Economic Outlook - February 2005

A famous forecaster and a top policy adviser discuss where the economy has been and where it’s going.
By Edward Martin

James Smith is director of the Center for Business Forecasting at the Kenan Institute of Private Enterprise at UNC Chapel Hill and chief economist for the national Society of Industrial and Office Realtors. He was a consultant to the President’s Council of Economic Advisers during the Reagan administration. Dan Gerlach is senior policy adviser for fiscal affairs to Gov. Mike Easley. He was director of the nonprofit North Carolina Budget and Tax Center and taught at N.C. State University before joining Easley’s staff in 2001.

BNC: Characterize 2004 and the year ahead.

Gerlach: In 2004, we saw the state with an above-average recovery in terms of adding jobs. We’ve seen the underlying strength of our service sector, not just in retail but in the business-, financial- and professional-services sectors. We expect to see that trend continue.

Smith: North Carolina is back in business. With our high proportion of manufacturing jobs, we went down ahead of the recession and then bounced back more rapidly. Now we’ve got to fix our horrible K-12 education system — our No. 1 problem — namely with a statewide voucher system.

Gerlach: I disagree on K-12. Our system is quite strong, especially in our early grades. We’re one of the nation’s leaders. Clearly, we can’t rest on our laurels because the dropout rate is a problem, and the governor is very interested in keeping young people in middle school and high school. We see a higher proportion of our high-school seniors going to college than ever before. Problem is, not enough students make it that far. That’ll be a focus of the governor’s second term.

What impact will Easley’s victory and Democrats controlling both the state Senate and House have on our economy?

Gerlach: It shows North Carolinians agree with the governor that education and economic development will create a more prosperous state. We saw that in the overwhelming vote to bring Dell here. [After the election, legislators approved a record $243 million incentives package for the Texas computer maker to build a plant in the Triad.]

Smith: Well, Dan still has his job, which was predictable. But the trick is, can they get North Carolina back on its normal post-World War II track of growing more rapidly than the national average, which has occurred in the last 12-to-14 months. In the last five years, we’ve slipped from the second- or third-largest economy, as measured by personal income, in the South to the fourth. Not a good direction.

Will we hear more about a lottery?

Gerlach: Yes. It puts us at a competitive disadvantage when everybody around us has one. We need more money for education. We’re growing so quickly we’re outstripping our facilities. It’s safe to say the governor will continue to talk about the need for a lottery.

Smith: Lotteries are for losers. It’s an immoral approach that says poor people are so dumb they willingly allow themselves to be taken to the cleaners. Lottery players are overwhelmingly poor, with low education and low language skills. They couldn’t calculate odds if they had to, and it’s rare to find a lottery that pays out more than 50% of the proceeds. In Las Vegas they pay 98%. If our good, honest Tar Heel workers want to go to Virginia or South Carolina, let them.

What do Bush’s re-election and Republican Richard Burr winning a U.S. Senate seat mean for the state?

Gerlach: It’s too early to tell. But a first step is, we need some kind of relief on the expiration of textile quotas in January. Hopefully, Senator Burr is communicating that to the president.

Smith: We’ve ripped off consumers for 30 years with those stupid quotas. I’m all for transition assistance to folks who lose their jobs, but the solution is to send them back to school and use our tax money to pay for it — not to have everybody else in the country paying more for textiles.

Gerlach: Because of globalization and manufacturing jobs lost to China, people are going to have to be better-educated. But we also need enforcement of trade laws already on the books. The governor has had to look in the eyes of 6,000 laid-off Pillowtex workers. It’s not much comfort to say you should have seen this coming.

Will the Bush administration’s record deficits hurt North Carolina?

Gerlach: Somebody’s going to have to pay for them, and most economists believe they’ll eventually affect the economy. We need to watch carefully that they don’t use this as an opportunity to shift costs down to the states.

Smith: I’d love to tell you deficits are the bane of our existence, but the top 75 studies of the last 25 years have failed to connect federal deficits — or surpluses — with interest rates, inflation, growth or employment. I’m sure they’re highly correlated with the amount of hot air from politicians.

Is offshoring a problem or a plus for North Carolina?

Smith: It’s the biggest phony-baloney issue I’ve ever heard. The Bureau of Labor Statistics in June told us it can identify 129,000 jobs nationwide offshored. But according to the federal government, one out of six of us gets his or her job from a foreign source. That’s 15 to 20 million jobs, and we’re wringing our hands over 129,000.

Gerlach: How, in the governor’s words, do we prepare ourselves for competition in the world? Look at where cars are made — Hondas are made in America, Ford is made in Mexico. The only way we’re going to succeed is to have the best-educated work force and provide the lowest possible costs. I agree with Jim — we can’t just pray to hold on to things with which we can’t compete anymore.

Would you say North Carolina is a net beneficiary of globalization?

Gerlach: No. Take textile and apparel jobs: The Carolinas are hit harder by trade policies than most states because we have more of those jobs.

Smith: I wouldn’t say we’re a huge beneficiary. But 38% of the students at Kenan-Flagler Business School are from another country. One of four patients at Duke, Wake, UNC or Presbyterian Hospital in Charlotte is a foreigner, so we’re exporting medical services. We’ve got Bank of America, one of the world’s leading banking institutions, and we export their services. We export a lot of computers and pharmaceutical products, agricultural chemicals, school buses and Freightliner trucks. We’re a magnet to the world.

Sum up Easley’s first term.

Gerlach: What we did right was we hit the budget crisis head-on. A lot of states didn’t. The governor made a lot of unpopular choices. But when the recovery came, we were in a better position than most states to capitalize on it. Secondly, the governor pushed economic development through the Job Development Investment Grant program and the One North Carolina Fund. We saw the problems and addressed them early. We didn’t try to sweep them under the rug. The things we need to work on now are getting high-schoolers to stay in school and controlling health-care costs.

Is that a major problem?

Gerlach: In the first two or three years of the administration, our health-care costs as an employer through the State Employees Health Plan and Medicaid increased 52% while everything else in state government was down. That can’t continue. Your thoughts, Dr. Smith, on the governor?

Smith: Gov. Easley was a wonderful attorney general, and I can’t imagine why on earth he wanted to be governor. We’ve got all this red ink and funding programs that are hard to get rid of. He did as well as anybody could, and I’m not going to be critical of the poor man. But until you cut spending, have a flat tax and get rid of income taxes, I can’t imagine why anyone would want the job.

How can health care be fixed?

Gerlach: It’s a huge issue. State employees are concerned because in the last four years they didn’t get a lot of wage increases. But one reason is, we’re putting a lot of their compensation into health care. We pay the entire health-care premium for employees, and our annual payment is $300-and-some million higher than when the governor took office. We’re going to have to devote more attention to people living healthier lifestyles. I say that as I put my cookie and Pepsi down.

Smith: Dan will agree with me that one of the most dreadful statistics just came out from the National Association of State Budget Officers. It was for fiscal year 2004: For the first time, the proportion of spending on Medicaid was 21.9% of state budgets, and spending on education was 21.4%. Medicare, Medicaid and Social Security are going to bankrupt the United States in a decade. There’s going to have to be some form of rationing. Health care is a luxury good. Economists know if your income goes up 1%, your health care goes up by far more than 1%.

Tar Heel doctors want a $250,000 cap on noneconomic malpractice damages.

Smith: My brother-in-law is a doctor in Texas, where they have that, and he says malpractice premiums are down and lawsuits dropped dramatically. We have a culture that says if you screw up, hire a lawyer and sue someone.

Gerlach: Sorry, but it’s more complicated than that. Part of the problem is, insurers haven’t gotten the return on investment they wanted. Noneconomic damages are something we can look at, but it’s not going to control the problem.

Are our economic incentives effective in recruiting industry?

Gerlach: Some are, some aren’t. The governor trimmed back some of the William S. Lee Act tax credits to make it harder for companies to qualify in prosperous counties, to avoid subsidizing things that would happen anyway. But reasonable people can differ when we get out to the margins, so we’ve tried to be very transparent, to do everything in the light of day. Basically, some have been very effective in attracting high-wage jobs.

Smith: The only thing you can say is ours are less horrible than some other states’. We lost Mercedes-Benz to Alabama because they paid through the nose. We lost BMW to South Carolina because they paid through the nose. We’re better off we didn’t burden the taxpayers. When you’re subsidizing competitors of the person who’s already here, that’s hard to sell. It’s a constant battle to keep the legislature from throwing money at a nonproblem. North Carolina is usually at the top of the list of places people want to move to and retire to. If we’d just get rid of the damned income tax, we’d be ahead of Florida, which has no income tax.

Gerlach: We’re not trying to outbid anybody with incentives. We’re just trying to take advantage of the natural head start we have in our educational system, including higher education and work-force training, then use enough incentives to make the deal. We’re creating the image that it’s a good state to do business in.

Smith: That may be true, but up until 1953 we had the largest economy in the Southeast. Now we’re fourth, behind Florida, Georgia and Virginia. If we could get Congress to outlaw incentives, all states would save money and economic activity wouldn’t change one dime. But unless you get Congress to do it, you have to be in the game.

The poverty rate in 2000 was 14.1% in rural areas versus 10.3% for urban areas. Can we change that discrepancy?

Gerlach: You certainly don’t want to level down. We’re trying to locate jobs in rural North Carolina that are going to stay. Not every county is going to have a textile plant. But if you’ve got a computer and a T1 connection, there’s a lot of stuff you can accomplish in rural areas.

Smith: It could make a huge difference if the federal government got rid of the ridiculous restrictions on drilling for natural gas off Cape Hatteras. They all think it’s out there. If they found it, it could be brought ashore in Eastern North Carolina, our most depressed area, and we’d have a boom in industries looking for cheap energy.

We hear a lot of complaining about our corporate income-tax rate, which is 6.9%. But isn’t that moderate compared with other states?

Gerlach: Yes, but the corporate tax rate combined with the individual rate — that’s the one that’s higher — needs to come down.

Smith: There’s no economic theory that justifies the corporate tax. It should be zero. Most small businesses are paying their personal income-tax rate on their Schedule C or Subchapter S businesses, so if you can get the personal rate down, we’ll be a mecca for small-business people. Figure it out and run everything as a flat tax on consumption, and do away with income taxes altogether.

What about sleeper industries? For example, a recent study said motor sports is worth $4 billion a year to North Carolina’s economy.

Gerlach: Motor sports is part — perhaps the biggest piece — of our automobile industry. We don’t have big players like BMW in South Carolina or Saturn in Tennessee, but we’re seeing incredible growth in parts suppliers. Beyond that, no state does the quality of research we do in biotechnology. We need to turn that into biotech manufacturing. California and Massachusetts are not places where you’re going to be able to make things. We’ve already got players like Wyeth Vaccines, which employs more than 1,000 in Sanford, and Merck pharmaceutical manufacturing in Wilson. We hope to see more biotech growth in rural areas.

Smith: One unsung thing is that people who come to North Carolina for graduate education stay to start a business. That’s happening all over the state.

Gerlach: One thing we have to do is take this explosion of research and channel it into products. We create the same number of patents as California and Massachusetts, but we’re not getting the economic activity coming out of our campuses.

Some fear we’ll lose the $10-billion-a-year military industry.

Gerlach: It’s unlikely any bases are going to be closed. Realistically, you’re not going to offshore your national defense. And deployment for the Iraq war hasn’t had the same bad effect on the economies of Jacksonville and Fayetteville as we saw in the Gulf War.

Smith: Where are you going to move an East Coast Marine training base? Plus we don’t have bases in metro areas that would have much higher value as something else. We get a lot of highly qualified MBA students who plan their military careers to finish in North Carolina so they can attend a local university. They stay here and start businesses.

Which regions of the state will prosper in 2005 and which won’t?

Gerlach: Growth will be sustained in all areas of the state.

Smith: Who’s going to grow the most? The Triangle — it usually does. Asheville just looks fabulous. I don’t see anything slowing down in Charlotte. And look at the incredible growth in Pinehurst and Southern Pines. It’s made Moore County one of our 10 highest-income counties.

Polls show that Tar Heels are optimistic. But should they be? The average weekly wage has increased less than $8 a week since 2001, and the state has 70,000 fewer jobs.

Gerlach: In 2001, the kind of manufacturing we had — durable goods, textiles, apparel — was hit hard, harder than other states. We lost most of those jobs from January 2001 until about October 2001, toward the end of the recession. In 2002 and 2003 we were gaining jobs in the service sector, but they were offset by losses in manufacturing. Now the decline in manufacturing jobs has gone, and jobs in the service sector are increasing. That’s reason to be optimistic.

Smith: In the last 100 quarters, ending with the second quarter of 2004, the U.S. economy has grown in 91 and shrunk in nine. So odds are 10-to-1 we’ll grow. We’ve gotten farther and farther behind Florida since 1953, and we’ve let those Georgians and even Virginians get ahead of us. But we should experience decent economic growth of 4% a year or better in each of the next four years — we may do better than 5% in 2005. Are we perfect? Nope. In a perfect environment, I’d have more money than Bill Gates and Warren Buffett combined. But I’m still optimistic.