Future Arizona's Economic Future Arizona's
Prepared For For
The Arizona Department of Commerce
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Economy.com, Inc.
August 2002
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Arizona Department of Commerce - August 2002
Economy.com, Inc.
Future A r i z o n a ' s Economic Fu t u r e Ta b l e of Contents
Executive Summary ........................................................................................................................ 1 1. Arizona's Economy Today ? End Of A Cycle; Beginning Anew ................................................ 3 1.1. Current Economic Trends .......................................................................................................... 3 1.2. Arizona's Economic Structure ................................................................................................... 5 2. The Broader View .................................................................................................................... 2.1. The Macroeconomic Outlook ................................................................................................... 2.2. Business Practices ................................................................................................................... 2.3. The Global Economic Environment ......................................................................................... 10 10 19 20
3. Arizona's Future At Risk .......................................................................................................... 2 8 3.1. Arizona Within the U.S. and Global Environment .................................................................. 28 3.2. Dependency Upon Migration and Growth .............................................................................. 31 3.3. Education and Workforce Quality ............................................................................................ 3 4 4. Methodology ? Arizona's Comparative Advantages ............................................................. 4.1. Analytical Methodology ........................................................................................................... 4.2. Factors of Comparative Advantage .......................................................................................... 4.3. Arizona's Measures of Comparative Advantage ....................................................................... 4.3.1 Business Climate and Quality of Life ............................................................................. 4.3.2 Infrastructure ................................................................................................................. 4.3.3 Health, Poverty and Crime ............................................................................................. 4.3.4 Demographics ................................................................................................................ 4.3.5 Credit Quality and Household Balance Sheets ............................................................... 40 40 40 42 42 49 56 61 68
5. Economic Opportunities ......................................................................................................... 70 5.1. Computer Software and Systems ............................................................................................. 71 5.2. Healthcare and Biotechnology ................................................................................................. 73 5.3. Industrial Machinery ............................................................................................................... 79 5.4. Communication Services ......................................................................................................... 80 5.5. High-tech Instruments............................................................................................................. 8 1 5.6. Forest Products ........................................................................................................................ 8 1 5.7. Engineering Services ? Research and Testing ........................................................................... 82 5.8. Transportation and Logistics ................................................................................................... 83 5.9. Agriculture/Food Processing/Agricultural Technology ............................................................. 85 5.10. Defense/Aerospace/Avionics .................................................................................................. 86 6. Economic Outlook .................................................................................................................... 8 7 7. Foundational Issues................................................................................................................ 91 7.1. Tourism ................................................................................................................................... 91 7.2. Financial Services .................................................................................................................... 92 7.3. Education and Workforce Quality ........................................................................................... 92 7.4. Healthcare ................................................................................................................................ 9 3 Economy.com, Inc. Arizona Department of Commerce - August 2002 i
8. Regional Briefings .................................................................................................................... 9 3 8.1. Maricopa Association of Governments (Maricopa County) ..................................................... 93 8.1.1 Current economic trends .............................................................................................. 93 8.1.2 Industrial Structure ...................................................................................................... 94 8.1.3 Measures of Comparative Advantage ............................................................................ 96 8.1.3.1 Population....................................................................................................... 96 8.1.3.2 Income ............................................................................................................ 96 8.1.3.3 Cost of Doing Business ................................................................................... 98 8.1.3.4 Cost of Living ................................................................................................. 99 8.1.3.5 Education and Workforce Quality ................................................................. 100 8.1.3.6 Health, Welfare and Crime............................................................................ 102 8.1.3.7 Infrastructure ................................................................................................ 102 8.1.4 Economic Opportunities ............................................................................................ 104 8.1.5 Economic Outlook ...................................................................................................... 105 8.1.6 Foundational Issues ................................................................................................... 105 8.2. Pima Association of Governments (Pima County) ................................................................ 8.2.1 Current economic trends ............................................................................................ 8.2.2 Industrial Structure .................................................................................................... 8.2.3 Measures of Comparative Advantage .......................................................................... 8.2.3.1 Population..................................................................................................... 8.2.3.2 Income .......................................................................................................... 8.2.3.3 Cost of Doing Business ................................................................................. 8.2.3.4 Cost of Living ............................................................................................... 8.2.3.5 Education and Workforce Quality ................................................................. 8.2.3.6 Health, Welfare and Crime............................................................................ 8.2.3.7 Infrastructure ................................................................................................ 8.2.4 Economic Opportunities ............................................................................................ 8.2.5 Economic Outlook ...................................................................................................... 8.2.6 Foundational Issues ................................................................................................... 8.3. Northern Arizona Council of Governments (Apache, Coconino, Navajo and Yavapi Counties) ........ 8.3.1 Current Economic trends ........................................................................................... 8.3.2 Industrial Structure .................................................................................................... 8.3.3 Measures of Comparative Advantage .......................................................................... 8.3.3.1 Population..................................................................................................... 8.3.3.2 Income .......................................................................................................... 8.3.3.3 Cost of Doing Business ................................................................................. 8.3.3.4 Cost of Living ............................................................................................... 8.3.3.5 Education and Workforce Quality ................................................................. 8.3.3.6 Health, Welfare and Crime............................................................................ 8.3.3.7 Infrastructure ................................................................................................ 8.3.4 Economic Opportunities ............................................................................................ 8.3.5 Economic Outlook ...................................................................................................... 8.3.6 Foundational Issues ................................................................................................... 8.4. Western Arizona Council of Governments (La Paz, Mohave and Yuma Counties) ........................... 8.4.1 Current economic trends ............................................................................................ 8.4.2 Industrial Structure .................................................................................................... 8.4.3 Measures of Comparative Advantage .......................................................................... 8.4.3.1 Population..................................................................................................... 8.4.3.2 Income .......................................................................................................... ii Arizona Department of Commerce - August 2002 106 106 106 108 108 108 108 110 110 111 113 114 115 115 116 116 116 118 118 118 119 120 120 121 124 124 125 125 126 126 126 128 128 129
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8.4.3.3 Cost of Doing Business ................................................................................. 8.4.3.4 Cost of Living ............................................................................................... 8.4.3.5 Education and Workforce Quality ................................................................. 8.4.3.6 Health, Welfare and Crime............................................................................ 8.4.3.7 Infrastructure ................................................................................................ 8.4.4 Economic Opportunities ............................................................................................ 8.4.5 Economic Outlook ...................................................................................................... 8.4.6 Foundational Issues ................................................................................................... 8.5. Central Arizona Council of Governments (Gila and Pinal Counties) .............................................. 8.5.1 Current Economic trends ........................................................................................... 8.5.2 Industrial Structure .................................................................................................... 8.5.3 Measures of Comparative Advantage .......................................................................... 8.5.3.1 Population..................................................................................................... 8.5.3.2 Income .......................................................................................................... 8.5.3.3 Cost of Doing Business ................................................................................. 8.5.3.4 Cost of Living ............................................................................................... 8.5.3.5 Education and Workforce Quality ................................................................. 8.5.3.6 Health, Welfare and Crime............................................................................ 8.5.3.7 Infrastructure ................................................................................................ 8.5.4 Economic Opportunities ............................................................................................ 8.5.5 Economic Outlook ...................................................................................................... 8.5.6 Foundational Issues ................................................................................................... 8.6. Central Arizona Council of Governments (Gila and Pinal Counties) .............................................. 8.6.1 Current economic trends ............................................................................................ 8.6.2 Industrial Structure .................................................................................................... 8.6.3 Measures of Comparative Advantage .......................................................................... 8.6.3.1 Population..................................................................................................... 8.6.3.2 Income .......................................................................................................... 8.6.3.3 Cost of Doing Business ................................................................................. 8.6.3.4 Cost of Living ............................................................................................... 8.6.3.5 Education and Workforce Quality ................................................................. 8.6.3.6 Health, Welfare and Crime............................................................................ 8.6.3.7 Infrastructure ................................................................................................ 8.6.4 Economic Opportunities ............................................................................................ 8.6.5 Economic Outlook ...................................................................................................... 8.6.6 Foundational Issues ...................................................................................................
130 131 131 133 134 135 136 137 137 137 137 138 138 140 140 141 141 143 143 145 145 146 147 147 147 148 148 149 150 151 151 153 155 156 157 157
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Arizona Department of Commerce - August 2002
iii
L i s t of Charts:
Pa g e :
Chart 1: Employment Downturn Worse Than 1991 Recession .................................................... 3 Chart 2: Manufacturing and Tourism Lead Downturn ................................................................. 4 Chart 3: Arizona Labor Market Conditions Still Weak ................................................................. 4 Chart 4: Income Growth Still Buoyant ......................................................................................... 5 Chart 5: Little Diversity in Arizona's Economy ............................................................................ 6 Chart 6: Arizona's Economic Diversity Not Improving ................................................................ 6 Chart 7: Decomposing Productivity Gains ................................................................................. 1 1 Chart 8: Accelerated Pace of Technological Change .................................................................... 1 2 Chart 9: R&D Spending Moves Higher ...................................................................................... 1 3 Chart 10: Internet Diffuses Rapidly ........................................................................................... 1 4 Chart 11: Percent Saving in Internet Mortgage Origination Costs ............................................. 1 4 Chart 12: Internet Economics .................................................................................................... 1 5 Chart 13: An Increasingly Global Economy ............................................................................... 1 6 Chart 14: Maquiladoras Losing Competitive Edge ..................................................................... 2 3 Chart 15: Foreign Affiliates in Arizona ....................................................................................... 2 3 Chart 16: Mexico Dominates Foreign-Born Population in Arizona ............................................. 2 4 Chart 17: Other Border States Absorb More of the Nation's Immigrants .................................. 2 5 Chart 18: Dollar Will Fall Further .............................................................................................. 2 7 Chart 19: Narrow Range of Exports ........................................................................................... 3 0 Chart 20: Five Largest Export Destinations ............................................................................... 3 0 Chart 21: Migration As Source Of Growth ................................................................................. 3 2 Chart 22: Migrants Follow Job Opportunities ........................................................................... 3 3 Chart 23: Educational Attainment ............................................................................................. 3 4 Chart 24: Below Average Proficiency in Arizona ......................................................................... 3 6 Chart 25: A College Degree Is Increasingly Valuable .................................................................. 3 7 Chart 26: Migrants Add to Intellectual Capital ......................................................................... 3 9 Chart 27: Factors of Comparative Advantage ............................................................................. 4 1 Chart 28: Arizona's Business Costs: Right On Average .............................................................. 4 3 Chart 29: Arizona Business Costs Near Average Among Tech States .......................................... 4 4 Chart 30: Arizona Cost Of Living Indexes ................................................................................. 4 5 Chart 31: Arizona's Living Costs Lower Than In Most Tech Centers ......................................... 4 6 Chart 32: Arizona Does Not Lack For Innovation ...................................................................... 4 6 Chart 33: Arizona's Innovation In Second Tier Of Tech States ................................................... 4 7 Chart 34: Evidence Of Innovation Throughout The State .......................................................... 4 7 Chart 35: Innovation Gets By Without Venture Capital ............................................................. 4 8 Chart 36: Arizona Does Not Fare Well For VC Among Tech States ............................................ 4 8 Chart 37: Poverty Rate Changes Little ....................................................................................... 5 8 Chart 38: Rapid Population Growth ........................................................................................... 6 1 Chart 39: Age Structure Of Population ...................................................................................... 6 2 Chart 40: Minority Distribution of Population .......................................................................... 6 3 Chart 41: Minority Population Shares, 1990 and 2000 ............................................................. 6 3 Chart 42: Population Growth by Region .................................................................................... 6 4 Chart 43: Net Migration Contribution to Population Change ................................................... 6 4 Chart 44: Population Share Over 65 Years Old .......................................................................... 6 5 Chart 45: Per Capita Income Gap Widens ................................................................................. 6 5 Chart 46: Wage and Salary Income Increasingly Important........................................................ 6 6 Chart 47: Wage and Salary Income Per Payroll Worker ............................................................... 6 6 Chart 48: Income Distribution More Evenly Distributed ........................................................... 6 7 Chart 49: Per Capita Income By Region ..................................................................................... 6 7 Chart 50: Real Regional Per Capita Income Growth ................................................................... 6 8 Chart 51: Credit Quality Worsening Moderately........................................................................ 6 9 Chart 52: Personal Bankruptcy Filings Per 1,000 Households................................................... 6 9 Chart 53: Population Growth, Maricopa County ........................................................................ 9 7 Chart 54: Income Growth, Maricopa County ............................................................................. 9 7 Chart 55: Cost of Doing Business, Maricopa County ................................................................. 9 8 iv Arizona Department of Commerce - August 2002 Economy.com, Inc.
L i s t of Charts:
Pa g e :
Chart 56: Eighth Grade Proficiency, Maricopa County ............................................................. 1 0 1 Chart 57: Educational Attainment, Maricopa County .............................................................. 1 0 1 Chart 58: Productivity, Maricopa County ................................................................................. 1 0 1 Chart 59: Poverty Rate, Maricopa County ................................................................................ 1 0 2 Chart 60: Infant Mortality Rate, Maricopa County ................................................................... 1 0 3 Chart 61: FBI Crime Index, Maricopa County ......................................................................... 1 0 3 Chart 62: Population Growth, Pima County ............................................................................ 1 0 9 Chart 63: Income Growth, Pima County ................................................................................. 1 0 9 Chart 64: Cost of Doing Business, Pima County ..................................................................... 1 0 9 Chart 65: Eighth Grade Proficiency, Pima County ................................................................... 1 1 1 Chart 66: Educational Attainment, Pima County..................................................................... 1 1 1 Chart 67: Productivity, Pima County ....................................................................................... 1 1 2 Chart 68: Poverty Rate, Pima County ....................................................................................... 1 1 2 Chart 69: Infant Mortality Rate, Pima County ......................................................................... 1 1 3 Chart 70: FBI Crime Index, Pima County ............................................................................... 1 1 3 Chart 71: Population Growth, Northern Arizona ..................................................................... 1 1 8 Chart 72: Income Growth, Northern Arizona .......................................................................... 1 1 9 Chart 73: Cost of Doing Business, Northern Arizona .............................................................. 1 2 0 Chart 74: Eighth Grade Proficiency, Northern Arizona ............................................................ 1 2 1 Chart 75: Educational Attainment, Northern Arizona .............................................................. 1 2 2 Chart 76: Productivity, Northern Arizona ................................................................................ 1 2 2 Chart 77: Poverty Rate, Northern Arizona ................................................................................ 1 2 3 Chart 78: Infant Mortality Rate, Northern Arizona .................................................................. 1 2 3 Chart 79: FBI Crime Index, Northern Arizona ........................................................................ 1 2 3 Chart 80: Population Growth, Western Arizona ....................................................................... 1 2 8 Chart 81: Income Growth, Western Arizona ............................................................................ 1 2 9 Chart 82: Cost of Doing Business, Western Arizona ................................................................ 1 3 0 Chart 83: Eighth Grade Proficiency, Western Arizona .............................................................. 1 3 1 Chart 84: Educational Attainment, Western Arizona ............................................................... 1 3 2 Chart 85: Productivity, Western Arizona .................................................................................. 1 3 2 Chart 86: Poverty Rate, Western Arizona ................................................................................. 1 3 3 Chart 87: Infant Mortality Rate, Western Arizona .................................................................... 1 3 4 Chart 88: FBI Crime Index, Western Arizona .......................................................................... 1 3 4 Chart 89: Population Growth, Central Arizona ........................................................................ 1 4 0 Chart 90: Income Growth, Central Arizona ............................................................................. 1 4 1 Chart 91: Cost of Doing Business, Central Arizona ................................................................. 1 4 1 Chart 92: Eighth Grade Proficiency, Central Arizona ............................................................... 1 4 2 Chart 93: Educational Attainment, Central Arizona ................................................................. 1 4 2 Chart 94: Productivity, Central Arizona ................................................................................... 1 4 3 Chart 95: Poverty Rate, Central Arizona ................................................................................... 1 4 4 Chart 96: Infant Mortality Rate, Central Arizona ..................................................................... 1 4 4 Chart 97: FBI Crime Index, Central Arizona ........................................................................... 1 4 4 Chart 98: Population Growth, Southeastern Arizona ............................................................... 1 4 9 Chart 99: Income Growth, Southeastern Arizona..................................................................... 1 5 0 Chart 100: Cost of Doing Business, Southeastern Arizona ...................................................... 1 5 1 Chart 101: Eighth Grade Proficiency, Southeastern Arizona .................................................... 1 5 2 Chart 102: Educational Attainment, Southeastern Arizona ...................................................... 1 5 3 Chart 103: Productivity, Southeastern Arizona ........................................................................ 1 5 4 Chart 104: Poverty Rate, Southeastern Arizona ........................................................................ 1 5 4 Chart 105: Infant Mortality Rate, Southeastern Arizona .......................................................... 1 5 5 Chart 106: FBI Crime Index, Southeastern Arizona ................................................................. 1 5 6
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Arizona Department of Commerce - August 2002
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Tables: L i s t of Ta b l e s :
Pa g e :
Table 1: Employment and GSP % share of total ............................................................................................... 7 , Table 2: Characteristics of Arizona's Basic Industries ....................................................................................... 8 Table 3: High school completion rates for 18-24 year olds not currently enrolled in school,98-00, % ........... 3 5 Table 4: Educational Attainment Indicators.................................................................................................... 3 8 Table 5: College Indicators ............................................................................................................................. 3 9 Table 6: Internet Connectivity ........................................................................................................................ 5 0 Table 7: Distribution of Irrigated Land ........................................................................................................... 5 2 Table 8: Health Indicators .............................................................................................................................. 5 7 Table 9: Population By Poverty Status, 1999 and 1989 .................................................................................. 5 9 Table 10: Crime and Human Welfare Indicators ............................................................................................ 6 0 Table 11: Population Growth Rates By Decade ............................................................................................... 6 1 Table 12: Economic Opportunities ................................................................................................................. 7 0 Table 13: Components of Economic Opportunities ....................................................................................... 7 2 Table 14: Economic Opportunities By Region ................................................................................................ 7 4 Table 15: Research Centers, Institutes and Programs at Arizona Universities ................................................ 7 5 Table 16: Comparative Advantage Indicators .................................................................................................. 8 8 Table 17: The Impact of Comparative Advantage Measures on Regional Economic Growth ........................... 8 9 Table 18: Arizona Economic Forecast Scenarios 2002-2012, annualized growth rate, % ................................ 9 0 Table 19: Characteristics of MAG's Basic Industries ...................................................................................... 9 5 Table 20: Characteristics of PAG's Basic Industries ...................................................................................... 1 0 7 Table 21: Characteristics of NACOG's Basic Industries ............................................................................... 11 7 Table 22: Characteristics of WACOG's Basic Industries ............................................................................... 12 7 Table 23: Characteristics of CAAG's Basic Industries ................................................................................... 1 3 9 Table 24: Characteristics of SEAGO's Basic Industries ................................................................................. 1 4 8 Appendix: Diversity Index, Arizona Counties and Regions, 2000/2001 ...................................................... 1 4 8
vi
Arizona Department of Commerce - August 2002
Economy.com, Inc.
Future Arizona's Economic Future Executive Summary Arizona is beginning a new economic cycle as it emerges from the recession of 2001. The changing U.S. and global economic environment is shifting the competitive landscape so that Arizona's driving industries of the past may not be sufficient to maintain its economic wellbeing going forward. Broad economic trends. The economy of the coming decade will be characterized by five broad factors. First, it will be driven by an accelerated pace of product development, requiring constant research and development. Second, the workforce will need to be increasingly well trained and productive to keep up with product cycles and to pull ahead of national and global competitors. Third, infrastructure such as telecommunications, electric utilities and surface transportation will need improvements to accommodate ever rising supply-chain management requirements. Fourth, labor and capital will need to be increasingly flexible and responsive to rapid changes in products and processes as the economy advances. Fifth, export markets will shift as Mexican industry moves up the value chain, free trade expands to South America, Asia captures more high-tech manufacturing and the dollar falls from recent highs. Industrial structure. Arizona's current economic structure still includes the proverbial Five C's of cotton, cattle, citrus, copper and climate, but it now is augmented by electronics and other tech industries, aerospace and back-office administrative services that expand the employment and production base. Indeed, of the Five C's, only climate-related industries provide any dynamism to the economy today. Financial services, business services, and production of missiles and space equipment round out the industries providing dynamism and economic growth in recent years. Electronics, aircraft, federal government and agriculture have added stability to Arizona's economy over the past decade. Mining's role in the economy diminishes as the economy expands. Moreover, while Arizona's economy has created new jobs at a remarkable pace, its current structure has failed to keep per capita income equal to the national average or to significantly improve poverty rates. Arizona's advantages. Arizona does have a number of advantages that will support the economy going forward. They include in-migration of a skilled workforce, business costs near average for the U.S. and below those of California, costs of living below most competing centers of technology, a proven presence of research and innovation, ample capacity at its major airport, high exposure to export trade, and extensive forest, farmland and scenic resources. Arizona's challenges. However, Arizona ranks near the bottom for a number of critical measures of comparative advantage indicating a need for further investment and policy considerations in the years to come. Workforce quality is of particular concern. While Arizona is able to attract skilled workers from outside the state, the local workforce does not measure up. Arizona ranks last for the rate of high school completion and nearly last for the share of high school graduates continuing on to college. Eighth-grade proficiency test results are below average and vary widely across the state's regions. State per capita spending ranks nearly last for K-12 education and 41st for higher education. Other measures also put Arizona in a poor light. Its vaunted quality of life is tarnished by a crime rate that consistently ranks among the top five. The quality and distribution of infrastructure is problematic. Many outlying areas are not well served by telecommunications and water systems. Highways face capacity constraints, and aging road surfaces on older highways are in need of rebuilding. Innovative businesses face a dearth of venture capital, which ranks last relative to the size of Arizona's economy when compared to competing tech-related states. Moreover, a tax structure weighted toward business taxes and away from personal taxes deters expanding firms from considering Arizona. Economy.com, Inc. Arizona Department of Commerce - August 2002 1
Outlook. Improving Arizona's measures of comparative advantage can make a difference, particularly with regard to per capita income growth. Five measures, including the tax burden, educational attainment, crime rate, SAT scores, and research and development show significant statistical relationships within Economy.com's state econometric forecasting system. To illustrate the impacts of these relationships, we assume that Arizona's ranking for these five measures of comparative advantage shift from their current average or below average levels to equal the current top-ranked state for each. This results in the model's projection for per capita personal income growth over the next ten years rising from a baseline forecast of 1.6% per year to a more rapid 3.4% annualized rate. Conversely, if they were to worsen to equal the bottom-ranked state for each measure, per capita income growth would slow to 0.5% per year. Projections of employment and output show similar results. Economic opportunities. A number of economic opportunities to improve Arizona's economic competitiveness in the decades to come have been identified based upon three criteria. First are industry growth projections for the U.S. economy. Second are estimated relationships between historical regional industry growth trends and Arizona's measures of comparative advantage. Third, industries selected have qualities that conform to more than one of the fundamental assumptions of the changing U.S. and international economic environment--technology based; highly productive; research intensive; linked to export markets; and consistent with local resources and the state's diverse regional economies. These opportunities are as follows, ordered by a combined rank of the first two criteria-- national outlook and local potential: 1. Computer software and systems integration 2. Healthcare and biotechnology 3. Industrial machinery 4. Telecommunications 5. High-tech optical, medical and measuring instruments 6. Forest products 7. Engineering services ? research and testing 8. Transportation, warehousing and logistics 9. Agriculture/Food processing/ Agricultural technology 10. Defense/Aerospace/Avionics industries Foundational issues. Aside from these specific opportunities for industrial and economic development, four specific issues relating to broader foundational issues of the state's economy and its regional distribution are identified. The first relates to tourism and quality of life. It is assumed that tourism will continue to be a driving force in Arizona's economy and so tourism, therefore, is not included in emerging opportunities. But aspects of tourism relating to museums and the cultural arts remain underrepresented in the state's economic structure. Their further development not only would enhance Arizona as a tourist destination, but would contribute to a quality of life of the highest standard that would help retain the skilled workforce that the state is able to attract. Second is financial services. There is a need to expand the availability and diversity of financial resources to support entrepreneurs, international trade, and direct investment in Arizona. This is especially evident to increase access to capital, in particular venture capital. Third is education and workforce quality. Perhaps the most resounding finding of this report is that numerous measures of education performance and outcomes are not only below average but also near the bottom of all states. Thus the continuing need to improve education and workforce training at all levels--K-12, community colleges, and the universities. Fourth is healthcare. While aggregate statistics of health are not bad in Arizona, they mask distributional issues of access and incidence of disease, limiting the long-term economic potential of the some of Arizona's more rural regions.
2
Arizona Department of Commerce - August 2002
Economy.com, Inc.
Future A r i z o n a ' s Economic F u t u r e Today 1 . Arizona's Economy To d a y ? End of a Cycle; Beginning Anew Trends 1 . 1 Current Economic Tr e n d s Labor Markets. Arizona's economy peaked in the spring of 2001 and was in recession at least through May 2002. Approximately 38,000 jobs were lost during this time and the unemployment rate has risen by about two percentage points, standing at 5.7%. The current recession is quite different from the previous one in 1991-1992. Indeed, while the previous recession was barely felt in Arizona, the state has gone from leader to slightly underperforming over the course of just one year. Its current pace of employment decline of -1.4% on a year-to-year basis is very near the -1.2% rate nationwide, although the state's downturn is a deeper shift from peak growth rates exceeding 4% in mid-2000 versus a 2.5% peak nationwide (see Chart 1).
Worse C h a r t 1: Employment Downturn Wo r s e Than 1991 Recession
12
Employment, % change year ago 3 mo. MA
9
Arizona
6
3
U.S.
0
Source: BLS
-3 82 87 92 97 02
Arizona was hit hard by the recession as it is exposed to a number of industries that were subject to waning demand over the past two years. The state's technologyrelated economy lead the state's recession as demand for semiconductors and other electronic equipment began to fall in early 2001. The situation was compounded by the events of 9/11 when nationwide travel and tourism industries suffered terribly (see Chart 2). Airline layoffs and flight cutbacks were sharp in Phoenix. Hotels, restaurants and resorts in Phoenix and Tucson were hit the hardest due to their greater dependence upon fly-in visitors. The rural areas that cater more to drive-in markets have remained remarkably stable. The downturn caused office vacancy rates in Phoenix and Tucson to nearly double over the past year. Thus, office and other nonresidential construction has also slowed dramatically. Finally, labor market conditions are still weak, as indicated by an increase in the number of unemployment insurance claims by more than 35% over the year through April (see Chart 3). Claims nationwide are up by 10% over the year. Another indication of the severity of Arizona's recession is a rise in personal bankruptcy filings over the year through the first quarter of 2002 by 14%, versus a 3% rise nationwide. Economy.com, Inc. Arizona Department of Commerce - August 2002 3
C h a r t 2: Manufacturing and To u r i s m L e d Downturn Tourism Led
8 6 4 2 0 -2 -4
Employment, % change year ago
Total
Travel & tourism Manufacturing
-6 -8
Source: BLS
-10 00 01 02
Labor Market Weak C h a r t 3: Arizona L a b o r Marke t Conditions Still We a k
75 60 45 30 15 0 -15
Unemployment insurance claims, % change year ago Arizona
U.S. Source: BLS
00
01
02
There are some indications that the worst of the recession is over for Arizona and that the second half of 2002 will start the next business cycle for the state's economy. For example, while payroll employment continues to fall, the unemployment rate has improved slightly to 5.7% from a peak of 6.0% in February. Employment in financial services has remained steadier and retail trade employment continues to rise. Some stability has also returned to the large business service and transportation industries, although payrolls are still down over the year. Income. The Arizona and U.S. economies both have an advantage at this point of the business cycle that they did not have during recessions over the previous three decades. That is, real per capita income has not fallen on a year-to-year basis, even if employment has. This likely is due to continued growth in labor productivity, which was a hallmark not only of the 1990s but also continuing through the 2001 recession up to today. Thus, consumer spending has held steadier, acting as a buoy for the broader economy in Arizona and nationwide. This pattern sharply contrasts with downturns in real per capita income in 1975, 1982 and 1991 (see Chart 4). 4 Arizona Department of Commerce - August 2002 Economy.com, Inc.
C h a r t 4: Income Growth Still Buoyant
8 6
Per capita income, % change year ago U.S.
4 2 0
Arizona
-2 -4
Source: BEA
-6 70 76 82 88 94 00
A primary purpose of this paper is to prepare a vision of how the next business cycle may appear. While no one knows how long the next cycle will last, this paper takes a view over the remainder of this decade to provide insight into the major macro and international economic trends, and how Arizona's comparative advantages may contribute to its economic growth and development during this time. 1 . 2 . Arizona's Economic Structure Trends. Industrial Trends. The old adage of Arizona's Five C's--cotton, cattle, citrus, copper and climate--can't be discounted quite yet. They still appear in one form or another among the basic industries that support the expansion of the state's economy.1 To this list, however, one must add electronics, aerospace and back-office administrative services, among others. Additionally, the Five C's must be further decomposed because growth trends in agriculture (cotton, cattle and citrus) and tourism and senior services (climate) are quite varied. Moreover, mining (copper), while it does generate income for the state, is not a growing industry over the long term. Some of the Five C's remain leading industries, but some are now lagging. Diversity. Economic Diversity. While Arizona's economy has grown over the decades and has broadened beyond the Five C's, it remains a narrowly focused economy with little diversity. According to Economy.com's index of industrial diversity, it ranks 40th among the states with an index value of 0.45 on a scale where 1.0 indicates a pattern of industrial diversity equal to the U.S.2 Moreover, it ranks last among states considered as Arizona's competitors for the development or attraction of technologybased industries (see Chart 5).
1
Basic industries are those that have a higher than average concentration in the local economy and either market their goods and services outside of the area or cater to those bringing income or wealth into the area, thus generating a stream of income into the local economy. For the purposes of this study, an industry with a location quotient greater than 1.05 is defined as a basic industry.
2 Industrial diversity is defined as the extent to which a state's industrial structure approximates the base industrial structure. Diversity is derived using the following formula: Diversity = 1/sum((EMPij/EMPBASEj)*EMPij), where EMP = share of employment in three-digit SIC industry j during period 2000-2001; i = local area; BASE = Either Arizona or U.S. The Diversity Index is bounded between 0 and 1; a value of 1 means the region has the same industrial structure as the base region, while a value of 0 means the region has a totally different industrial structure. The formula is derived from the Hachman Index, Bureau of Business Research, University of Utah, 1994.
Economy.com, Inc.
Arizona Department of Commerce - August 2002
5
C h a r t 5: Little Diversity in Arizona's Economy
0. 90
Industrial Diversity Index, U.S. = 1.00 Source: Economy.com
0. 85 0. 80 0. 75 0. 70 0. 65 0. 60 0. 55 0. 50 0. 45 0. 40
TX IL MD CO MA NJ MN NY VA GA NH OR WA NC CA AZ
C h a r t 6: Arizona's Economic Diversity Not Improving
0. 60 0. 55 0. 50 0. 45 0. 40 0. 35 0. 30
Industrial Diversity Index, U.S. = 1.00
Source: Economy.com
0. 25 71 76 81 86 91 96 01
Not only is the state's diversity low, but it has not improved over the past 15 years relative to the U.S., despite very strong economic growth during much of this time (see Chart 6). It is important to remember that the diversity index is a relative measure that compares the distribution of economic activity to that of the U.S. Thus, while the economy certainly has diversified with the addition of technologybased and service-producing industries, the broad U.S. economy has diversified to an even greater extent. For example, construction's share of employment in Arizona at 7% remains about equal to its average share over the past 20 years and about two percentage points above the U.S. share. The risk going forward, therefore, is that the state economy may not be diversifying enough to take advantage of emerging trends during the remainder of this decade. 6 Arizona Department of Commerce - August 2002 Economy.com, Inc.
Ta b l e 1: Employment and GSP, % share of total GSP, E m p l o y m e n t (2001) Arizona U.S. 0.4 0.4 7.3 5.1 9.3 13.4 78.3 60.1 21.7 39.9 4.9 5.4 4.9 5.1 18.6 17.8 6.6 5.8 31.3 31.1 6.8 7.9 16.6 15.9 G r o s s State Product (2000) Arizona U.S. 0.7 1.3 5.9 4.7 15.6 15.8 84.0 57.6 16.0 42.4 7.1 8.3 6.5 6.8 10.5 9.0 18.4 19.5 22.2 21.8 5.3 5.5 11.6 11.6
Mining Construction Manufacturing Durable Non-durable Tr a n s p o r t a t i o n & Utilities W h o l e s a l e Tr a d e Trade R e t a i l Tr a d e Trade F i n a n c e , Insurance & Real Estate Services Health Services Government
Sources: BLS, BEA, Economy.com
Imbalances. General imbalances in the economic structure arise from an overabundance of construction, retail trade and government employment. Manufacturing plays a relatively small role in terms of employment, accounting for just over 9% of employment versus over 13% nationwide. Because manufacturing production is concentrated in just a few high-value industries, however, manufacturing's share of the value of total output-- about 16% in Arizona in 2000--is about equal to the national share (see Table 1). Government employment is high due to the large presence of federal lands and federal programs related to the Indian reservations in Arizona. The classification of some Indian tribe enterprises as government activity also biases upward the data for government employment or output. Thus, government will always have a rather high share of employment, which will keep Arizona's diversity index relatively low despite an expanding and diversifying economy. Nevertheless, its index of diversity has not risen in 15 years. Lagging Leading and Lagging Industries. We combine results from the affiliated State Economic Base Study with research by Economy.com to characterize the role of Arizona's basic industries in supporting the economy's growth through the past business cycle (see Table 2). While by definition all basic industries support the local economy and contribute to its expansion through the stream of income that they generate, they do not all contribute to the area's dynamism by creating a changing and diversifying economy. Thus, the state's basic industries are divided into four groups: Dynamic industries, Growth industries, Stable industries and Deconcentrating industries.3 The traditional Five C's of Arizona's economy are distributed across these four different characteristics. Copper (represented by the mining industry) is a deconcentrating industr y. By measure of employment, wages or output, the industry has contracted since the mid-1990s. If employment is the measure, the industry has fallen from a peak payroll that was seen back in the mid-1970s. The industry has been volatile as the price of copper rises and falls, but its significance to the economy is decreasing. The three agricultural C's of the economy are characterized as stable or deconcentrating. Farm labor and management services are stable components of the basic economy. Indeed, real gross product of farms in Arizona rose by an average annual rate of 3.2% during the
3
Dynamic industries have had employment growth exceeding an 8% annualized rate between 1991 and 2001 and a location quotient that has risen by more than 3%. Growth industries have had employment growth exceeding 6% and a location quotient that has risen by more than 1%. Stable industries have had employment growth of less than 6% annualized and a stable location quotient. Deconcentrating industries have employment growth less than 6% annualized and a declining location quotient.
Economy.com, Inc.
Arizona Department of Commerce - August 2002
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Ta b l e 2: Characteristics of Arizona's Basic Industries D y n a m i c Industries Mining and manufacturing of construction materials Amusement and recreation services Transportation services Management and public relations services Medical service and health insurance carriers G r o w t h Industries Missiles and space vehicles manufacturing Banking, depository institutions Business services, including call centers and temporary help S t a b l e Industries Air transportation Electronic components and accessories manufacturing Aircraft and parts manufacturing Restaurants Real estate and insurance agents Federal government Farm labor and management services D e c o n c e n t r a t i n g Industries Hotels and lodging Crop and soil preparation services Metal mining
thirteen years of available data ending in 2000 according to the Bureau of Economic Analysis, versus 2.6% nationwide. Moreover using a location quotient based upon output for farms and food processing, the concentration of agriculture in Arizona has remained stable in recent years. Thus, despite the fact that crop and soil management services are characterized as declining, agriculture as a whole may be considered a stable basic industry in Arizona. The impact of the fifth C in Arizona's economy, climate, is evident in a number of the state's basic industries. First through a variety of components of the tourism industry, for which climate, of course, is critical. Amusement and recreation services and transport services are dynamic industries. Air transportation and restaurants are stable industries. It is important to note, however, that at least through the course of the past business cycle between 1991 and 2001 the hotel industry is classified as a deconcentrating industry. Employment in the industry did grow rapidly through 1997, but then remained largely unchanged while it compensated in 1998 through 2000 for previous overbuilding. The industr y's employment began to fall in early 2001 at the onset of the recession, and then plummeted following the downturn in travel following 9/11. Thus, the industry is still largely overbuilt, at least among Class A properties in Phoenix and Tucson, and it will take some time before it expands once again. Climate is also a determinant in industries identified in the Economic Base Study as "Growth Industries", i.e. industries that are expanding simply because of the rapid speed of the state's economic growth. And much of this growth can be tied to the climate's attractiveness for migrants from other states. Dynamic industries such as the production of construction materials and, to a certain extent management and public relations, are directly related to expansion of the economy due to migration.4 Similarly, banking services and real estate and insurance agents can be traced directly to demand by the expanding population.
4 The industry termed mining and production of construction materials is a combination of the mining of production stone and the production of millwork, plywood and structural members, wood buildings and mobile homes, and cut stone and stone products.
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Arizona's economy, however, is now much more than the Five C's. Technology now plays a critical role in the economy's dynamism. Among its basic industries, one of the state's growth industries and two of its stable industries are technology related. Employment in the manufacture of missiles and space vehicles is a growth industry that has expanded steadily since 1994. Also, temporary help services are used widely by technology industries to keep the workforce flexible enough to adjust to their frequently volatile cycles of production. Over 40% of employment in business services is accounted for by personnel supply firms, i.e. temporary help. Thus, temporar y help services are a critical component of Arizona's tech-based industries and are a part of its growth structure. Electronics, aircraft, and aircraft parts manufacturing are among the largest of Arizona's basic industries. Over the course of the past business cycle, components of these industries, including semiconductors, aircraft parts and avionics grew rapidly through 1998. Payroll growth in electronics halted in 1999 and 2000, however, and had an outright decline in 2001. Similarly, the aircraft industry also peaked in 1998, but fell in each of the subsequent years due to consolidation within the industry and the sluggishness of defense spending at home and abroad. These industries maintained their relative concentration in Arizona, however, as their downturns in recent years reflected national and international demand conditions rather than any loss of comparative advantage in Arizona. Indeed, other centers of aircraft manufacturing such as Seattle, St. Louis and Wichita saw steeper declines in the industr y's employment than seen in Arizona. There is no industry directly called back-office services. Yet the importance of this activity can be seen from the presence of medical service and health insurance carriers among the dynamic industries, and banking and business services among the growth industries. Banking is here despite the relative lack of a major banking headquarters in the state. Similarly, medical service and health insurance carriers as a dynamic industr y, without a major headquarters in the state, is a further indicator of the presence of back-office operations in Arizona. Two remaining industries are among the state's basic industries. First is the federal government, which contributes to the economy through its ownership of vast tracts of land through the National Park Service, U.S. Forest Service, Bureau of Land Management, and the broad programs of the Bureau of Indian Affairs. Federal payrolls and federal procurements represent income and expenditure flows that come to Arizona from outside sources, in this case from federal tax receipts generated largely outside of Arizona. Second, transport services are linked to travel and tourism as will as to manufacturing through the arrangement of passenger and other miscellaneous transport services. To summarize, the factors that drive Arizona's economy have indeed diversified away from the Five C's with technology-based industries and business and back-office services. Yet the economy still depends to a great extent on tourism-related industries, real estate and construction, agriculture and government. And indeed, there are real advantages in terms of area's natural endowments that will continue to support these industries going forward. But there may be limits to the pace of growth in these traditional industries, and dependence upon other drivers such as electronics manufacturing leaves the economy vulnerable to industry restructuring and migration overseas. Thus there is a need to search for possible paths of further diversification and economic growth.
Economy.com, Inc.
Arizona Department of Commerce - August 2002
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2 . The Broader View This section focuses on assumptions that will shape the pace and structure of the U.S. macro and international economies in the years ahead. These assumptions will have significant impacts upon the outlook for Arizona's economy and upon appropriate policy directions that may help to support the economy, to continue to attract investment, and to maintain the state's competitiveness in the national and global economic environment. 2 . 1 The U.S. Macroeconomic Outlook The U.S. macroeconomic outlook over the next decade is bright, characterized by generally strong growth, low unemployment and low inflation. Real GDP growth is expected to average between 3% and 3.5% per annum, the unemployment rate will average near 5.5% and consumer price inflation will average near 2.5%. Measures of household living standards will also improve, including continued increases in the homeownership rate, real household incomes and net worth. While the economy is likely to experience a recession sometime in the next decade, the nation's business cycle is becoming increasingly less volatile. The next downturn will likely be as modest and short-lived as the just-ended recession. The economy's performance in the next decade will not measure up to the boomlike conditions that prevailed during the second half of the 1990s, however. That period was boosted by extraordinarily optimistic expectations that in hindsight were clearly overdone. The economy also faces significant longer-term risks, ranging from the possibility of further terrorist attacks, significant disruptions to energy supplies, and mounting government fiscal problems that will only be exacerbated when the large baby-boom generation begins to retire later this decade. Most fundamentally, the economy's long-term performance is determined by the growth in underlying productivity and changes in the labor force. Both are considered in the discussion that follows. Productivity Growth. The acceleration in the economy's potential growth since the mid-1990s is the result of stronger growth in underlying productivity. To understand how underlying productivity growth has accelerated and why this growth will be maintained, consider that it is ultimately driven by three factors, including the composition of the labor force, capital intensity, and multifactor productivity growth. A more educated and skilled worked force is clearly more productive than one that is not. The quality of the workforce also changes over time given demographic trends and the returns to education. Capital intensity refers to the amount and quality of the capital--equipment and structures--that labor has to work with. Labor that works with more sophisticated computers and offices with good Internet connections, for example, will be more productive. Multifactor productivity is effectively a catch all, and includes anything that is not accounted for by changes in labor composition and capital intensity. It is generally believed that technological change is one of the primary contributors to MFP If technology is advancing more . quickly or is being implemented more effectively, then MFP will accelerate. In the more than half a century since World War II, productivity growth has averaged 2.4% per annum. According to the BLS, 20 basis points of that growth is attributable to the improving composition of the labor force, 80 basis points is the
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C h a r t 7: Decomposing Productivity Gains
48-99 48-73 73-79 79-90 90-95 95-99 9 9-05E 0 5-10E
0.2 0.2 0.7 0.3 0.5 0.3 0.5 0.4
0.8 1.0 0.6 0.8 0.4 1.0 0.7 0.5 1.1 0.5 0.6
1.4 2.1
Nonfarm Productivity Growth Labor Composition Cap ital Intensity Mul tifactor Productivity
1.3 1.3
Source: BEA
0.0
0. 5
1. 0
1. 5
2. 0
2. 5
3. 0
3. 5
result of growing capital intensity and the remaining 140 basis points is due to growth in MFP (see Chart 7). Improvements in the quality of the workforce have become an increasingly important source of productivity gains. In the years following WW II the workforce was becoming more educated, but due to a surge of new workers including women and baby boomers, the workforce was very inexperienced. Twenty year olds, with little if any work experience, surged as a share of the working age population in the 1960s and 70s, peaking at close to one-third of workers by the early 1980s. Experienced 50 year olds also declined as a share of the working age population throughout this period. The quality of the labor force has been steadily improving since then. One-third of the productivity gains during the 1990s was due to an increasingly more educated and experienced workforce. College graduates are now one-fourth of the population over the age of 25. The quality of the workforce will continue to improve and add at least as much to productivity gains during the next decade as it has during the past decade. The boomers are now aging into their most experienced, educated and thus productive working years. There will be more 50 year olds than 20 year olds a decade from now. With the explosion in business investment in computer and telecommunication technologies, it is surprising that the BLS found that increasing capital intensity contributed less to productivity gains during the 1990s than any other time since WW II. One-third of the productivity growth experienced during the decade was due to an expanding stock of capital. In the 1970s and 80s, in contrast, increasing capital intensity was responsible for two-thirds of the growth in productivity. This can be partly explained by businesses aggressively purchasing increasingly shorterlived computer related equipment. Given higher depreciation rates, businesses must invest even more just to maintain their net capital stock. There has also been less spending on long-lived structures, such as office buildings and warehouse space, during the past decade. Increasing capital intensity should at worse be able to contribute as much to productivity gains in this decade as it did in the previous decade. There is every indication that businesses will continue to invest aggressively in both equipment and Economy.com, Inc. Arizona Department of Commerce - August 2002 11
structures. Depreciation rates should also stabilize in coming years as businesses complete their most significant computer purchases. The most significant difference between the stronger productivity growth of the first quarter century after WW II and the past quarter century is a dramatic shift in the growth in multifactor productivity. Between 1948 and 1973, MFP grew at now what seems like a whopping 2.1% per annum. Since 1973, per annum MFP has grown by substantially less than half that. This startling drop off in MFP growth is the subject of considerable debate. Possible partial explanations include the oil price shock of that period, which made much of the nation's energy-intensive capital stock obsolete, and a slowing in the pace of technological change. The economy is in the midst of an apparent acceleration in the pace of technological change. This is most evident in advances made in semiconductor technology. Intel formally introduced the 286 chip, which had an initial clock speed of 6MHz, in early 1982 (see Chart 8). The power of succeeding generations of chips, which have been introduced nearly every three years, has grown quickly. There have also been significant advances in the sophistication of computer software. Microsoft introduced Windows 3.1 in 1992, Windows NT and 95 in 1995, Windows 2000 around Y2K, and Windows XP most recently, all of which has heightened the
Accelerated Pace Technological C h a r t 8: Ac c e l e r a t e d Pa c e of Te c h n o l o g i c a l Change
130 125 120 115 110 105 100 95 90 85 80
Productivity of nonfinancial corporations, output per hour, all employees, 1992 = 100
Pentium III Pentium II
Internet usage surges Windows 5.0 Windows 3.1 price wars Source: BLS 386 286 486 1.5% per year 2.5% per year Pentium
80
83
86
89
92
95
98
01
acceptance and effectiveness of PC technology. There is no indication that the pace of technological change is slowing. While many factors have likely contributed to the heightened pace of technological change, stronger business R&D spending has been instrumental. This is particularly true since the mid-1970s (see Chart 9). The currently strong R&D spending also augurs well for the future pace of technological change and thus productivity growth. Over the next decade, underlying productivity growth is expected to average between 2.0% and 2.5% per annum (see Chart 7). Approximately one fourth of the growth will be due to improving labor composition, another one fourth of the growth will result from rising capital intensity, and MFP growth will account for the remaining one-half of the growth. Although necessary, projecting productivity growth is a particularly intrepid endeavor. Not only is it based on expectations for future technological progress, it is based on a view of how quickly and effectively new and existing technologies are 12 Arizona Department of Commerce - August 2002 Economy.com, Inc.
C h a r t 9: R&D Spending Moves Higher
1. 9 1. 7 1. 5 1. 3 1. 1 0. 9 0. 7
Private R&D spending as a share of GDP
Sources: NSF, BEA
0. 5 55 60 65 70 75 80 85 90 95 00
implemented. There are numerous historical examples of technologies that moved only slowly from invention to widespread economic use. The steam engine was invented in the 18th century as a way to pump water out of mines. It remained simply that for many years, only becoming a source of power for industry, transport and ultimately electricity decades later. The laser is a 20th century example of a technology whose import was completely misjudged, at least initially. Invented at Bell Labs, laser technologies are now a vital part of the telecommunications industry, in addition to a wide range of other applications from measurement to navigation and surgery. Lawyers at Bell Labs were initially unwilling, however, to even apply for a patent on the laser, thinking it had no possible relevance to the telephone industry. It is increasingly apparent that not only has the pace of technological change accelerated in recent years, but that the diffusion of technology is more rapid and it is being implemented more effectively. Synergies are developing across technologies as seemingly different as the microprocessor, the laser, fiber optics and satellites. Nowhere are these synergies more apparent than on the Internet. The acceptance of the technologies embodied in the Internet has been unprecedented. As of the end of 2000, nearly one-half of all households were connected to the Web. Only five years after households and businesses were able to access the Web, there were some 50 million users (see Chart 10). It took the cable TV industry a decade to reach 50 million customers from its inception in the early 1980s, 13 years for TV to reach that landmark, and 38 years for radio. The effective economic use of the Internet has also been unprecedented. The web is reducing transaction costs between businesses and between businesses and consumers, allowing for the rapid dissemination of more and better information and lowering entry barriers into numerous industries (see Chart 11). A recent Microsoft study on the mortgage origination process provides a telling example. The conversion of the origination process to a full-service, Web-based electronic channel is estimated to reduce closing costs, which currently are close to 3-percentage points, by two-thirds. The cost savings result from efficiencies ranging from easier access to data on the borrower to more rapid securitization of the loans. Information to the lender and borrower is much enhanced. Lenders can quickly gather credit and employment histories on borrowers, while borrowers gain access to information on the plethora of mortgage loans that are available. Entry barriers into the mortgage
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Arizona Department of Commerce - August 2002
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C h a r t 10: Internet Diffuses Rapidly
35 30 25
Household penetration rates Sources: Infobeads, CEMA
Internet (1995)
Cable (1976)
20 15
TV (1951)
10 5 0 1 2 3 4 5
Radio (1922) Years from introduction
Percent C h a r t 11: Pe r c e n t Saving in Internet Mortgage Origination Costs
Core
Finalizin g Prelimin ary
Design
% saving in Internet mortgage origination costs Source: Microsoft
Transaction
0
5
10
15
20
25
lending business also decline as lenders no longer need to have a branch or loan origination office, just a web site. The lower transaction costs and entry barriers and enhanced information that the Web affords have substantial economic ramifications. Most importantly, competitive pressures rise and businesses are induced to specialize (see Chart 12). Heightened competition is a direct result of lower entry barriers and enhanced information. Business specialization will also occur as transaction costs across various business activities decline. The typical business today conducts a wide range of activities, including everything from the actual production of a good or service, to its distribution and marketing, and all the associated financial, accounting, legal and human resource functions. Historically, the cost of doing these activities within the firm was lower than the cost of contracting for these activities outside the firm. The dramatic reduction in transaction costs afforded by the Web changes all that. 14 Arizona Department of Commerce - August 2002 Economy.com, Inc.
C h a r t 12: Internet Economics Chart
Economic Distribution
Entry Barriers ? physical & financial capital ? brand & information
Constrained Inflation
Market Potential ? globalization ? pricing on demand curve
Internet ? transaction costs ? information
Specialization ? outsourcing
Risk Management & Sharing
Location of Work &Home
? economic redundancy ? financial innovation
Accelerated Productivity
Businesses will increasingly concentrate on their very specific comparative advantage, and leave all else to other firms with their own comparative advantages. This to some degree is already happening, as businesses have been aggressively outsourcing an increasing number of their activities. The Web will accelerate this process. The greater competition and specialization proffered by the Internet directly results in enhanced productivity growth and, at least in the near-term, constrained inflation. While the benefits accruing from the Web are implicit in the previous analysis and productivity projections, any estimates are highly uncertain and variable. The Internet is altering the manner in which the economy operates in ways that were not readily foreseeable even just a few months ago. This is of course at the heart of the debate over the economy's recent performance and the appropriate conduct of economic policy. Force Labor Force Growth. The economy's potential rate of growth over the next quarter century will be constrained, however, by an anticipated slowing in the growth in the labor force. Labor force growth is determined by the growth in the working age population and changes in the labor force participation rate. Growth in the labor force has been slowing since the 1970s when it peaked at 2.7% per annum, slowing to 1.7% in the 1980s and 1.2% in the 1990s. Behind this slowdown has been both slower working age population growth and much smaller gains in labor force participation. The labor force is expected to expand even more slowly in the coming decade, decelerating to growth of 1% per annum, as the large baby boom generation begins to retire. Expectations that participation rates will rise only marginally from current levels is due in part to much smaller further anticipated gains in female participation. The steady increase in female participation rates experienced during the 1970s and 1980s slowed substantially during the 1990s. It was inevitable that the growth in female participation would eventually slow. The participation rate for females between the ages of 35 and 44, for example, rose from one half in the late 1960s to 77% currently. The growth in female participation has also slowed as a result of the improvement in housing affordability in recent years. Strongly rising home prices and mortgage interest rates locked an increasing number of households out of homeownership during the 1970s and 1980s. At its low point in the early 1980s, the household earning the median income could afford to purchase only 60% of the median priced Economy.com, Inc. Arizona Department of Commerce - August 2002 15
home at prevailing interest rates, according to the National Association of Realtors. For families to afford to purchase a home, two-incomes were required and the female participation rates rose quickly. Since the late 1980s, weaker house-price growth and falling mortgage rates led to a dramatic rise in affordability. Affordability is currently near levels last seen in the early 1970s, and given the prospects for continued high housing affordability, female participation rates are not expected to rise significantly. Participation rates are also no longer rising in part due to a shift in employer hiring practices. Employers are increasingly requiring their existing labor force to work longer hours rather than hire new employees to meet increasing demand for their goods and services. The relatively high fixed costs of hiring labor, including health, unemployment, and workers compensation costs, have been an important impetus in this change in hiring practices across many sectors of the economy, and is unlikely to change. Business Cycle. Despite last year's recession, there is strong evidence to Business suggest that business cycles have and will increasingly become less pronounced. Prior to World War II the average expansion lasted only 25 months and the average recession at 22 months lasted nearly as long. In the past quarter century, expansions have averaged well over five years and recessions less than one year. The expansion of the 1990s was the longest in the nation's economic history. The increasing longevity of economic expansions and shortening of recessions is the result of a number of long-running structural changes shaping the U.S. economy and the dynamics of the business cycle. These include the increased globalization of the economy, financial deregulation and innovation, a more flexible workforce and the heightened pace of technological change. These changes are impeding the development of those economic imbalances that often precede recessions and heightened the ability of the economy to adjust to those shocks that ultimately induce recessions. Increased globalization of the U.S. economy through greater trade, direct investment and foreign immigration has dampened the business cycle. Exports and imports of goods and services currently account for nearly 30% of GDP up from 20% , at the start of the 1990s and 10% at the start of the 1970s (see Chart 13). Trade law liberalization and international financial deregulation from the collapse of the Bretton Woods fixed exchange rate agreement in the early 1970s to the recent passage of the NAFTA and GATT agreements have contributed to the globalization of the economy.
C h a r t 13: An Increasingly Global Economy
30 28 26 24 22 20 18 16 14 12 10
Export & import share of GDP (constant $) GATT NAFTA
Intermodal transportation Collapse of Bretton Woods Financial/airline deregulation
286 chip Source: BEA
70
74
78
82
86
90
94
98
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Improvements in transportation, distribution and communication technology and infrastructure have also stimulated trade. U.S. recessions during the past quarter century would have been substantially more severe if international trade were not as important to the economy. In the nadir of the 1973-75, 1980 and 1990-1991 recessions, for example, year-over-year real GDP growth would have declined by as much as 1% more if it were not for an improving trade balance during those downturns. Trade flows have also served to rein in the economy during the boom periods of expansions, forestalling wage and price pressures and thus subsequent downturns. Trade flows generally move counter cyclically since U.S. and world economies are oftentimes at different stages in their business cycles. In the U.S. recession year of 1991, for example, the Mexican and Japanese economies expanded by over 3% and the German economy grew by more than 5%. In contrast, when the U.S. economy was surging in 1994, the Japanese economy hardly grew and the German economy was decelerating quickly. Globalization does pose a risk to the U.S. business cycle, however, by further exposing the economy to external exogenous shocks. The 1995 Mexican peso collapse and subsequent economic crisis, for example, was a factor in the slowing of the U.S. economy. Although by itself the Mexican crisis was not sufficient to undermine the U.S. expansion, if combined with a similar crisis in Asia, for example, a U.S. recession might have occurred. Financial deregulation and innovation are also dampening the business cycle by lifting constraints on credit availability to households and businesses. This is most clearly seen in the housing and mortgage markets. Prior to the commencement of banking deregulation in the 1970s, short-term housing demand was largely determined by the availability of mortgage credit. Mortgage credit availability was in turn determined by the availability of deposits at thrift and, to a less extent, banking institutions. Deposit flows were highly volatile, however, since deposit rates were fixed by Regulation Q. When the Federal Reserve tightened monetary policy there were substantial deposit outflows from thrifts and banks as investors moved their savings to higher-yielding money market instruments. During this period of disintermediation the mortgage and housing markets shut down, significantly exacerbating an economic slowdown. Policymakers recognized the disruption to the economy resulting from swings in mortgage credit availability and phased-out Regulation Q by the early 1980's. Policymakers also facilitated credit availability with the expansion of the secondary mortgage market through the establishment and support of Ginnie Mae, Fannie Mae and Freddie Mac. Single-family mortgages owned and insured through mortgage pools by these federally sponsored institutions now account for approximately twothirds of all outstanding mortgages. Mortgages are owned by investors worldwide, ensuring that mortgage credit is always available to homebuyers at a price. Financial innovation and deregulation have also mitigated credit constraints in commercial real estate markets. The rapid securitization of commercial real estate debt in the 1990s has more closely tied conditions in real estate markets to world capital markets. According to the Federal Reserve Board, nearly one-fifth of nonfarm commercial real estate and multifamily mortgages are owned by REITs, asset-backed security issuers and federally sponsored mortgage pools. This is up from less than 4% at the start of the 1990's and 2% a decade ago. The increasing dependence of commercial real estate on world capital markets may also impose a discipline on real estate development. Investors evaluating real estate market securities in competition with other financial securities will quickly lose their Economy.com, Inc. Arizona Department of Commerce - August 2002 17
appetite for real estate securities if underlying market conditions turn soft. Capital will be reinvested in other financial assets raising the cost of capital for real estate development. This may make it more difficult for the substantial overbuilding to develop that oftentimes plagues real estate markets, resulting in real estate market and business cycle downturns. The consumer loan market is increasingly less subject to credit constraints due to financial innovation and deregulation. Capital is plentiful for all types of consumer loans ranging from auto and credit card loans to home equity loans. This is largely due to the surging growth of the asset backed securities market, which has expanded to over $1 trillion since its inception in the early 1980s. Although credit has long been available to so-called A-quality consumer borrowers with relatively good credit and employment histories, most of the growth in consumer lending in recent years has been to poorer B and C-quality consumer borrowers. Until recent times these borrowers were creditconstrained, foregoing spending during soft economic periods when incomes were weak but unleashing their pent-up demand when the economy rebounded. This resulted in substantial volatility in consumer spending. With more ample credit currently available, consumer spending and the business cycle are more stable. The provision of greater credit to consumers through loans and leases has resulted in rising household debt service burdens, personal bankruptcy filings and credit losses for lenders, however. Although lenders have tightened loan standards in response to the deterioration in credit quality, competition in the consumer loan market remains high and may prompt lenders to take on added risk once credit conditions stabilize. Consumer leverage is an economic imbalance that oftentimes prevails prior to a recession. Unlike past recessions in which consumers reduced their debt service burdens, they continued to take on debt through the 2001 recession. Thus, the consumer debt service burden remains a problem and is a significant risk to the current economic recovery. Greater flexibility in the nation's labor markets is also dampening the business cycle. Labor market flexibility has been enhanced by the growth in the contingent workforce. Contingent workers include independent contractors, those who work for temporar y help agencies and contract firms and the self-employed. The growth in temporar y help employment over the past quarter century has been extraordinary. The share of total employment in such jobs is near 2.0%, from essentially nothing a quarter century ago. Contingent workers can quickly be deployed to industries where demand for their services is strongest from industries were demand is weaker. The costs of shifting contingent workers to jobs where and when they are needed are relatively low since most do not receive severance or other benefits. Labor markets have also become more flexible as employees are increasingly willing to shift the number of hours they work to meet changing demand for the goods and services they produce. Labor market flexibility is also manifested in the willingness and ability of labor to relocate. The increased flexibility of the workforce has come at a cost to some workers in the form of constrained compensation, underemployment and the economic and other costs of moving, but it has enhanced the economy's ability to adjust to shifting conditions that could ultimately result in recession. The business cycle is also being tempered by the heightened pace of technological change. Technological advances, for example, have reduced the role of inventory shifts in shaping the business cycle by reducing the amount of inventories that businesses hold relative to sales. This has occurred through the adoption of inventory management techniques such as just in time and materials resource planning, which
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have been made possible by advances and strong investment in computer, scanner and telecommunications technology. 9/11. The economy's longer-term prospects will be impacted from the economic fallout of 9/11. At the very least, global outlays on the military and on maintaining personal and business safety will be more substantial in the years ahead. This spending does nothing to raise productivity gains and thus living standards. Indeed, the collapse of the Soviet Bloc in the mid and late 1980s and the subsequent decline in military outlays provided a substantial boost to the U.S. economy during the past decade. Perhaps the costs of combating global terrorism will be more evenly distributed across global economies than was the military spending associated with combating Communism, but perhaps not. The government surpluses projected for the beginning of the decade will not materialize for several years to come as additional militar y outlays and public spending will deplete reserve funds. The terrorist acts may also undermine recent efforts to open the U.S. economy more fully to foreign immigration. An early agreement between the U.S. and Mexico to allow for a more open immigration policy seems unlikely now. Stronger immigration to the U.S. will be necessary for the U.S. economy to continue to grow strongly and to support the large number of us who will become retirees and rely on Social Security and Medicare in the decades ahead. The most significant casualty of the terrorist actions, however, will likely be the personal privacy of all Americans. It may be necessary for the government to keep closer tabs on all of us to maintain the safety we will all demand. This may very well have serious deleterious implications for the free flow of ideas and creativity so essential to the entrepreneurship and productivity of the U.S. economy. 2 . 2 Business Practices Emerging from the assumptions outlined above are a number of business practices that will shape the direction and pace of the economy going forward. Such practices include product development, labor force requirements, supply chain management, labor outsourcing and financing. Product Development. The accelerating pace of technological change will drive industry to be increasingly research intensive and will generate increasingly short product cycles. This has two consequences for a local economy. First, for any industr y to become or remain dynamic, it must have access to R&D capacity and the financing to support it. R&D can take shape in-house within a large organization that takes advantage of internal resources. It can operate as a public-private partnership such as through university R&D facilities or other public investments. Or it can take place independently, supported by venture capital. Shorter product cycles caused by accelerating technological change cause manufacturing plants to become obsolete more quickly than in the past. This will happen either because the product manufactured becomes obsolete, or because the product becomes a mass-produced commodity more quickly, causing its manufacture to be shifted to a lower cost location. So while product manufacturing will be an increasingly volatile activity in terms of capacity and location, R&D will remain more of a constant. Thus, long-term economic growth will be better supported by manufacturing and services if it is accompanied by a significant research and development component. Force Labor Force Needs. Employers will search for the most talented workforce available to support the R&D work necessary to keep up with accelerating product cycles and global competition. They will do this either by locating only where there is Economy.com, Inc. Arizona Department of Commerce - August 2002 19
an ample and well-trained workforce, by importing skilled labor, or by linking to global sources of skilled labor. The growth of Silicon Valley is an example of the first instance, in which local universities produce skilled workers and entrepreneurs producing new products and services. Less visible but equally important has been the use of community colleges in the Southeast and elsewhere to improve workforce quality in order to attract investment. Much of the Mountain West is an example of the second instance, in which migration flows of well-trained workers have boosted the quality of the workforce. The software industry is an example of the third instance when it taps into skilled labor pools globally to maintain 24-hour product development efforts. The assumption of slower labor force growth in the U.S. in the coming decade means that the domestic workforce will have to become increasingly productive in order to compete with the increasing ability to tap into foreign sources of skilled labor. Thus, it is not only traditional labor-intensive industries that will face global competition, but increasingly so with technology-related industries as well. Labor Outsourcing. This will lead either to increased flexibility of in-house workforces, or more likely, the expanding use of a contingent workforce made of parttime workers, temporary workers, independent contractors and the self-employed. Thus, as with the need to support supply-chain management through improved telecom, labor outsourcing will increasingly require the use of off-site labor linked through telecommunications to a central site, and an ample pool of skilled workers willing to work flexible hours on diverse tasks. Supply -chain management. This is more than just-in-time inventory management. This means a more technology-intensive application of telecommunications and software for transportation, warehousing and manufacturing. This means that quality of transportation links will be critical to avoiding delays. It means substantial investment in telecom and electric utility infrastructure to ensure adequate and consistent support of supply-chain management no matter the location. Finally it means that the labor force will have to be increasingly flexible to change shifts and responsibilities to adapt to rapid changes in supply-demand relationships. Financing. The increasingly flexible economy will require flexible sources of financing that can respond immediately to research, development, and production needs. Venture capital and other sources of development capital proved their worth during the 1990s. But the eventual failure of many VC supported enterprises makes it clear that such funding will be undertaken only with much more due diligence in the future. Thus, budding entrepreneurs will need to develop partnerships in finance and business management to effectively take advantage of such resources. But even more important, sources of financing will have to locate close to operations in order to respond effectively to the flexible financial needs of business. This pertains not only to the more speculative nature of start-up firms, but to the increasingly flexible production and R&D activities at existing firms. A local and engaged financial services industry, made up of a broad range of traditional and less traditional financial service firms, will be a necessary factor for economic growth. 2 . 3 The Global Economic Environment The global economy will see four fundamental changes begin to emerge in the coming decade. The first will be the emergence of global trading blocks. NAFTA will likely expand to include South America. East Asia and Europe will also emerge as more formal trading blocks. The expansion of NAFTA would initially generate increased potential for U.S. exports as trade barriers fall, although any agreement to expand NAFTA would be incremental, and the impact would be slow in coming. 20 Arizona Department of Commerce - August 2002 Economy.com, Inc.
Longer term it would continue the movement of lower-wage industries from the U.S. as it improves demand for U.S.-made capital equipment and knowledge intensive services. Trading blocks will solidify in Europe and will arise in East Asia as the industries and economies within these regions more closely integrate their operations to meet regional demand. This generates some potential for more contentious trading relationships with the U.S., although the risks are minor. Second, growth of the huge Chinese market and its entrance into the World Trade Organization will generate major shifts in global trade patterns. Regional comparative advantages in Asia for manufacturing will shift toward China. In response, southeast Asian economies will shift toward higher-value goods and services, generating further competitive pressure for U.S. firms. But the growth of the Chinese market also offers strong potential demand for U.S. goods and services. Third, aging populations in Japan, Europe and North America and the need to fund pension and health care services will place considerable fiscal burdens on government. Unless saving rates rise, expanding budget deficits have the potential to put pressure on interest rates over the next 15 to 20 years in high-income countries, providing further comparative advantage to emerging economies. Fourth, increased standardization in existing high-tech industries will lead to further transfers of business operations to low-cost economies. This leads to an increasing importance of the ability of the U.S. to develop emerging industries, which will require sufficient capital investment. But even more importantly, it will require ever improving human capital from which innovation originates. The remainder of this section will discuss these factors in greater detail in relation to the expected pattern of the global economy in the coming years. Recovery. Pattern of Global Recovery. The economy of the industrialized world is in the midst of a nascent recovery. However, the strength and pace of the rebound is more tepid than previously expected. As a result, the potential boost to overall trade volumes will also be less vibrant. After rising nearly 13% in 2000, U.S. export volume fell by nearly 5% last year. The outlook has certainly improved but Economy.com projects that exports from the U.S. to the rest of the world will continue to decline this year before rebounding quickly next year. The rebound in the global business cycle will drive export demand first for primar y and intermediate commodities. As manufacturing production picks up, demand for industrial supplies, commodities, and natural resources should rebound the quickest, followed by intermediate goods, and then advanced final goods. Among intermediate goods, however, the tech slump will linger in the near term as business investment in IT networking equipment, computers and components remains weak before rebounding in 2003. Given the diverging performances of various industries in the early stages of the recover y, individual countries will recover at different rates, thereby influencing trade flows between the U.S. and its trading partners. Those experiencing rising incomes will be well placed to increase demand for U.S. goods. Increased demand for natural resources and industrial commodities will certainly benefit East Asia, namely Malaysia and Indonesia, which are among the most commodity dependent economies in East Asia. South Korea is poised to lead Asia out of recession as its sales of household appliances and autos and auto parts in U.S. markets have been crucial in offsetting weakness in its troubled IT investment market. Europe's recovery will lag behind that of Asia. The pace of the recovery across the continent is uneven with Spain, Ireland, and France showing the firmest conditions, followed by Italy. On the other hand, the manufacturing-dominated north central portion of the euro zone, namely Germany and the Netherlands, remains weak and Economy.com, Inc. Arizona Department of Commerce - August 2002 21
continues to weigh on the outlook for the entire region. Lastly, Latin America suffers from some of the more severe downside risks for a near-term recovery, namely overburdening debt problems, stubbornly high inflation and an unstable political environment. As a result, the economic turmoil in Brazil and Argentina is weighing on the economic outlook for this region, which will therefore be one of the last to recover. Export Risks. Near term, the risks to the outlook for exports remain on the downside. The slump in demand for IT equipment is expected to extend through the end of this year. So, an even more anemic economic recovery could delay the rebound of global business investment. Moreover, the impact of the 9/11 terrorist attacks is an increase in the cost of shipping in and out of U.S. ports due to increased security measures and insurance costs. Longer term, Arizona's dominant export product, electrical and computer equipment, will improve. With business investment expected to rebound over the course of 2003, such improvement in demand conditions for high-tech industries will feed through to exports. Aside from overseas demand for intermediate components, emerging economies in Asia and eastern Europe, with relatively undeveloped telecom infrastructures and a growing need for enhanced communications systems, will generate demand for IT equipment, providing upside potential for exports. The entry of China into the WTO in December 2001 also provides substantial upside potential for overall trade volumes. The opening of the world's most populous consumer market could be a boon for makers of a variety of durable goods and also the providers of telecommunications, financial, and insurance services, especially after tariff reductions are completed by 2005. Similarly, high-end consumer goods and specialty food products could find expanded market potential in China and elsewhere. The pace of economic reforms, however, and hence the ability of other countries to realize the full benefits of trade with China, remains an area of uncertainty. A Special Case: Mexico. Weak U.S. demand has caused a cyclical decline in Mexico. shipments of maquiladora products, generating near-term weakness in Mexico's manufacturing industries. But the industry itself has become less competitive globally over the past year, causing the industry to shrink and thus reducing demand for exports of intermediate goods from Arizona. Ironically, the NAFTA trade agreement is a contributing factor to the industry's current woes; the agreement, enacted in 1994, required Mexico to strip maquiladoras of their duty-free status by 2001 for intermediate goods originating outside of North America, causing the prices of some imported raw materials and intermediate goods to rise (see Chart 14). The attractiveness of Mexico as a destination for foreign direct investment has subsequently fallen, prompting companies to shift some operations to Asia and the Caribbean. As a result, many of the jobs and production at maquiladora plants lost over the past year will not return quickly. A cyclical upturn in the U.S. and Canada and a weaker peso will provide some near-term stimulus. But expectations for the industr y's long-term growth, and hence the potential growth of exports from Arizona, may be weaker as Mexican industry restructures toward more high-value industries in the coming years. Over the remaining years of this decade, higher-value industries in Mexico will have less reason to locate close to the U.S. border. This may well provide some improved comparative advantages for Arizona. In the early years of free trade with the U.S., producers needed to be within a fixed distance of the border to gain taxadvantaged status for imported intermediate inputs. Given the smaller size of the Mexican communities adjacent to Arizona compared to those along the California and Texas borders, Arizona benefited less. Mexican industry in the future will be less concentrated on the border, and it will produce higher-value products with a higher 22 Arizona Department of Commerce - August 2002 Economy.com, Inc.
C h a r t 14: Maquiladoras Losing Competitive Edge
25
In-bond export industry, % change year ago
10 5 0
Real value added (L)
20 15 10 5 0 -5 -10
Sources: BLS, BEA Employment (R)
-5 -10 -15 -20 Jan 01 Apr Jul Oct Jan 02
-15
Foreign Affiliates C h a r t 15: Fo r e i g n Af f i l i a t e s in Arizona
4. 0 3. 8 3. 6 3. 4 3. 2 3. 0 2. 8 2. 6
Source: BLS
Employment in foreign affiliates, % of total
2. 4 87 88 89 90 91 92 93 94 95 96 97 98 99
value-to -weight ratio. Thus, lengthening transport links between such production locations as Hermosillo, Guadalajara, and even Monterrey, and markets in the American Southwest and Pacific Northwest place Arizona squarely in the middle of this expanding supply-chain management and marketing distribution pattern. Foreign Direct Investment. Foreign direct investment (FDI) in Arizona has grown, most noticeably in the second half of the 1990s, and has contributed to boosting the state's economic prosperity. Relative to other states, however, Arizona does not rank highly in terms of the number of workers employed by foreign companies as a share of total employment, ranking 42nd out of 50 states (see Chart 15). There are several reasons why growth in FDI accounts for a smaller share of total employment compared to other states like Hawaii, the Carolinas, New Jersey, and Connecticut. Most investment capital comes from investors in Canada and Europe, who favor the East Coast due to its proximity and its densely populated markets. In the case of Hawaii, that state benefits from its proximity to East Asia. Economy.com, Inc. Arizona Department of Commerce - August 2002 23
Arizona attracts more of its FDI from Asia due to the strong presence of electronics and electrical equipment in its industrial base. Investment in commercial property by Asia-Pacific affiliates accounted for nearly 35% of all foreign commercial property investment in Arizona in 1999 (the latest available data) compared to 30%, nationally. Moreover, growth in Asia-Pacific investment in Arizona has grown at a pace that far outpaced the nationwide average. In 1987, investment from this region accounted for only 3% of total FDI in Arizona, compared to just over 20% of national FDI during the same year. Manufacturing has been the driving force behind growth in jobs provided by foreign companies, accounting for 20% of total FDI employment. Indeed, the state's well-established tech base served it well in rejuvenating FDI in the late 1990s. Looking forward, the state has several structural factors that should serve to attract further FDI once the Pacific Asian economies fully recover. A high quality of life, affordable housing, favorable business costs and strong population growth will all serve to attract further FDI longer term. Immigration. Strong rates of net in-migration have boosted population growth in Arizona and will continue to do so across the forecast horizon. More specifically, international migration has supported the state's population growth. Final estimates for immigration into Arizona over the past decade are not yet available from the 2000 census. However, there are statistics on the number of Arizona residents born outside the U.S., which provides insight into the important role that the state plays in
Mexico Foreign-born Population C h a r t 16: Me x i c o Dominates Fo r e i g n - b o r n Po p u l a t i o n in Arizona
Latin America
Foreign born population by country of origin, % of total foreign born population Source: 2000 BOC Source: BOC
Asia
Europe
Northern America 0 20 40 60 80
absorbing the nation's immigrants. According to 2000 census data, Arizona's foreign-born population had risen by 150% to over 656,000 during the 1990s, accounting for over 25% of the population increase over the decade. Of these new foreign-born residents, over 70% originated from Latin America, mostly from Mexico (see Chart 16). The 1990s represented the continuation of an emerging trend where growth in the foreign-born population accounts for a rising share of Arizona's population growth. Indeed, while total population growth was actually stronger during the 1960s, foreign-born population growth reached new heights in the 1990s. Arizona's population grew by 74% in the 1960s, while the foreign-born population grew by only 50%. However, during the 1990s, Arizona's total population grew by a still24 Arizona Department of Commerce - August 2002 Economy.com, Inc.
strong 40%, but foreign-born population surged by more than 150%. While many of these new residents may have migrated to Arizona from within the U.S., impending census figures on immigration will likely illustrate that the relative economic performances of Arizona and neighboring Mexico during the 1990s encouraged strong international migration directly into Arizona. Indeed, the role of documented and undocumented Latin American immigrants in driving foreign migration trends was stronger in the 1990s than the previous decade; the presence of Latin Americans in Arizona's foreign-born population grew by nearly 190% during the 1990s. Arizona's proximity to the region means that, like the other border states of California, New Mexico, and Texas, Latin America figures substantially in its demographic pattern. However, relative to California and Texas, it appears that international migration accounts for a smaller share of total population growth in Arizona (see Chart 17). It is more than a fleeting coincidence that growth in the foreign-born population was strong during the past decade. The 1990s marked for Arizona a period of strong economic growth. Conversely, it was period of volatility for the Mexican economy during the mid-decade peso crisis and the later contagion of the global economic crisis in 1998. Continued cross-border migration will depend upon the relative growth of the Mexican and U.S. economies going forward. If indeed the border-region maquiladora industries continue to downsize or move offshore, the unemployed in Mexico would have further incentives to migrate to the U.S. However, as Mexican industr y begins to move up the value chain, and if Mexican industry can successfully locate in some of the poorer regions of the country farther south, regions that are major sources of immigration to the U.S., the tide of immigration would slow. The U.S. economy will continue to provide a significant pull factor for immigration, but it is unlikely that it will be as strong as it was during the second half of the1990s. Financial Investment. Direct foreign investment in Arizona will face friction in the coming years from an easing of capital flows into the U.S. There are four reasons for this changing trend in capital flows.
C h a r t 17: Other Border States Absorb More of the N a t i o n ' s Immigrants
California
Texas
Arizona
Foreign born population growth, % share of total population growth 1990-2000 Source: BOC
New Mexico
0
10
20
30
40
50
60
70
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Arizona Department of Commerce - August 2002
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First, interest rates spreads between the U.S. and global markets are widening. Signs of resurgent inflation in the euro zone, in particular, are causing interest rates there to rise ahead of rates in the U.S. This is causing the European Central Bank to begin tightening monetar y policy earlier in an effort to rein in inflation. Higher interest rates in Europe will cause some shift in capital flows toward Europe. Second, a depreciating dollar further discourages direct foreign investment in the U.S. As the dollar diminishes in value, dollar based earnings translate into less local currency when profits are repatriated, meaning that overall returns to foreign investment in the U.S. are diminished. Third, productivity in the U.S. will continue at a strong pace in coming years. But increased capital investment and the potential for some easing of restrictive labor laws in Europe generate some potential for accelerating productivity growth in Europe and elsewhere in the coming years. This too adds friction to foreign capital flows as investors find investment opportunities outside of the U.S. increasingly attractive. Finally, the uncertainty of U.S. equity markets may continue longer term should there be continued revelations of accounting and business irregularities among publicly traded companies in the U.S. Overseas investor sentiment already is showing its willingness to shift to local equities rather than to continue to direct investment toward the U.S. With these four factors potentially working against the continued long-term flow of capital toward the U.S., it will be more difficult to attract foreign investment than in recent years. During much of second half of the 1990s and through the months immediately following 9/11, the U.S. was consistently seen as a safe haven for investment as well as a place where strong productivity growth would generate higher returns for investors. Risks to the future pace of foreign investment in the U.S. are largely on the downside going forward, with considerable uncertainty caused by continued threats of terrorism in the U.S. Dollar/Price Effects. Were it not for the counter-intuitive movements of the dollar over the past year, the U.S. recession would have been more severe. The current account deficit, now 4% of GDP and the economic recession indicated that the dollar , should have weakened throughout 2001. With an economic recovery on the horizon, the dollar should then have begun to appreciate as U.S. exports rebound and potential returns on equity investment become more attractive. Instead a more severe economic downturn overseas, strong productivity growth that promised higher returns, and the global role of U.S. financial markets as a safe haven resulted in an unyielding appetite for U.S. stocks, bonds, and derivative investments. The dollar began a period of self-propelling appreciation as the stronger dollar boosted the U.S. returns of foreign investors, fuelling yet more investment from overseas. But this trend is now over and the dollar will continue to depreciate in the near term and will remain near a decade low as foreign investment portfolios become less concentrated in U.S. equities (see Chart 18). The result will be cheaper prices for U.S.-made goods overseas, and more expensive prices for imported goods in the U.S. This will give more pricing power to U.S. firms within domestic markets as they will not have to compete so rigorously with imports. It also means that U.S. exports will gain greater acceptance as they become more price competitive in the global market. Thus, a managed and gradual deflation of the U.S. dollar will generally have positive impacts on the U.S. economy. The most important downside effect will be a moderate boost to inflation as import prices rise and domestic producers attain greater pricing power for their goods.
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C h a r t 18: Dollar Wi l l Fa l l Fu r t h e r Will Fall Further
135 125 115 105 95 85 75
Weighted-average exchange value: U.S. $, Mar73 = 100 Source: Federal Reserve Board, Economy.com
73 76 79 82 85 88 91 94 97 00 03 06 09 12 15
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Arizona Department of Commerce - August 2002
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Future At 3 . Arizona's Fu t u r e At Risk 3 . 1 . Arizona Within The U.S. And Global Environment L i m i t s of Current Economic Structure. Arizona's current economic structure poses some significant downside risks for the remainder of the decade. Current drivers of the economy will play a key role in the future only if at least one of the following occurs. First, if an industry faces extraordinary exogenous demand in the coming years due to changes either in demographic trends, fiscal policy or global trade. Second, if an industry is able to increase its productivity through workforce improvements and capital investment. Third, if an industry is able to develop new technology or to become an early adapter of new technology. Fourth, if an industry can remain competitive with global producers through any of the three factors above. Dynamic Industries. Among the dynamic industries of the past decade, only amusement and recreation services has a clear positive outlook due to exogenous demand drivers. Demographic trends drive this optimistic outlook as baby boomers have increasingly higher disposable incomes as they age, and are increasingly willing to travel and spend on related services. Also, the children of boomers are coming of age and will be demanding amusement and recreation services at an accelerating pace. There also is further potential for public relations and management services, particularly as firms require help to transition to increasingly flexible business models foreseen in the coming years. Mining and manufacturing of construction materials will remain stable at best, but there is little chance of any acceleration in demand as the Southwest and the entire nation are coming off of a building boom that will not likely be repeated for some time. Transportation services is an industry that will have to change rapidly as ticketing and freight brokerage services and logistics come to rely increasingly upon the Internet. Medical and health insurance carriers will face severe cost pressures in coming years as medical costs rise and the ability to raise rates diminishes. The potential for some of the dynamic industries is great, but each faces challenges in terms of the proper application of technology and use of its capital and labor resources. Thus, the dynamic industries may still drive Arizona's economy, but they will need to continue to transform to meet the challenges of the future. Growing Industries. Among the three industries in this category, missiles and space vehicles retains very good potential due to exogenous demand from rising defense expenditures. But challenges remain, as defense needs shift from the Cold War to the war on terrorism. Thus, future exogenous demand is not yet fully understood. The banking industry offers good potential as well, but will not likely accelerate its presence unless regional or national financial service operations stake a greater presence in Arizona and adapt to changing financing needs of emerging industries. Business services, however, do retain very good potential as their broad array of hightech services, including computer programming and the increasing need for temporar y help services help reshape an expanding economy. Stable Industries. The stable industries present the greatest risk to the economy in the coming years. The airline industry, for example, is in serious financial trouble. Phoenix-based America West was the first airline to request federal loan guarantees following the falloff in air travel demand post-9/11 and others are following. The change in airline travel not only poses serious financial difficulties, but also is forcing the industry to completely reevaluate its business practices. Technology plays an increasingly large role in the management of route structures, and the capital/
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labor ratio is in flux as the industry reconsiders its labor contracts. The industry could be facing another period of consolidation as the decade progresses. Electronics manufacturing faces serious competitive threats from overseas producers in line with emerging U.S. and global trends discussed above. While the near-term outlook should improve with a global economic recovery, the longer-term future of this industry will depend on the amount of research and development work that continues locally and that generates new products that are R&D intensive such as medical or advanced measurement and controlling devices. Real estate and insurance agents are more symptomatic of "growth-related" industries in Arizona. In other words, they grow simply because of strong migration and the income and wealth that are brought to the state by migrants. Thus, they offer little potential to drive the economy going forward and are not even basic industries in the true sense of the word. The federal government also generates little upside potential. If anything, as the defense department claims a larger share of the federal budget, federal agencies within the interior and agriculture departments could face stable budgets at best. Some upside potential is evident for the aircraft and parts industry as exogenous defense spending filters through the broad aerospace industry. Arizona ranked 9th in 2001 for total defense procurement spending and 5th when ranked by procurement spending as a share of gross state product, underscoring the state's exposure to defense spending. Similarly the lower-paying restaurant business generates some upside potential from a long-term rise in tourism spending. But here there is a strong contrast between the potential for high-paying jobs in the highly productive aerospace industry, versus lower-paying jobs in tourism and hospitality. Tourism would have more upside potential to drive the economy if it had a larger component within cultural activities and the arts. Thus, while the stable industries represent some of the state's largest employers, and many of its jobs are very well paid, there is a greater risk that many of these industries contract in the coming years rather than remain stable components of the economy. Deconcentrating Industries. Of the deconcentrating industries, the hotels and lodging industry does offer some upside potential as travel demand catches up to the industry's overcapacity. Thus, longer term, hotels and lodging may once again provide good potential for economic growth as supply is more balanced with expanding demand. Crop and soil preparation services and the broader agriculture industry does offer some upside potential in the West and Southeast regions of the state, but only with some significant investment in the industry that intensifies its use of capital and more intensive processing of raw commodities. Metal mining is in the midst of a long-term secular decline within the state and nation. As long as resources remain, the industry will continue to contribute to the economy, but at a decreasing rate. L i m i t s of Arizona's Export Structure. Arizona's export markets are important for the economy. Commodity exports of $12.5 billion amounted to nearly 8% of total gross state product in 2001. This is not far from the national average of just under 7%, but it does rank Arizona eighth in terms of export exposure. Thus, the downturn in export markets, starting first with the global financial crisis in 19971998, followed by the global economic downturn that began in 2001 has played a significant role driving Arizona's economy in recent years. Export Commodities. Arizona's export markets drive a narrow range of industries that play an outsized role in the state's economy, namely electronics and aerospace. Electronics accounted for 44% of state commodity exports in 2001; Economy.com, Inc. Arizona Department of Commerce - August 2002 29
transportation equipment (largely aircraft and aerospace equipment in Arizona) accounted for another 20% (see Chart 19). Thus, nearly two-thirds of Arizona's exports are produced by just two of its industries. And, indeed, by just a few of the state's largest firms. This concentration is higher than average. The median exposure to states' single largest commodity is 32%. When summing up all state exports by commodity, no industr y accounts for more than 23% of the total. The median exposure to states' two top commodities is just 47%, well below Arizona's 64%. Export Destinations. The range of export destinations is less concentrated, with 29% going to Mexico, 11% to Canada, 8% to the U.K., 7% to Malaysia and 5% to France. The majority of exports to Mexico, Canada and Malaysia are electronic products. Trade with the U.K. has shifted quickly from electronics to aerospace products over the past five years. Trade with France is nearly all in aerospace (see Chart 20).
C h a r t 19: Narrow Range of Exports
Computer & elec. products
Transportation equip.
Machinery (ex. elec.)
Fabricated metal products Elec. equip., appliances & components 0 10
Exports by commodity, 2001 % of total Source: BOC
20
30
40
50
C h a r t 20: Five Largest Export Destinations
Mexico
C
