The State New Economy Index

As America emerges from what may be the shortest economic slump in memory, there is increasing evidence that New Economy factors — including high productivity rates, better inventory management, more flexible labor markets, and a greater share of jobs in the service sector — were in fact responsible for the brevity of the slowdown. As the remarkable U.S. expansion of the 1990s appears to be continuing, the New Economy seems to have passed the first real test of its resiliency. And the structural changes being driven by the New Economy have not receded or been impeded by the changes of the last year; rather, they are as strong as ever.

As these structural changes continue to sweep through our national economy, they are restructuring and reshaping the 50 state economies. In 1999, at the height of the New Economy euphoria, PPI released its first State New Economy Index, which included 17 indicators to measure the degree to which state economies were structured and operated according to the tenets of the New Economy. In 2002, after the New Economy has proved itself and is being viewed by most with a more careful and realistic eye, PPI's 2002 State Index uses 21 economic indicators to measure these differences and assess states' progress as they adapt to the new economic order. With these indicators as a frame of reference, the report then outlines a state-level public policy framework aimed at boosting the incomes of all Americans.

While in 1999 many thought that the New Economy changed everything (including the need for companies to make a profit), in 2001 many scoffed at it as simply a flash in the pan or, worse, a myth spun by an over-imaginative media. Many questioned if after the superb economic performance of the 1990s we were doomed to return to the dismal days of the late 1970s and 1980s. The reality is that the New Economy was neither an epochal and dizzying transformation nor a slogan generated by some dot-com companies looking to inflate their IPO prices. Rather it was and is the kind of profound transformation of all industries that happens perhaps twice in a century. Such a change is equivalent in scope and depth to the rise of the manufacturing economy in the 1890s and the emergence of the mass-production, corporate economy in the 1940s and 1950s. As we pass through one of those groundswells that regularly but infrequently reshape the economy (and society) from top to bottom, there will be occasional bumps along the way — like the recent economic downturn — but these are the negative phases within what we can expect to be a much longer growth period.

While there was considerable bad news that gave doubters even more reason to doubt, the reality never was as bad as it was portrayed to be. The NASDAQ fell from its commanding heights of 5,000 in 2000 to roughly 1,850 in March 2002, but it was still 43 percent higher than when Alan Greenspan warned of "irrational exuberance" in 1996. In 2001, almost 110,000 jobs were lost at dot-coms, many due to failures, including such high-fliers as pets.com and webvan.com. 1

But even so, the total number of U.S. dot-com domains grew 54 percent from July 2000 to July 2001. And the recession so far has turned out to not really be a recession, since we have so far only experienced one negative quarter of GDP growth (3rd quarter, 2001), not the two consecutive ones required to constitute a recession. Moreover, unlike past slowdowns, productivity has actually grown, at an annual and stunning rate of 5.1 percent in the 4th quarter of 2001. And while unemployment was up, its peak of 5.8 percent (December 2001) was generally lower than average levels throughout the 1980s.

Moreover, even though the tech sector is not the high-flyer it was just a year ago, there's a fallacy in the leap from bad news in high-tech and even in the broader economy to the death of the New Economy. Those who think the New Economy was some late-90s flash-in-the-pan staked to the emergence of dot-coms are roughly equivalent to the great wits who shouted "Get a horse!" at early motorists broken down on the side of the road. In the early 1930s, people might have equated the bankruptcy of car companies with the end of the auto era. But obviously that was just the beginning. In all regards, it looks like the worst is behind us and we are poised for a period of robust New Economy growth, perhaps less spectacular than the dizzying days of 2000, but strong all the same. It's clear that this was more than a one-time burst of energy that has dissipated. Rather, we've barely scratched the surface of New Economy digital transformation. To paraphrase Mark Twain, reports of the New Economy's demise have been greatly exaggerated.

Broadband Internet connections continue to grow by more than 50 percent a year. Venture capitalists invested more in 2001 than in any year prior to 1999 and more than they did in the years 1990 to 1996 combined. Corporate R&D as a share of GDP reached an all-time high in 2000. E-commerce retail sales in the last year grew 2.5 times faster than total retail sales. Business investments in information technology fell relative to 2000 levels, but were 15 percent higher than 1999 levels. And a host of new technologies, including voice recognition, expert systems, smart cards, e-books, cheap storage devices, new display devices and video software, intelligent transportation systems, "third generation" wireless communication devices, and robots, are poised to be commercialized.

But even though the IT revolution is still only in its adolescence and exciting times are ahead, we need to remember that the New Economy was never just about the Internet and what investor Jim Clark and writer Michael Lewis dubbed the "next new thing."

Rather, the New Economy is about the transformation of all industries and the overall economy. As such, the New Economy represents a complex array of forces. These include the reorganization of firms, more efficient and dynamic capital markets, more economic "churning" and entrepreneurial dynamism, relentless globalization, continuing economic competition, and increasingly volatile labor markets. And there is every reason to believe that these forces that produced a turnaround in productivity and wage growth in the last half of the 1990s will continue to produce equally strong growth in the first decade of the 2000s. As a result, there are a number of new economic realities that states need to contend with.

First, new industries, especially traded services and E-businesses, are becoming a more important share of the economic base of regions. As manufacturers continue to dramatically boost productivity, factory jobs continue to decline as a share of total employment while jobs in services grow. For example, Navistar's Indianapolis engine plant spent $285 million in new investments between 1995 and 2000 with the result that while it took 900 people to produce 175 engines a day in 1994, the same 900 workers produce 1,400 today. As a result of efforts by Navistar and the nation's other 360,000 manufacturing firms, manufacturing jobs now account for just 13.4 percent of employment. Even in traditionally manufacturing-oriented states like Michigan and North Carolina, manufacturing employment is only 19.8 percent and 18.2 percent of all jobs, respectively. This is not to say that manufacturing is not important; it's usually the economic base sector that brings in money from outside the region that in turn supports local-serving businesses (e.g., dry cleaners). But it does mean that states that look to growing sectors, many of which will be outside of manufacturing, will be the ones that succeed.

Second, most industries and firms, even "traditional ones," are organizing work around technology. While the "high-tech" firms the media focuses on develop new technologies, to be successful all firms must be using advanced technology. For example, manufacturers who use more technologies (e.g., computer-aided design) in their production processes pay higher wages, export more, and are more productive than manufacturers who do not. States whose policies make it easy for firms and their employees to access and use technology will come out ahead.

Third, the old sources of competitive advantage — access to raw materials, transportation routes, or customer markets; low costs; and a large labor pool — are becoming less important. In an economy in which less than 20 percent of economic activity consists of creating, processing, or moving physical goods, access to raw materials, transportation, and markets means less. As an increasing share of economic inputs and outputs are in the form of electronic bits, the old locational factors diminish in importance. And when an increasing share of firms are gaining competitive advantage from innovation, quality, and productivity-driven cost reductions, the old advantages of low wages, low taxes, and low input costs are less important. States that provide an environment in which firms can become more productive and innovative will outperform those that can only offer low costs.

Fourth, states' economic success will increasingly be determined by how effectively they can spur home-grown technological innovation and entrepreneurship. While it's true that most states cannot hope to replicate Silicon Valley or Boston's Route 128, they can have economies that prosper as a result of locally based companies developing new product and service innovations. In the old economy, many states relied on industrial recruitment to attract branch plants and facilities from more innovative states. In the New Economy, tomorrow's jobs will come from fast-growing entrepeneurial firms and not from the small number of business relocations. As a result, states need to shift their focus from "hunting and gathering" (industrial recruitment) to gardening (promoting growth from within).

Finally, when the most valuable input for many firms is the skills and talent of their workforce, a pool of skilled workers is the most important locational factor. In the old economy workers often followed companies, so attracting companies made more sense. In the New Economy, it's not so simple. As knowledge workers become a more important factor in production, companies often locate where knowledge workers already live. This means that the old practice of economic development, which focused exclusively on providing help to firms, must give way to a broader approach that includes making a state more attractive to skilled workers by improving quality of life, workforce development systems, and government operations.

The old economic growth game was all about attracting industry, and to do this states stressed access to old economy factors of production including cheap land, willing workers, raw materials and transportation, and, of course, low costs and low taxes. Advertisements states placed in business magazines a half century ago exemplify this approach. For example, a 1955 issue of Fortune magazine featured an ad touting "Debt Free Indiana" stressing the state's natural resources: "Low-cost coal. Limestone, Natural gas. 'Clay Center of the World.' Petroleum. 'White Clay,' rich in 5 aluminum. Gypsum. Rock asphalt, Dolomite. Fluorspar. Water, sand, gravel, wood, corn, and soybeans." The ad bragged about its "enviable strike and lockout record" and its access to the Ohio River. Indiana wasn't alone; in a mass production, corporate economy, most states touted their access to natural resources and transportation routes and their low costs.

How things have changed! As more companies become knowledge-based, instead of resource-, labor-, or capital-based, the success factors have been transformed. Today business magazines feature ads like the one in a recent issue of Fortune that touts Tennessee's "superior quality of life....strong commitment to secondary and higher education and an expanding technology infrastructure.... Our location is our best recruiting tool — People love living and working in Tennessee." 2

But the recognition of a New Economy goes far beyond magazine ads. Since PPI published the first State New Economy Index, an increasing number of states have begun to recognize the realities of the New Economy and many have reoriented their state economic strategies. Based in part on the recommendations in PPI's first State New Economy Index, Hawaii's legislative leaders crafted one of the nation's most far-reaching New Economy package. A number of states, including Arizona, Iowa, and New Hampshire, have developed statewide strategic plans informed by PPI's work and focused explicitly on success in the New Economy. At least 29 governors proposed new technology initiatives in their "State of the State" addresses in 2001. The 13-state Southern Growth Policies Board released Invented Here: Transforming the Southern Economy, a 10-year strategic plan to create an innovation-driven economy in the South. Numerous states have also begun to focus on fostering and retaining knowledge workers, not just knowledge companies. Economic development leaders in virtually all states now acknowledge the impact of the New Economy and the need for their states to adapt to its new realities.

Notwithstanding the progress made by many states, there's more work to be done. Some states, particularly those home to few high-tech companies, question whether the New Economy has relevance for them. But this overlooks the fact that the New Economy affects all regions. Other states ask how they can attract or grow "companies in New Economy industries." But the key is not necessarily attracting companies in New Economy industries, but rather ensuring that all the companies become New Economy companies — in other words, adopting the latest technology, training their workforce, exporting to global markets, etc.

Finally, many states continue to see industrial recruiting, or as some call it, "buffalo hunting," as the route to their economic salvation. And they don't mind providing large financial incentives to rope those buffalo, even though most incentives simply subsidize what companies would have done anyway. The most successful states, in fact, are the ones that do the best job of helping entrepreneurial companies grow. Moreover, the key to recruiting companies in an economy in which skills are the scarcest resource is attracting or "growing" knowledge workers. That's why states with few knowledge workers can provide all the free land, tax holidays, and other inducements they want, but will find it virtually impossible to attract innovative, knowledge-based companies unless they also make themselves attractive to knowledge workers. As a result, ensuring a clean environment, abundant amenities, and a superior quality of life is something economic developers can no longer dismiss as an irrelevant and expensive diversion from the real task of cutting deals to attract companies.

The last section of this report outlines a progressive, innovation-oriented public policy framework designed to foster success in the New Economy. There are eight key policy areas that states must address:

1. Focus on the quality, not just the quantity of jobs.
2. Know your state's function in the global economy.
3. Get smart about business incentives.
4. Co-invest in the skills of the workforce.
5. Co-invest in an infrastructure for innovation.
6. Support industry clusters.
7. Boost quality of life.
8. Help more regions succeed in the New Economy.

States that focus their policy efforts in these areas will be well positioned to experience strong growth, particularly in the incomes of residents across all socioeconomic strata. And that is the true objective. Developing a vibrant New Economy is not an end in itself; it is the means to advance larger progressive goals: higher incomes, new economic opportunities, more individual choice and freedom, greater dignity and autonomy for working Americans, and stronger communities.

The Progressive Policy Institute (PPI)
Technology, Innovation, and New Economy Project
600 Pennsylvania Ave., S.E., Suite 400, Washington DC 20003
Phone: (202) 547-0001
www.ppionline.org

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