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s Investing Private aM Public Capital in the Urban Future Just as today's urban areas reflect past patterns of capital investment, those of tomorrow will reflect the flow of capital that is occurring now. Private capital flows to economic activities and, incidentally, to the places where those activities occur. The activities that attract private capital and the speed with which they attract it can have a profound impact on patterns of development and, as we have seen, on how areas evolve in the urban system. Because they rarely reach major money and stock markets, local and state policies appear to have relatively little effect on the flows of private capital to firms; the market and federal policies are far more influential. State and local policies are, however, far more important factors in the location of firms. Public investment in urban infrastructure, environmental regulations, and economic development policies can influence where firms are able to locate. Federal policy also substantially affects the level of state and local public investment and the kinds of facilities that are pro- vided. This chapter discusses the implications for urban areas of policies that would stimulate the flow of capital to those sectors of the economy that show promise of strong performance in international markets and others that need modernization or are important to national interests. Such policies are significant for urban policy because they could accelerate the trans- formation of urban areas; they raise significant issues about the use of capital resources in urban economic development. The level and quality of public investments are other aspects of national urban policy that can 71

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72 Rethinking Urban Policy affect how well, and how fast, urban areas are able to adjust to a major shift in economic structure. We thus consider the need to make sufficient capital available for infrastructure to support economic development. We conclude the chapter by discussing a framework for urban economic de- velopment strategy. INVESTMENT IN PRODUCTIVE SECTORS When we talk about the flow of capital to particular sectors of the economy, we do so with considerable modesty. The state of knowledge of capital markets and how they work is still rudimentary. What causes investors to move their money from one sector to another and especially from one region to another is not always clear. Classes of investors seek different objectives: some are content with secure, long-term low yields; others take high risks in hope of quick, high returns. The sources of capital are diverse. Financial institutions, businesses, pension funds, and indi- viduals make millions of calculated or impulsive decisions every day. They consider factors ranging from exhaustive studies by market and industrial analysts to their horoscopes. Net flows of capital reflect the cumulative result of those decisions. In this context one factor that influ- ences investor choice is public policy. Whether it is deliberately interventionist or passive toward capital mar- kets, public policy affects levels of risk and rates of return on investments. It also influences how investors perceive certain sectors of the economy. For example, monetary and fiscal policies affect how much capital is available to the private sector for investment and its cost to borrowers. Credit and tax policies may encourage investments in industries such as housing or energy development. Direct subsidies may improve yields from investments in agriculture or defense industries. Indirect subsidies such as tax credits or loan guarantees can reduce risks for activities such as research and development or new enterprises. Although they do not fully determine the direction of capital flows, the effect of national economic policies on the flow of capital to different sectors of the economy is increasingly recognized as a serious national problem (Schwartz and Choate, 1980:65-88; U.S. Congress, Joint Eco- nomic Committee, 19741. In spite of gaps in our understanding of just how or to what extent policy affects capital flows, some sectors have been consciously subsidized over a long period of time housing, agriculture, defense, and transportation are examples. An estimated 13.9 percent of the GNP in 1980 was consumed in subsidies to various industries, exclu- sive of the costs to consumers of various special barriers to international competition, such as tariffs, market quotas, cartelization (Reich, 19821.

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Investing Private and Public Capital in the Urban Future 73 Whatever the original reasons for these subsidies, they have often con- tinued, almost as entitlements, without serious assessment of their impact on the flow of capital to other sectors that might improve both national economic efficiency and interregional or intergroup equity (Schwartz, 19834. The lack of any coherent strategy results in part from the fact that most subsidies arose initially more from the success of specific industries in legislative lobbying than from a careful determination that their net effect assisted the economy in meeting international competition, increased productivity, or provided for real growth in the GNP. Once established, such subsidies are extremely difficult to terminate because they produce an organized constituency that represents both labor and management; it often spans the ideological spectrum from right to left. The withdrawal of subsidies, whether direct or indirect, can create genuine economic dislocation. Adjustment problems are no less severe than those created by technological change or foreign competition. Fi- nancial institutions, for example, have undergone major restructuring in the wake of changes in monetary and credit policies and as a result of changes in federal regulations. Similarly, the sectoral consequences of the 1981 Economic Recovery Tax Act are substantial, but many of them were both unanticipated and unintended (Palmer and Sawhill, 19821. In the absence of any conscious sectoral perspective, national macro- economic policies are highly susceptible to political pressure and panicked governmental responses to industrial crises, as in the cases of Lockheed, Chrysler, Wisconsin Steel, or the thrift industry. While all or any of the actions taken to rescue these industries or firms might be defended from a rational economic policy perspective, they offer no suggestion of what U. S . policy might be toward the next crisis. Moreover, the ad hoc approach to sectoral policy that they illustrate tends to focus on the most troubled among specific industrial sectors, leaving the growth sectors of the econ- omy to chance. Sectoral Policy and Its Critics This lack of coherence has led a growing number of economists and business interests to propose that the United States establish an industrial or sectoral policy aimed at strengthening the international competitive ~ Reich (1982) points out that in 1980 five times as much was being spent on research and development in the commercial fisheries industry as in the steel industry and that while the timber industry received tax breaks of $455 million, the semiconductor industry received none (also see Schwartz and Choate, 1980).

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74 Rethinking Urban Policy position of U.S. industries and at facilitating the adjustment of the econ- omy to structural changes (Bell and Lande, 1982; Business Week, June 30, 1981; Leone and Bradley, 1981; Reich, 1982; Schwartz and Choate, 19801. The advocates of this position argue that national economic policy has been concerned primarily with the aggregate growth of capital and that, while this is necessary, it is not sufficient when the overall restructuring of the national economy is occurring simultaneously with the internal restructuring of many sectors and industries. Thus in contrast with the thrust of traditional national economic policy, sectoral policy would be more concerned with capital allocation than with aggregate capital for- mation. It would focus on the most productive pattern of investment,2 favoring those linked industries that show strong promise as international competitors and as sources of economic growth as well as other industrial groups that are important to national interests. At the same time, sectoral policies would seek to develop the industrial infrastructure and the skilled work force that is needed to support those linked industries. They would also recognize the need to balance the growth of regions, to maintain a strong productive capacity in certain industries, and to assist workers forced to retrain or relocate in order to defuse the resistance to economic change likely to come from those who would be hardest hit (Reich, 1982:751.3 The critics of sectoral policy contend that it would involve the govern- ment in planning the economy and in the selection of industrial winners and losers through a political process rather than through the market. National economic policy, they argue, should concentrate instead on cap- ital formation, letting the market determine where capital should flow. The basic concern of the national government should, therefore, be on the aggregate growth of the economy, without regard to where that growth occurs regionally or in which sectors of the economy. While advocates of sectoral policy point to the success of other coun- tries, particularly Japan, in promoting the growth of some industries and facilitating the shrinkage of others that were less competitive, the critics remain skeptical of the actual effect of public policy on national economic 2 The evidence is weak that the restructuring of the economy that has occurred, as such, has increased productivity at least as productivity is usually measured. Since 1973 the effect on productivity has been slightly negative (Jorgenson, 1980). A more recent study concludes, however, that the shift to services has had a negligible effect on productivity decline, a fact that is attributable mainly to shifts in goods-producing industries (Kutscher and Mark, 1982). 3 Such authors as Reich (1982) and Schwartz (1983) distinguish their proposals from "reindus- trialization," which implies an effort to revitalize industries with a declining share of world markets or those that make products that have little growth in demand.

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Investing Private and Public Capital in the Urban Future 75 performance. They see government intervention primarily as a ratification of market or industry choices rather than as a decisive factor in them. They point to failures in decisions or refusals of industries to follow policy and to great differences in national attitudes toward monopolies, labor relations, and banking systems as constraints on transferring cooperative approaches to industrial policy, such as those in Japan, to the United States (Eads, 198 14. Critics also argue that the market, with all its faults, is still far better at selecting competitive industries than a bureaucracy or the Congress. The market provides a reliable feedback mechanism that tests the sound- ness of investment. Because government-induced investments generate constituencies devoted to the perpetuation of the intervention even if it is unsuccessful from the point of view of the overall economy any industrial policy would lack the self-correcting discipline of the market. The result would be unnecessary overinvestment in some sectors and underinvestment in others because of political choices (Eads, 19811. A Strategy for Sectoral Policy As we have discussed in Chapter 4, macroeconomic policy makes choices that may favor some industries or sectors over others. The result is an implicit industrial policy. The decision-making process is not structured in a manner that requires the consequences of those choices to be weighed against each other. In many cases, subsidies are not identified and their costs are not even acknowledged (Eads and Graham, 19824. Political choices about the economy tend to be made largely in terms of anticipated first-order consequences, that is, will they stimulate or dampen the growth of the GNP? In an increasingly interdependent econ- omy, second-order consequenceseffects on specific sectors of the econ- omy or on economic regions though often unintended, may be more significant. These consequences are also harder to foresee or forecast. There is a need for a more sophisticated understanding of these second- order consequences and for consideration of alternative policies that might have more salutary effects or fewer adverse impacts. Just as the Full Employment Act and the creation of the Council of Economic Advisers and the Joint Economic Committee have made the President and the Congress more sensitive to the first-order consequences of their economic decisions, it is now desirable to require wider understanding of second- order consequences for particular sectors of the economy and for urban areas. Given the pluralism of our political economy, it may not be possible, even if it were deemed desirable, to produce an internally consistent,

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76 Rethinking Urban Policy comprehensive, and explicit sectoral policy. In that light the task is to understand the policy system well enough to obtain a better result from the implicit policies. This suggests a conscious strategy as distinguished from a specific policy or comprehensive law on the subject. It also allows for a more experimental approach in an area in which too little is known to justify a doctrinaire program. Such an approach recognizes that some sectors and activities may indeed be more promising than others for improving the competitiveness of U.S. industries in the world economy; to the extent that our competitiveness is enhanced, the number of jobs and the levels of income would be increased. In this approach, economic policies should be examined to see whether they are likely to reduce friction that impedes the development of those sectors that are growing in response to market forces (Schwartz and C:hoate, 1980:109ff.~. This approach to sectoral strategy is concerned with accel- erating or at least not impeding the shift of capital and workers from declining to more promising sectors, as they are defined by the market. It is also concerned with revitalizing and modernizing those sectors that are important to national security, such as energy, machine tools, and basic metals (National Academy of Engineering, 1983), and to other national interests, such as public health and agriculture. Sectoral strategy is concerned not only with the traditional or troubled industries, such as the automotive sector, in which new capital is needed for modernization, but also with emerging industries, such as genetic engineering and international health services, and with sectors in which the United States may already be dominant but could maintain or expand its market position, such as computer technology. This strategy assumes that some sectors can be expected to shrink and others to grow as they adapt to new technologies, new markets, and new relationships within the economy (Schwartz, 19831. In addition to marginally influencing the flow of capital to those sectors with strong market potential, sectoral strategy should support investment in the development of the resources and systems they need to thrive. This includes support for research and development, either directly or indirectly through incentives built into macroeconomic policies (Mansfield, 19821.4 It also includes support for infrastructure (both public and private), training the labor force, and improving management and productivity systems. 4 See Landau (1982) for a discussion of the importance of research and development to the national economy and the relationship of tax policies to research and development. The delay between invention and innovation and the discontinuity between old and new technologies appear to be serious issues in need of policy attention (see Girifalco, 1981).

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Investing Private and Public Capital in the Urban Future 77 Different sectors require different treatment during their growth cycles. While price deregulation may be sufficient to reinforce enormous flows of capital to energy-related industries, a quite different, more detailed approach is required to speed modernization of the automobile, steel, and machine tool industries. For them it is important not only to introduce new technology, such as robotics, but also to bring about major institu- tional changes in research and development, to change the locations of some parts of the production process, to change management and labor relations processes, and to improve international trade and marketing con- ditions (National Research Council, 1983~. Public policy can affect the degree and timing of these changes. Tax credits for plant modernization or research and development, trade agreements, and the regulatory climate all affect investment decisions. Strategies appropriate to growth in high technology may also require more than general tax credits for investments. Special incentives or pro- grams for high-risk ventures seem required, particularly since one of the principal forms of capital in new small enterprises is the talent of a few scientists, engineers, and managers (Landau, 19821. Front-end venture capital for such enterprises may often be far more crucial than tax abate- ment or tax credits. It may also be important to consider changes in supporting institutional systems, such as small-business development cor- porations, patent law reform, university-corporate relationships (Giamatti, 1982), and university-government relationships (National Academy of Sciences, 19831. In this sector and others, such as health services, the supply of trained workers is a basic requirement for growth. The avail- ability of business services can also be critical to high-risk, small-scale enterprises. This is suggested by the high survival rate of firms assisted by Control Data Corporation's Business Technology Centers (Norris, 19821. Considerations such as these argue that the principal instruments of macroeconomic policy could, at a minimum, be better informed and sharp- ened by a conscious identification of those sectors that show considerable promise for growth, those that are in trouble, and how each is likely to be affected by existing or proposed policies (Eads and Graham, 1982~. Macroeconomic policies could also benefit from an effort to identify their intended (or at least their anticipated and probable) consequences for flows of capital to particular sectors of the economy and how they might, cor- respondingly, affect the structure of the labor market. Although economic theory has not reconciled the conflicts in perspective between macro- economic and microeconomic thought, a unified theory does not seem necessary in order to establish a regularized feedback process to allow these two perspectives to confront and be informed by each other (Landau, 1982; Michalski, 19821.

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78 Rethinking Urban Policy The admonition of critics of industrial policy that it would be unwise for government to try to choose specific winners and losers is sound. Experience with government support of research and development in seven different industries suggests that the support was most successful when it was associated with government procurement or a well-defined public objec- tive, when the expenditures were guided by the scientific community, and when potential users guided fund allocations. Programs in which govern- ment officials tried to identify projects that would be commercial winners were the least successful (Nelson, 19821. It should be possible, however, to do a better job of coordinating national economic policies to complement or reinforce the strategies of industrial sectors as they seek to strengthen their positions in the market. It should also be possible to reinforce the ability of market participants to plan ahead more confidently but still leave private investors free to evaluate business opportunities and to make decisions (Michalski, 1982~. In this sense, sectoral strategy is not national planning but an attempt to make the economy more adaptable and dynamic. Its objectives are to smooth the movement of capital and labor out of declining industries and to ensure that capital, labor, and other support is available to the more promising and essential sectors. It aims to "accelerate and smooth the adjustments that capital and labor markets would otherwise achieve more slowly on their own" (Reich, 1982~. Implications of Sectoral Policy for Urban Areas Policies that prop up industries with poor futures on an equal basis with industries that have promising futures ultimately waste resources and do not really improve the long-run economic prospects of the urban areas in which the troubled industries are located. The capacity of urban areas to adjust to the new roles they must play depends heavily on the performance of those sectors that are central to their economies and on their ability to attract and nurture new kinds of economic activity. From an urban per- spective, a sectoral strategy at the national level would help urban areas understand better where the economy is headed and how their communities and labor forces may be affected. It would help them identify the parts of their local economies that have the most potential for growth in market shares and jobs as well as those that have less, even though they may continue to be viable enterprises. Neither a general recovery of the national economy nor a more coor- dinated approach to policies affecting the flow of capital to particular sectors will result in an even distribution of economic opportunity and wealth among regions and urban areas. The introduction of a sectoral

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Investing Private and Public Capital in the Urban Future 79 perspective into the shaping of national economic policies would alter some of the urban effects of macroeconomic policies, but it would not confront many of the most difficult issues of urban economic adjustment. The phenomenon of simultaneous growth and decline within many urban areas will continue. So will the concentration of services in the national and regional centers and the decline of some of the older manufacturing centers as capital flows are directed to higher-yielding investments that, incidentally, are located elsewhere. Some areas will get richer while others become poorer. There will still be substantial labor redundancy in places where old industrial and labor markets are contracting and changing structurally, even while some local industry is being revitalized. The rate of job creation will diverge on the basis of the economic function each metropolitan area performs. There will still be serious institutional barriers to the mobility of workers from one industry or occupation to another and from one metropolitan area or region to another. Sectoral strategies are concerned primarily with the mainstream of the economy. This means that in all likelihood the reinforcement of capital would flow to high-technology enterprises, producer services, and some nonprofit services such as health and education. Substantial and accel- erated growth would be expected in those places that have the natural resources, labor forces, or other established growing industries on which these activities depend and the institutional base, external economies, and environment conducive to their needs. Similarly, the higher-level work- ers professionals, technicians, and managers- could expect greater gains from national economic growth than could service, clerical, and blue- collar workers. Within individual areas and within the urban system, there will be firms, places, and people that lose and gain. A change in national tax policy, for example, that provides increased incentives for research and development could provide some advantages to cities in which research institutions associated with growing industries are located. Policies that make it easier to sell services abroad would help urban economies in which large-scale business service firms are concen- trated, chiefly the diversified and specialized service centers. Large-scale military expenditures are most helpful to the military-in- dustrial centers and to those diversified or specialized centers that contain substantial suppliers of military hardware or services. Some defense ex- penditures, especially for research and development, and set-asides for procurement from depressed areas are important tools for urban economic development when they are consciously used to complement market forces in the diffusion of innovation to other industries and to different urban areas (Rees, 1983~.

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80 Rethinking Urban Policy It is important to recognize that modernizing an industry does not nec- essarily mean restoring the same jobs in the same places. The urban areas that could be most affected by sectoral policies aimed at modernizing the automobile industry can be easily identified. But modernization may in fact entail closing inefficient plants, mechanizing much of the work, and relocating some operations in other regions or countries. Two hard-to-swallow realities should be acknowledged: (1) greater competitive advantage in any single set of linked industries does not necessarily lead to more jobs in all of the industries in that sector, and (2) all places do not stand to benefit equally from structural adjustments (Schwartz, in press). There are, in fact, substantial conflicts between sectoral and regional or urban policies (Garn and Ledebur, 19821. INVESTMENT IN PLACES Shifting From Distress to Opportunity In a perfect world no policy would be necessary for those left behind. They would adjust to the emerging economy, and a new market equilib- rium would be established. In the real political economies of advanced nations, however, friction impedes adjustment and prolongs it because the economic system is not pure and because its parts places, people, and firms are not interchangeable and have considerable inertia. Some places and people have less resilience, less capacity for positive adjustment to different long-term economic roles, than others. Because the growing and declining sectors are not evenly distributed among the regions of the country and among the different types of areas within the urban system, there is a need for a spatial as well as a sectoral perspective on national economic strategy. What happens at the level of the urban area is important to the national economic system. When local unemployment is prolonged, some of the unemployed become unemployable. The decline of local industry can lead to a shrinkage of resources available for maintaining infrastructure and services. A change that may appear minor from the national perspective can be calamitous in the communities in which it is concentrated. Because of the preexisting mix of industries and occupations in specific commu- nities and because of enormous investment in capital stock, there are far more rigidities to overcome at the local level than free market theory acknowledges. What appears as a national equilibrium can be composed of offsetting conditions of disequilibrium among urban areas, in which capacities for adjustment vary widely.

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Investing Private and Public Capital in the Urban Future 81 Historically, national urban policy has consisted primarily of place- oriented policies. These have included local planning assistance, urban redevelopment programs, employment training programs,5 and a variety of income and fiscal transfer programs (Hanson, 1982; President's Com- mission for a National Agenda for the Eighties, 1980~. Although these programs were substantial in number and have involved billions of dollars over the past two decades in direct grants, fiscal and income transfers, and tax expenditures or credits, they have been marginal to national eco- nomic policy. Like sector-related policies, urban policy often has been made as if national economic policy did not exist (Howell, 1981:346- 3471. There has been a tendency among national policy makers to think of distressed cities and urban neighborhoods as backwaters rather than as parts of the mainstream of policy. Criticism of place-oriented policies by the President's Commission on the Eighties and the Reagan administration is valid to the extent that these policies were often designed to delay economic changes through subsidies to obsolete enterprises, skills, or settlements (U.S. Department of Housing and Urban Development, 19821. But such criticism is too sweeping. While some place-oriented policies have probably been counterproductive to constructive economic change and some have simply been ineffective, others have materially assisted cities, industries, and workers in making a transition to new functions and in generating better long-range local economic opportunities.6 In general, however, program evaluations are so fragmentary that conclusions about whether programs have worked belong more to the realm of political than empirical judgment. About all that can safely be said is that place-oriented programs have had a minor if not negligible effect on the primary forces at work on the urban and national economy (Vaughan, 1977:132-1374. But most of these policies were not intended as measures to alter primary economic forces. They were conceived instead to address specific local conditions, such as phys- ical deterioration, lack of job skills, or poor public services. Place-oriented policies have typically been targeted on the basis of indices of "distress." Because of the politics involved in developing statutory formulas for the distribution of funds, some have argued that s The Comprehensive Employment and Training Act, however, was not strictly a place-oriented policy. 6 For example, see evaluations of the Urban Development Action Grants program conducted by the Reagan administration (Housing and Development Reporter, February 1, 1982:687) and the Comprehensive Employment and Training Act (Mirengoff et al., 1980a, 1980b; also see Glick- man, 1980).

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86 Rethinking Urban Policy in tandem with other strategic tools, such as leveraged loans and infras- tructure improvements. DEVELOPING A NATIONAL SYSTEM OF INFRASTRUCTURE No national or local economy can prosper without an adequate system of facilities to support trade and commerce, to ease the travel of workers, and to dispose of waste generated by urban life and industrial production. There has long been a consensus that the federal government has a re- sponsibility for promoting the development of a national system of in- frastructure that can attract, support, and serve economic growth in all regions of the country. ~3 This has meant, historically, a major contribution by the federal government to sharing the cost of the necessary facilities with state and local governments. A national system of infrastructure includes the international and in- terregional transportation system, advanced communications capability, an energy supply and distribution system that is reasonably stable and serves all regions of the country, adequate regional water supplies, and waste disposal facilities that do not endanger the public health or safety. A national system also involves adequate systems of urban facilities that make it possible for the economy to function efficiently. While all of these are components of a national system, the same level of federal participation is not required for each. Electric power and energy pipelines and most industrial waste disposal or reclamation systems can be provided primarily by private industries. Federal involvement can be limited primarily to tax policies that encourage business investment in the facilities providing the necesary service and to regulations that deal with fair pricing and environmental protection. Most urban infrastructure is provided by state and local governments through their own capital fi- nancing systems, primarily general obligation and revenue bonds. When facilities are financed through revenue bonds, users pay fees that retire the debt. Federal assistance has been crucial to the ability of state and local governments to finance some public works, however. If substantial federal financing of facilities is available, limited state and local funds can sometimes be devoted to other projects. Some parts of the national system are financed primarily by the federal government, either rlire.ctiv ns in the. cane. of wnte.r reclamntion and water- |3 Both the Reagan and Carter administrations, for example, identified urban infrastructure as a major concern of national policy (U.S. Department of Housing and Urban Development, 1980, 1982). Major business groups have also strongly encouraged federal support of urban public works (Committee for Economic Development, 1977).

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Investing Private and Public Capital in the Urban Future 87 ways projects, or indirectly, as in the case of the interstate highway program. Except when it retains operating jurisdiction, the federal gov- ernment provides little in the way of operating support for the capital projects it helps finance. The urban mass transportation program has been an exception to this generalization, but the Reagan administration has proposed that the operating subsidies for public transportation be termi- nated. While a direct and substantial financial role for the federal government in every aspect of the country's infrastructure is unnecessary and unde- sirable, there is a national interest in ensuring that the infrastructure is provided, that it adds up to a national system, and that it is kept in good operating condition. Despite the broad consensus that the quality of in- frastructure is important to the national interest, the nation as a whole in recent years has fallen behind in maintaining existing systems and con- structing new facilities.'4 The causes are complex. Many of the public facilities built during the depression and the early post-World War II period now need replacement or major repair. Systematic maintenance programs have rarely been as attractive as new construction. Public expectations have risen for the performance and quality of facilities. The costs of debt service have risen, and repairs and new construction have been postponed. The growth of urban social programs has competed with maintenance and debt service for local budget priority. The Need to Assess Need The federal government is, and is likely to continue to be, a major source of funding for key elements of urban infrastructure that are directly related to economic development, particularly transportation and urban sanitary systems. In addition to specific facility grant programs, a sub- stantial amount of the money made available to localities through the Community Development Block Grant program is used for local public works projects.'5 Aside from the issue of the adequacy of funding for these programs, there is a fundamental problem that should be promptly addressed because its resolution will affect the future levels of expenditure |4 The exact level of need is in considerable doubt, but there is agreement that it is substantial. Estimates of need range from less than $1 trillion (Peterson et al., in press) to $3 trillion (Choate and Walters, 1981). The problem is complicated by the absence of reliable data on existing conditions in many cities and by the use of standards that often exceed possible funding levels (National Research Council, 1982a; O'Day and Neumann, 1984). |5 Since 1975, when the program began, 30 percent of all Community Development Block Grant funds available have been used for public works.

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88 Rethinking Urban Policy at all levels of government as well as the costs to users of the system. That is the problem of assessing need and establishing priorities for ex- penditures. To a considerable degree, federal standards for construction or performance of these systems drive estimates of need. Since all esti- mates of need are far higher than any foreseeable level of combined federal, state, and local expenditures for public works, the cost-effectiveness as well as the scientific or engineering basis for some of the standards that are currently used should be closely reexamined (Hatry, 1981; O'Day and Neumann, 1984; Public Technology, Inc., 19801. The federal government should sponsor research on cost-effective stan- dards and techniques for needs assessment and disseminate the results. It should promote the development of guidelines for use by local govern- ments and states in assessing the condition of their infrastructure and in setting priorities and creating funding mechanisms for both construction and maintenance programs. Financing Urban Capital Improvements Even if savings are possible through adopting more cost-effective stan- dards for performance and through developing better techniques for ex- tending the life of existing facilities and for replacing them, a major new investment in public facilities in a number of urban areas clearly is needed. Given the level of investment that will be required to provide, repair, replace, maintain, and operate urban infrastructure, many state and local governments will not be able to achieve acceptable levels of service with- out some form of federal assistance. One critical contribution of the federal government to urban infrastruc- ture has been the income tax exemption for interest from state and local bonds, although it is debatable whether it would be more equitable and less costly to subsidize local capital programs directly than to take the loss in taxes. This policy, however, has made possible the financing of public works at relatively low rates of interest until recently, when bond rates soared into double digits, effectively doubling the cost of debt service in the course of a few years. High interest rates on general obligation bonds have forced postponement of bond issues and deferral of construc- tion and major renovation or replacement projects by many governments. Continued deferral leads to even greater deterioration of facilities, resulting in higher operating costs for governments and lost productivity for the private sector and contributing to a jurisdiction's overall economic prob- lems. Even in more favorable markets, cities and states with weak credit ratings have an extremely difficult time marketing their bonds at reasonable rates of interest. The bond rating of cities varies considerably, and in

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Investing Private and Public Capital in the Urban Future 89 recent years more major cities have lost ground in the bond market ratings than have gained (Government Finance Research Center, 19821. The cost of money for capital improvements is only one aspect of the problem. For many decades, municipal bond markets were remarkably stable, with interest rates hardly fluctuating from year to year. Long-term capital improvement and debt retirement programs were possible. In recent years, however, the bond market has become volatile, with greater fluc- tuations occurring over a month than used to occur over several years. This has made long-term financial planning extremely difficult for many governments. These uncertainties have been compounded by fluctuating funding levels for intergovernmental capital programs and changes in direction or emphasis in the kinds of facilities eligible for federal assis- tance. It is not of much value to a city if funds are available for bridge repair when its most pressing need is for a new water system. Other institutional problems abound at local and state levels. Only a few jurisdictions have strong capital planning, budgeting, and management systems. Consequently, needs are often inadequately measured, and prior- ities are established more often on a political basis than in a framework of effective investment in a jurisdiction's capital plant. Many of these problems should be addressed by state and local gov- ernments, regardless of federal infrastructure policy. Their resolution could be facilitated, however, and the uncertainties of the bond market and of federal assistance, which are well beyond state and local control, could be ameliorated by establishing a national infrastructure bank linked to similar banks at the state level (Peterson, 19841.~6 An infrastructure bank could be capitalized by consolidating current capital grant programs and issuing Treasury bonds. Such an approach should be preferred over a new block grant because it offers a long-term commitment to a long-term problem. Instead of making direct grants to jurisdictions, it could lend, refinance, or guarantee loans from the state infrastructure banks for part of the cost of projects. Loans tend to impose a tighter discipline than grants; since they must be repaid, they require more careful attention to such matters as maintenance and user-fee fi- nancing, when that is feasible. This approach would reintroduce long- term stability to the financing of public facilities and permit better long- term capital planning. The bank could provide, first, a source of capital that could enable urban areas to catch up with their backlog of facility needs. Second, the bank could use its considerable leverage as a lender and its technical expertise to bring about needed institutional reforms, ]6 Governor Thomas Kean of New Jersey has proposed such a state infrastructure bank.

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90 Rethinking Urban Policy such as restructuring financial management systems, requiring loan re- cipients to develop programs for regularly assessing the condition of their facilities, developing long-range capital programs, and improving and adequately funding facility operations. The latter could include require- ments that appropriate revenue-producing facilities recover full user costs and that loan recipients establish depreciation accounts sufficient to meet or at least substantially offset the eventual replacement costs incurred when a facility wears out. Such accounts could help prevent future crises in facility financing. In many respects, leverage for strengthening state and local institutional capacity for financing and managing public facilities is more important to the long-term quality of infrastructure, and to urban economic development, than any one-time infusion of capital (Peterson, 1984). Setting Priorities for Investment in Public Facilities One of the recurring criticisms of federal programs in support of urban public works is that they distort local priorities because of the varying amounts of money available for different programs and because some programs have more favorable ratios of federal-to-local support than oth- ers. Consequently, it is argued, local and state governments tend to "need?' what the federal government will finance with the least local matching contribution. In addition, there are few federal programs that provide any support for the operation and maintenance of the highly sophisticated facilities that are built with federal funds. Thus a bargain in facility con- struction often becomes a burden to operate for the jurisdiction or for its users. The consolidation of all urban public facilities grants programs into a single national infrastructure bank would permit state and local govern- ments to draw on it to help support their own capital improvements pro- grams to aid the economic transformation of a community. Loans could encompass major maintenance and replacement programs that properly should be financed through long-term debt. Before grants or loans from the fund are approved, there should be assurances that a jurisdiction has a long-range capital budget and a plan for financing the operation of the facility. The proportion of the program financed by the federal bank could be related to the fiscal capacity of the jurisdiction to finance its capital debt in the context of its overall fiscal condition. Peterson (1984) has estimated that a national infrastructure bank cap- italized initially at $20 billion could provide the leverage and stability needed to help the nation's urban areas catch up with their public facility investments. The determination of how much capital to make available

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Investing Private and Public Capital in the Urban Future 91 can be made only in the context of all other federal budget commitments. It seems clear, however, that there is a growing perception of a crisis in urban infrastructure and that existing levels of expenditure by all levels of government will need to be increased. One important reason for increasing the level of national financing for urban public facilities is to accelerate the process of economic transition and to help cities equip themselves with the basic public systems appro- priate for their functions. In a number of older cities where the economy is contracting, this may mean closing down rather than replacing obsolete parts of their infrastructure, mothballing excess capacity, and enhancing the capacity and performance of parts of the system that support growing and developing sectors and neighborhoods. Growing urban areas may need to create new systems or enhance existing facilities. In newly developing urban areas, the economic functions being performed may not require total re-creation of all the large-scale integrated systems that have characterized municipal engineering for the last 90 to 100 years. Smaller systems may be more appropriate for some new patterns of urban settlement and de- velopment. In other cases it may be possible to substitute management strategies for new capital improvements. A FRAMEWORK FOR URBAN ECONOMIC DEVELOPMENT STRATEGY Using Economic Leverage The objective of urban economic development policy is to strengthen the local economy, which usually means diversification and adjustment toward more economically competitive activities. The basic technique for achieving that objective is leverage using available resources and pol- icies to facilitate higher levels of private investment in those activities than would otherwise occur. The federal government can exercise some of this leverage through more careful formulation of its economic policies and through the creation of banks that wholesale leverage capital for public and private investments in urban areas. The ultimate effectiveness of such leverage, however, depends on how state and local governments use the leverage capital available to them. Using Capital and Maintenance Budgets Both state and local governments should recognize the importance of their capital and maintenance budgets to their economic strategies. It is their transportation systems, water and sewerage systems, parks, and other amenities that influence the specific location of private capital investments.

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92 Rethinking Urban Policy Public facilities can be used to influence the location of employment centers. A few states and localities have begun to make deliberate use of them in this manner, both to encourage economic development in places where it can best assist in meeting economic development objectives and as a means of containing public costs.'7 A number of states notably California, Florida, and Oregon as well as many local governments have used public facilities as a major growth management tool that favored urban over rural areas by denying urban infrastructure to the latter. A jurisdiction may stage the development process by scheduling the exten- sion of facilities to particular areas. Not only is the presence of facilities important, but the level of service is also critical to future investment decisions by private business (Federal Reserve Bank of New York, 19811.~8 Using Joint Development Techniques Infrastructure can be used as part of a package in joint development projects to improve an area's attractiveness to investors. This strategy is particularly appropriate for transit and parking facilities that are integrated into a project but financed with public bonds rather than at commercial interest rates. In addition, such facilities may qualify for federal grants or may involve land or air rights that can be used to reduce private front- end costs. In such cases the land and facilities may be used as investments, the government retaining an equity interest through a limited partnership; the land may be leased to the developer, cutting development costs and providing larger future revenues than would be obtained through taxation of the project; or the land may be sold below market price, recovering the revenue conceded in the sale through later appreciation in the value of the property (Gladstone Associates, 19784. For these kinds of leveraging arrangements to be possible, the states' basic enabling laws governing capital programming, condemnation pow- ers, and land management must be flexible enough to permit state and local governments to select the most workable techniques for a particular activity. State law should permit and encourage joint ventures without specifying the form they must take. This should include authorizing local |7 For example, the governor of Maryland issued an executive order in June 1982 requiring all state agencies to relate their facilities programs to support economic development considerations and to reinforce local development plans (also see Schwartz, 1982). ~8 For example, the Houston Chamber of Commerce estimates that traffic tieups cost Houstonians $1.9 billion a year. One major company, Diamond-Shamrock Oil, relocated to Dallas, reportedly because of traffic problems (New York Times, September 28, 1982:A16).

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Investing Private and Public Capital in the Urban Future 93 governments to enter joint ventures as equity partners with private cor- porations. Land assembly is often essential to successful development, particularly in the older parts of cities in which ownership has been fragmented, preventing industrial expansion and the development of attractive designs for reuse. Some states have broadened their eminent domain doctrines to include public benefits as well as public purposes, allowing condemnation of land for resale to private entities for industrial development even though urban renewal powers are not used. It should also be possible for local governments to lease publicly owned land or to use their interests in the land as equity. Either action can have substantial leverage on the profit- ability of a project that has several options for location in a given met- ropolitan area. Avoiding Ineffective Incentives While greater flexibility is needed in the ability of government to fashion institutional arrangements to meet the needs of specific projects in order to carry out overall development strategies, there are disadvantages to indiscriminate subsidizing of private economic development. Local tax abatement schemes, for example, have been shown to have little leverage in actually attracting investment, compared with such other measures as venture capital, high-quality services, and public facilities. Industrial rev- enue bonds can provide leverage capital, as can the use of tax increment financing districts to support service and facility improvements for an industrial park or business district, but these devices should be used only when the private investments they supplement or subsidize are likely to achieve local goals for jobs, tax base growth, and adjustment to new economic functions. Indiscriminate use of industrial revenue bonds can put local jurisdictions into a subsidy-bidding war with each other for investments. Such com- petition often wastes tax capacity and does not add to the total metropolitan economy. If industrial revenue bonds can be used to secure investments that would not otherwise be made, they are valuable tools in economic development strategy. If they merely work to displace development from one community to a neighboring one or shift activity from one local business to another, there is little justification for the federal subsidy of such bonds. Careful consideration should be given to limiting the use of all lever- aging mechanisms to activities that meet the criteria discussed above. This can avoid their use as props for dying industries or as weapons in inter- jurisdictional competition for tax base. Such an approach also emphasizes

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94 Rethinking Urban Policy the urgent need for states to institute fiscal equalization programs (which are discussed in Chapter 7) and not only help meet fiscal problems but also make possible more rational policies with regard to the development of infrastructure and the location of employment centers in metropolitan markets. Using Regulations Reform of development regulations is another aspect of regional and local policy that deserves some attention. Most systems of regulation have grown up in response to perceived abuses of public interests by developers. They are not, therefore, designed to facilitate development or to increase its economic value but to prevent or ameliorate egregious externalities. In many communities, investors have come to regard the regulatory process as capricious, uncertain, and costly. In reforming the regulatory system, we should remember that major urban projects increasingly are negotiated between public planning and development agencies and private developers, rather than approved through the rigid application of rules. This requires that broad authority be dele- gated to talented negotiators for both the public and private participants. It also requires considerable procedural skill in the public review aspects of the process and an aptitude for balancing conflicting financial, com- munity, and other interests. There are no formulas for a successful reg- ulatory system, but there are reasonably clear policy objectives: regularity in the basis for decisions, a fair process, substantial reductions in the amount of time it takes to obtain final approval, and opportunity for high- quality design. Reform of the regulatory process need not mean a lowering of standards of design or performance. There is now extensive experience with planned development regulations and performance or incentive zon- ing demonstrating that a better built environment is possible through a more flexible regulatory system. Using Urban Design Finally, an urban economic development strategy should include a strong urban design element. While it need not be provided in great detail, a design concept that establishes an image, theme, or strong idea for future development can guide and stimulate both public agencies and private investors to provide the overall scale, amenities, sense of place, linkages, and sorts of activities that make a place function well as a center of economic and social life rather than as a sterile collection of buildings and facilities. Such concepts may need amendment as experience is gath-

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Investing Private and Public Capital in the Urban Future 95 Bred, so that there is plenty of room for alternative designs and ability to meet changing market conditions. Design is not only a way of identifying the character of a neighborhood, a district, or a whole city; it is also an important tool for a realistic leadership statement on the future of the area or some part of it. Every major privately initiated urban revitalization effort has worked from a design concept. Imaginative and sensitive design can provide the symbolism that is often needed to mobilize public and financial support. It need not be grand or costly to have a strong effect on the quality of the environment and hence its attractiveness to other investors. The innovative reuse of old buildings, as in Ghirardelli Square or Faneuil Hall, can do a great deal to change the character of a much larger area. A new project, such as Baltimore's Harbor Place or Nicolet Mall in Minneapolis, illustrates how good design can play a critical role in reorienting the city's self-image and can con- tribute to its economic transformation. Attention to neighborhood design, the streetscape, pedestrian spaces, and the linkages between business dis- tricts, cultural facilities, and other features of a city or region can make a difference in the kind of investment climate that is created. Good urban design is functional. It is not abstract but practical and facilitates the functions that the city intends to perform. As we know more about modern services, for example, it should be possible to design places in which they can operate efficiently and comfortably. As capital becomes less constrained, convenience and amenity can be powerful competitive advantages. The design process is an exercise in policy informed by technology and art. It is important to develop urban design ideas through a process of consultation and legitimization so that they reflect values important to the community. And it is also important to leave room in designs for adjust- ments the market may find it necessary to make. CONCLUSION The framework that we have outlined for capital investment in the urban future is flexible. It does not depend on any given level of federal? state, or local spending or other activity. It seeks only to identify basic consid- erations that could help urban areas make the transition from old economic patterns to the assumption of new roles in an advanced economy. Clearly the level of resources devoted to urban development is important. The less there is, the more important it is to have a clear strategy for using what is available as effectively as possible. For some things, of course, there must be sufficient resources or the job should not even be undertaken. ;

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96 Rethinking Urban Policy Stripped to its essentials, this framework suggests that public policies be aware of their effects on the sectors of the economy. National economic policy should consciously encourage those sectors that the market has shown a tendency to favor or that have prospects of being strong com- petitors. A more competitive national economy should result. Successful sectoral policy, however, could have serious adverse effects in some urban areas because of the way in which our economic activities and labor force are geographically distributed. We therefore need parallel policies that encourage a flow of capital to urban areas for investment in their more promising sectors and to help them attract such activities. By acting as a wholesaler rather than a retailer of such capital, the federal government can avoid the rigidities of past urban capital programs and leave enough flexibility for local leadership to tailor investment strategies to its special needs. Finally, an important element of capital investment strategy is a policy to ensure the development of a national system of infrastructure that can attract, support, and serve an advanced economy. This does not demand that the federal government directly finance all of the needed improvements in national and nationally related urban public facilities. It does mean that the federal government must pursue policies that ensure that someone builds and maintains them. State and local decision makers should devise means of using the resources and powers at their disposal, from whatever source, in a manner that gives them as much leverage as possible on private capital investment. These policies, pursued alone, would seldom neutralize and would often accelerate the trend toward a sharp division between rich towns and poor towns. In an economically advanced nation, it is neither equitable, effi- c1enl, nor politically prudent to pursue polices that leave some areas lagging so far behind that they operate as a drag on the whole economy. In later chapters we discuss options for stabilization policies, actions to foster the development of strong local institutions to manage the transition of local economies, equalization of fiscal capacities among state and local governments, and other strategies to help the less resilient areas and their people adjust to an advanced economy in a positive way and to accelerate that transition. Thus far we have dealt primarily with investments in physical capital. As our discussion of what is happening to our cities strongly suggests, investment in human capital is of equal if not more importance for the future of America's urban economy. We turn in Chapter 6 to strategies for addressing that issue.