwest farm commodities. Conversely, an expanded volume of crop and livestock marketings and a sizable increase in government payments to crop producers will hold gross farm earnings close to last year's relatively high level. Farm production costs will likely be flat again this year due to moderating pressures on input prices and a slight decline in crop acreage.

Industry

The District's economy in January and February of this year has been leading the nation in many key sectors, particularly manufacturing, retail trade, and housing activity. For example, the recent gains in District manufacturing have been broad based, with producers of steel, appliances, autos, and heavy-duty trucks all reporting improvements as they enter 1993. Appliance producers, in fact, reported a surge in production at the end of 1992, in part linked to improving housing demand but also to an effort by dealers to stock up on 1992 models before new energy efficiency standards take effect on newer models. Steel producers are booking orders as far as two quarters ahead because of the desire of some customers to ensure deliveries. However, profit margins are depressed, and one producer has scheduled two price increases on cold rolled steel for the first half of 1993 in hopes of raising the price of a ton of steel above costs. Class 8 heavy-duty truck producers report that public freight carriers have been ordering trucks in large quantities since July 1992, with the current order intake rate running at an impressive 180,000 units annually, triggered in part by pent-up demand but also by higher fuel-efficiency standards on new models. Sales of Class 8 trucks in 1992 were up sharply (20 percent) from a year earlier but only reached 119,000 units, a good improvement from last year but still well under peak levels of former years. One producer is expecting sales to reach as high as 160,000 units in 1993, which would be near the previous peak level in 1988.

Still, a key reason for the strength in manufacturing activity has been the increase in car and light truck assembly in the fourth quarter of 1992 and first quarter of 1993. If assembly plans hold for the remainder of the first quarter, the auto industry will have its highest (seasonally adjusted) quarter of assemblies in four years, benefiting not only District assembly plants but also the steel, fabricating, and auto-supplier industries located in the District.

The competitive strength and diversity of District producers among sectors that are doing relatively well is reflected not only in our direct talks with producers but also in surveys that provide a broader scope to our District coverage. For example, purchasing managers' surveys from around the District are providing a direct confirmation of what corporate executives are reporting. The production components of purchasing managers' surveys from around the District, including Detroit, indicate moderately expanding production activity in early 1993. In fact, the production component of the Chicago survey reached its highest level since 1988. This continuing strength in the auto and other manufacturing industries should help sustain the District's relatively favorable showing for retail sales and employment in recent months.

Reports on District retail sales in January and February are indicating continued strength in spending after the strong Christmas selling season last year. For example, a large department store in the District has told us that year-over-year sales growth has continued, despite the fact that sales were quite strong at this time last year and weather in February was unseasonably harsh. District gains were concentrated in seasonal merchandise, household goods, and big-ticket items in general. Several retailers in Michigan, including the Detroit area, had better-than-expected sales gains in January and February. Such gains are in line with government data on growth in personal income, which showed District states on average doing slightly better than the national average through the third quarter of 1992 (most recent data available). Nevertheless, several established retail chains in the District are facing stiff competition from new discount chains that are aggressively moving into the District--in some cases occupying buildings left behind by those retail chains that are retrenching.

The strength in demand for home furnishings and appliances indicated by District retailers is derived in part from the continuing gains in the District's housing sector. A major realtor in the Chicago area has told us that single family home sales in January were the second best January ever for the company, exceeded only by last year, when warm weather combined with a pickup in market share to produce a surge in sales. February is running ahead of last year, however, so that the year-to-date gap with last year is quickly closing (again despite the occurrence of the coldest weather of the winter in February). For the state of Illinois as a whole, realtors were seeing accelerating existing home sales through the fourth quarter of last year. A building materials supplier in Michigan has been experiencing double-digit sales growth in January and reported that builders in the area expect housing sales in the area to be at double digit rates for 1993.

Employment growth remains the primary concern for the sustainability of the District's, as well as the nation's, recovery. While employment gains in January and February of 1993 continue to be hard won, various sources of information indicate employment in the District has continued to increase. For example, the employment component of the Chicago purchasing managers' survey, after bottoming out in early 1991, reached a five-year high in January and then backed off in February. A January survey of metalworking firms in the greater Chicago area showed that hiring activity was strong and that some businesses were beginning to find shortages of skilled workers. And, it should be noted that the recent benchmark revisions for payroll employment in Michigan showed an upward revision of more than 70,000 jobs (which would mean that the state's employment today is about half of the way back to its prerecession peak rather than virtually flat over the recovery as indicated by the original data). Finally, Manpower Inc., which surveys businesses quarterly, reported a net increase in the number of midwestern firms expecting to hire workers in the second quarter of 1993 of 18 percent, compared with 16 percent in the nation as a whole. Most firms in the District were more optimistic in the latest Manpower report, with even Michigan firms expecting more hiring activity (with the exception of those located in Detroit).

Despite these indicators of an employment pickup, most large businesses in the District either have hiring freezes in place or are actively downsizing their workforce. Overtime is running at high levels, and demand for temporary help is strong. But the decisions to hire permanent workers are being made sparingly and with the greatest reluctance and will continue to be until the recovery shows greater staying power than it has to date. The recent announcement by Dow Chemical in Midland, Michigan, of pending layoffs, however, still illustrates the problem of job creation.

While the auto industry has been a boost to the District's economy recently, it may also be a source of instability because of the concern that car sales will not match industry expectations of 13.5 to 14 million units in 1993 (an increase of as much as a one million in unit sales of cars and light trucks over 1992). Auto production for the second quarter of 1993 is expected to be above year-ago rates but could show a decline from the seasonally adjusted annual rate in the first quarter. One reason is that Ford and Chrysler will be closing plants earlier than usual to make model changeovers.

How much of a cutback in auto production occurs in the second quarter will ultimately be determined by auto sales strength. In the first two months of 1993, light truck sales have been quite strong, with mid-February ten-day sales rates at more than 5.0 million units (annual rates), compared with last quarter's near-record sales rate of 4.8 million units. However, car sales have been a different story. Car sales have been running at about 6.4 million units through mid-February (except for the first ten days of January), which is about equal to the fourth-quarter rate and in the last ten-day period, sales slumped to 5.5 million units for cars and to 3.8 million units for light trucks, which industry analysts attribute to consumer concerns about higher taxes. Still, Big Three producers are better positioned to increase their market share than in the past, in part because imports have been increasing prices at a faster pace than the Big Three and in part because Big Three quality has generally improved. Still, sales will have to increase in the second quarter if the industry is to maintain second-quarter production schedules. While it is encouraging that retail sales in general have not experienced a retrenchment on the part of the consumer, one has to believe that new sources of disposable income through employment growth will be needed to sustain growth in consumer spending.

In assessing the role of the Seventh District economy in the current environment, it must be remembered that the Seventh District's economy has been playing an unaccustomed role in the national economy in the early 1990s--that of a stabilizing force in economic growth. In the past, the District has been highly cyclical, accounting for much of the nation's job losses in recession and much of the job gains in the early stages of recovery. To be sure, the District's cyclicality was augmented by the long-term decline of its manufacturing sector. The District's manufacturing sector is no longer shrinking and may indeed be regaining some of the market share lost in past years. And, its improved competitiveness may also be making its cyclical industries less sensitive to cyclical swings in the national economy. This is because the District's cyclical industries are better able to hold on to market share (because of their improved competitiveness) than in the past. Moreover, the District should be less directly affected by the defense industry cutbacks. However, because the District is vulnerable to a sudden downturn, if the national economy weakens, I would be cautious about relying too much on the District's economy to be an engine of economic expansion indefinitely.

Monetary Policy: Meeting the Challenges

Recognizing the problems confronting the District, I have consistently favored monetary policy actions that would foster financial conditions necessary for sustainable economic growth. It has been obvious from our continuing and extensive contacts in the District that the economy would need assistance to deal with the significant structural drags on job creation and growth. It has also been clear that the needed adjustments would be painful, but a vital, growing national economy cannot be assured as long as there are significant financial and industrial imbalances. Restructuring has resulted in major gains in productivity for District firms. But as much as productivity gains are needed to maintain competitiveness and promote long-term economic growth in our District, there is a continuing concern about what this means for job creation and the income gains necessary to generate improved standards of living.

In my view, the role of monetary policy in this environment is to provide a financial environment that will assist in correcting the financial imbalances and restructuring issues discussed above. The basic goal of monetary policy must be to maximize the economic well-being of the nation as a whole. This means promoting financial conditions consistent with maximum sustainable growth. Specifically, it is my view that it is incumbent upon monetary policy to maintain a level of sustainable growth in the economy accompanied by sufficient job creation to absorb new workers and sufficient investment to ensure our ability to produce and compete in today's global economy. This is not to say that we can or should ignore other aspects of our environment such as inflation or other signals of long term problems but that these conditions need to be considered in light of the real performance of the economy.

As you well know, our economy over the past few years has been experiencing significant difficulties in maintaining an adequate rate of real growth. Economic progress has been uneven across both regions and industries. Economic statistics during this period have not always provided sufficient information to form an adequate picture of the economy. In this environment I have, consequently, tended to rely heavily on information from our Boards of Directors in Chicago and Detroit, our Small Business and Agriculture Advisory Councils, groups of industry observers meeting with us, frequent individual contacts with District firms, and continued participation in regional economic development groups in all of our District states, as well as major contacts through the Council of Great Lakes Governors and the Council of Great Lake Industries. These types of contacts in the Seventh District and elsewhere in the Federal Reserve System are extremely helpful in the formulation of monetary policy. As I see it, examination of District conditions is an important tool in keeping the monetary policy process in touch with challenges faced by the economy.

The most recent economic downturn provides a graphic illustration of exactly why it is so important to keep policy firmly grounded to local business conditions. Given the low level of inventories, the quick response by firms to the shortfall in demand, and falling interest rates, both economic theory and most forecasting models suggested that the recession should have ended quickly and that without any additional policy actions the economy should have experienced a solid bounceback in jobs and growth.

It was our contact with local businesses, banks, and other groups that suggested that the recovery was much slower than usual getting started and was likely to be fragile. The debt buildup of the 1980s and the substantial requirements to restructure corporations that had grown larger than their markets could sustain were going to generate a significant drag on economic activity. Interest rates were reduced well in advance of the slowdown and continued to ease over this period despite periodic indications that the economy was on the verge of taking off.

Since mid-1989, the Federal Open Market Committe has taken actions that resulted in the federal funds rate falling from a high of 97/8 percent to 3 percent today, a reduction of more than 675 basis points. The discount rate and the three-month Treasury bill rates are at their lowest levels since 1963 and the thirty-year bond, which has a somewhat shorter history, is at its lowest rate in history. I believe that without the types of District concerns and contacts that keep the policy process in tune with the underlying economy, far less would have been done and the economy would have faced a far harsher retrenchment. Remember that economists basing their analysis entirely on economic statistics would have us believe that the recovery began in early 1991. While this time is correct in a statistical sense, contact with the District suggested that the recovery was much slower getting started than usual and that continued policy actions were necessary.

Monetary policy needs to remain sensitive to current economic conditions and challenges. Policy must take into account the whole range of economic experiences and special characteristics of each period. Inflation posed major problems for long-term growth in the early 1980s. Today, in my assessment, we are operating in an economic environment that could be described as approaching price stability. In the current environment, job creation and balance sheet restructuring are the major challenges facing monetary policy. This is not a change in philosophy or goals but a simple recognition of what today's problems are versus yesterday's. At today's 3 percent inflation rate, inflation does not represent the same type of threat to the economy that it did at 10 percent. But we should not forget that this very significant improvement in inflation was achieved at a very high cost in both human and economic terms and that if growth were allowed to exceed its long-run potential for an extended period of time that inflation would return. Generating the maximum sustainable growth rate for the economy must remain the primary and essential mission of monetary policy.

In conclusion, I would like to reiterate that while I am guardedly optimistic about the economy both in my District and in the nation, it is the issues of structural impediments to growth and job creation, in terms of debt levels, international competition, and other issues of restructuring that dominate the economic landscape. If we continue to make progress on these fundamental issues and begin to see an increase in employment levels, the economic outlook for the next few years is quite positive.