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December 3, 2008

Summary of Commentary on

Current Economic Conditions

by Federal Reserve District

Summary

Prepared at the Federal Reserve Bank of Minneapolis and based on information collected before November 24, 2008. This document summarizes comments received from business and other contacts outside the Federal Reserve System and is not a commentary on the views of Federal Reserve officials.

Overall economic activity weakened across all Federal Reserve Districts since the last report. Districts generally reported decreases in retail sales, and vehicle sales were down significantly in most Districts. Tourism spending was subdued in a number of Districts. Reports on the service sector were generally negative. Manufacturing activity declined in most Districts, and new orders were soft. Nearly all Districts reported weak housing markets characterized by reduced selling prices and low, but stable, sales activity. Commercial real estate markets declined in most Districts. Lending contracted, with many Districts reporting reductions in residential, commercial and industrial lending and tightening lending standards. Agricultural conditions were mixed with a relatively good harvest but concerns about profitability. Mining and energy production and exploration started to soften due to lower output prices.

District reports generally described labor market conditions as weakening. Wage pressures were largely subdued. District reports characterized price pressures as easing in light of some decreases in retail prices and declines in input prices, particularly energy, fuel, and many raw materials and food products.

Consumer Spending and Tourism

Consumer spending weakened during the reporting period. Retail sales were described as weak or down in the New York, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Dallas and San Francisco Districts. In Kansas City, consumer spending slowed sharply. Recent retail sales were steady compared with early fall but were lower than a year ago in Philadelphia and were mixed in Boston. Some Districts reported decreased purchases of big-ticket items, including furniture, appliances, electronics and luxury items. Discount stores reported stronger sales volumes than department stores. Inventory levels were relatively stable, as many stores anticipated the recent slowdown in sales. District reports indicated that retailers were preparing for a relatively slow holiday sales season. New York noted that this season is likely to feature more price discounting than last year. Boston, Philadelphia, Cleveland and Dallas reported that some retailers have cut back capital expenditure plans for 2009.

District reports indicated that vehicle sales deteriorated since the last report. Sales of more expensive and less fuel efficient vehicles were particularly slow. However, Kansas City noted an increase in demand for used cars. Chicago, St. Louis, Minneapolis, Kansas City and San Francisco reported that a number of car buyers had difficulty obtaining financing.

Tourism activity was relatively slow. Fall tourism was down in New York, Atlanta, Chicago, Minneapolis, Kansas City and San Francisco, while tourism conditions were mixed in Richmond. Kansas City and San Francisco reported slower restaurant business. Atlanta noted that business travel was down, while San Francisco reported a rising incidence of canceled corporate meetings in Southern California. In contrast, reservations at a ski resort in the Richmond District were somewhat stronger for the Thanksgiving and Christmas holidays, and some tourism businesses in the Minneapolis District were cautiously optimistic for the winter season in part due to lower gasoline prices.

Services

Activity in the services sector generally contracted in most Districts since the last report. New York, Richmond, Chicago, Minneapolis, Dallas and San Francisco reported deteriorating conditions. Most of these Districts were seeing weakness across a wide range of services, including advertising, architecture, business support, information technology, legal services and temporary help firms. Boston reported mixed conditions for information technology services, ranging from declines of 10 percent to gains of 25 percent. Minneapolis and Dallas reported growing demand for bankruptcy services, and Richmond noted that telecommunications and CPA firms were facing strong demand.

Manufacturing

Manufacturing activity declined noticeably since the last report. All 12 Districts reported weaker manufacturing conditions, to varying extents. Boston, Philadelphia, Cleveland, Richmond and Kansas City reported reductions in orders. Almost all Districts noted reductions in exports. Philadelphia, Cleveland, Richmond, Chicago and Atlanta reported lower shipping volumes. Dallas reported weakness in most forms of transportation. Nearly every District reported decreased demand for construction materials; Cleveland and Chicago noted, in particular, decreased steel production. Several Districts reported multiple plant shut-downs, and expectations for capital expenditure were down. A few sectors saw increased activity. Boston, Chicago, St. Louis and San Francisco noted stronger demand for aerospace manufacturers. St. Louis, Dallas and San Francisco reported increases in food processing.

Real Estate and Construction

Residential real estate continued at a slow pace nationwide. Sales were down in most Districts, but mixed activity was noted in the Boston, Atlanta and Minneapolis Districts. Boston, New York, Cleveland, Richmond, Atlanta, Chicago, Minneapolis, Kansas City and Dallas noted decreases in housing prices. Inventories of unsold homes remained high in the New York, Atlanta, Kansas City and San Francisco Districts, but declined in Chicago and Minneapolis. Philadelphia, Richmond, Chicago and Kansas City reported relatively stronger demand for lower- and middle-priced "starter homes."

Commercial real estate markets weakened broadly. Vacancy rates rose in Boston, New York, Richmond, Chicago, Kansas City and San Francisco, but were mixed across markets in the St. Louis District. Leasing activity was down in almost all Districts. Rents fell in the Boston, New York and Kansas City Districts. Despite reductions in construction materials costs, commercial building activity declined in many Districts with tighter credit conditions as a factor.

Banking and Finance

Business and consumer lending activity continued to slow in most Districts. New York reported weakening loan demand in all categories, while Kansas City and San Francisco also witnessed substantial lending declines. Lending activity in other Districts was mixed among loan categories. In contrast, Philadelphia indicated that its banks saw loan volume rise in November, and some regional banks reported picking up new business borrowers. Cleveland reported that business loan volume has been steady to higher, and some bankers reported actively marketing their loan business.

Credit standards rose across the nation, with several Districts noting increases in loan delinquencies and defaults, especially in the real estate sector. Credit conditions remained tight. Chicago reported that FDIC actions and Federal Reserve lending had improved liquidity and slowed deposit outflows. Dallas indicated that government capital investments have led larger institutions to feel less constrained in their lending, while some smaller banks reported that scrutiny from regulators was making new deals more difficult to forge.

Agriculture and Natural Resources

Districts reported mixed results in agriculture. Chicago, St. Louis, Minneapolis, Kansas City and Dallas expected decent harvests. However, Richmond, Chicago and Minneapolis reported delays in harvests due to wet weather. Atlanta, Chicago, Minneapolis, Kansas City, Dallas and San Francisco reported decreases in several crop and/or cattle prices. Chicago, Kansas City, Dallas and San Francisco noted that cattle producers' profits were squeezed. Tightening credit conditions for agricultural producers were noted in the Kansas City, Dallas and San Francisco Districts. The bankruptcy of a large ethanol producer created uncertainty for crop producers near its Midwest plants.

Activity in the energy and mining sectors decreased since the last report. Atlanta, Minneapolis, Kansas City, Dallas and San Francisco reported softening in oil and gas activity due to lower prices and, in some cases, weather disruptions. Meanwhile, mining activity decreased in the Minneapolis District.

Labor Markets

Signs of labor market slowing were evident in several District reports. Boston, Richmond, Chicago and Dallas reported that demand for temporary staff decreased. Boston and Cleveland noted that seasonal hiring has been scaled back at retail stores. Several businesses in the Atlanta District reported that layoffs accelerated and hours declined. Chicago noted that further weakness in the demand for labor was expected in a number of sectors. Dallas reported that job cuts were particularly pronounced in the manufacturing sector. San Francisco reported job cuts and hiring freezes across a wide range of industries. However, demand for skilled labor remained strong in Chicago, contacts in Boston reported difficulty filling open positions in some professions and Minneapolis cited difficulty finding skilled workers in some areas.

Wage pressures were largely subdued. Richmond reported that wages for temporary employment remained unchanged, while wages in the retail sector declined. Aside from health care and other high-skill technical positions, most contacts in Atlanta suggested that wage pressures continued to diminish. Business operators in the Minneapolis District indicated that they expect only modest wage increases in their communities during 2009. Chicago, Kansas City and Dallas reported minimal wage pressures. In San Francisco, the region's few open positions have been attracting large numbers of applicants, thereby alleviating upward wage pressures.

Prices

District reports characterized price pressures as easing in light of some decreases in retail prices and declines in input prices, particularly for energy, fuel, and many raw materials and food products. In the New York District, firms across a wide range of industries reported that their selling prices have leveled off, while prices paid have decelerated. Philadelphia noted that reports on input costs and output prices showed a general decline. Cleveland reported that transportation surcharges were removed for some contacts. In Atlanta, most District contacts reported that they did not plan to raise output prices due to lower input costs and weaker demand. A manufacturer in Minneapolis noted success in passing along input cost increases to customers, but will likely lower prices going forward. Manufacturers in Kansas City reported a sharp deceleration in raw materials prices. Many contacts in Dallas reported that they resisted price-cutting pressures from their customers, but that they expected to lower prices over the next several months. San Francisco noted declines in the prices of transportation services. A number of District reports mentioned that retailers were widely discounting prices in anticipation of a slow holiday sales season.

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First District--Boston

Reports from business contacts in the First District indicate the economy slowed further in the third and fourth quarters to date. Retailers report that sales are softening and, in some cases, are below year-earlier levels; manufacturers cite declines in orders or sales from a year ago, some of which are sizable. Most software and information technology services respondents see a slowdown currently or in the near future, while temp firms cite a marked falloff in business in November. Upward price pressures are said to have eased markedly. Commercial and residential real estate markets remain weak, although on the residential side, September or October saw steep price declines and sales about level with a year earlier.

Retail and Tourism

First District retailers cite mixed sales results for October and early November, but even those contacts with sales increases from a year earlier report a softening. Retailers say that consumers are scaling back spending, and they expect consumers to spend less on the holidays this year.

Inventory levels continue to be tightly managed. Capital spending reports are mixed for the remainder of the year, but all contacted retailers plan to cut spending for 2009. The majority of respondents have invoked hiring freezes and a few have recently reduced or are considering reducing headcounts. Seasonal hiring for the holidays appears to be scaled back from previous years. Several contacts indicate that credit availability has started to improve; however, one contact notes a reduction in the availability of consumer financing.

Overall, First District retailers are concerned and watchful in their outlook, especially with regard to the upcoming holidays. The majority of contacts express the view that the next six to twelve months will be challenging.

Manufacturing and Related Services

Manufacturers and related services providers headquartered in the First District say that sales and orders have weakened in the fourth quarter to date. Some firms indicate that the deterioration has been dramatic, and that market demand is the worst they can remember. Many companies making major equipment, automotive parts, and consumer-good components report that demand has decreased at double-digit rates from late 2007 or from earlier in 2008. Some respondents indicate that overseas sales are weakening as a result of slumping economies or the strengthening dollar, while others say that overseas sales continue to grow, particularly in Asian markets. In contrast to prevailing trends, contacts report rising sales of aircraft parts and energy-management products. In addition, demand for medical and scientific instruments and supplies is said to be holding up fairly well.

Most manufacturers say that overall materials costs are flat to decreasing, and that transportation costs have come down. However, contacts indicate that some suppliers have not reduced prices immediately or automatically as metals and oil prices have fallen. In such cases, manufacturers are pressuring suppliers for price reductions or are anticipating price reductions as contracts expire or are renegotiated. Reports on selling prices are mixed. Some contacts indicate that their prices are under downward pressure as markets erode. Others have increased their prices slightly or expect to do so in early 2009.

Almost all of the manufacturing and related services respondents report that they are taking steps to reduce their U.S. wage bills. Measures include layoffs, furloughs, and selective pay cuts. In addition, some companies report they are dismissing temporary workers, restricting employee travel, or reducing purchases of consulting services.

The majority of manufacturing respondents indicate that they are trimming capital expenditures, citing a need to spend more cautiously or preserve cash flow. Some contacts report that financing costs have risen to abnormally high levels.

Most manufacturers express caution or concern about their sales in coming months. About one-half say they expect their business to be in decline through the end of 2009. Others cite heightened uncertainty with respect to the economy and financial markets, and have contingency plans should conditions turn out to be worse than currently expected.

Software and Information Technology Services

First District software and IT services firms report mixed outcomes in the fourth quarter to date, with year-over-year revenues ranging from declines of about 10 percent to gains of nearly 25 percent. A few contacts note that clients are delaying deals until there is less market uncertainty or are slowing down payments, thus elongating the sales cycle. Many respondents have felt increased pressure from customers to reduce prices, while others are paying closer attention to spending in order to maintain profits. Some firms are anticipating hiring freezes or layoffs; meanwhile, others plan to continue expanding. All contacts express apprehension regarding the economy and many anticipate a difficult year ahead. Although some firms are hoping for modest to high growth in 2009, contacts say they recognize the unpredictability of financial markets and are proceeding "cautiously."

Staffing Services

The sentiment among New England staffing respondents is gloomy. While contacts report varied year-over-year revenue changes in the most recent quarter, all have experienced flat to sharp declines in business during the past several weeks. Labor demand has slowed, especially for workers in general administrative and financial occupations, and the majority of respondents say that the demand for permanent hires has weakened even more than for temps, with one contact reporting a 20 percent decline in revenues from permanent placements over the past year. Rising unemployment has improved labor supply, but it is still difficult to fill positions for engineers, programmers, healthcare lab personnel, and IT-professionals. A few contacts remark that clients are asking to renegotiate bill rates downward, by 5 percent to 15 percent, which will in turn place downward pressure on pay rates in the coming months; another respondent notes that applicants have been more flexible recently about accepting lower offers.

Staffing executives in the First District are very worried about the crisis in the financial markets and the effect it is having on clients, with one contact noting, "Everybody's spooked. There's no hiring going on at all." The end of the year typically marks a slower time for the staffing industry as clients are closing their books and terminating projects, but respondents expect this year to be much worse. One contact anticipates at least a 20 percent drop in revenues during the fourth quarter of 2008, and most are hoping to maintain revenues but expecting declines in 2009.

Commercial Real Estate

The mood among contacts this period is downbeat. A Boston respondent is concerned that the "bearish mood" has spread to sectors of the regional economy previously described as robust, such as higher education. The same contact describes the credit squeeze as "murderous," and cites the example of a major downtown Boston project which remains stalled for lack of the last $50M in financing, despite having secured tenants that would occupy a significant share of the space. A commercial property lender in Boston reports that lending remains extremely conservative at their bank, as they approach their own borrowing limits and strive to maintain adequate cash reserves. In Connecticut, sales volume is reportedly very low and financing limited.

The office rental market in Boston is showing growing signs of weakness, with very low leasing volume and softening rents--the latter are reportedly down 10 to 15 percent from their peak in early 2008. Absorption is negative and vacancies have edged up to around 11 percent downtown and to 15 or 16 percent in the Boston suburbs. There is talk of looming layoffs in the financial sector that will put further upward pressure on office vacancies. Another Boston contact notes that retail vacancies are not being filled, and he is aware of upcoming store closings that will add to retail vacancies in the next few months. In Maine, rents are down 10 to 20 percent across all sectors, but vacancies are holding steady, and no large job losses or store closings have been reported yet.

The outlook is pessimistic. Absorption is expected to remain negative in Boston throughout 2009. Contacts in Maine and Connecticut are concerned that firms will be going out of business or announcing large layoffs, adding to commercial vacancies and putting further downward pressure on rents. Credit market conditions are not expected to improve significantly in 2009, either.

Residential Real Estate

In a change from August numbers, home sales in the New England region showed modest declines and some increases in September and October compared to the year before. However, these numbers reflect deals that were initiated 45 to 60 days earlier, and some contacts report that activity has slowed again since the troubles in the financial markets in September and October.

Single-family home sales in Massachusetts increased 5 percent year-over-year in September and were up again in October, including a 13 percent year-over-year increase in the Boston area. Home sales in New Hampshire increased 1 percent year-over-year in October. Home sales in September decreased 1 percent year-over-year in Rhode Island and 5 percent year-over-year in Connecticut. These improvements in year-over-year sales changes compared with August coincided with substantial price declines. Median home prices were down 8 percent in Connecticut, 13 percent in Massachusetts, and 17 percent in Rhode Island in September compared to a year earlier. Median home prices in New Hampshire fell 13 percent year-over-year in October. In the Massachusetts multi-family home market, sales increased 40 percent year-over-year in the third quarter while prices dropped 35 percent.

While most contacts see the September sales numbers as a positive sign, they express doubt about whether the improved sales patterns will continue; respondents in Boston and New Hampshire say the market was very quiet in October and November. One contact continues to think that the downturn in the housing market will last through the end of 2009.

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Second District--New York

The Second District's economy has deteriorated substantially since the last report. Both manufacturers and other firms report widespread declines in business activity and employment levels, and a growing number plan to curtail capital spending in the months ahead. Firms in a broad array of industries report that both their input costs and selling prices have leveled off, after rising through the third quarter. Retailers report weak sales for October and early November, though inventories are not said to be too out of line; retailers say that prices are flat to lower. An annual survey of consumers in the region suggests that holiday season spending will be considerably lower than in 2007. Tourism activity in New York City is reported to have declined sharply in recent weeks. Both residential and commercial real estate markets have softened substantially since the last report, most notably in Manhattan. Finally, bankers report widespread weakening in loan demand across all segments, substantial tightening in credit standards, and higher delinquency rates on all types of loans.

Consumer Spending

Retail sales were said to be well below plan in October and early November, with same-store sales running 5 to 10 percent lower than a year earlier. One large chain notes that its sales performance might have been weaker still, if not for unseasonably cold weather in early November spurring sales of outerwear and winter apparel. The most pronounced weakening has been in New York City, which had been out-performing the rest of the region until recently. In contrast, two retail contacts in the Buffalo-Niagara region report that sales have remained fairly brisk through October. Despite the overall weakness in sales, retail inventories are not reported to be substantially above desired levels. Retail contacts report that this season is shaping up to be more promotional than last year's, with steeper markdowns and effective prices generally lower than in 2007. Looking ahead to the upcoming holiday season, retailers anticipate year-over-year percentage declines in same-store sales ranging up to the low double digits. Based on an annual supplementary question on the Conference Board's November consumer confidence survey, consumers in the Middle Atlantic region plan to spend roughly 10 percent less on holiday-season gifts than in last November's survey.

Tourism activity in New York City has weakened sharply since the last report. Overall revenues of Manhattan hotels have plummeted in recent weeks: after running about 10 percent ahead of comparable 2007 levels in the third quarter, revenues are reported to be down more than 10 percent from a year earlier in October and are estimated to be down more than 20 percent in early November. The recent drop-off reflects declines in both occupancy rates and room rates. Also, Broadway theaters report that business slowed in mid-October and has remained weak since. Comparisons with 2007 are not relevant, due to a strike last November, but both attendance and revenues have been sluggish, running more than 10 percent lower than two years ago. Average ticket prices have been relatively steady.

Construction and Real Estate

Housing markets in the District have deteriorated further since the last report. A major residential appraisal firm reports substantial deterioration in New York City's housing market over the past two months: prices of Manhattan co-ops and condos are reported to have fallen by 15 to 20 percent since mid-summer, though it is hard to get a clear handle on prices due to thin volume--much of the recent activity is reportedly from desperate sellers. Transaction activity has dropped off noticeably, and there has been a large increase in the number of listings. Some buyers that had signed contracts for units under construction earlier this year are having trouble getting financing at the contract price now that market values have dropped. Many of those having difficulty selling their apartments are putting them up for rent, boosting the number of rental listings substantially--particularly in doorman buildings. Average asking rents are reported to be down 1 to 4 percent from a year earlier.

New Jersey's housing market has also deteriorated substantially since the last report. A building industry expert describes buyer traffic at new developments as almost non-existent and notes that larger construction firms are backing out of new developments and cutting jobs, while a number of smaller firms are contemplating either moving into the rehab segment of the market or going out of business. Multi-family development, which had been holding up somewhat through the summer, has ground to a halt more recently. A real estate contact in northern New Jersey indicates that selling prices for existing homes are down 20 to 25 percent from a year ago, but that the number of transactions has held up, as sellers are increasingly negotiable; many potential sellers have taken their homes off the market, keeping the inventory of unsold homes relatively low. The low end of northern New Jersey's housing market is said to be holding up fairly well, whereas the market for higher-priced homes (over $400K) is described as moribund. In contrast, real estate contacts in western New York State report that prices have continued to increase modestly through October, though sales volume has tapered off moderately.

Commercial real estate markets in the New York City area have weakened noticeably. Manhattan's office vacancy rate continued to climb in October, rising more than ½ point, led by Midtown. Leasing activity has slowed markedly, and many tenants are requesting short-term renewals, with landlords generally willing to oblige. Actual rents have continued to decline, while asking rents, which had remained slightly above 2007 levels through the third quarter, have now turned down as well. There has been a particularly sharp increase in the amount of available sub-lease space--largely from financial firms. Office markets on the outskirts of New York City are also reported to be softening, but not as dramatically as Manhattan's.

Other Business Activity

There have been widespread signs of weakening in the labor market. A major New York City employment agency, specializing in office jobs, reports that there are now very few job openings, and a large and growing supply of job applicants. Many of the recent job candidates are people let go from entry level management jobs. Hiring by large investment banks remains nearly non-existent; more recently, legal firms, hedge funds and private equity firms have cut back dramatically on hiring.

More generally, paralleling the weakness reported in our recently-released survey of New York State manufacturers, non-manufacturing firms in the District report widespread deterioration in employment, as well as in business activity. Non-manufacturing firms also anticipate further declines in both employment and business activity in the months ahead, and a growing number plan to reduce capital spending. A growing proportion of firms--both manufacturers and other firms--report tightening credit conditions over the past three months. Firms across a wide range of industries report that their selling prices have leveled off, while their prices paid have decelerated.

Financial Developments

Bankers report weakening demand for loans in all categories--most noticeably in the residential mortgage segment, where 68 percent of bankers report lower rates and 6 percent reported higher rates. For all loan categories, respondents indicate widespread tightening of credit standards. The percentage of bankers reporting higher standards ranged from 45 percent in the residential mortgage category to 54 percent in the commercial and industrial loan category; none of the bankers surveyed indicates an easing of credit standards. Respondents note an increase in the spreads of loan rates over cost of funds for both commercial loan categories but no change in spreads for consumer loans and residential mortgages. Respondents indicate no change in the average deposit rate. Finally, bankers report fairly widespread increases in delinquency rates across all loan categories.

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Third District--Philadelphia

Business conditions in the Third District remained generally weak in November. Manufacturers, on balance, reported declines in shipments and new orders. Retailers indicated that the pace of sales was nearly steady during November but down from the same month last year. Motor vehicle dealers reported very slow sales. Bank loan volume moved up in November, but credit quality deteriorated. Residential real estate sales and construction continued to fall. Commercial real estate investment and construction activity declined further. Business firms in the region reported decreases in input costs and output prices in November, particularly for basic commodities.

The outlook among Third District businesses is generally not positive. Manufacturers forecast decreases in shipments and orders during the next six months. Retailers are not optimistic about the holiday shopping period. Auto dealers do not expect sales to improve in the near future. Bankers anticipate slow loan growth and further weakening in credit quality. Residential real estate agents and home builders expect sales to remain slow for the next several quarters at least. Contacts in commercial real estate expect leasing and construction activity to remain at low levels as long as financial conditions remain volatile.

Manufacturing

Third District manufacturers surveyed in November reported declines in shipments and new orders, on balance, compared with October. Nearly one-half of the manufacturers surveyed noted decreases in those measures, and only one-fifth reported increases. Reports of declining demand exceeded reports of rising demand in practically all the major manufacturing sectors in the region. The falloff in demand was especially large for firms that manufacture construction-related goods and materials. One maker of housing products said, "The industry is at a standstill, and there will be a massive shakeout by next spring."

The outlook among Third District manufacturers has become more pessimistic in the past month. Among firms polled in November, a little more than one-third expect new orders and shipments to decline during the next six months, and a little less than one-third expect increases. Area manufacturers have reduced capital spending plans since last month, and future outlays are now slated to decline, on balance. Area manufacturers also plan to reduce inventories, on balance, during the next six months. Area manufacturers are cutting inventories in response to declining production, and some are reducing inventories of commodities to avoid losses on their value as prices decline. As one manufacturer of metal products noted, "Inventory liquidation is the order of the day until a price floor is achieved."

Retail

Most of the retailers contacted for this report indicated that customer traffic and sales were nearly steady during November after declining from September to October. Nevertheless, many stores reported that this November's results were below those of November of last year. Discount stores continued to post better performances than most other types of stores, although some stores selling apparel noted a seasonal pickup in sales of outerwear. Store executives said price markdowns have been widespread and steep, which has given some support to sales but is negatively affecting profit margins. The outlook for the holiday shopping period among Third District retailers is not optimistic. They expect restrained buying by consumers, and even retailers who believe holiday-period sales could exceed current expectations say extensive discounting will mean that there might be "volume but no profit," as several remarked. Many of the retailers contacted in November said they expect sales to remain sluggish in the first half of 2009, and they have cut back on expansion plans and capital spending in general.

Nearly all the auto dealers in the region surveyed in November reported a very slow pace of sales, well below the rate of a year ago, although a few noted a slight improvement from the September and October sales rate. Dealership closures continued, with some going out of business due to falling sales and others closing because they have not been able to obtain inventory financing. Dealers see no signs of a rebound in sales, and they expect more dealerships to close in the months ahead.

Finance

Total outstanding loan volume at Third District banks rose in November, according to bankers contacted for this report. There have been gains in business loans, real estate loans, and consumer credit. Several regionally based banks said they have picked up new business borrowers who have terminated relationships with large nationwide financial intermediaries. Most of the banks contacted for this report said that credit quality measures continued to deteriorate for both business and personal loans, and that delinquencies and defaults on loans to real estate developers and builders, including residential and some commercial developers, have risen markedly. Nearly all banks indicated they were tightening credit standards; some said they were imposing "stricter underwriting criteria across the board," and others said they were allowing "fewer exceptions" to underwriting standards for new loans. Looking ahead, bankers generally expect, at best, slow expansion in lending in 2009.

Bankers reported strong competition for deposits. Many are raising rates on transactions and savings accounts and on certificates of deposit. The upward trend in deposit rates has raised concern among bankers that net interest margins will remain tight well into next year. Several bankers noted that higher rates have prompted some growth in deposits but that stronger deposit growth will be needed to obtain sufficient funds to meet their loan growth targets.

Real Estate and Construction

Residential real estate activity in the Third District has softened in recent weeks. Residential real estate agents and builders reported little progress in reducing inventories of homes for sale. One real estate agent said the market has stalled because buyers are unable to sell their current homes and are unwilling to buy until they do so. A residential builder indicated that traffic has slowed but not stopped; however, "Good buyers are viewing homes, but they can't get comfortable about making a purchase." Another said starter homes are the most active market, but the number of potential buyers is being constrained by difficulty obtaining mortgages. Builders and agents do not predict an increase in sales for at least several quarters, and they expect the upturn to be slight.

Commercial real estate firms indicated that construction, leasing, and purchase activity continued to fall in November. A number of previously announced commercial projects have been indefinitely postponed, and work has slowed or stopped on several projects already under construction. Contacts expect commercial real estate investment and construction activity to remain at low levels as long as financial conditions continue to be uncertain.

Prices

Reports on input costs and output prices reveal a general decline since the previous Beige Book. Manufacturing firms noted a broad decrease in commodity prices for the materials they use, and many have reduced the prices of their own products in order to maintain current sales rates or minimize declines. Retailers generally reported early and steep markdowns for the upcoming holiday sales season.

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Fourth District--Cleveland

Overall economic activity in the Fourth District has weakened markedly since early October. The downward trend in factory output and steel shipments that began in the middle of the third quarter continued. Residential construction remains very weak, with no improvement expected during 2009. Commercial builders told us that inquiries have been falling off, and they anticipate a slowdown in business through at least the first half of next year. Sales by District retailers were characterized as flat to down, while reports from auto dealers indicate that purchases of new and used cars have dropped. Business loan volume has been steady to up, while consumer lending activity has weakened. Energy production is stable. And freight transport volume declined across most industry sectors.

Reports show a drop in employment levels, primarily in manufacturing, residential construction, and auto dealerships. Staffing firms reported that job openings were flat to slightly down, with openings concentrated in health care and financial services. Wage pressures remain contained across all industry sectors. Almost all respondents affiliated with manufacturing, construction, and energy companies said that raw materials prices were stable or showed a moderate decline.

Manufacturing

Output at District factories was flat to down during the past six weeks, with several reports indicating double-digit reductions in orders. On a year-over-year basis, a majority of our contacts said that production fell. Most respondents expect that output will continue to slow going into 2009. Capacity utilization was at or below normal levels. Almost all steel producers and service centers reported a worse-than-expected slump in shipping volume. The only end markets showing some strength are energy and aircraft. All of our contacts believe that market conditions for steel will weaken further in the upcoming months. In contrast, the data show a rise in District auto production during October on a month-over month basis, with foreign makers accounting for most of the increase. October's increase reflects a normal seasonal adjustment from lower production levels during September. In terms of year-over-year comparisons, production fell, with domestic nameplates absorbing the entire downturn.

Capital spending remains on plan; however, two-thirds of our respondents reported that they plan to cut back on capital expenditures during 2009. Companies with strong balance sheets were successful in renewing credit lines. However, the agreements contained additional covenants and the cost of credit was higher. Almost all of our respondents said that the prices they pay for raw materials have declined, some significantly. Moreover, only one producer raised his prices during the past six weeks, while several reported lowering the prices of their products. Looking forward, a majority of our contacts expect that cost pressures will continue to subside. Half of our respondents said they have either laid off employees or intend to do so in the near future. Further, we heard several reports of companies eliminating overtime or initiating hiring freezes. Wage pressures are not an issue.

Real Estate

Residential contractors reported extremely weak home sales during the past six weeks, with Internet and foot traffic showing steep declines. Looking forward, builders are not expecting any industry turnaround through 2009. Credit remains available to homebuilders and buyers, especially from community banks. However, lending standards have tightened, rates have increased, and banks are requiring higher down payments. Prices for building materials continue to moderate, especially lumber and drywall. Half of our respondents told us that they have marked down the list prices of their houses, and inventories have been pared to match current sales levels. General contractors and subcontractors reported reductions in staff levels and no wage pressures.

Most commercial builders told us that business started to slow down during the past six weeks, and they expect the decline will continue through at least the first half of 2009. Several firms attributed the slowdown, in part, to difficulties in financing projects. Backlogs remain relatively strong, while inquiries have been falling off. Contractors reported holding their prices steady; however, a few expect some margin contraction in 2009. Construction materials prices have stabilized. Workforce levels were largely unchanged, and no wage pressure was reported.

Consumer Spending

District retailers reported October sales were flat to down on a month-over-month basis across all industry segments. The sole exception was a national discount chain, which reported increased sales. Looking forward, respondents expect a relatively weak holiday shopping season. Apart from paper products, vendor prices were stable. Sellers of paper products told us that they are passing through price increases to their customers. Reports from auto dealers indicate that purchases of new and used cars have declined over the past six weeks. Low-priced models that get good gas mileage had the highest sales volume. Dealers do not expect much improvement in the upcoming months. Capital expenditures by retailers remain on target; however, half of our contacts said they plan to cut back on spending during the next 6 to 12 months. For the most part, staffing levels at retail stores have not changed; however, seasonal hiring will be less than last year. Several auto dealers said they have cut additional staff since our last report. No wage pressures were reported.

Banking

In general, business loan volume has been steady to up, with some of the increase attributed to drawdowns on existing lines of credit. Interest rates trended upward, reflecting higher pricing of risk and a pass-through of increased bank borrowing costs. On the consumer side, installment loans were flat to down, while the use of home equity lines of credit remained solid. Pricing for consumer loans also showed a slight increase. Several bankers told us that they are actively marketing their loan business. Nonetheless, they are cautious in extending new loans, with credit standards continuing to tighten. Credit quality of incoming applicants was characterized as stable to slightly down. For a majority of our respondents, spreads have widened a bit during the past six weeks. Overall, core deposits are growing, especially at banks that are paying competitive rates on CDs and money market accounts. Staffing levels remain steady and no wage pressure was reported.

Energy

On the whole, energy production has been stable during the past six weeks. Expectations call for oil and natural gas production to remain steady or increase, while coal production is expected to weaken during the upcoming months. Reports indicate that the prices received for oil and natural gas fell significantly since their July peaks. Materials and equipment costs have moderated, especially for diesel fuel. Capital expenditures are on plan, with little change expected during the next few months. Workforce levels held steady, and no hiring is expected in the near future. Wage pressures that existed earlier in the year have diminished.

Transportation

Freight transport service companies experienced an overall decline in shipping volume and revenues since our last report. Company officials told us that the housing, auto, consumer products, and steel industries are primarily responsible for the drop-off. Expectations call for activity to remain weak through at least the first quarter of 2009. Transport pricing remains competitive, and there are reports that fuel surcharges are being removed in some places. Capital spending remains on target but at low levels for most companies. Almost all expenditures are allocated solely for equipment replacement. Little change in capital spending is expected during the upcoming months. For the most part, hiring was limited to driver turnover. However, we heard several reports of potential layoffs due to industry-wide capacity reduction. Any wage increases fell within industry norms.

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Fifth District--Richmond

The Fifth District economy weakened during late October and early November. Retail sales contracted as shopper traffic waned, and demand dropped for big-ticket items, such as cars and furniture. Manufacturers reported falling shipments and new orders while export activity declined. Both retailers and manufacturers cut employment in recent weeks. Meanwhile, the housing sector failed to improve as mortgage demand was weak and credit standards tightened for most loan products. Contacts reported that the only measurable movement of houses occurred among homes in the low-to-middle price range. Furthermore, commercial real estate markets were sluggish as leasing activity decreased, new construction stagnated, and contacts had difficulty obtaining loans. Price pressures in the District eased in the last six weeks as the prices of manufactured goods fell, raw materials and retail prices grew at a slower pace, and services firms' prices were little changed.

Retail

Retail sales contracted since our last report, as big-ticket sales fell sharply and shopper traffic declined. A seller of building supplies said his market was "dead," and store managers at department stores in Virginia Beach, Va., and central North Carolina said their sales contracted. Among our contacts at car and light truck dealerships, sales of domestic brands continued to fall. A West Virginia domestic car dealer told us he had gone from average sales of 250 cars per month to selling only six cars in November 2008. In contrast, a Virginia Beach dealer reported seeing a slight pickup in sales of vehicles with foreign nameplates. Retailers made deep cuts in employment, and wages declined in recent weeks. Retail price growth moderated during the period.

Services

According to contacts, revenues generally declined at services-providing firms since our last report. A healthcare executive in central North Carolina told us that people whose health insurance expired following a job loss had cut back on visits to primary-care groups located at his facilities. Along with the president of another hospital in North Carolina, he voiced concern that this would soon result in sicker people in emergency rooms, with no way to pay. Other services businesses also faced a weaker market. District financial services firms reported that the mood of clients remained negative despite "hints" of loosening credit. However, telecommunications businesses and CPA firms stated that demand for their services was strong. Overall, services employers cut jobs in recent weeks, and several contacts said they were planning hiring freezes in the near future. Average wages grew modestly, while price growth at services firms was nearly zero.

Manufacturing

District manufacturers reported that activity contracted further in recent weeks with notable weakness in shipments, new orders, and employment. A furniture maker in North Carolina told us that the furniture business had "frozen shut" across the country and across all of his furniture lines. He reported that the recent furniture market in High Point, N.C., was lightly attended with few orders placed and indicated that his company had laid off employees. A producer of paper products in North Carolina said that even though waste paper prices had been reduced by 50 percent and energy costs were down, business was terrible--which he attributed to the unavailability of financing. He pointed out that if market conditions did not improve over the next six months, his business would be in danger of failing. Other contacts noted that finished goods prices declined, which they attributed to slower business and weaker demand for their products. In addition, they indicated that input price pressures had eased, reflecting the pullback in energy and commodity prices.

Port activity slowed "considerably" in October and early November, according to our contacts. Exports fell at each of the District's major ports, where contacts reported seeing "a lot more ship space available." Shipping rates for bulk goods decreased notably in recent months, leading exporters, when possible, to switch from container shipping to bulk shipping, thus reducing the demand for containers and increasing the number of outbound empty containers. Additionally, import activity cooled in Norfolk, Va., and Baltimore, Md., where the number of inbound containers declined and imported autos were "sitting around." In contrast, imports increased "aberrantly" in Charleston, S.C., between September and October, according to a local port official.

Finance

Commercial lending activity remained soft in recent weeks. Nearly all contacts reported that demand for loans was "flat" to "slightly down," although one lender at a Virginia community bank said her office had "been busy since we haven't pulled back in our lending." Changes in credit standards were mixed, with some lenders reporting a slight tightening of loan-to-value ratios and stricter credit policies, while others indicated no revisions over the last six weeks. A banker covering Virginia and the Carolinas noted "continued deterioration" in the financial portfolios of his clients--especially for consumer related businesses--while other District contacts reported that credit quality was generally stable.

Demand for home mortgages continued to be weak in late October and early November. Lenders reported a further slowdown in activity across the District, with a Washington, D.C., contact noting that most of his firm's business was stemming from foreclosure and short sales in the northern Virginia area. Credit standards remained tight in recent weeks as some institutions raised required credit scores and further reduced product offerings. However, contacts in the Washington area reported a slight loosening in standards for a limited number of loan products.

Real Estate

Fifth District housing markets remained generally sluggish in recent weeks. A Richmond Realtor reported little activity in house sales, although he noted that, "we are going through a seasonal change right now." He reported that houses in the middle price range were selling but mostly to first-time homebuyers. Additionally, he said the uncertainty of the economy had everyone in a "holding pattern"--people looking to sell their homes were waiting to see if the housing market will turn around. Meanwhile, market volume rose in the northern Virginia area; a Realtor in the area was optimistic about December house sales, which he said would "reduce his inventory and ready the market for when spring hits." On the other hand, an agent in Greensboro, N.C., reported very slow house sales, with major concessions to buyers being made. He said there had been some movement in lower-priced houses, but not enough to keep builders afloat; several builders in his area were on the verge of "closing shop." Meanwhile, an agent in Greenville, S.C., reported a 17 percent decrease in volume. House prices were steady across much of the District although a few contacts reported slight decreases.

Commercial real estate contacts across the District generally noted slower leasing activity since our last report. Agents reported a moderate volume of deals going through, although clients were increasingly stretching out the decision making process. Rental rates trended down in Richmond but held steady in most other cities. In Washington, D.C., Norfolk, Va., Charlotte, N.C., and Greenville, S.C., contacts reported a rise in landlord concessions--such as free rent and tenant improvements--while agents in Baltimore, Md., Richmond, and Raleigh, N.C., noted an uptick in broker incentives. Changes in occupancy rates varied. Vacancies moved higher for retail space in Richmond and Columbia, S.C., office space in Raleigh and industrial space in Charlotte. Elsewhere in the District, vacancy rates were mostly unchanged, but contacts in Washington and Norfolk expected increases in coming months. Contacts reported that financing was harder to obtain as lenders were requiring lower loan-to-value ratios. Little new construction was announced in recent weeks and agents across the District reported that deals were being shelved or canceled due to the current economic environment and difficulty obtaining financing.

Tourism

Assessments of tourist activity were mixed in recent weeks. Coastal contacts in the Outer Banks of North Carolina and in Myrtle Beach, S.C., told us that the fall season had been very soft, which they attributed to weaker consumer spending and wide-ranging concerns about the economy. In contrast, a manager at a ski resort in Virginia said that his bookings were steady and sales of time shares were on par with last year. He also indicated that reservations were somewhat stronger for the Thanksgiving and Christmas holidays. Adding to the upbeat tone, tourism officials in the Washington, D.C., area told us that they were anticipating record attendance for the Presidential inauguration in January, which would benefit hotels and restaurants in that region.

Temporary Employment

Fifth District temporary employment agents reported weak demand for workers in October and early November. An agent in Raleigh, N.C., said people were willing to take jobs that pay less in order to keep working. In contrast, an agent in another area of Raleigh was optimistic that demand would strengthen over the next several months. A Richmond, Va., agent expected demand to weaken further in coming weeks due to the "terrible economy." In general, wages remained unchanged across the District.

Agriculture

Cooler-than-normal temperatures coupled with above average rainfall helped replenish soil moisture in much of the District, but delayed field work in some regions. Analysts in Virginia and West Virginia told us that soggy field conditions hindered soybean harvests, while contacts in South Carolina noted that wet conditions had slowed planting and crop-combining activities. In contrast, small grain plantings were ahead of schedule in Maryland and North Carolina, and the cool, wet conditions in Virginia improved small grain and cover crops. Fruit producers in Maryland and South Carolina reported that the apple harvest had been completed, and the peanut and cotton harvests were nearing completion in Virginia. In addition, the Christmas tree harvest was in full swing in North Carolina as producers prepared for the holiday season.

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Sixth District--Atlanta

Economic conditions in the Sixth District weakened further in October through mid-November. Retail spending deteriorated, holiday sales expectations were bleak, and activity in the tourism sector declined. Residential real estate contacts indicated that sales and construction activity remained extremely weak. Average home prices in many areas declined, pressured by the large number of foreclosed properties for sale. Commercial contractors noted a further decline in nonresidential construction. Most manufacturing contacts noted reduced production and declines in new orders. Credit conditions remained tight for both businesses and consumers. Labor markets weakened further and holiday-related hiring plans were restrained. Cost pressures for businesses eased on declining commodity prices and weaker demand.

Consumer Spending and Tourism

District retail contacts indicated that they were more pessimistic in October and early November than in the previous report. While households benefitted from declines in gasoline prices, this did not appear to be enough to boost overall retail spending. Sales activity heading into the holiday season was described as weak, and expectations for December sales were somber. The majority of retail contacts reported that inventories were above plan. In an attempt to stimulate sales, several retailers noted that they have expanded store hours, increased advertising, and plan deeper discounts. Some stores have begun to offer layaways as an incentive for budget-conscious shoppers who are unable or unwilling to use credit. Automobile dealers observed that sales deteriorated further, and that traffic was well below year-ago levels. Several dealers noted that they were trying to boost fleet and lease sales in an attempt to offset declines in the retail market.

After being a relative bright spot in the District economy for most of the year, tourism activity deteriorated more recently. Reportedly, visitor numbers at tourist destinations weakened, and visitors were spending less per trip. Several cruise lines and resorts were aggressively discounting prices in an effort to boost traffic. Business travel was also down according to contacts in the convention industry.

Real Estate and Construction

Reports from homebuilders and Realtors indicated that new and existing home sales remained weak in October through mid-November. Many contacts reported that worsening employment conditions and the unavailability of financing was restraining sales. However, some markets, particularly in Florida, saw modest gains in sales over weak year-ago levels. District homebuilders continued to pull back on construction in the face of historically high inventory numbers. Home prices continued to soften in the District with contacts indicating that the large volume of foreclosed properties for sale was exerting downward pressure on new and existing home prices. According to District contacts, the outlook for residential sales and construction activity remains weak.

Most District commercial contractors continued to report declines in activity. More projects were postponed or cancelled because of funding constraints and weak economic conditions. Nonetheless, contacts also noted that more existing space had been put back into the commercial real estate market, particularly in retail. Going forward, most commercial real estate contacts anticipate softer leasing demand, while developers expect commercial construction activity to decline further.

Manufacturing and Transportation

Most manufacturing contacts reported declines in production and new orders during October and early November compared with a year earlier. The decline in production was exacerbated by a decrease in export demand. Many reports noted additional cuts to payrolls and hours, with most expecting weak conditions to persist into the new-year. Several firms remarked that they had scaled back their capital investment plans. Transportation contacts reported lower shipments of automotive and construction materials, far offsetting modest gains in shipments of chemicals and coal. Most contacts reported that holiday-related shipments of consumer goods were down significantly from last year.

Banking and Finance

According to most banking contacts in the District, business and consumer lending activity decreased during October through mid-November. Credit conditions remained tight, and competition for deposits increased. Some contacts, especially in the real estate industry, observed that the restricted access to credit was forcing them out of business. Most banking contacts indicated that they did not expect credit conditions to change materially in the near-term as banks focused on repairing their damaged balance sheets.

Employment and Prices

District employment trends weakened further in October through mid-November. Several businesses noted that layoffs accelerated and that hours declined. Retailers scaled back holiday-related hiring plans because of weak sales expectations, although the negative reports were fairly widespread across most industries. For businesses that reported they were hiring, several indicated difficulty in recruiting workers because of increasing relocation costs resulting from having to sell an existing home.

Because of lower input costs and weaker demand, most District contacts reported that they did not plan on raising output prices. Contacts in manufacturing, business equipment supply, and construction mentioned that costs had stabilized after a long run of increases in recent years. Sources in the tourism industry noted difficulty raising prices because of a sharp drop in demand. Some retail and food service contacts reported a few instances of higher input costs, but also indicated that they were generally unsuccessful in passing these costs on to customers. Apart from some healthcare and other high-skilled technical positions, most contacts suggested that wage pressures continued to diminish.

Natural Resources and Agriculture

Energy industry contacts reported that much of the damage that resulted from Hurricanes Ike and Gustav to the region's oil, gas, and petrochemical infrastructure had been repaired by mid-November. Total production of oil and natural gas had not returned to pre-hurricane levels, however. Falling energy prices and tight financing conditions prompted several energy industry firms to consider cutting new investment and expansion plans.

Cotton farmers reported price declines despite the smallest regional crop in 25 years, which was a result of a drop in global cotton demand. While domestic poultry demand remained subdued, poultry producers experienced relatively strong export sales to Asia, Mexico, and Eastern Europe.

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Seventh District--Chicago

Economic activity in the Seventh District declined in October and early November, and contacts expressed concern over the potential length of this downturn. Consumer spending decreased and labor market conditions weakened; residential and nonresidential construction both declined; and manufacturing activity moved lower. Credit conditions remained tight, but improved in some markets. Cost pressures from material and energy prices eased, and wage pressures continued to be low. There were further delays in corn harvesting due to precipitation. Corn, soybean, milk, hog, and cattle prices all fell during the reporting period.

Consumer Spending

Consumer spending decreased in October and early November, as households continued to tighten their budgets. Retailers reported declines in sales, particularly for big-ticket items, as the response to discount pricing promotions was seen as sluggish. Fast-food restaurants and discount stores continued to fare better than their higher-priced counterparts. Contacts expressed concern that the holiday shopping season would be weak. Gasoline sales fell despite the decline in prices, and tourism activity in the District was lower. Auto dealers reported lower demand for luxury vehicles as well as continued weakness in sales of less fuel efficient vehicles. Service center activity picked up as car owners chose to maintain or repair existing vehicles instead of buying new ones. Contacts also indicated that credit for consumer auto loans remained tight, with an increasing number of banks tightening standards or exiting the business.

Business Spending

The pace of business spending declined from the previous reporting period. Several contacts reported delaying or postponing hiring or capital spending projects. Others noted greater caution given the high level of uncertainty surrounding the economic outlook. Labor market conditions in the District also weakened. Layoffs were reported in several industries, and covered both hourly and salaried workers. Some of these job cuts were in progress while others were planned for the future. Further weakness in the demand for labor was expected in retail trade, transportation and warehousing, temporary help, and professional services. Manufacturing, construction, and financial services employment remained weak but were expected to see smaller declines going forward. Contacts also noted a reduction in hours worked. Staffing firms reported a decline in demand for their services. However, the demand for skilled labor remained strong.

Construction and Real Estate

Construction activity declined in October and early November. Residential building continued its steady decline. Project delays and cancellations persisted and credit remained tight. Housing prices continued to fall and residential rents softened in some parts of the District. Contacts reported low levels of showroom traffic and that prospective home buyers consisted mostly of first-time and other buyers who were unencumbered by the need to sell an existing home. However, several contacts noted that inventories of unsold new homes had declined some from their recent highs. Mortgage originations and refinancings were down due to tightening credit standards, an increase in mortgage rates, and declining home equity as well as other factors weighing on housing demand. Nonresidential development and construction also declined, with several contacts reporting a weaker outlook than in September. Slowing activity was cited for public works, office, retail, and industrial construction. Cancellations and project delays were again reported. Furthermore, several contacts noted downward pressure on commercial rents and an uptick in vacancy and sublease space. The availability and cost of financing also continued to be of concern for developers.

Manufacturing

Manufacturing activity in the District declined from the previous reporting period. However, contacts noted that inventories continued to be at comfortable levels. Activity weakened substantially in the domestic steel industry. Contacts in the lake freighter industry have taken boats out of service early due to lack of demand for raw materials for the steel industry. Demand also softened for construction machinery, medium- and heavy-trucks, and for manufacturers with close ties to housing, such as building materials, home appliances and furnishings. In contrast, manufacturers of heavy machinery used in sectors such as oil and gas extraction and mining continued to report strong activity, although one manufacturer noted that "the steam is coming out of these markets." Production of pharmaceuticals and medical goods remained a source of strength. Aviation manufacturing contacts noted that even though the Boeing strike had ended some lingering negative effects of the walkout on production may remain. Exporters reported that demand from Europe continued to slow, and that demand in emerging markets such as China was also weaker. Automakers noted an uptick in sales in November from their low levels in October. Contacts in several industries expressed concern over the effect of a possible failure of one of the automakers on demand for their products. Most contacts reported little impact of tighter business credit on their own operations. However, several contacts noted reports of difficulties faced by others in their industries including exporters, suppliers, smaller firms, and the automakers.

Banking and Finance

Credit conditions in the District continued to be tight, but improved in some markets. Though the cost of funds for banks and other financial institutions remained elevated, it improved from September. The FDIC's debt guarantee program and Federal Reserve lending were said to have improved liquidity in the interbank market. Banking contacts noted a decline in business loan demand as nonfinancial firms were deleveraging. They also indicated that credit line utilization had stabilized after a brief spike in September, and that the increased coverage of FDIC insurance had slowed deposit outflows. A contact in commercial real estate finance reported that loan quality had begun to deteriorate, and that banks were tightening standards while non-bank credit availability was decreasing. In addition, the secondary markets for commercial as well as nonconforming residential mortgages were noted to have tightened further. Conditions in the commercial paper market were noted to have improved, although one contact stated that difficulties were starting to appear for nonfinancial firms. Contacts also indicated greater liquidity in the credit default swap market, but that the net cost of capital had increased as credit risk continued to boost borrowing spreads.

Prices and Costs

Material and energy prices moderated from the previous reporting period. Several contacts noted declines in gasoline, steel, and scrap prices. In contrast, price increases were reported for concrete, plastics, and shipping containers. Fuel surcharges also continued to be of concern as the price of diesel fuel remained elevated. Contacts also reported that despite recent declines in raw materials prices, some costs remained elevated due to contracts signed earlier in the year. Wage pressures were limited, with some downward impetus reported. Pass-through of previous input price increases to downstream prices continued; albeit to a lesser degree, with several contacts in retail trade lowering prices in response to weaker demand.

Agriculture

The soybean harvest finished in the District, but the corn harvest experienced delays due to precipitation, especially in Iowa. Soybean yields were down from a year ago, although overall output was higher due to the shift in acreage planted toward beans. Conversely, corn yields were up, but reduced acreage resulted in lower overall output. Much of this year's corn and soybean harvest had already been sold ahead at profitable prices, with most of the rest going into storage instead of being sold at today's lower prices. With little interest in selling crops today, the spreads between futures and cash prices declined. The ethanol industry was squeezed by lower prices for ethanol, with some firms also facing cost pressure due to corn purchased under earlier contracts at elevated prices. A major ethanol producer filed for bankruptcy protection, creating uncertainty for farmers with contracts to sell corn to the firm in the future. Milk, hog, and cattle prices moved lower, and there were concerns about bankruptcies in the livestock industry.

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Eighth District--St. Louis

Business conditions in the Eighth District have continued to weaken. Retail and auto sales in October and early November were down, on average, compared with year-ago levels. Since our last report, manufacturing experienced significant declines, but the services sector improved slightly. Residential real estate activity decreased, while commercial real estate was mixed. Banks reported tightening in credit standards and weaker demand for loans during the three-month period ending in October.

Consumer Spending

Contacts reported that retail sales in October and the first half of November were down, on average, over year-earlier levels. About 81 percent reported decreases, while the rest reported increases. About 64 percent reported that sales were below expectations, and 23 percent said that sales were above expectations. Essential items were strong sellers, while high-end furniture, apparel, and gift items sales slowed. About 46 percent noted that inventories were at desired levels, but the remainder said they were too high. The sales outlook among retailers for the rest of 2008 was generally pessimistic, with 58 percent expecting decreases over 2007 levels and 27 percent expecting increases.

Car dealers surveyed reported that, compared with last year, sales in October and the first half of November were down, on average, with all contacts reporting a decrease. One-third noted that used car sales had increased relative to new, and 38 percent reported an increase in low-end vehicle sales relative to high-end. About 46 percent reported recent increases in rebates and incentives, while 8 percent reported fewer rebates. Two-thirds reported a recent increase in rejections of finance applications. About 88 percent said that their inventories were too high (mostly on new cars, high-end cars, trucks, and sport utility vehicles), and 12 percent had inventories at desired levels. For the rest of 2008, 92 percent of the car dealers expect sales to decrease over 2007 levels, but 8 percent expect sales to increase.

Manufacturing and Other Business Activity

Overall manufacturing activity has continued to decline since our previous report. Several firms in paper products manufacturing, machinery manufacturing, wood products manufacturing, glass/glass product manufacturing, and auto parts and automobile manufacturing announced plans to idle production. Firms in the cement, primary metal, fabricated metal, building products, machinery, printing, animal slaughtering/processing and auto parts manufacturing industries reported plans to close plants. Multiple firms in the primary metal, household appliance and machinery manufacturing industries reported job losses. Firms in electrical product, plastic parts, apparel, lumber, furniture, boat manufacturing, animal slaughtering/processing, and food manufacturing industries announced plans for layoffs. Mineral and primary metal manufacturing and the plastic products manufacturing industries experienced strikes, decreasing production. On the other hand, contacts in aerospace product/parts, auto parts, food and primary metal manufacturing reported plans to expand existing facilities and operations. A firm in the auto parts manufacturing industry announced plans to rehire and start production after a three month plant idling. Firms in electrical equipment, machinery, natural gas, and auto parts manufacturing reported plans to open new facilities. These firms also reported plans to hire additional workers.

Contacts in business support services reported new contracts and hiring plans. A firm in the transportation services sector announced expansion and new hiring plans. Firms in medical, financial, business support, tourism, rental/leasing, information and dry cleaning/laundry services, however, announced plans to lay off workers.

Real Estate and Construction

Home sales continued to decline throughout the Eighth District. Compared with the same period in 2007, October 2008 year-to-date sales were down 14 percent in St. Louis, 19 percent in Memphis, 20 percent in Little Rock, and 22 percent in Louisville. Residential construction continued to decline as well. September 2008 year-to-date single family housing permits fell in nearly all District metro areas compared with the same period in 2007. Permits declined 35 percent in Little Rock, 41 percent in Louisville, 42 percent in St. Louis, and 57 percent in Memphis.

Commercial real estate was mixed. The third quarter 2008 industrial vacancy rates in St. Louis and Memphis decreased over the second quarter of 2008, while industrial vacancy rates in Louisville and Little Rock increased. During the same period, suburban office vacancy rates decreased in St. Louis, Little Rock, and Memphis, but increased in Louisville. Downtown office vacancy rates decreased in Memphis and St. Louis but increased in Louisville and Little Rock. A non-residential construction contact in St. Louis reported concerns about current credit market conditions. A commercial construction contact reported that interest in new projects has slowed sharply throughout the District. An industrial construction contact in Little Rock reported that activity has held steady and that, because of the upcoming construction of several facilities related to wind energy, the outlook is positive. A contact in Louisville reported that industrial developers are cautiously optimistic about the fourth quarter.

Banking and Finance

A survey of loan officers showed a decline in overall lending activity in the three months ending in October. Credit standards for commercial and industrial loans and for commercial real estate loans tightened, while demand for these loans ranged from unchanged to weaker. Meanwhile, credit standards for consumer loans ranged from tightened somewhat to unchanged, while demand for these loans was also weaker. Demand for all types of residential mortgage loans was moderately weaker, while credit standards for these loans tightened somewhat.

Agriculture and Natural Resources

Good weather conditions helped farmers make significant progress with harvesting, which was nearly finished as of mid-November. Between October and November, yield estimates for crops changed by less than 6 percent except for cotton in Arkansas (which decreased by 10 percent), sorghum in Illinois and cotton in Tennessee (both increasing by about 10 percent). Most District states were ahead of normal with winter wheat planting, but crop growth was slightly behind normal in most states. Similar to last year, at least 90 percent of the winter wheat in each state with available data was rated fair or better.

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Ninth District--Minneapolis

Ninth District economic activity contracted since the last report. Decreased activity was noted in consumer spending and tourism, services, construction and real estate, manufacturing and mining. However, the energy sector was mixed and agricultural conditions improved since the last report. Labor markets continued to weaken. Overall wage increases were modest, while a number of product prices decreased.

Consumer Spending and Tourism

Consumer spending decreased. A major Minneapolis-based retailer reported that same-store sales in October were down almost 5 percent compared with a year earlier. Furthermore, a major Minnesota-based electronics retailer reported that October same-store sales were down almost 8 percent from a year ago. A North Dakota mall manager reported that sales during the first half of November were down but sales were up 3.5 percent in October. A number of retailers were pessimistic about the upcoming holiday sales season. According to preliminary results of the Minneapolis Fed's annual business outlook poll, 85 percent of respondents expect consumer spending to decrease in their communities in 2009 compared with 47 percent in last year's poll.

Tighter credit standards for auto loans hindered some vehicle sales. According to an auto dealers association in Minnesota, recent vehicle sales were down; smaller, fuel-efficient cars continued to gain market share, while larger SUVs and trucks lost. Early November auto sales were "awful," according to a Minnesota dealer of domestic vehicles.

Fall tourism was down modestly compared with a year ago, although some tourism businesses were cautiously optimistic for the winter season due in part to lower gas prices. In South Dakota, fall tourism was off slightly; some cancellations were noted at hunting reserves in the eastern part of the state, according to an official. Meanwhile, in northwestern Wisconsin, tourism activity was relatively strong, although some high-end restaurants and retailers noted sharp declines in business.

Services

Activity in the services sector decreased since the last report. Services industry respondents to the Minneapolis Fed's business outlook poll expressed disappointing results and expect decreased sales, employment and capital investment in 2009. Contacts from architectural and information technology firms reported a slowdown in new business. However, professional business firms dealing with financially distressed companies and bankruptcy lawyers were the most optimistic and were experiencing a boom in business.

Construction and Real Estate

Construction activity decreased. Results from the business outlook poll indicated that 73 percent of construction industry respondents expect sales to be down in 2009, and 71 percent expect to decrease investment. In the Duluth, Minn., area, large projects that have been started are continuing forward, but projects on the drawing board have been delayed, according to a Bank director. Residential construction was down slightly. October residential permits in Sioux Falls, S.D., and Fargo, N.D., were down 13 percent and 21 percent, respectively. Residential permits in Minneapolis-St. Paul were flat from a year earlier.

Commercial real estate slowed. A contact from a Minneapolis-St. Paul commercial real estate firm said tighter financing is constraining sales, while a contact in Fargo said activity was flat. Residential real estate remained depressed. Home sales in Sioux Falls were down 8 percent, and a Realtor in western Montana estimated sales were down more than 20 percent. October closed sales in the Minneapolis-St. Paul area increased 12 percent from the previous year, but prices continued to slide.

Manufacturing

Overall manufacturing activity was down since the last report. Based on results from the business outlook poll, respondents from the manufacturing sector expect decreased sales, employment and capital investment in 2009. According to preliminary results of a November survey of manufacturers by the Minneapolis Fed and the Minnesota Department of Employment and Economic Development, manufacturers expect declining orders, employment and production in 2009 after a flat 2008. Meanwhile, an October survey of purchasing managers by Creighton University (Omaha, Neb.) indicated significantly decreased activity in Minnesota, but increased activity in the Dakotas.

Energy and Mining

Activity in the energy sector was mixed, and the mining sector contracted since the last report. Oil and gas exploration continued at a strong pace, but showed some recent signs of weakening. Wind energy farms continue to be built; however, several bioenergy facilities were shut down due to lower output prices and high input costs. Several mines in the District reduced production due to decreased metal prices. For example, two iron ore mines in northern Minnesota cut production by 30 percent.

Agriculture

Agricultural conditions improved since the last report. Results of the Minneapolis Fed's third-quarter (October) survey of agricultural credit conditions indicated that lenders expect overall agricultural income and spending to be up in the fourth quarter. Even though the harvest is behind the pace of a year ago for most major District crops, production is expected to increase for corn and remain level for soybeans from last year's bumper crop.

Employment, Wages and Prices

Labor markets weakened since the last report, as a number of companies announced layoffs. For example, a Minnesota vehicle manufacturing plant will lay off 760 workers during December. Also in Minnesota, a health care provider announced plans to eliminate up to 350 jobs, a provider of semiconductor equipment recently announced plans to lay off 200 employees over the next 12 to 15 months and a lumber plant closed in October for an indefinite period affecting 140 workers. A residential window manufacturer announced plans to lay off 52 employees at a plant in northwestern Wisconsin. A Montana lumber mill laid off 23 employees. Initial claims for Minnesota unemployment insurance were up 31 percent in October compared with a year earlier. Employers in the Billings, Mont., area expect to keep staff levels about the same over the next six months. In contrast, contacts in North and South Dakota reported trouble finding skilled workers.

Wage increases were modest. More than 40 percent of business outlook poll respondents expect wages to increase 1 percent or less in their communities during 2009. The outlook for wage increases in most sectors is flat to up slightly.

A number of prices decreased since the last report. Minnesota gasoline prices in mid-November were more than $1.50 per gallon lower than prices at the end of September and $1.10 lower than a year ago. Lumber prices decreased from the last report and from year ago. A Bank director noted that agricultural input prices, including fertilizer and fuel, were recently decreasing, but so were agricultural commodity prices. Aluminum, copper and steel prices were also down. A Minnesota manufacturer noted success in passing along input cost increases to customers, but will likely lower prices going forward.

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Tenth District--Kansas City

The Tenth District economy weakened in October and November. Consumer spending and manufacturing activity declined, and the slowdown in commercial real estate intensified. Residential real estate activity continued on a downward trend and the energy sector slowed moderately, while agricultural conditions were largely unchanged. Bankers reported tighter credit standards, lower loan demand, and weaker loan quality. Most business contacts expressed little optimism about economic activity going forward. Price pressures eased further with falling energy prices, and wage pressures diminished due to weakness in the labor market.

Consumer Spending

Consumer spending slowed sharply in October and November, and expectations for future activity also diminished. Retail sales fell from the last survey period, and most retailers expected a continued downward trend going forward. Store managers reported a slowdown across nearly all spending categories, with luxury items especially weak. Store inventories remained fairly flat, however, as the recent weak sales were largely expected. Auto sales also dropped from the previous period, with continued weakness expected in the months ahead. Several auto dealers noted strong demand in the used car market, but many contacts cited increased difficulties in obtaining financing for used cars. Travel and tourism activity remained sluggish, with several hotel contacts reporting less business travel. Virtually all tourism contacts expected travel activity to weaken further in coming months. Restaurant traffic was down sharply from the previous survey. Several restaurant contacts noted a particular decline in senior citizen traffic, which they attributed to recent losses in retirement income.

Manufacturing

Manufacturing activity declined sharply after slowing in the late summer months. Overall production was weak at both durable and non-durable-goods producing plants. Most plant managers reported sizable decreases in shipments, new orders, and order backlogs, and several firms reported recent layoffs or temporary plant shutdowns due to falling demand. Expectations for future factory activity also dropped considerably, and many firms anticipated declines in revenues for 2009. Some contacts noted that tight credit markets had prevented customers from moving forward on planned projects. Export orders continued to fall from high levels posted in the first half of the year, but some contacts expected a slight rebound in exports heading forward.

Real Estate and Construction

Residential real estate activity weakened further in October and November, while the slowdown in commercial real estate activity intensified. Home sales decreased from the previous survey, and expectations for future sales were also sluggish. Real estate agents reported higher demand for lower-priced homes than for homes in the mid to upper-level price range. Home inventories stabilized somewhat, but still remained at very high levels. Residential construction activity slowed, with several contacts reporting an increase in builder bankruptcy filings. Mortgage origination loans declined further, and contacts reported a considerable drop in home refinancing. Commercial real estate activity fell across the District, and future expectations remained weak. Contacts cited much tougher lending restrictions and reduced investment activity. Vacancy rates increased substantially from the prior period, and absorption declined further. Rental rates also fell considerably, with levels well below a year ago. Most real estate contacts expected a decrease in revenue growth for 2009 due to slower sales and reduced credit access.

Banking

Bankers reported lower loan demand, tighter credit standards, and weaker loan quality since the last survey. The net fraction of banks reporting a decline in overall loan demand was substantially greater than in the previous survey, and demand was reported to be down for all major loan categories except agricultural loans. Most community banks reported no signs of customers drawing down lines of credit, but some large companies reported using credit lines with large banks due to strains in commercial paper and bond markets. About the same fraction of banks as in the last survey said they had tightened credit standards, and such tightening remained especially high for commercial real estate loans. Assessments of current loan quality were similar to the last survey, but expectations for future loan quality declined. Just under half of respondents reported increases in deposits, and most attributed the increases to a flight to quality. One bank noted that availability of deposits had become a much bigger constraint on its lending than capital, due to aggressive competition for funds from large institutions.

Energy

Energy activity moderated somewhat, as oil and natural gas prices fell further. Most contacts reported a decrease in drilling activity, though generally from very high levels. Producers' expectations for future drilling also dropped markedly, with several contacts expecting the national rig count to fall by approximately 25 percent over the next year. Natural gas wellhead prices were especially low in some areas of the District, due to full pipelines. While most contacts expected a modest rise in oil and natural gas prices in coming months, several noted risks to a rebound in regional drilling in 2009. These included increased productivity of recently deployed rigs, the return of previously shut down Gulf Coast production, and the potential for weaker than expected demand.

Agriculture

Agricultural conditions held steady in October and November. The fall harvest was almost complete and winter wheat emergence progressed normally. Above-average corn and soybean yields, especially in Nebraska and Kansas, helped support farm incomes. A drop in cattle and hog prices due to slower domestic and export meat demand squeezed profit margins for livestock operators. Farm loan demand strengthened with rising input costs, and the availability of funds for operating loans fell modestly. District contacts reported increased collateral requirements for farm loans and expected further tightening in credit conditions in coming months. After a seasonal summer pause, farmland values moved higher this fall.

Wages and Prices

Price pressures eased further in October and November, and wage pressures were limited due to softer labor markets. Manufacturers reported a sharp deceleration in raw materials prices, and fewer producers than in previous surveys planned to raise selling prices. One contact noted that steel prices--for rebar and scrap metal--had dropped approximately 30 percent since the last survey. Overall retail prices were generally stable, but some contacts expected prices to moderate in coming months. Fewer firms than in previous surveys reported labor shortages, resulting in minimal wage pressures. Many contacts indicated wage growth in 2009 would be less than in past years due to uncertain economic conditions and lower forecasted revenue growth.

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Eleventh District--Dallas

There was a broad-based weakening of the Eleventh District economy in October and the first half of November. While there were a few exceptions, most businesses reported declines in production and/or new orders. Both manufacturing and staffing services noted a particularly sharp reduction in activity. Many contacts reported that they were being impacted by the weakness in the national economy and the crisis in the credit markets. Almost all respondents voiced concern about the near-term outlook with expectations of improvement ranging from about four to twelve months away.

Prices

There has been a broad-based easing of price pressures since the last survey. Many respondents reported that they resisted price cutting pressures from their customers but that they expected to lower prices over the next several months. Many respondents, particularly in durable goods manufacturing, said that they had not yet passed on cost increases from the beginning of the year and that even though costs had fallen in recent months, margins were still slim. Retailers reported that they had begun to offer discounts earlier than normal in anticipation of a weak holiday season.

In mid-November crude oil prices dropped below $50 per barrel from near $90 in early October. Oil product prices have fallen along with crude oil, as gasoline prices at the pump are down by about 40 percent and diesel is down by 30 percent. Natural gas prices have held steady at around $6.50 per thousand cubic feet although contacts said that if the winter is mild it is likely that prices will fall.

Labor Market

Many respondents reported that they were cutting hours and temp positions and that overall employment was flat to down. Job cuts were particularly pronounced in the manufacturing sector. Two out of three respondents in the paper industry said that they were cutting at least 10 percent of their workforce. Many respondents said that while conditions had weakened that they were trying to hold on to their skilled workers. Several companies had requested that their employees voluntarily reduce hours or take days off without pay. The main exception was accounting firms which continued to add staff but at a slower pace. Staffing services reported a significant decline in demand for temporary workers. Most industries reported little if any wage pressures.

Manufacturing

Most manufacturers reported declines in activity since the last survey and did not expect improvement until at least the first quarter of 2009. Most producers said that their inventories are lean and near desired levels.

Construction-related manufacturers reported falling activity due to continued low demand from residential builders and a drop off in demand from commercial construction. Producers of stone, clay and glass reported that demand fell sharply since the last survey. Primary and fabricated metal producers report that production has remained relatively flat but that new orders are down significantly. Many contacts expressed concern that commercial builders no longer have access to credit which will likely reduce demand for construction-related materials well into 2009.

Respondents in high-tech manufacturing report that orders have weakened since that last survey. Orders from businesses for high-tech machinery and equipment fell sharply. Demand for consumer products was moderately weaker with some low-end electronics seeing some strength. Contacts reported that they were surprised by the sudden weakness in demand from businesses in Asia although consumer demand appears to be holding up. Most respondents reported that inventories were near desired levels, although one respondent noted that they were above desired levels and that they will be paring them down over the next few months. Respondents expect demand from businesses to continue weak for six to twelve months and consumer demand to improve near the second quarter of 2009.

Paper manufacturers reported continued declines in demand, with corrugated boxes particularly weak. There were several industries that were exceptions to the recent decline in activity. Food processors reported that demand increased since the last survey. Demand for emergency services vehicles continues to be strong and aircraft parts contacts anticipate increased orders over the next several months.

Retail Sales

Overall retail sales softened since the last survey although respondents said that conditions remain better than most areas in the country. Discount stores are not slowing as much as department stores. Respondents report that the average dollars spent per customer is falling. This is consistent with reports that nondiscretionary items are driving sales and big ticket items like electronics and house wares have been hit especially hard. This trend is expected to continue through the holiday season and many respondents said they are cutting back capital expenditures for 2009.

Auto dealers report that sales and traffic have dropped further from the low levels six weeks ago. Most respondents think the market will continue to be very weak at least until mid-2009 and are keeping inventories at a bare minimum.

Services

Staffing firms report that they are seeing weakness across a wide range of industries. Contacts report that some positions have been eliminated and others are taking longer to fill. Demand is mostly for contract work and short-term assignments while orders for direct hires have dwindled. Sales at accounting service firms continues to grow at a moderate pace and contacts say they are cautiously optimistic about demand over the next few months. Demand for legal services has been steady to slightly weaker. Transactional demand is weak, particularly for banks and real estate firms, while litigation and bankruptcy activity remains strong. Legal firms report that receivables are slowing and getting more difficult to collect.

Airlines report that business demand has declined and future bookings suggest continued weakness over the next several months. Demand for barge services has slowed and contacts said they expect conditions to weaken further in the months ahead. Intermodal services and railroads reported decreased volumes. Railroads said that there were significant declines in shipments of construction-related materials, autos, pulp and paper, petroleum products and chemicals.

Construction

Housing market conditions worsened significantly over the past six weeks, according to contacts. Homebuilders said sales in October and early November were extremely weak and current traffic is nonexistent. There were reports of buyers walking away from their new homes, forfeiting their deposits. Respondents noted consumers' concerns about the financial and economic environment have them in survival mode; the last thing on their minds is buying a home. Builders continued to curb new construction.

Elevated foreclosures and large price incentives from some builders exerted downward pressure on prices. Home values have held up relatively well in Texas markets, and the recent dips remain modest compared to other parts of the country, say contacts. Respondents said apartment demand remains relatively solid and rental growth remains positive but slower.

Commercial real estate contacts said leasing activity and investment continue to be hampered by credit conditions. Businesses have abruptly halted leasing and expansion decisions, as they take a wait-and-see approach. The commercial investment market has ground to a halt with lenders unwilling or unable to lend and investors unwilling to take any risk. On a bright note, contacts noted businesses were acting orderly and pragmatically, just waiting for things to bottom out, and were not behaving in a panic mode.

Financial Services

Financial industry contacts report that fewer single-family and commercial real estate deals are getting done. Consumer lending is somewhat softer with credit card sales volume decreasing, and some deterioration in overall loan quality. Contacts foresee a weak, highly-uncertain economy and continue to evaluate potential borrowers with the same high level of scrutiny as reported in the last survey. Credit standards remain tight and banks are being extremely careful about double-checking the quality of every deal they make. While credit unions are also being extremely careful, they said that they have been slightly more aggressive. Downsizing in staff is occurring at a number of institutions, both as a result of mergers/acquisitions as well as the weak economy. While the cost of capital is still elevated, larger institutions reportedly feel less constrained after receiving TARP money and somewhat more comfortable supplying loans. At the same time, it's been harder for many lenders to widen loan interest-rate spreads further over the last six weeks. Several contacts, especially smaller banks, reported stiffer guidelines from regulators making it difficult to forge any new deals. While competition for new deposits is tough, institutions saw an increase in deposits due to a flight to quality from riskier investments.

Energy

Refiners have largely recovered from Hurricane Ike, and have operated in recent weeks at 87 percent capacity utilization, down about 2 percentage points from the same time last year. Oil services and machinery companies are beginning to see the leading edge of a downturn in drilling activity. The price of natural gas in mid-November was high enough to avoid major cuts in drilling. However, the price may be at risk due to ample winter inventories, higher-than-expected Canadian supplies, US production up 6 percent over the last 12 months, and recession-reduced industrial loads. Cuts in capital spending have been announced by a number of producers.

Agriculture

Growing conditions in much of the District remained generally favorable. However, contacts said the recent hurricanes caused over $1 billion in crop and livestock losses. There is a lot of fear among agricultural producers about the impact the ongoing financial crisis will have on the cost of credit and their ability to access it when they refinance agricultural loans for 2009. Crop and cattle prices have plummeted since the last survey.

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Twelfth District--San Francisco

Economic activity in the Twelfth District weakened decidedly during the survey period of mid-October through late November. Upward price pressures eased overall because of declines in the prices of energy and some commodities and widespread discounting in the retail sector. Most retailers struggled with unusually weak demand on a seasonal basis, and demand for services continued to fall. Manufacturing activity slowed further. Agricultural sales generally continued at a brisk pace, but energy providers faced declining demand and falling output prices. Activity in District housing markets remained weak on net, and demand for commercial real estate continued to erode. Contacts from financial institutions reported weaker loan demand amidst sharply restricted credit availability and further tightening of lending standards.

Wages and Prices

Upward pressures on prices moderated during the survey period. Prices continued to fall for energy and selected commodities, including many food products and raw materials, and contacts noted declines in the prices of transportation services. Despite widespread declines in input prices, a few contacts noted the continued pass-through of past increases to final prices. Extensive discounting held down final prices for many retail items, and retailers anticipate further discounting, in line with expectations for an unusually weak holiday spending season.

Upward pressures on wages have largely disappeared. Contacts reported job cuts and hiring freezes across a wide range of industries, causing unemployment to rise in most areas. The few open positions have been attracting large numbers of applicants, thereby alleviating upward wage pressures. Wage gains have slowed markedly for worker groups who previously had seen rapid growth, notably those skilled in the use of advanced technologies.

Retail Trade and Services

Retail sales deteriorated further, and contacts expect significantly weaker holiday spending than in prior years. While sales remained largely stable for necessities such as food, contacts reported further declines in sales of big-ticket discretionary items such as furniture and household appliances and luxury items such as jewelry. Sales also slowed for electronic items and outdoor equipment, which had shown growth in recent survey periods. The sales slowdown was especially pronounced for traditional department stores, which have reduced inventories accordingly, but discount chains fared much better as consumers switched away from high-priced items. Sales fell further for all types of automobiles, and limited credit availability remained a significant constraint on purchases.

Demand for services declined further compared with the previous survey period. Providers of health-care services reported slower activity and concerns over their ability to issue debt to fund needed capital spending. Sales continued to weaken for providers of professional services such as advertising, legal services, accounting, and consulting. Providers of real estate services such as title insurance reported very low levels of activity, with further reductions in some areas. Travel activity fell in major District destinations: contacts from Southern California reported a rising incidence of canceled corporate meetings, and tourist visits and spending have dropped sharply in Hawaii. Restaurants throughout the District have seen their business drop off; some have closed, and more closures are expected in coming months.

Manufacturing

District manufacturing activity slowed further during the survey period of mid-October through late November. Makers of semiconductors and other information technology products reported a recent slowdown in sales due to a drop in domestic and overseas demand. Producers of wood products continued to struggle, with one contact describing the current lumber market as being the "worst in 25 years." Capacity utilization rates at petroleum refineries remained well below their longer-term average. Metal fabricators faced weak demand, which was held down in part by constraints on their customers' access to financing. One bright spot was manufacturing activity for commercial aircraft makers, which resumed at high levels following the resolution of a protracted labor dispute. Demand remained strong for food manufacturers, although signs of weakening have emerged of late. Firms in manufacturing and other sectors reported further curtailments of recent and planned capital spending.

Agriculture and Resource-related Industries

Demand remained strong for agricultural producers but weakened for providers of natural resources. Although sales continued at a brisk pace for most agricultural products, significant declines in some output prices and higher financing costs put increased pressure on margins. Among oil extractors, weaker demand and lower output prices have reduced the viability of higher cost expansion projects, causing many to be delayed or shelved.

Real Estate and Construction

Activity in the District's housing markets remained weak on net, and demand for commercial real estate eroded further. Home sales were spurred in some areas by the availability of foreclosed units at rock-bottom prices, but the overall sales pace continued to be quite slow in most areas and fell considerably in some, such as parts of the Pacific Northwest. Foreclosure rates remained elevated in parts of Arizona, California, and Nevada, and they rose further in other states, notably Utah and Idaho. Demand for commercial real estate declined, with increases in office and industrial vacancy rates reported for various cities. Contacts reported limited investment in new commercial properties, due in part to constraints on credit access.

Financial Institutions

District banking contacts reported that lending activity and credit conditions weakened significantly during the survey period. Demand for commercial and industrial loans continued to fall, with the decline characterized as sharp in some areas, and new residential mortgages stayed stuck at low levels. Contacts reported that loan delinquencies and credit losses rose moderately during the survey period. Although some banks reported no reduction in their ability to provide credit in recent months, credit access remained quite restricted in general: banks and other financial institutions maintained tight standards for all types of loans, and even high-quality borrowers faced substantial impediments to acquiring funds through debt and private equity.

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January 14, 2009

Summary of Commentary on

Current Economic Conditions

by Federal Reserve District

Summary

Prepared at the Federal Reserve Bank of St. Louis and based on information collected on or before January 5, 2009. This document summarizes comments received from business and other contacts outside the Federal Reserve System and is not a commentary on the views of Federal Reserve officials.

Overall economic activity continued to weaken across almost all of the Federal Reserve Districts since the previous reporting period. Most Districts noted reduced or low activity across a wide range of industries, although a few Districts noted some exceptions in some sectors.

District reports indicate that retail sales were generally weak, particularly during the holiday season. A majority of Districts noted deep discounting during the holiday sales season. Vehicle sales were also weak or down overall in the Districts reporting on them. Manufacturing activity decreased in most Districts. Declines were noted in a wide range of manufacturing industries, with a few exceptions. Services sector activity generally declined across the Districts, with exceptions in some sectors of the Boston, Richmond, and Chicago Districts. Additionally, several Districts noted weaker conditions in transportation services and slow or decreased demand in tourism activity. Conditions in residential real estate markets continued to worsen in most Districts. Reduced home sales, lower prices, or decreases in construction activity were noted in many Districts. Commercial real estate markets deteriorated in most Districts, with weakening construction noted in several Districts. Overall lending activity declined in several Districts, with tight or tightening lending conditions reported in most Districts. Credit quality remained a concern in several Districts. Agricultural conditions were mixed in response to varying weather conditions across the Districts. Mining and energy production activity generally declined since the previous report.

Most Districts reported a general weakening of labor market conditions. Lower energy prices were noted in many of the Districts, and, except for the Richmond District, which mentioned higher prices for raw materials, most reporting Districts noted declining input prices. Wage pressures remained largely contained, and some Districts reported pay freezes or reductions in compensation.

Consumer Spending

Reports of retail sales during the holiday season were generally negative in most Districts. Retail sales during the holiday season were weak or mostly down in the Boston, New York, Philadelphia, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco Districts. However, some contacts in the Boston and New York Districts noted that sales picked up after the holidays. Retail sales in the Cleveland District were flat to down in November (on a month-over-month basis). Most retailers in the Richmond District had disappointing sales during the holiday season. Discount stores fared relatively better in the Philadelphia, Cleveland, Atlanta, Chicago, and San Francisco Districts, although discount stores in the Dallas District reported weak holiday sales. Deep discounting during the holiday season was reported in the New York, Philadelphia, Atlanta, Chicago, Minneapolis, Kansas City, Dallas, and San Francisco Districts. Several Districts reported that luxury and big-ticket items (e.g., jewelry, appliances, and electronics) were weak sellers. Richmond reported that sales of gift cards were weaker than the previous year. In the New York District, cold-weather apparel was a relatively strong seller. Many retailers in the Philadelphia, Atlanta, Kansas City, and Dallas Districts expected continued weakness or sluggish sales. However, expectations were mixed in the Cleveland District, and retailers in the Boston District were watchful.

Each of the ten Districts that reported on vehicle sales indicated that sales during the season were weak or down overall (Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco). Sales of domestic brands were especially weak in the Richmond and Dallas Districts. Chicago reported increased demand for light trucks and San Francisco reported a slight increase in sales of larger used vehicles. Both of these changes were reported to be in response to falling gas prices. In addition, Dallas reported an increase in sales of used vehicles. Several Districts reported a negative outlook among car dealers.

Manufacturing and Other Business Activity

Manufacturing activity continued to fall in most Districts since the previous report, with declines reported across a wide range of industries. Cleveland noted a slump in steel shipping and Chicago noted that domestic steel production slowed. Dallas and Philadelphia indicated that industries related to construction experienced large drops in orders, and Richmond noted that import activity for construction and household products remains notably low. San Francisco reported that activity for producers of wood products remains depressed. Kansas City, St. Louis, Cleveland, and Dallas noted decreases in auto and auto-related manufacturing activity. Cleveland, Dallas, and San Francisco reported that capacity utilization was below normal levels or declined. Boston, Philadelphia, Cleveland, Minneapolis, Chicago, and Kansas City mentioned reductions in capital spending or plans to reduce capital spending in 2009. In contrast, firms in defense and medical-device production in the Minneapolis District reported increased activity, and San Francisco noted that aerospace manufacturing continued at a high level. Food manufacturing and processing remained active in the Philadelphia and Dallas Districts and solid in the San Francisco District.

Activity in the services sector declined throughout most Districts. Cleveland, Richmond, Atlanta, St. Louis, Kansas City, and Dallas reported slowed or declining activity for transportation services, often related to the shipping of construction and manufactured goods. San Francisco, St. Louis, New York, Chicago, Kansas City, and Minneapolis reported declines in travel or tourism-related services. Richmond and Atlanta noted that tourism activity was mixed, and Boston indicated that a majority of consulting and advertising firms reported stable to strong demand. Service activity at auto dealers continued to be robust in the Chicago District, and it increased in the Dallas District.

Real Estate and Construction

Residential real estate activity continued to weaken in nearly all Districts. Boston, Philadelphia, Cleveland, Richmond, Atlanta, St. Louis, Kansas City, and Dallas reported that home sales were weak or had declined. San Francisco reported that despite some pickup in recent months, home sales continued to be quite slow in most parts of the District. In the New York District, the market for new homes continued to weaken in New Jersey, and the higher-priced housing markets nearest to New York City were characterized as especially weak. While the Minneapolis District reported that late December saw an up-tick in residential sale activity in the Minneapolis-St. Paul area, it was reportedly driven by foreclosures and short sales. Increased home sale cancellations were common in a few Districts. Contacts in the Dallas District reported that home sale cancellations remained prevalent, in some cases outpacing sales. Elevated cancellation rates and weak showroom traffic in the Chicago District led developers to remain cautious about expanding inventory levels, and some building contractors in the Cleveland District reported increased inventories because of take-backs from home sales that fell through. Boston, Philadelphia, Atlanta, Kansas City, and San Francisco reported that home prices continued to soften or fall. Median selling prices declined in and around New York City and were reported to have edged down in the Dallas District. Richmond, however, reported that home prices remained steady.

Reporting Districts generally saw a decrease in homebuilding. Atlanta reported that homebuilders continued to pull back on home construction. The Philadelphia and Chicago Districts noted that residential building continued its decline. Residential construction was down in the St. Louis District, remained weak in Cleveland, and was quiet in Minneapolis.

Commercial real estate markets deteriorated in most Districts. Contacts in the Boston District described the commercial real estate market as grim and depressing, and market conditions continued to deteriorate in Richmond. In the Minneapolis District, a contact noted that the market remained in a downturn that has now lasted more than a year. Commercial real estate transactions in the Dallas District have reportedly ground to a halt. Leasing activity was minimal in the Boston District, continued to fall in the Philadelphia District, and was assessed as ranging from slowing to frozen in the Richmond District. Contacts in the Chicago District reported increases in sublease space. Office and industrial leasing is expected to remain steady through the first half of 2009 in the St. Louis District, but San Francisco reported that conditions in their commercial office market remained exceptionally weak. The New York District reported that Manhattan's office vacancy rate climbed to its highest level in two years. Contacts in the Chicago District noted elevated vacancy rates, and contacts in the Kansas City District expected higher vacancy rates going forward. Contacts in the Atlanta District also anticipate that more commercial space will become available.

Reports about commercial construction activity also were downbeat. In the Philadelphia District, commercial construction activity continued to fall. Cleveland reported that construction backlogs have declined for some contractors. Commercial contractors in the Atlanta and Chicago Districts reported declines in building activity and noted that more projects were cancelled or postponed. In St. Louis, contacts in commercial and industrial construction predicted a challenging environment in early 2009. San Francisco reported that commercial construction activity was very limited. Construction-related manufacturing contacts in the Dallas District reported that demand from commercial construction is shrinking rapidly.

Banking and Finance

Most Districts that reported on lending activity indicated that it continued to decline or remained weak, and many Districts reported that credit conditions remained tight or tightened further. Overall lending activity was reported to have slowed or declined in New York, St. Louis, Kansas City, and Dallas; it remained soft or weak in the Chicago and San Francisco Districts. Philadelphia reported a slow rise in outstanding loan volume with gains in real estate loans and consumer credit, but no business-loan growth. Demand for commercial loans was stable to decreasing in the Cleveland and Richmond Districts. Kansas City reported that demand fell for commercial and industrial loans, while San Francisco indicated that commercial and industrial loan volumes were at very low levels. In contrast, St. Louis reported a slight increase in commercial and industrial loans. New York, Cleveland, Richmond, Chicago, Kansas City, and San Francisco noted an increase in residential mortgage refinancing activity. Demand for consumer loans declined in the Cleveland, Kansas City, and Dallas Districts. St. Louis reported an increase in loans to individuals.

Regarding credit conditions, Boston reported that credit availability continues to be a major barrier to commercial real estate activity, and San Francisco noted that the availability of credit remains quite constrained. The New York and Atlanta Districts indicated a general tightening of credit standards, while Kansas City noted tighter standards for commercial real estate and commercial and industrial loans. Credit standards were described as unchanged to tightening further by Cleveland and Richmond, while Dallas noted that depository institutions maintained tight credit standards. Chicago reported that credit conditions remained tight. Credit quality declined or remained a concern in the New York, Philadelphia, Cleveland, Chicago, Kansas City, Dallas, and San Francisco Districts. Default rates on commercial loans are expected to rise in the Boston District. Richmond indicated mixed reports on credit quality.

Agriculture

Weather conditions since the previous report had mixed effects on agricultural activity. Recent rain eased drought conditions in most of the Atlanta District, while parts of the Dallas District were still severely dry. Weather conditions allowed for fieldwork in the Atlanta and Minneapolis Districts but delayed fieldwork in the Richmond and Chicago Districts. The winter wheat crop in the Kansas City District was in good condition, while winter wheat development in the Richmond District was hindered by cooler temperatures and rain in recent weeks. The livestock sector in the Kansas City District and the poultry sector in the Atlanta District reported slowed activity, while production of red meat and some types of poultry decreased in the St. Louis District. The Atlanta, Kansas City, Dallas, and San Francisco Districts reported that farm input costs (e.g., fuel and fertilizer) have moderated or declined recently. Dallas reported that commodity prices have dropped, but Chicago and Kansas City reported that corn and soybean prices have rebounded slightly.

Natural Resource Industries

Activity in the energy sector declined in several Districts since the previous report, with a number of Districts linking the decrease to lower energy prices. In the Atlanta and Minneapolis Districts, oil and gas exploration declined. Kansas City reported a dramatic slowing in energy activity, and Dallas reported a decrease in drilling activity and a decline in the number of active oil rigs since the previous survey. In contrast, energy production did not change in the Cleveland District, and coal production in the St. Louis District was higher in December 2008 than in December 2007. Looking ahead, contacts in the Cleveland and Kansas City Districts expect drilling activity to decline for the first few months of 2009. Regarding capital spending, contacts in the Atlanta District indicate that oil and gas exploration firms re-evaluated expansion plans in response to lower oil prices and difficulty obtaining credit. Energy producers in the Kansas City District are cutting capital budgets, but producers in the Cleveland District expect little change to their capital spending in early 2009. Finally, iron ore production in the Minneapolis District decreased since the previous report.

Labor Markets

Most Districts reported a general weakening of labor market conditions. Most Districts reported that layoffs continued, and Boston, Cleveland, Richmond, Atlanta, and Dallas noted hiring freezes for select firms. Atlanta, Chicago, and Dallas reported reduced hours to control costs. Job losses in the manufacturing sector were reported by contacts in the Cleveland, Richmond, Chicago, St. Louis, Minneapolis, Kansas City, and Dallas Districts. Dallas noted that layoffs were becoming widespread in the energy industry, and New York noted that a substantial number of job reductions in the financial sector have yet to show up in payroll statistics. Richmond reported weaker demand for temporary workers. In contrast, contacts in Chicago indicated that demand for skilled workers remained strong. Richmond noted that demand was strongest for workers providing professional and support services, workers with high-level technical skills, and workers proficient in computer software. Chicago noted employment growth in the education, government, and healthcare fields. St. Louis also noted job growth in some small business support services firms. Cleveland reported continued hiring in defense-related and healthcare industries.

Prices

Consumers saw sizable holiday price cuts in retail stores in a majority of the Districts. Retail contacts in the New York, Philadelphia, Atlanta, Chicago, Minneapolis, Kansas City, Dallas, and San Francisco Districts reported heavy holiday discounting. Retailers and restaurant contacts in the Kansas City District lowered prices and anticipated further declines in the months ahead. Lower energy prices were noted throughout many of the Districts. Most contacts in the Atlanta District reported reduced input price pressures, and about half of the contacts in manufacturing and related services in the Boston District reported falling input prices. Boston reported large price decreases for energy, oil-based materials, paper, and cotton in particular. In the Kansas City District, raw materials prices fell sharply, and manufacturers in general reported a corresponding decline in finished product prices. Manufacturers in the Philadelphia District also reported decreases in commodity prices and some reported a reduction in the prices of their own products as well. Contacts in the Cleveland District observed that the downward trend in raw materials prices has started to level off and that pricing of manufactured products remained relatively stable. On the other hand, the Richmond District noted that raw materials prices rose at a slightly quicker pace since last reported. Contacts in the San Francisco District reported that they expect upward price pressures to remain very limited during early 2009.

Wages

Wage pressures remained largely contained in most Districts. The Cleveland, Chicago, Dallas, and San Francisco Districts reported little to no wage pressures. Richmond noted that wage gains in the retail sector held up, but average wage increases slowed for service firms. Wage increases were modest in the Minneapolis District, and wage pressures diminished in the Kansas City District. A few Districts experienced slowing wage gains in sectors that had previously seen rapid wage advances, notably the energy sector in the Cleveland District and the technology sector in the San Francisco District. According to reports from the New York District, year-end bonuses at financial firms are seen falling 20 to 30 percent from a year ago at some of the smaller firms but more substantially at the larger establishments. The Boston, Chicago, and San Francisco Districts also noted that some contacts are enacting or considering pay freezes or reductions in compensation.

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First District--Boston

Business activity in the First District continued to slow at the end of 2008. Retailers report sluggish holiday sales, and manufacturers cite smaller increases or actual declines in revenues or orders in the fourth quarter compared with a year earlier. Selected business services firms are somewhat more upbeat, with demand in the fourth quarter stable versus year-ago levels. Residential and commercial real estate markets remain very weak. Respondents expect more of the same or further softening, at least through the first quarter. Many contacts point to declining costs as a silver lining.

Retail

Contacted First District retailers report weak sales for the holiday months of November and December, but several contacts note that sales were not as soft as expected. On average, same-store sales are flat to down by single-digit percentages among contacted retailers. However, a few respondents indicate that sales picked up either just before Christmas or after New Year's Day, and continue to be stronger than anticipated.

Retailers continue to manage inventory levels tightly and are cutting 2009 capital spending plans. Respondents have invoked hiring freezes and some are considering reducing headcount in the near future. One contact notes that lack of consumer credit has negatively affected sales.

Overall, First District retailers are watchful in their outlook as they expect consumers to "hunker down" over the next few months.

Manufacturing and Related Services

Almost all manufacturing and related services contacts headquartered in the First District say that the pace of business slowed in fourth quarter 2008 compared to trends earlier in the year. Makers of products purchased by consumers, retailers, and restaurants generally characterize business as "sluggish" or "slow." Some of these firms are experiencing double-digit decreases in revenues or orders from year-earlier levels. Capital goods producers report that most of their business customers are spending cautiously as a result of economic uncertainties. Some specifically mention that they did not experience the usual year-end surge in equipment sales reflecting customers' rush to use current-year budgets or preparations for the coming year.

About one-half of the respondents indicate that falling input costs had a beneficial impact on margins in the fourth quarter. They cite large price decreases for energy, oil-based materials, paper, and cotton in particular. The remaining respondents mostly report that input prices have been stable. Roughly half of the contacted manufacturers and related services providers raised selling prices by single-digit rates in late 2008 or expect to do so in early 2009, while the remaining firms report no changes or are rethinking planned increases. A few respondents say they have experienced or expect to experience downward price pressures as a result of the weakening economy.

Most contacted firms anticipate cutting employment and capital spending in 2009. Those reporting on intended pay increases for 2009 say they will be below those in recent years. Companies typically are planning raises that are 0.5 percentage point to 1.5 percentage points lower than in 2008, but some are enacting partial or across-the-board pay freezes.

All responding manufacturers and related services providers express some degree of caution or concern about their sales throughout 2009. Contacts with a strong competitive position or selling to slow-moving market segments are relatively optimistic and expect little or no revenue growth. Others are very concerned as they "manage one day at a time" or foresee potentially large drop-offs in business during the first quarter. Overall, respondents view the economic environment as highly uncertain and subject to substantial downside risks in the coming year.

Selected Business Services

The majority of consulting and advertising firms contacted in the First District enjoyed stable or strong demand in the fourth quarter and during 2008. Responding businesses--most of which are consulting firms--report over-the-year growth ranging from 2 percent to 35 percent. Demand from the healthcare sector continues to be strong and is expected to improve further in 2009. However, demand from the building and retail sectors is said to have weakened significantly.

In the fourth quarter, costs remained stable or decreased for all the firms contacted. Several firms report introducing cost-reducing strategies, and most respondents held wages and salaries stable in 2008. The majority of New England business services respondents did not increase prices in 2008 and expect to keep them stable in 2009; firms that might increase prices are confident of market acceptance. Headcounts were stable or up year-over-year among contacted firms. Respondents' plans for 2009 range from holding employment stable to increasing headcounts 10 percent to 15 percent.

Most New England consulting firms are optimistic about the 2009 outlook. They expect to continue growing, especially after the first quarter of 2009. They suggest this positive scenario might change, however, if the economy has not started to recover by the second half of the year.

Commercial Real Estate

Conditions in the commercial real estate market deteriorated further in the month of December. Contacts describe the situation as "grim" and "depressing." Credit availability continues to be cited as a major barrier to sales activity. One contact reports that a senior lending officer for commercial property at a large bank has been instructed to "try to prevent developers from making further draws on existing lines of credit." In contrast, however, a regional lender based in Boston notes that, for the first time in many months, an originator of securitized commercial real estate loans financed the purchase of a small retail shopping center.

In Connecticut, leasing and sales activity for commercial real estate are virtually non-existent, according to our contact, and law firms are experiencing negative fallout due to the dearth of transactions. Hartford's major insurance companies have begun to lay off workers; while the cuts have been measured so far, expected job losses in the coming months could have a significant impact on the region's office vacancy rate. In Rhode Island, industrial plant closings have been observed and more are expected in the near term; our contact reports these closings will result in vacancies that will be hard to fill. In southern Rhode Island, there is an estimated 4 to 5 years' supply of office space currently on the market; while the situation is better in downtown Providence, office vacancies are expected to climb there as well in the coming months.

In Boston, leasing activity is reportedly minimal in all sectors, and is occasioned only by necessary lease renewals or forced moves, as tenants expect rents to continue to fall. One contact reports that their retail clients are "staying alive and continuing to pay the rent," although he expects retail closings to emerge in the first quarter as firms come to terms with weak holiday sales. Sales activity is non-existent for large commercial deals (over $50M) and slow for smaller deals. Capitalization rates (ratio of net operating income to property value) edged up again in the Boston area and contacts expect them to increase an additional 50 to 75 basis points in the coming months across all property types; rising cap rates are consistent with reports that commercial property values are down both regionally and nationally. Low transactions volume makes it difficult to track property value movements for metro areas in New England, but one contact notes that portfolios of geographically-diversified commercial real estate owned by large pension funds will be written down by 20 percent to 30 percent for the year 2008.

The outlook remains very pessimistic. Contacts do not expect recovery in commercial property markets in the course of 2009. More layoffs are expected across all sectors in the region, leading to rising vacancy rates. Default rates on commercial loans are also expected to rise, both regionally and nationally. Regarding the latter, one contact is concerned that banks and life insurance companies holding commercial real estate loans are not preparing adequately for further capital losses.

Residential Real Estate

After modest decreases and some increases in sales in New England in September and October, home sales dropped sharply year-over-year in November. In Massachusetts, Maine, and New Hampshire, November home sales dropped 22 percent or 23 percent year-over-year. Massachusetts condo sales declined 27 percent year-over-year in November. While the rest of the region saw decent sales numbers in October, Connecticut's home sales declined 17 percent compared to the year before.

Prices also continued to decline. The median home sales price in Massachusetts fell 14 percent year-over-year in November while the median condo price declined 9 percent. Median home prices dropped 17 percent in New Hampshire and 8 percent in Maine in November compared with a year earlier. In Connecticut, the median home sales price declined nearly 11 percent year-over-year in October.

Financial market stress and resulting problems in the general economy are said to be having a major impact on residential markets. One contact believes that worries about employment are discouraging potential buyers. Other respondents express concern about the efficacy of federal legislation intended to stimulate the housing market; they specifically note issues with the tax credit for new homebuyers, including consumer information gaps about the time lag between home purchase and receipt of the credit and the need to pay back the credit eventually.

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Second District--New York

The Second District's economy has weakened somewhat more since the last report, though some sectors appear to have stabilized to varying degrees. The labor market has shown further signs of deteriorating, particularly in New York City. Retailers generally report that holiday-season sales were somewhat lower than in 2007 and a bit weaker than anticipated; retail prices were flat to down modestly, while retail inventories were at or near desired levels. Tourism activity in New York City slowed further in November and December. Both residential and commercial real estate markets were mixed since the last report, with New York City weakening more than other areas. The financial sector has weakened further, and sizable declines in both employment and compensation are anticipated in 2009. Finally, bankers report declining loan demand across all categories, continued widespread tightening in credit standards, and higher delinquency rates--especially on loans to the household sector.

Consumer Spending

Retail sales for the holiday season are described as sluggish but not disastrous. Same-store sales are reported to have been down moderately in December, compared with a year earlier, and somewhat below plan--especially in New York City. At least some of the weakness was attributed to severe weather in the days leading up to Christmas. However, one major chain reports a noticeable pickup in sales in the final days and maintains that weather was not much of a factor. Post-holiday sales are reported to be up somewhat from a year ago and ahead of plan. In general, sales of cold-weather apparel are characterized as relatively strong, while sales of luxury items are reported to have been somewhat sluggish. Contacts report somewhat heavier discounting than during last year's holiday season, though selling prices, on average, were reportedly flat to down modestly from a year earlier. Major retail chains report that year-end inventories were at or near desired levels.

Consumer confidence was generally at or near record lows in November and December: After hitting a record low in November, Siena College's monthly survey of New York State residents showed consumer confidence edging up in December, while the Conference Board reports that consumer confidence among residents of the Middle Atlantic states (NY, NJ Pa) dropped to its lowest level on record in December.

Tourism activity in New York City has shown further signs of weakening since the last report. Both occupancy rates and room rates at Manhattan hotels tumbled in November and remained weak in December, pushing overall revenues down nearly 20 percent from a year earlier. Broadway theaters also report further weakening in business: attendance in December was down roughly 7 percent from a year earlier, while revenues fell 2½ percent; moreover declines were increasingly steep toward the end of the month. Further declines are anticipated, as nine Broadway shows closed just this past weekend and another four plan to wind up their runs by the end of January--an unusually weak start to a new year.

Construction and Real Estate

Housing markets in the District have been mixed but generally weak since the last report. A New Jersey industry contact reports that the market for new homes continues to weaken, reflecting an ongoing overhang of inventory, but notes some leveling off in the resale market--both in terms of volume and prices. However, the more high-priced areas nearest to New York City are still characterized as especially weak. In particular, one contact specializing in the higher end of the market reports that sales activity has slowed considerably--with buyers increasingly reluctant, many sellers are taking their homes off the market. Home prices at are estimated to be down roughly 20 percent from their peak levels of a couple years ago.

New York State Realtors report that home sales continued to weaken in November, falling nearly 24 percent from a year earlier and that median selling prices posted double-digit percentage declines in and around New York City but were mixed across upstate New York. There appears to have been substantial deterioration in Manhattan's housing market, based on reports from both a major appraisal firm and a large real estate brokerage. Co-op and condo sales fell roughly 9 percent from a year earlier in the fourth quarter, led by a 25 percent drop in sales of existing apartments (re-sales). In contrast, closings of newly-constructed units surged 35 percent from a year earlier, but these largely comprised contracts negotiated in late 2007 and early 2008. Based on current contracts, overall apartment prices fell by 20 percent or more from the third to the fourth quarter and the number of transactions fell sharply. Manhattan's apartment rental market has also weakened substantially, with asking rents reported to be down across the board in November, and 2 to 6 percent lower than in June; moreover, an industry report maintains that the reported decline in asking rents likely understates the true weakness in the market, with a growing number of landlords offering concessions. The inventory of available rental units reportedly increased 17 percent between September and November, with a particularly large rise in the number of high-end listings.

Office markets in the District were mixed in the fourth quarter. Manhattan's office vacancy rate climbed to its highest level in two years, while asking rents fell 8 percent from the third quarter and were down 5 percent from a year earlier. An industry contact notes marked weakening in December, in particular. However, office markets in the outlying areas were steady: Vacancy rates in northern New Jersey, Westchester and Fairfield County (CT) were little changed at high levels, while Long Island's rate fell to a two-year low; asking rents were little changed from a year ago in all these areas. Office markets in upstate New York metro areas were steady to somewhat stronger in the fourth quarter, with vacancy rates down slightly and rents up modestly overall.

Other Business Activity

A contact monitoring the financial sector maintains that the industry is still far from hitting bottom. At the larger institutions, a substantial number of job reductions in the pipeline have yet to show up in the payroll statistics, due to ongoing severance payouts. Moreover, year-end bonuses are seen falling 20-30 percent from last year at some of the smaller, healthier firms but more substantially at the larger establishments.

More generally, labor market conditions remain very weak. Both manufacturing and non-manufacturing firms in the District report that they expect employment to decline over the course of 2009, by an average of roughly 2 percent. The overall number of layoffs is expected to be significantly greater in 2009 than in 2008, particularly among non-manufacturing firms. While fewer workers are expected to quit this year than last, somewhat more are expected to retire. Separately, a major New York City employment agency, specializing in office jobs, reports that activity has been very quiet in recent weeks, though the environment is difficult to gauge during this typically slow hiring season; however, a further large increase is noted in the number of people looking for jobs--in particular, people recently let go from financial firms, notably hedge funds.

Financial Developments

Bankers report continued weakening demand for loans in all categories, though to a lesser extent than in November. The one segment in which declines in loan demand are increasingly widespread is in non-residential mortgages. For the first time since last Spring, more bankers indicate increases than decreases in home refinancing activity: 33 percent report an increase while 14 percent report a decrease. Banks continue to report widespread tightening in credit standards across all loan categories. Respondents, on net, note some decline in the spreads of loan rates over cost of funds for the residential mortgage loan category. For all other loan categories, however, bankers report little or no change in spreads. Banks also report widespread declines in average deposit rates. Finally, bankers report increased delinquency rates for all loan categories--most notably in the consumer loan and residential mortgage categories, where the proportions of bankers reporting increased delinquencies reached record highs of 57 percent and 49 percent respectively.

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Third District--Philadelphia

Business conditions in the Third District remained soft in December. Manufacturers, on balance, reported declines in shipments and new orders. Retailers indicated that sales were far below the level of a year ago, and motor vehicle dealers reported continued sluggishness in sales. Bank loan volume rose slightly in December, but credit quality continued to deteriorate. Residential real estate sales and construction remained on a declining trend. Commercial real estate investment and construction activity continued to be slow. Service sector activity generally declined during December. Business firms in the region reported decreases in input costs and output prices in December, and retailers made extensive markdowns for the holiday shopping period.

The outlook among Third District businesses is generally pessimistic. Manufacturers forecast decreases in shipments and orders during the next six months. Retailers expect a slow sales pace during the winter. Auto dealers do not expect much improvement in sales. Bankers anticipate slow loan growth during the year. Residential real estate agents and home builders expect sales to remain slow at least until mid-year and possibly longer. Contacts in commercial real estate expect leasing and construction activity to remain at low levels until overall economic conditions improve. Service sector firms expect activity in 2009 to be slower than in 2008.

Manufacturing

Third District manufacturers reported continuing declines in shipments and new orders, on balance, from November to December. Nearly one-half of the manufacturers surveyed noted decreases in those measures, and around one-fourth reported increases. Reports of declining demand exceeded reports of rising demand in all the major manufacturing sectors in the region except food processing. The drop in orders continued to be especially large for firms that manufacture construction-related goods and materials and business and industrial equipment. One maker of industrial machinery said, "Customer capital budgets are being dramatically reduced," and several producers of metal products noted order cutbacks and extensions of delivery dates by customers.

The outlook among Third District manufacturers remains generally pessimistic. Among firms polled in December, a little more than one-third expect new orders and shipments to decline during the next six months, and less than one-third expect increases. Area manufacturers continued to cut capital spending plans, and the number of firms planning to reduce future outlays increased from November to December.

Retail

Third District retailers generally reported year-to-year declines in sales in December. Customer traffic and sales were generally far below year-ago levels despite several days of extended opening hours and widespread discounting during the month. Sales of jewelry and apparel were especially weak, according to retail contacts. They also said that discount stores were generally the only retailers that achieved year-to-year increases in sales. Despite the disappointing results, most stores were not left with excessive inventories. Discounting early in the season shifted sales to early December and reduced the amount of post-Christmas buying, but conservative stocking by stores generally resulted in "a little less merchandise on the shelves on December 26," according to one store executive. The outlook among the region's retailers is not positive. Many anticipate a prolonged period of retrenchment by consumers, and they expect a significant number of retail firms to close some of their stores or cease operations entirely during 2009.

Third District auto dealers reported a continuing slow rate of sales in December. They said a reduction in financing for car purchases was seriously limiting sales. Dealers also reported difficulty obtaining inventory financing. Looking ahead, they expect some improvement in sales if banks and finance companies increase financing for car buyers, but they expect more dealers to go out of business unless sales move up significantly from the recent pace.

Finance

Total outstanding loan volume at Third District banks rose slowly in December, according to bankers contacted for this report. There have been gains in real estate loans and consumer credit but no growth in business lending. One banker noted that "Companies are shrinking operations and need less financing." Other bankers said that consolidation among large banks with branches in the region has been attended by a slowdown in those institutions' business loan marketing efforts. Most of the banks contacted for this report said that credit quality continued to decline for both business and personal loans. Banks polled in December generally reported steady deposit growth and adequate liquidity. Looking ahead, bankers expect slow expansion in lending in 2009, although some said growth in lending could get a boost from new relationships with firms and nonprofit entities that are turning to banks in lieu of capital markets for funding.

Real Estate and Construction

Residential real estate activity in the Third District continues to weaken. Residential real estate agents and builders reported that sales remained on a downward trend. Although the number of homes for sale has edged down, time on market has increased. Real estate agents noted that many prospective buyers are making low bids for houses and asking for further price reductions after signing sales agreements. One agent said that "We are seeing a lot of sellers renting their homes because they are not prepared to accept what buyers are willing to offer." In general, real estate agents said average selling prices continued to fall in most parts of the region, and that price declines have been more widespread in the higher price ranges. Builders and agents expect current market conditions to persist at least until the spring, and many believe improvement might not take hold until 2010.

Commercial real estate firms indicated that construction, leasing, and purchase activity continue to fall, and project postponements continue to be announced, especially for retail-oriented development. Although some new office and hotel projects have been proposed in the region, contacts do not expect commercial real estate investment and construction activity to pick up until general economic conditions improve and tenants commit to occupy new buildings.

Services

Service sector firms generally reported lower levels of activity in December compared with November. Some business services firms indicated that their client firms were reducing their use of outsourced services because their own activity has slowed and as part of their general efforts to reduce operating expenses, especially for non-essential functions. Business and professional service firms noted that prospective clients are increasingly focused on immediate cost-reducing or revenue-enhancing benefits of purchased services. Firms providing many types of personal services reported slower business and declining revenue as a result of declines in both the number and dollar value of transactions. The outlook among area service firms has weakened since the last Beige Book, and several of those contacted for this report are planning for reduced activity in 2009.

Prices

Reports on input costs and output prices indicate a further general decline since the previous Beige Book. Manufacturing firms continued to note decreases in commodity prices for the materials they use, and a growing number have reduced the prices of their own products. Retailers generally reported steep markdowns for the holiday sales season, and many implemented further discounting in the days after Christmas.

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Fourth District--Cleveland

Economic activity in the Fourth District weakened further during late November and December. The downward trend in factory output and steel shipments that began in the middle of the third quarter continued. Residential construction remains very weak, with no improvement expected during 2009. Commercial builders are experiencing declining backlogs and a fall-off in inquiries. Sales by District retailers were characterized as flat to down, while purchases of new and used cars continued to fall. Business and consumer loan activity has weakened, while core deposits were stable to increasing. Little change in energy production was noted. And freight transport volume declined across all industry sectors.

Reports show a drop in employment levels, primarily in manufacturing, construction, and freight transport services. Staffing firms reported an overall decline in job openings as well. However, healthcare and defense-related businesses are still hiring. Wage pressures remain contained across all industry sectors. There has been a significant pullback in capital spending by manufacturers, retailers, and freight transport providers, with further cutbacks anticipated during 2009. The downward trend in raw materials prices has started to level off.

Manufacturing

Output at District factories was flat to down during the past six weeks, with several reports indicating double-digit reductions in orders. On a year-over-year basis, production levels declined. Respondents expect demand will remain very soft through 2009. For the most part, capacity utilization is below normal levels. Almost all steel producers and service centers reported a worse-than-expected slump in shipping volume, with several contacts noting that end markets are weak across the board. Our contacts believe that the demand for steel will weaken further during the first quarter of 2009. We also heard several reports that foreign steel producers are beginning to price more aggressively. District auto production declined sharply during November on a month-over-month and year-over-year basis. The declines were felt by both domestic makers and foreign nameplates.

Almost half of our contacts said that their companies have trimmed back or halted capital expenditures during the past couple of months. Further, many of them expect additional cutbacks or a freeze on capital spending during 2009. Several manufacturers told us that they have successfully renewed their credit lines since our last report. However, the agreements contained additional covenants, and the price of credit was higher. Contacts indicated that the downward trend in raw materials prices has started to level off. Product pricing remains relatively stable, with some reductions noted. Looking forward, manufacturers expect little inflationary pressure during 2009. A majority of our respondents said that they have laid-off contractors and permanent employees. In addition, several companies eliminated overtime and initiated hiring freezes. Wage pressures are contained.

Real Estate

Residential contractors reported extremely weak home sales during the past six weeks; nonetheless, several noted an uptick in Internet and foot traffic. Looking forward, most builders are not expecting an industry turnaround through 2009. Although residential mortgage rates have dropped, banks continued to tighten credit standards and are demanding higher down payments from home buyers. We heard a few reports that banks are very reluctant to finance contractors. Prices for building materials and labor continued to moderate. There has been little change in the list prices of new homes, though builders are discounting. Some contractors reported increased inventories due to take-backs from home sales that fell through, and several builders are now renting out unsold spec houses and condominiums. General contractors and subcontractors reported widespread staff reductions and no wage pressures.

Most commercial builders told us there has been some slowing in construction activity during the past couple of months, and they expect this trend will continue during 2009. Several firms attributed the slowdown to difficulties in financing projects and uncertainty on the part of clients. Backlogs have declined for some contractors, while inquiries have fallen off. Construction material prices remain stable. Builders told us that they are becoming more competitive in their pricing, and some expect margin contraction in 2009. A few general contractors laid off employees, and wage pressures are not an issue.

Consumer Spending

District retailers reported that November sales were flat to down on a month-over-month basis across all industry segments. The sole exception was a national discount chain that experienced increased sales. Two respondents noted a slight pick-up in sales at the beginning of December, reflecting normal seasonal patterns. Retailers had mixed expectations regarding sales during the first quarter of 2009. On balance, vendor prices remained stable since our last report. Accounts from auto dealers show that purchases of new and used vehicles continue to decline. Dealers do not anticipate any improvement until the second half of 2009 at the earliest. A majority of our retail contacts said they plan to cut-back or freeze capital spending during 2009. Other than some seasonal hiring, staffing levels at retail stores were stable. In contrast, several auto dealers said they have cut additional sales and support personnel since our last report. Little wage pressure was reported.

Banking

In general, commercial and industrial lending has been stable to declining. Although banks' benchmark funding rates have been falling, nearly all bankers said that lending spreads are holding constant or widening. This is due in part to several bankers having put in place a floor under lending interest rates. On the consumer side, demand for installment loans fell, while the use of home equity lines of credit remained solid. There has also been a significant increase in refinancing applications for residential mortgages. Pricing for consumer loans showed little change. Loan standards remained stringent or have tightened further during the past six weeks. A majority of bankers reported that credit quality for consumer and business loan applicants has deteriorated, while the number of loan delinquencies has increased. Overall, core deposits were steady to increasing, with most of the increase attributed to a flight to safety. Staffing levels remain relatively stable; however, several banks are considering staff reductions in 2009 via layoffs or attrition. No wage pressure was reported.

Energy

On the whole, energy production has been stable during the past six weeks. Expectations call for oil and natural gas production to increase during the upcoming months, with some of the increase attributable to typical seasonal fluctuations. Nonetheless, a moderate decline in drilling activity is expected during the first half of 2009. The outlook for coal production is mixed. Reports indicate that the prices received for oil and natural gas continue to fall from their July peaks; however, the downward trend for natural gas has moderated. Energy producers saw little change in materials and equipment costs with the exception of diesel fuel, which has declined. Further, capital spending remains on plan, with little change expected during the next few months. We heard a few reports that coal mine operators are experiencing difficulty obtaining credit. Coal producers reported modest staff expansions, with some additional hiring expected in the upcoming months. Wage pressures that existed during the second half of 2008 have diminished.

Transportation

Freight transport service companies experienced a greater-than-expected decline in shipping volume and revenues. Company officials told us that although weakness exists across all market segments, much of the drop-off is attributed to consumer products, autos, and construction materials. Expectations call for activity to remain very weak through at least the first quarter of 2009. Most transport companies reported pulling back on capital spending during the past few months, with further cutbacks anticipated. Many respondents told us that they are no longer hiring any drivers due to industrywide capacity reductions. As a result, there has been a lessening in driver turnover. Further, office staffing positions are being eliminated, and there were no reports of wage pressures.

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Fifth District--Richmond

Reports from business contacts indicated that economic activity in the Fifth District slowed further in recent weeks, with disappointing holiday retail sales, declining activity at District ports, and continued weakness in real estate. Retail sales--including sales of big-ticket items--fell, and although the pace of payroll cuts in retail abated a bit, services firms reported workforce downsizing. District manufacturers noted declines in shipments, new orders, and employment while both import and export activity declined at District ports. In residential real estate, lenders reported an increase in refinancing due to lower interest rates, but home sales were sluggish and contacts described either tightened or unchanged credit standards. Commercial real estate conditions softened as contacts observed little sales activity and virtually no new construction. Meanwhile, temporary employment agents mentioned weaker demand for workers due to economic uncertainty and the reluctance of businesses to invest in new projects.

Retail

Most Fifth District retailers were disappointed by holiday sales this year. For some merchants, the decline accelerated as the holiday shopping period progressed. Contacts also told us that foot traffic was down, though not to the same degree that sales declined. Several retailers also said that in recent weeks more customers paid with cash than with credit cards. The manager at an established metropolitan-Washington, D.C., department store said, "We've had to use more coin (for change) than ever before." In Virginia Beach, Va., a discount store manager reported that customers were paying less than usual per transaction. In addition, most retailers told us that gift card sales were weak compared to previous years' sales. Contacts attributed the slide in retail sales to consumer fears of job loss and anxiety about possible changes to existing credit card agreements. Automobile and light truck dealers continued to report falling sales. A dealer in the Tidewater area of Virginia said his domestic car sales in the last four weeks were the worst he had experienced since the 1970's. Retail payroll cuts continued, but at a slower pace, since our last report. Wage growth held up, while retail price growth moderated.

Services

According to our contacts, revenues contracted sharply at most services firms in recent weeks, although a handful of security businesses and telecommunications firms reported stronger revenue growth. An administrator at a central North Carolina hospital said fewer elective procedures were scheduled in recent weeks, and a large care facility in central Virginia reported increased cost-saving efforts to avoid cutting staff. Executives at financial services firms noted that their clients continued to be wary. In addition, a CPA at a firm just outside Baltimore, Md., told us his small business clients were "feeling the squeeze" of the sagging economy. Services firms generally downsized since our last report. A contact at a North Carolina healthcare system reported a hiring freeze for administrative employees, although his facility continued to hire patient-care personnel. A Virginia airport contact said several empty positions would not be filled, and a contact at a central North Carolina non-profit firm told us that the requirement for a break-even cash flow would likely lead to eliminating additional employees in 2009. Average wage growth slowed at services firms, while price growth edged up slightly.

Manufacturing

District manufacturers reported that the contraction in activity deepened in recent weeks as shipments, new orders, and employment slipped further. A producer of paper products in North Carolina told us that business was down considerably and that they were planning to run only 7-9 days in December instead of the normal 24 days. He indicated that if these conditions continued for the next several months, they might have to close a facility. A furniture maker in North Carolina said that business was down 25 percent since the start of the third quarter and was, at best, tepid in the earlier part of the year. He reported that several suppliers and retailers had gone out of business, and stated that, "this is the worst business since 1982." Contacts reported that raw materials prices rose at a slightly quicker pace since our last report. A number of manufacturers reported that their margins were compressed due to a growing inability to pass along price increases.

Activity at District ports declined quickly in November and December. Contacts reported reduced levels of import and export containers, and a "precipitous drop" in container rates. On the import side, activity related to construction and household products--such as plywood and furniture--remained notably low. Exports of power-generating products remained the only bright spot at one District port, while used car shipments to the Middle East and Africa were still doing well at another. Despite these instances, contacts reported seeing some scaling back of shipping schedules.

Finance

Residential lenders reported an increase in activity in recent weeks, which they attributed to lower interest rates, after a "dismal" November and early December. Contacts reported a rise in residential refinances, which accounted for 80 percent of applications in some areas of the District. However, purchase applications remained low, and one contact monitoring the region noted that "we haven't seen the uptick we usually would have with a similar decline in rates." Credit standards continued to tighten at some institutions, while others reported no change. Lenders noted that more time intensive underwriting and stricter qualifications were preventing some applicants from taking advantage of lower rates. Additionally, contacts noted an increase in clients drawing on home equity lines in recent weeks. In commercial lending, contacts reported stable to lower demand for loans. Lenders remained cautious as they shied away from real estate investment, reduced loan-to-value ratios and heavily scrutinized balance sheets. Reports on credit quality were mixed, with some contacts noting a slight deterioration of clients' portfolios and others reporting no material changes.

Real Estate

Fifth District Realtors continued to report generally sluggish home sales in recent weeks, although several added that this was typical for the season. A Richmond agent told us that although the lower interest rates had increased affordability, there were still some buyers who remained "on the fence" in anticipation of interest rates dropping even further. He reported an increase in refinancing activity but noted that lenders were being very thorough in evaluating applications, and that appraisers were being careful to value homes based on comparisons with other properties sold in the last few months. Several Realtors reported a rise in inventory and a Realtor in Greensboro, N.C., reported that builders continued to give major concessions to prospective buyers to boost sales. Agents in Washington, D.C., and Fairfax, Va., told us that the low mortgage interest rates had not only given buyers more buying power but had also spurred investor interest. House prices across the District were reportedly holding steady.

Commercial real estate conditions continued to deteriorate in recent weeks. Assessments of leasing activity across the Fifth District ranged from slowing to "frozen." Contacts stressed that transactions were taking longer to close due to client indecision and difficult financing conditions. A Roanoke, Va., agent reported that "the few deals that are closing are all taking longer than 180 days to complete, when they usually take 90 to 180 days." Quoted rental rates were mostly unchanged, although agents in Washington, D.C., and Richmond, Va., believed that rates would be declining if transactions were actually occurring. Vacancy rates crept up across Virginia and the Washington area, but held steady in other District markets. Little sales activity and virtually no new construction were reported. Contacts said that some banks were still financing projects, but with stronger constraints, including higher equity requirements and a greater percentage of pre-leased spaced.

Tourism

Reports on District tourism were mixed. Contacts along the coast told us that bookings were somewhat weaker compared to our last report and to a year ago, which they attributed to the waning economy. A hotelier at Virginia Beach, Va., said that state-sponsored group bookings were much weaker due to budget cuts in Virginia. Analysts in North and South Carolina indicated weaker holiday bookings and fewer inquiries about Christmas and New Year's reservations. In contrast, a manager at a ski resort in Virginia told us that his hotel was "packed" during the week between Christmas and New Year's, crediting the increase to a bout of colder weather which enhanced their snow-making capabilities.

Temporary Employment

Fifth District temporary employment agents reported generally weaker demand for workers in recent weeks, due in part to economic uncertainty and weak business investment. An exception was a Raleigh agent who was optimistic that demand for workers at his agency would improve from its current level as businesses would be planning for the new year. Most agents reported continued difficulty obtaining clients. Demand was strongest for workers with high-level technical skills, workers proficient in common computer software, and workers providing professional and support services.

Agriculture

Above-average precipitation accompanied by below-normal temperatures delayed harvesting activity and hindered crop development in most of the District. Contacts in Virginia reported that excessive rainfall delayed the soybean harvest; approximately twenty-two percent of the crop had yet to be harvested. Other contacts in Virginia indicated that frost and snow had spoiled pastureland as a source of forage and that most cattlemen had switched over to supplemental feed. Furthermore, analysts in Virginia and North Carolina told us that winter wheat had been slow to emerge due to the cooler temperatures and rain in recent weeks. Nonetheless, analysts in South Carolina noted that ample rainfall had improved winter grazing conditions. In addition, small grain planting had been completed in North Carolina and was nearing completion in Maryland.

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Sixth District--Atlanta

Economic conditions in the Sixth District were weak through December. Holiday sales results were near or below year-ago levels and auto sales were dismal. Further declines in new orders were reported by most manufacturing contacts. Residential real estate contacts described new and existing home sales and construction activity as weak and that average home prices continued to decline in most areas. Commercial contractors also noted ongoing softness in nonresidential construction. Lending standards at District banks remained tight. Labor markets weakened further through the end of the year with contacts across most industries noting additional layoffs and reduced hours. A majority of business contacts reported reduced input prices.

Consumer Spending and Tourism

District retail contacts indicated that holiday sales were generally weak. Contacts said that sales of luxury and big-ticket items were particularly weak, while apparel sales also struggled. Several contacts noted that discounting was deeper and more prevalent this holiday season because of fierce competition in an effort to clear inventories. Discount stores generally fared better as budget conscious consumers shopped for bargains. Looking ahead, weakness is expected to persist in the near term and may result in some retailers closing underperforming stores. Additionally, some businesses indicated that their inability to finance inventory purchases would mean they may close some stores.

District vehicle sales were off sharply in November and December. Contacts cited both tight consumer credit and overall lower demand as contributing to the weakness. Dealers across the region are reportedly cutting advertising and payrolls to cope with the current business climate.

Tourism activity was mixed from mid-November through the holiday season. Florida appeared to benefit from the usual influx of winter residents, but contacts report that overall visits to the state were below year-ago levels. Nonetheless, aggressive promotions and cheaper gasoline prices appeared to boost travel in to several Florida destinations.

Real Estate and Construction

Reports from homebuilders and Realtors indicated that new and existing home sales were weak from mid-November through December, with most noting that overall sales were down significantly compared with the already low levels of a year earlier. District homebuilders continued to pull back on home construction. New home inventories declined in Florida and Georgia, according to contacts, while elsewhere in the District the number of new homes on the market increased somewhat. Existing home inventories remained at high levels. Home prices continued to soften in the District; contacts indicated that the large volume of foreclosed properties for sale was exerting downward pressure on both new and existing home prices. According to District contacts, the near-term outlook for residential sales and construction activity remains weak.

Most District commercial contractors continued to report declines in activity, and more projects were cancelled or postponed. Going forward, commercial real estate contacts anticipate more space will become available and rents will soften, particularly in the retail sector.

Manufacturing and Transportation

A majority of manufacturing contacts noted that production and new orders remained below year-ago levels. Export orders also declined--a sharp change from earlier in 2008 when exports were expanding. Production is expected to remain sluggish according to manufacturing contacts.

Most transportation service firms reported weak freight demand and excess shipping capacity in November and December. Shipments of retail, automotive, and construction-related goods, as well as inter-modal cargoes were reported down sharply from a year earlier, with only coal and minerals posting small gains.

Banking and Finance

According to most banking contacts, District lending conditions continued to tighten during mid-November and December. Lending standards have been raised and loan covenants strengthened, making it harder for some banks to find customers with financial positions strong enough to qualify for loans. Worsening economic conditions caused banks to restrict lending to specific industries. Especially hard hit were those segments related to the housing and the automobile industries. Banks also appeared less willing to take on new commercial projects and instead focused on serving their existing customers.

Employment and Prices

Employment conditions in the District weakened through the end of the year, with numerous accounts describing hiring freezes, layoffs and reduced hours in December. Weakness was fairly widespread.

Most District contacts reported reduced input price pressures. Manufacturers reported that prices for both raw materials and finished goods were below year-ago levels and are expected to decline further in the short term. Even as input price pressures have eased, some businesses noted falling profit margins because of the need to discount output prices.

Natural Resources and Agriculture

Weather conditions were favorable for fieldwork, and most areas received moderate rainfall during November and December. Apart from northeast Georgia, severe drought conditions abated in the Sixth District states. The moderation in fuel and fertilizer costs is expected to improve the near-term financial outlook of some agricultural producers. Poultry exports slowed in response to lower foreign demand.

According to contacts, oil and gas exploration companies scaled back operations and re-evaluated expansion plans in response to lower oil prices and difficulty obtaining financing.

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Seventh District--Chicago

Economic activity in the Seventh District declined further in December, with contacts noting lower consumer and business confidence. Consumer spending decreased and labor market conditions weakened. Construction declined, and manufacturing activity moved lower. Credit conditions remained tight, but improved in some markets. Contacts reported increased concern with expenses given declining economic activity and rising uncertainty over the economic outlook. In agriculture, field work was limited in December by bad weather.

Consumer spending

Consumer spending decreased in December. Despite heavy discounting, retailers reported declines in sales, particularly for clothing and big-ticket and luxury items such as electronics, appliances, and jewelry. However, discount stores fared better than their higher-priced counterparts. Tourism activity in the District also slowed, with hotel occupancy down in December. Auto dealers again reported declining sales, while service center activity continued to be robust. Sales were sluggish for Detroit three nameplate vehicles. According to some of our contacts, this weakness reflected the uncertainty surrounding the future of these automakers. However, several contacts indicated that the recent declines in gas prices had stimulated demand for light trucks. Dealers were also reportedly closely monitoring inventory to avoid paying end-of-year fees on unsold vehicles.

Business spending

The pace of business spending declined further from the previous reporting period. Several contacts reported scaling back or putting on hold capital spending plans given the uncertainty surrounding the economic outlook. Labor market conditions in the District also weakened. Layoffs were reported in financial services and several manufacturing industries, including a number of automotive suppliers. Several manufacturing contacts also noted reductions in hours worked. The government, education, and healthcare sectors continued to expand employment. However, growth in the latter two also began to show signs of slowing in parts of the District. The demand for skilled labor remained strong, but a contact noted that many applicants lacked the skills necessary to fill available jobs. Recruitment activity stabilized in December after declining sharply in November.

Construction and Real estate

Construction activity declined in December. Residential building continued its steady decline. Developers remained cautious to expand inventory levels given persistent weakness in showroom traffic and elevated cancellation rates. Several contacts noted excess capacity in the condo market. Mortgage applications rose significantly, particularly for refinancing, spurred by declining mortgage rates. Mortgage originations continued to be low with many potential borrowers unable to meet the more stringent lending standards put in place in 2008. Nonresidential construction also declined. The availability and cost of financing continued to be of concern for commercial developers, with additional cancellations and project delays reported. Contacts noted elevated vacancy rates, increases in sublease space, and continued downward pressure on commercial rents.

Manufacturing

Manufacturing activity in the District decreased from the previous reporting period with several contacts reporting lower orders and production cuts. Activity in the domestic steel industry slowed further as production was scaled back amid declining demand. However, a contact noted that a future increase in demand may come from service centers where inventories remained low in December. Other metals-related industries also noted softening conditions. Demand weakened further for heavy machinery and medium- and heavy-trucks. A contact noted that agricultural equipment dealers were able to offer spring delivery dates on farm equipment that had been previously fully booked into 2009, as cancellations increased and exports waned. Exporters reported that demand from abroad continued to slow. A few contacts reported tight credit conditions negatively impacted the demand for their products. In addition, a contact noted that some manufacturers have begun to ask for deposits on orders to reveal the true extent of future demand for their products.

Banking and Finance

Credit conditions in the District remained tight. The demand for liquidity continued to be high in December. Credit risk concerns persisted and borrowing spreads remained elevated. Banking contacts reported continued weakness in loan demand, as nonfinancial firms reevaluated capital spending plans given the uncertainty surrounding the economic outlook. Consumer auto lending remained tight, but a group of regional credit unions and GMAC both announced efforts to revive lending during the reporting period. Liquidity in the secondary residential mortgage market was noted to have improved after the Federal Reserve's announcement of its intent to purchase agency debt and mortgage-backed securities. Loan quality continued to be of concern for residential real estate loans. Contacts also noted retail trade and firms with heavy exposure to volatile commodity prices as sources of potential risk to quality. In addition, several contacts in commercial real estate finance pointed to potential further deterioration in quality as variable interest rate loans come due for refinancing this year.

Prices and Costs

Contacts reported increased concern with expenses given declining economic activity and rising uncertainty over the economic outlook. Despite recent further declines in material and energy prices, some contacts continued to report pressure on costs remained. However, others noted the benefits of lower food and energy prices on margins. In retail trade, downward pressure on prices intensified during the holiday shopping season, leading to tighter margins as retailers were unable to pass on increases in costs from wholesale prices. Wage pressures were limited. However, several contacts noted that firms were choosing to freeze or cut pay instead of laying off workers to lower labor costs. In addition, contacts also reported that firms were reducing or eliminating elements of non-wage compensation.

Agriculture

Fall field work was limited in December by the weather. In addition, farmers had an incentive to wait until the spring as fertilizer prices began to fall from very high levels. A portion of farmers had already locked in fertilizer orders at high prices, but some only put down modest deposits. Corn and soybean prices rebounded toward the end of the reporting period, after declining into December. Even so, farmers tended to hold onto crops rather than sell them. At current crop prices and given higher input costs for corn planting, District farmers favored planting more soybean acres and fewer corn acres this spring. Farmers were considering other options for planting rotations as well, in case corn and soybean prices failed to move higher. Contacts expected more renegotiations to lower cash rental rates, since 2009 net farm income was expected to decline from 2008. Operating loans remained available for agriculture to meet higher demand due to increased input costs from a year ago. Hog prices edged up in December, which, combined with lower feed costs, allowed for an improvement in margins. Milk and cattle prices were down.

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Eighth District--St. Louis

Economic activity in the Eighth District has continued to decline since our previous report. Manufacturing activity weakened further and the services sector contracted. Residential real estate market activity continued to decrease. Commercial real estate markets have held steady but commercial and industrial construction activity has softened. Overall lending at a sample of small and mid-sized District banks declined during the three-month period from mid-September to mid-December.

Manufacturing and Other Business Activity

Manufacturing activity has continued to decline since our previous report. Several manufacturers reported plans to close plants and reduce operations in the near future, while a smaller number of contacts reported plans to expand operations. Several firms announced job layoffs in the face of ongoing and projected weak demand. Firms in the plastics, furniture, paper, animal slaughtering/processing, automotive parts, electrical equipment, food, footwear, and railroad car manufacturing industries reported plans to close plants in the District, resulting in a significant number of job losses in these industries. Contacts in fabricated and primary metal, electrical equipment, and automotive parts manufacturing reported plans to lay off workers. Several large projects for the auto industry were put on hold and production was halted because of demand uncertainty. In contrast, firms in sugar manufacturing, machinery manufacturing, and other transportation manufacturing announced plans to open new plants in the District and hire additional workers. Firms in the plastic products and chemical products ended job strikes and signed new labor contracts, while firms in furniture manufacturing benefited from a new foreign-trade zone designation.

The District's services sector reversed the gains from our last report, with several major employers announcing large job cuts. Contacts in business support services, information services, and engineering services reported large layoffs and salary reductions. Firms in educational services, information services, leisure/hospitality services, and several firms in transportation services also reported plants to consolidate operations and lay off workers. In contrast, a few small firms in business support services reported job growth and a contact in one small private firm in education services expressed optimism about growth in 2009. General retailers reported lower sales in the fourth quarter of 2008 compared with a year ago, particularly among stores that specialize in electronic goods or home furnishings. Auto sales in the fourth quarter of 2008 were down compared with the same period last year, and several dealerships closed while others reported a negative outlook for 2009.

Real Estate and Construction

Home sales continued to decline throughout the Eighth District. Compared with the same period in 2007, November 2008 year-to-date home sales were down 15 percent in St. Louis, 19 percent in Memphis, 22 percent in Little Rock, and 23 percent in Louisville. Residential construction also continued to decline throughout the District. November 2008 year-to-date single-family housing permits fell in nearly all District metro areas compared with the same period in 2007. Permits declined 35 percent in Little Rock, 42 percent in Louisville and St. Louis, and 58 percent in Memphis.

Commercial real estate markets seem to be stable throughout the District but commercial and industrial construction is slowing. Contacts throughout the District reported that office and industrial leasing is expected to remain steady through the first half of 2009. A contact in Louisville noted, however, that any automobile plant closings could quickly change the leasing environment in that area. Commercial and industrial construction contacts throughout the District predict a challenging environment in early 2009. Construction activity in the Memphis metro area has seen a slowdown throughout most of 2008 and is expected to remain soft in 2009. In particular, Shelby County, Tenn., has had no new industrial construction since late 2007 and no new industrial construction is expected for DeSoto County, Miss., in 2009.

Banking and Finance

Total loans outstanding at a sample of small and mid-sized District banks decreased 1.4 percent from mid-September to mid-December. Real estate lending, which accounted for 73 percent of total loans, decreased 2.0 percent. Commercial and industrial loans, accounting for 17.3 percent of total loans, increased 0.6 percent. Loans to individuals, accounting for 5.2 percent of loans, increased 0.6 percent. All other loans, which accounted for 4.5 percent of total loans, decreased 1.4 percent. Over the same period, total deposits at these banks decreased 3.0 percent.

Agriculture and Natural Resources

As of mid-December, year-to-date bales of cotton ginned (separated from the seed) in the District states were down by 30 percent over the same period in 2007. Arkansas had 32 percent fewer bales ginned than the previous year, Mississippi had 48 percent fewer, and Missouri and Tennessee each had 11 percent fewer. Total commercial production of red meat in the District states decreased by 7 percent in November over year-earlier levels. In November 2008, the total weight of young chickens slaughtered was 12 percent lower than November 2007. Total coal production in the District states was 3 percent higher in December 2008 than December 2007, while total coal production in 2008 was the same as 2007.

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Ninth District--Minneapolis

Ninth District economic activity decreased slightly in most sectors since the last report. Decreased activity was noted in consumer spending, tourism, services, construction and real estate, manufacturing, energy, mining and agriculture. Labor markets continued to weaken, as a number of companies announced layoffs since the last report. Overall wage increases were modest. A number of prices continued to decrease since the last report, but the pace of decline seems to have stabilized.

Consumer Spending and Tourism

Holiday sales were down somewhat in a number of areas. Contacts in Montana reported decreases in sales ranging from 5 percent to 40 percent, but grocery store sales were at least level with last year. A mall manager in Montana noted that December sales were down from last year--the first year-over-year decrease in more than 20 years. A bank director noted that retail sales in South Dakota were up slightly during the holiday season, but deep price discounts ate into profit margins. A representative of a Minneapolis-area mall noted that traffic was slower than typical during the early and middle parts of the holiday shopping season, but it picked up toward the end. Meanwhile, a representative of an auto dealers' association in South Dakota reported that recent vehicle sales were down substantially.

Tourism activity was down slightly from a year ago. A ski resort in northeastern Minnesota reported that visit numbers through the holidays were down from a year ago. Convention and conference business in the St. Paul area has trended downward since last fall, while tourism activity was down slightly from a year ago in Duluth, Minn. Snowmobiling and ice fishing activity was relatively strong in northwestern Wisconsin, according to a chamber of commerce representative, but business at restaurants was slow.

Services

Activity in the services sector decreased since the last report. Slow activity was reported by contacts from the legal, architectural and information technology areas. Medical service contacts reported mixed conditions, with services for the aging increasing but elective procedures decreasing.

Construction and Real Estate

Commercial construction declined. The value of commercial permits fell significantly in Sioux Falls, S.D. Severe cold and snowy conditions hampered construction activity. Residential construction remained quiet. A contact reported that home building activity in the Bozeman, Mont., area was slow. November new home permits in the Minneapolis-St. Paul area were down about 30 percent from a year earlier. In the Kalispell, Mont., area, where the housing sector had been strong until recently, November permits were down 26 percent from a year ago.

Commercial real estate activity decreased. A representative of a Minneapolis-based commercial real estate firm said that the market remains in a downturn that has now lasted over a year; a different firm reported increasing office and industrial vacancy rates. Several areas in the district saw increased retail vacancy, with further store closings expected. While remaining slow, the residential real estate market showed signs of increased activity. An association of Realtors in Minneapolis-St. Paul noted that the number of sales in late December increased from year-earlier levels, driven by foreclosures and short sales, but significantly lower home prices kept dollar volumes down. Realtors in Fargo, N.D., and Sioux Falls noted that lower mortgage rates seem to be spurring some buyers into action.

Manufacturing

Overall manufacturing was down from the last report. A December survey of purchasing managers by Creighton University (Omaha, Neb.) indicated significantly decreased activity in Minnesota and South Dakota, but slightly increased activity in North Dakota. Numerous manufacturing companies reported weakened demand and expected to reduce capital spending and employment. An aluminum maker in Montana announced plans to stop production. However, some defense contractors and medical device companies reported increased manufacturing activity.

Energy and Mining

Activity in the energy and mining sectors decreased since the last report. Late December oil and gas exploration declined from late November. Meanwhile, most iron ore mines in the district decreased production and expect a big reduction in output in 2009 from 2008 levels. Several mine operators in Montana were worried about lower metals prices and reduced demand.

Agriculture

Agricultural conditions deteriorated since the last report. Extremely cold weather and higher than normal snowfall stressed cattle. A Montana cow and calf operator reported that cattle needed increased levels of feed and water. A South Dakota feedlot reported some deaths due to the frigid weather. However, the frozen ground allowed farmers to progress on the late harvest.

Employment, Wages and Prices

Labor markets continued to weaken, as a number of companies announced layoffs since the last report. In Minnesota, a major manufacturer recently announced more than 2,000 job cuts companywide, a water filtration manufacturer announced 1,600 job cuts companywide, a supplier of suspension assemblies for disk drives will lay off about 1,000 employees and an airplane manufacturer laid off 500 employees in December. Due to decreases in orders during the fourth quarter, a Minneapolis-based spray and fluid equipment maker will cut 150 jobs and a company that makes street sweepers and large floor-cleaning machines will cut 240 jobs. A number of health care providers have announced layoffs in the Minneapolis-St. Paul area, although demand for health care workers remains in some areas. Many more prospective workers are applying for open positions compared with a few months ago in Montana. Job postings at a workforce center in northwestern Montana were at historically low levels, according to the center's manager. A South Dakota credit card services firm announced 50 layoffs. A temporary staffing agency survey of Minneapolis-St. Paul businesses showed that 14 percent of respondents expected to hire workers during the first quarter, while 10 percent expected to reduce staff.

Wage increases have remained modest. Wages for manufacturing workers in district states increased 2.6 percent for the three-month period ended in November compared with a year earlier.

A number of prices continued to decrease since the last report, but the pace of decline seems to have stabilized somewhat. Prices for a number of metal-based products, including copper and steel, decreased since the last report. A bank director noted that scrap aluminum prices have dropped 50 percent during the past few months. Minnesota gasoline prices at the end of December were $1.40 less per gallon than a year ago. While phosphates and other agriculture-related chemicals have decreased in price since the last report, they remain well above year-ago levels.

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Tenth District--Kansas City

Economic activity in the Tenth District deteriorated in December. Consumer spending weakened, and expectations for future spending declined further. Manufacturing activity dropped sharply, and both commercial and residential real estate activity continued to contract. Energy activity decreased markedly in response to falling natural resources prices. Contacts lowered expectations for future farm income, but growing conditions in the agriculture sector improved. Bankers reported increasing deposits, declining loan demand, and deteriorating loan quality. Prices continued to fall for raw materials and, to a lesser extent, finished products. Labor market conditions weakened further, leading to fewer wage pressures and lower salary increases for 2009.

Consumer Spending

Consumer spending was generally down in December, and expectations fell across all sectors for the months ahead. Retail sales were lower than last year, and contacts reported that heavy discounting cut profit margins at many stores. Sales were especially weak for large-ticket durable goods, jewelry, and high-end merchandise. Retail and mall contacts anticipated sluggish sales in the coming months. Auto sales weakened from the previous period, and all contacts expected further contraction in the months ahead. Inventory levels were unchanged since the last survey, but most auto dealers said inventories were still too high. Auto credit tightened further, and dealers struggled to obtain financing for buyers. Travel and tourism activity declined in December, with one contact noting a pullback from foreign travelers. Hotels in the mid- and lower-tiers fared better than upscale properties. Restaurant sales improved from the previous survey but were still lower than year-ago levels. Restaurant contacts anticipated less traffic in the next three months.

Manufacturing and Other Business Activity

Manufacturing and other business activity weakened during the latest survey period. Overall, production fell across all types of manufacturing. Plant managers also reported declines in shipments, new orders, and order backlogs. Firms continued layoffs, and many shortened the length of the average employee workweek. Companies with ties to the automotive and railroad industries experienced the greatest number of layoffs. Expectations for future factory activity remained pessimistic, and plants cut their capital spending plans sharply. Firms anticipated lower production, fewer shipments and a smaller number of new orders in the months ahead. Export orders fell further, and firms remarked that they could no longer rely on foreign markets. Transportation services activity slowed during December and was expected to be flat over the next few months. Firms cut back on capital spending, and one trucking firm said that it was driving more empty miles. Another trucking company said that for the first time in two years it had enough qualified drivers.

Real Estate and Construction

Residential and commercial real estate activity slowed further in December. Home sales decreased from the last survey period, and contacts expected sales to be flat in the coming months. Home inventories were unchanged since the previous survey and were close to year-ago levels, though still quite elevated. Prices continued to drop, and expectations of lower prices in the future were common. Mortgage lenders reported an increase in home refinancings in response to lower interest rates. Commercial real estate activity declined across all segments: office, retail, hotel, and industrial. Contacts expected depressed prices, higher vacancy rates, and lower absorption rates. Rental rates also fell considerably, with levels well below a year ago.

Banking

Bankers reported a decline in loan demand, deterioration in loan quality, and increase in deposits since the last survey. The net fraction of banks reporting lower overall loan demand was about the same as in the previous survey. Demand fell for commercial and industrial loans, commercial real estate loans, and consumer installment loans. However, demand for residential real estate loans was unchanged following significant declines in the previous two surveys. Compared to the last survey, there were more reports of tighter standards on commercial and industrial loans but fewer on residential real estate loans. Tighter standards were particularly prevalent for commercial real estate loans. Assessments of current loan quality were little changed from the last survey, but expectations for future loan quality declined further. Just over half of respondents reported increases in deposits. A few banks said maintaining margins between interest income and interest expense was becoming more difficult with interest rates falling so sharply.

Energy

Energy activity slowed dramatically in December as oil and natural gas prices continued to fall. Almost all contacts reported a decrease in drilling activity over the last month, and all contacts expected activity to continue to decline over the next three months. The number of active drilling rigs in the District fell during the latest survey period and reached the lowest level since late 2005. Furthermore, oil and gas firms were cutting their capital spending budgets and other costs due to the fall in energy prices. Most contacts believed that the downturn in prices was demand driven, but they were somewhat hopeful that demand for natural gas and other heating products would support activity during the winter months.

Agriculture

Agricultural growing conditions improved in December, but farm income expectations weakened. The winter wheat crop was reported in good condition due to adequate fall moisture, and corn and soybean prices rebounded slightly from harvest-time lows. But with commodity prices well below summer highs, rents and prices for cropland eased, although they remained well above year-ago levels. Farm input costs eased slightly with lower fuel and fertilizer costs. Despite reduced feed costs, however, the livestock sector continued to struggle with waning global demand for meat products. Farm income expectations weakened further, and District contacts reported a reduction in capital spending. The availability of funds for agricultural loans held steady while collateral requirements increased further.

Wages and Prices

Price pressures continued to ease, and wage pressures also diminished in December. Raw materials prices fell sharply, and manufacturers in general reported a corresponding decline in finished product prices. Trucking contacts also reported that input prices, including fuel, continued to fall from the record highs of the summer. Retail and restaurant contacts lowered prices and anticipated further declines in the months ahead. Labor shortages were minimal, and wage pressures diminished. The number of contacts expecting to hire additional workers in the next few months fell drastically. One contact commented that projected salary increases for 2009 were the lowest since 2001. Many contacts trimmed labor costs by reducing their workforce, eliminating overtime, shortening the workweek, and lowering bonuses.

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Eleventh District--Dallas

Economic conditions in the Eleventh District continued to weaken from mid-November to year-end 2008. Contacts across a broad range of industries noted reduced demand and uncertainty about the outlook. Manufacturing, commercial construction, energy and transportation services generally reported the largest drop in demand while residential construction remains at low levels. Accounting and legal services seemed to hold up the best although they reported that demand was flat to slightly down. Bank lending declined due to tighter credit and weaker loan demand. Most respondents don't expect conditions to improve until the second half of 2009 with a growing number of respondents now looking at early 2010.

Prices

In general most service firms reported no change in prices while most goods producers reported declines. Many manufacturing respondents noted that while energy costs have come down, lower capacity utilization rates have put upward pressure on per unit production costs. Retailers reported large discounts were needed to move merchandise over the holiday season. Many contacts reported that fuel surcharges for transportation that were instituted earlier in 2008 were being dropped.

Light sweet crude oil fell to $37 per barrel by year-end, the lowest price since 2004, from $55 per barrel in mid-November. Contacts said a huge over-supply of crude oil driven by the US and global slowdown led to the decline and that consecutive cuts by OPEC were not sufficient to stem the decline. Oil product prices fell as fast as crude oil, leaving refiner margins weak. On-highway prices for both gasoline and diesel fell by about 50 cents per gallon since the last survey and natural gas prices declined by about a $1 per Mcf from $6.50 per Mcf in mid-November.

Labor Market

Labor markets remained weak as most contacts reported that they had maintained or reduced employment since the last survey. Labor markets were weakest in manufacturing where many firms extended temporary plant closings or reduced operating hours. Many manufacturing contacts reported that they had laid off temporary or hourly workers and that they are likely to reduce full-time staff at the start of the year. Layoffs were becoming widespread in the energy industry, and they are expected to grow in 2009. Many contacts reported hiring freezes and reported little if any wage increases.

Manufacturing

Most manufacturing contacts reported declines in demand and reductions in capacity utilization. Most contacts said that they have managed to keep their inventories at desired lean levels but an increased number of contacts reported that inventories had risen to higher than desired levels.

Construction-related manufacturers reported continued declines in shipments and orders even after adjusting for normal seasonal reductions. Most producers reported reductions in jobs and expect further cuts in early 2009. Some contacts noted that the recent plunge in commodity prices provided only slight relief in the cost of production since capital costs per unit of output have increased as capacity utilization has declined and because pricing on rail and truck transportation and coal have not fallen due to long-term contracts. Contacts continue to report that demand from commercial construction is shrinking rapidly with the main exception being government sponsored projects. Contacts reported that the outlook has gotten worse and most do not expect a turnaround until late 2009.

Most respondents in high-tech manufacturing industries report that demand has fallen moderately since the last survey. Weakness was widespread across global markets and products. Most firms said that they were planning to reduce employment over the next several months. Respondents reported lean inventories, although one respondent said the recent reduction in demand from Asia had caught them off guard and that they were working aggressively to reduce inventories. While one respondent noted that their factories were running at only 40 to 45 percent of capacity, another respondent said that the current downturn is not nearly as bad as the high-tech recession in 2001. Most respondents expect some improvement in demand sometime in the second half of 2009.

Paper manufacturers reported continued declines in production and orders. Demand for corrugated paper used for boxes and packing material has fallen sharply. Contacts noted that this is a reflection of the overall weakness in manufacturing as producers of a wide range of products are shipping less output. Noted exceptions to the weakness are food processors, where contacts suggest that their industry remains recession-proof.

Respondents reported that while margins for gasoline were particularly weak, refinery capacity utilization held steady at about 85 percent. Respondents in petrochemicals and derivative plastics said that demand and prices have fallen sharply since the last survey. The decline in demand stemmed from declines in domestic housing, autos, and general manufacturing activity, as well as export markets. At least 10 large plants have shutdown on the Gulf Coast in recent weeks, and others have cut runs. Layoffs have been widespread among firms and their contractors.

Retail Sales

Almost all retailers reported weak holiday sales. The weakness was broad-based and included discount stores. One contact noted that it was the worst holiday season for his company in 38 years. Weakness was broad-based across department store products but contacts noted particularly sharp declines in demand for jewelry and men's clothing. A contact with stores throughout the District said that year-over-year sales declined the most in Dallas and the least in Houston. Department store contacts expect demand to be weak throughout most of 2009.

Auto dealers report that sales and traffic continue to fall from already depressed levels. While domestic brands have been hit the hardest, contacts report that recent declines have been broad-based across all vehicle brands. Respondents report that manufacturer incentives are ample but that they are not having as much impact as in the past. One respondent said that in order to reduce his inventory, he likely will not order any new vehicles until February. A bright spot is used car sales and repair services which have increased slightly since the last survey. Most contacts expected very weak new vehicle sales at least though the first half of 2009. Contacts are hoping for some improvement in the second half of the year but are cautious since the outlook remains very uncertain.

Services

Staffing firms report that demand remains sluggish. Most contacts report that there is little demand for permanent hires. Although their customers are keeping many short-term contract positions, they are not adding new positions. Contacts said that demand has been reduced by temporary plant closings, many of which have been extended due to weak demand conditions. Contacts report that some staffing firms are beginning to lower rates to remain competitive and retain market share.

Accounting and legal firms report that activity was flat to slightly down since the last survey and that receivables are getting slower and harder to collect. Legal firms reported new real estate projects have dropped off sharply and that many projects are being put on hold for an indefinite period of time. International business has also declined. Offsetting this has been an increase in litigation and bankruptcy services.

Airlines report that demand continues to weaken and that it is likely to continue to fall over the next six months. Respondents in container cargo and intermodal trade report a sharp drop off in activity since the last survey due to declines in international trade volumes. Intermodal transport services also noted a decline in demand. Shipping companies reported that the largest declines in volumes have been to retailers although consumer shipments have also weakened.

Construction and Real Estate

Housing conditions in the District remain very weak, according to respondents. Home sales have fallen considerably since credit conditions tightened, and respondents report that traffic remains nearly nonexistent. Contacts reported that cancellations remain prevalent, in some cases outpacing sales. Median home prices have edged down but have avoided the double digit declines prevalent in other areas of the country. Respondents say that compared to other areas in which they do business, Texas continues to fare better despite the poor conditions.

District respondents said apartment demand fell over the survey period. New construction added units at the same time move-outs increased, leading to increases in vacancy rates. Commercial real estate transactions--both leasing and investment--have ground to a halt. Contacts reported "nothing is going on". Outlooks remain uncertain, although one contact noted scattered signs of optimism, with people talking of possible opportunities in 2009.

Financial Services

Financial services contacts in the District continued to report a slowdown in loan demand. Contacts reported that real estate deals were basically nonexistent except for the very low risk ones. Most contacts have seen a slight deterioration in credit quality, but quality is still stable overall. On some loans, contacts have increased the interest rate by methods such as basing spreads off the LIBOR rather than the prime, and setting a floor on the prime.

Depository institutions report maintaining tight credit standards, and most report generally stable deposits. The slowdown in loan demand has been broad-based. Demand has decreased for mortgages and consumer loans, particularly auto loans and credit card issuance and purchase volume. Real estate lenders are very concerned about 2009 while other lenders expect either flat or very modest growth.

Energy

Oil services and machinery contacts reported that drilling activity has declined in response to lower energy prices. The U.S. rig count slid by 15 percent, or 300 rigs, from the peak in August, with two-thirds of the decline coming in the last six weeks of the year. Texas is down 157 rigs since the peak, and 85 rigs of this decline have come in the last six weeks. Contacts reported that the brunt of the decline is land-based and natural- gas directed. Relatively expensive shale and tight gas led the upturn, and is now leading the downturn as well. Contacts said that offshore and international activity has held up much better, and should continue to do so, based on sponsorship by companies with a longer-term perspective and much deeper pockets.

Agriculture

The cotton harvest is about 85 percent complete, and yields are lower than expected. Regions in Central Texas are suffering from a severe dry spell. The winter wheat and oats crops and pastureland are in need of rain in most parts of the District. Livestock are in fair condition but supplemental feeding is ongoing due to lack of pasture. Commodity prices have plunged from their earlier peaks but fertilizer prices have not declined as much, leaving farmers with low winter crop prices and high planting costs.

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Twelfth District--San Francisco

Economic activity in the Twelfth District weakened on net during the survey period of December through the beginning of January. Upward price pressures continued to ease overall, largely as a result of declines in the prices of energy and some commodities, and upward wage pressures have largely disappeared. Holiday season retail sales were very sluggish, and demand for services continued to soften. Manufacturing activity dropped significantly on net. Demand for agricultural products generally remained stable, but conditions weakened further for oil extractors. Conditions remained feeble in District housing markets, and demand for commercial real estate continued to fall. Contacts from financial institutions reported very weak loan demand and tight credit availability.

Wages and Prices

Upward pressures on prices eased further during the survey period. Prices for energy and selected commodities, including assorted foodstuffs and selected construction materials, continued to fall. Final prices for a wide variety of retail items were held down by extensive discounting. With few exceptions, contacts reported that they expect upward price pressures in their respective industries to remain very limited or to moderate further during early 2009.

Contacts reported little or no upward pressure on wages. With unemployment rising in most areas, companies have seen an increase in the quantity and quality of applicants for open positions, which limits upward wage pressures. Some contacts also reported that they are implementing or considering wage freezes, which employees appear increasingly willing to accept. Wage gains continued to slow for worker groups that previously had seen rapid growth, notably those skilled in the use of advanced technologies.

Retail Trade and Services

Contacts reported an exceptionally weak holiday sales season. The slowdown in retail sales continued to be more pronounced for traditional department stores, while discount chains fared better as consumers curbed their discretionary spending and focused on necessities. Several contacts described the holiday spending season as the weakest in memory, although some also noted that early expectations for weak sales helped to keep inventories largely under control. Demand weakened further for electronic items, which had been a bright spot earlier in 2008, and also for furniture and household appliances. Demand for new automobiles continued to languish, although falling gas prices spurred slightly improved sales of larger used vehicles, such as SUVs. Unit sales of gasoline remained sluggish, despite the price declines.

Demand for services fell further compared with the previous survey period. Providers of health-care services reported continued declines in activity. For providers of professional services such as advertising, legal services, accounting, and business consulting, demand continued to fall, and contacts noted concerns regarding the ability of clients to pay. Travel activity declined further: contacts from Southern California reported that much weaker demand for hotel rooms has followed recent supply expansions that had heightened the competition for bookings; in Hawaii, tourist visits and spending were down by double-digit amounts relative to 12 months earlier, and hotels and related businesses have been laying off staff.

Manufacturing

District manufacturing activity weakened significantly during the survey period of December through the beginning of January. Sales of semiconductors and other information technology products slowed substantially in recent months, causing capacity utilization to fall and inventories to rise, accompanied with layoffs by some companies. Activity for producers of wood products remained extremely depressed, with further curtailments in production and employment expected due to the sluggish pace of home construction. Capacity utilization rates at petroleum refineries remained well below their longer-term average. Metal fabricators struggled with very weak demand, which reduced capacity utilization to unusually low levels and forced some companies to impose restricted work schedules. Activity continued at high levels for aerospace manufacturers, although contacts cited uncertainty regarding demand for commercial aircraft and national defense products in coming months. Food manufacturers saw solid demand in general, albeit with some reductions due to scattered business failures among their retail customers.

Agriculture and Resource-related Industries

Demand generally remained stable for agricultural producers but weakened further for oil extractors. Sales continued at a solid pace for most types of agricultural products, while input costs fell, particularly for fuel and fertilizer. Among oil extractors, weaker demand coupled with ample worldwide supply caused inventories to rise and prices to fall, further reducing the economic viability of higher-cost capacity expansion projects.

Real Estate and Construction

Housing market activity in the District remained feeble during the survey period, and demand for commercial real estate fell further. Despite some pickup in recent months, the pace of home sales continued to be quite slow in most parts of the District; home prices continued to fall, with the pace of decline quickening in some areas. Conditions in the commercial office market remained exceptionally weak, with demand for new and existing space reportedly held down by credit market constraints and uncertainty among potential tenants regarding future business conditions. Construction activity was very limited, except for specialty projects such as hospitals and government facilities.

Financial Institutions

District banking contacts reported that loan demand remained very soft. Commercial and industrial loan volumes were at very low levels, as few businesses sought to expand production capacity or inventories. Credit quality deteriorated further, and the availability of credit remains quite constrained, with contacts reporting that some banks have withdrawn from entire lending lines. The sole bright spot was an increase in mortgage applications, especially for refinancing conforming home loans, which was spurred by the recent drops in interest rates on such loans.

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About this Study

The Joint Operating Environment is intended to inform joint concept development

and experimentation throughout the Department of Defense. It provides a perspective

on future trends, shocks, contexts, and implications for future joint force commanders

and other leaders and professionals in the national security field. This document is

speculative in nature and does not suppose to predict what will happen in the next

twenty-five years. Rather, it is intended to serve as a starting point for discussions

about the future security environment at the operational level of war. Inquiries about

the Joint Operating Environment should be directed to USJFCOM Public Affairs,

1562 Mitscher Avenue, Suite 200, Norfolk, VA 23551-2488, (757) 836-6555.

Distribution Statement A: Approved For Public Release

About this Study ii the JOE | The Joint Operating Environment 2008

The Joint Operating Environment

(JOE)

Distribution Statement A: Approved for Public Release

November 25, 2008

Requests for this document must be referred to:

United States Joint Forces Command

Center for Joint Futures (J59)

112 Lake View Parkway, Suffolk, VA 23435.

Attention: Joe Purser, 757-203-3928

https://us.jfcom.mil/sites/J5/j59/default.aspx iii the JOE | The Joint Operating Environment 2008

Foreword

Predictions about the future are always risky. Admittedly, no one has a crystal ball. Regardless, if we do not try

to forecast the future, there is no doubt that we will be caught off guard as we strive to protect this experiment

in democracy that we call America.

The Joint Operating Environment (JOE) is our historically informed, forward-looking effort to discern

most accurately the challenges we will face at the operational level of war, and to determine their inherent

implications. We recognize that the future environment will not be precisely the one we describe; however, we

are sufficiently confident of this study’s rigor that it can guide future concept development. While no study can

get the future 100 percent correct, we believe it’s most important that we get it sufficiently right, and that the

daunting challenge of perfection not paralyze our best efforts. When future war comes, our concept developers

across the Armed Services should have the fewest regrets if today they study, challenge, and implement solutions

to the security implications defined here in the JOE. In our line of work, having the fewest regrets defines

success when the shocks of conflict bring the surprise that inevitably accompanies warfare.

America retains both the powers of “intimidation and inspiration.” We will continue to play a leading role in

protecting the values that grew out of the wisdom and vision of our nation’s original architects. We must be

under no illusions about the threats to our shared values, but we must also recognize the military as only one,

albeit critical aspect of America’s strength. This strength must specifically recognize the need to adapt to the

security challenges we face, whether or not the enemy chooses to fight us in the manner that we would prefer.

America’s military cannot be dominant yet irrelevant to our policy makers’ requirements.

As the JOE goes to print, we face a challenging set of circumstances. The JOE maintains a longer term view

and avoids a preclusive vision of future war. Any enemy worth his salt will adapt to target our perceived

weaknesses, so the implications contained in this study cannot be rank ordered. But the implications do serve

as the basis of the companion Capstone Concept for Joint Operations (CCJO), which outlines how the Joint

Force will operate in the future. If the JOE serves as the “problem statement,” the CCJO serves as the way the

Joint Force will operate in the future to “solve” the problem. These two documents should be seen as two parts

of the whole.

In a field of human endeavor as fraught with uncertainty as war, it is essential that we maintain an open mind in

our approach. Our responsibility is to turn over this military to our successors in better condition than we who

serve today received it. We encourage criticism of our work. We plan to update the JOE routinely in response

to your input. Creativity in technological development, operational employment, and conceptual framework is

necessary, and it’s our intent that the JOE inspires an openness to change so urgently needed when both high-

and low-intensity threats abound.

J. N. MATTIS

General, U.S. Marine Corps

Commander, U.S. Joint Forces Command

iv Foreword iv the JOE | The Joint Operating Environment 2008

The JoinT operaTing environmenT

Challenges and Implications for the Future Joint Force

Introduction 3

Part I: The Constants 5

A. The Nature of War 5

B. The Nature of Change 6

C. The Challenge of Disruptions 8

D. Grand Strategy 9

Part II: Trends Influencing The World’s Security 10

A. Demographics 10

B. Globalization 13

C. Economics 14

D.Energy 16

E. Food 19

F. Water 20

G. Climate Change and Natural Disasters 21

H.Pandemics 21

I. Cyber 22

J. Space 23

K. Conclusion 23

Part III: The Contextual World 24

A. Competition and Cooperation Among Conventional Powers 24

B. Potential Challenges and Threats 26

1. China 26

2. Russia 29

3. The Pacific and Indian Oceans 32

4. Europe 33

5. Central and South America 33

6. Africa 34

7. The Center of Instability: The Middle East and Central Asia 34

C. Weak and Failing States 35

D. The Threats of Unconventional Power 36

E. The Proliferation of Weapons of Mass Destruction 36

F. Technology 37

G. The Battle of Narratives 39

H.Urbanization 40

Part IV: The Implications for the Joint Force 42

A. War in the Twenty-first Century 42

B. Preparing for War 43

C. The Conduct of Military Operations in the Twenty-first Century 44

D. Professional Military Education 48

Part V: Some Leading Questions 50

A. Defense Economics and Acquisition Policies 50

B. The Personnel System 50

Part VI: Concluding Thoughts 51CONTENTSThe JoinT operaTing environmenT

Challenges and Implications for the Future Joint Force

Introduction 3

Part I: The Constants 5

A. The Nature of War 5

B. The Nature of Change 6

C. The Challenge of Disruptions 8

D. Grand Strategy 9

Part II: Trends Influencing The World’s Security 10

A. Demographics 10

B. Globalization 13

C. Economics 14

D.Energy 16

E. Food 19

F. Water 20

G. Climate Change and Natural Disasters 21

H.Pandemics 21

I. Cyber 22

J. Space 23

K. Conclusion 23

Part III: The Contextual World 24

A. Competition and Cooperation Among Conventional Powers 24

B. Potential Challenges and Threats 26

1. China 26

2. Russia 29

3. The Pacific and Indian Oceans 32

4. Europe 33

5. Central and South America 33

6. Africa 34

7. The Center of Instability: The Middle East and Central Asia 34

C. Weak and Failing States 35

D. The Threats of Unconventional Power 36

E. The Proliferation of Weapons of Mass Destruction 36

F. Technology 37

G. The Battle of Narratives 39

H.Urbanization 40

Part IV: The Implications for the Joint Force 42

A. War in the Twenty-first Century 42

B. Preparing for War 43

C. The Conduct of Military Operations in the Twenty-first Century 44

D. Professional Military Education 48

Part V: Some Leading Questions 50

A. Defense Economics and Acquisition Policies 50

B. The Personnel System 50

Part VI: Concluding Thoughts 51CONTENTS

https://us.jfcom.mil/sites/J5/j59/default.aspx the JOE | The Joint Operating Environment 2008 1

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the JOE | The Joint Operating Environment 2008

The JoinT operaTing environmenT The JoinT operaTing environmenT

“War is a matter of vital importance to the State; the province of life or death; the

road to survival or ruin. It is mandatory that it be thoroughly studied.” 1

Sun Tzu

Introduction

The next quarter century will challenge U.S.

joint forces with threats and opportunities ranging from

regular and irregular wars in remote lands, to relief and

reconstruction in crisis zones, to sustained engagement

in the global commons. During this time, the causes

of conflict will vary from rational political calculation

to uncontrolled passion. Our enemy’s capabilities will

range from explosive vests worn by suicide bombers to

long-range precision-guided cyber, space, and missile

attacks. The threat of mass destruction – from nuclear,

biological, and chemical weapons – will likely expand

from stable nation-states to less stable states and even

non-state networks.

It is impossible to predict precisely how

challenges will emerge and what form they might take.

Nevertheless, it is absolutely vital to try to frame the

strategic and operational contexts of the future, in order

to glimpse the possible environments where political and

military leaders will work and where they might employ

joint forces. The value of such efforts lies not so much

in the final product, but much more in the participation

of senior leaders and decision-makers in the discussion.

Only by wrestling with the possibilities, determining the

leading indicators, and then reading the signposts of the

times will the Joint Force have some of the answers to

the challenges of the future. The alternative, to focus

exclusively on the here and now or to pass this mission

to the bureaucracy, will certainly result in getting caught

flat-footed, reacting to near-term crises as they arise, at

great cost in blood and treasure.

Thinking about the future requires an

understanding of both what is timeless and what will

likely change. As Thucydides suggested in the fifth

century BC, “the events which happened in the past…

(human nature being what it is) will at some time or other

and in much the same way be repeated in the future.”2

Many features will not change. The challenges of the

1. Sun Tzu, The Art of War, trans. and ed. by Samuel B. Griffith (Oxford,

1963), p. 63.

2. Thucydides, The History of the Peloponnesian War, trans. by Rex Warner

(London: Penguin Books, 1954), p. 48.

future will resemble, in many ways, the challenges that

American forces have faced over the past two centuries.

In spite of the current intellectual climate in much of the

developed world, conflict will not disappear. War has been

a principal driver of change over the course of history and

there is no reason to believe that the future will differ in

this respect. Neither will the fundamental nature of war

change. War will remain primarily a human endeavor.

In contrast, changes in the strategic landscape,

the introduction and employment of new technologies,

and the adaptation and creativity of our adversaries will

alter the character of joint operations a great deal. Here

too, the past can suggest much about the future – the

nature of change, its impact on human societies, and the

interplay among human societies in peaceful and warlike

competition. While much will stay the same, change will

also continue to be a driving force in human affairs.

One cannot rule out the possibility that U.S.

military forces will be engaged in persistent conflict over

the next quarter century. In the next twenty-five years,

there will continue to be those who will hijack and exploit

Islam and other beliefs for their own extremist ends. There

will continue to be opponents who will try to disrupt the

political stability and deny the free access to the global

commons that is crucial to the world’s economy. In this

environment, the presence, reach, and capability of U.S.

military forces, working with like-minded partners, will

continue to be called on to protect our national interests.

Merely sustaining the health of the Joint Force, never mind

adapting and transforming, is far more complicated in a

period of persistent conflict, with its toll on equipment,

people, and national will.

The nature of the human condition will guarantee

that uncertainty, ambiguity, and surprise will dominate

the course of events. However carefully we think about

the future; however thorough our preparations; however

coherent and thoughtful our concepts, training, and

doctrine; we will be surprised. Even the wisest of statesmen

have found their assumptions about the future confounded

by reality. The eighteenth century British leader, William

Pitt, the Younger, declared in a speech before the House

of Commons in February 1792: “Unquestionably there

https://us.jfcom.mil/sites/J5/j59/default.aspx Introduction 3

The JoinT operaTing environmenT The JoinT operaTing environmenT

has never been a time in the history of our country when,

from the situation in Europe, we might more reasonably

expect fifteen years of peace, than we have at the present

moment.”3 Within a matter of months, Britain would

become embroiled in a conflict that would last nearly a

quarter of a century and would kill more Europeans than

any other war in history up to that time.

In the broadest sense, the Joint Operating

Environment examines three questions:

l

What future trends and disruptions are likely to affect

the Joint Force over the next quarter century?

l

How are these trends and disruptions likely to define

the future contexts for joint operations?

l

What are the implications of these trends and contexts

for the Joint Force?

By exploring these trends, contexts, and

implications, the Joint Operating Environment provides a

basis for thinking about the world over the next quarter

century. Its purpose is not to predict, but to suggest ways

leaders might think about the future.

If war at its essence is a human endeavor, then it

follows that one of the most effective ways to understand

human nature is by a close consideration of history. As

such, rather than futuristic vignettes, the Joint Operating

Environment uses history as a principal way to gain insight

into the future. The discussion begins with the enduring

nature of war, the causes and consequences of change and

surprises, and the role of strategy. Part II then describes

some trends, discontinuities and potential trouble spots

that joint forces may confront. Part III analyzes how these

trends and disruptions may combine into contexts that

will likely define joint operations over the next quarter

century. Part IV describes the implications of these

contexts for the Joint Force as it confronts an uncertain

future. This section also suggests how senior leaders might

think about creating a force that is suited to address the

challenges that these contexts will present. This is the

unique contribution of the Joint Operating Environment

to the broader discussion about the future. Before

concluding, Part V offers some “leading questions” about

topics that may fall outside the traditional purview of this

study, but that nonetheless have important implications

for the future Joint Force.

We will find ourselves caught off guard by

changes in the political, economic, technological,

strategic, and operational environments. We will find

ourselves surprised by the creativity and capability of our

adversaries. Our goal is not to eliminate surprise – that is

impossible. Our goal is, by a careful consideration of the

future, to suggest the attributes of a joint force capable

of adjusting with minimum difficulty when the

surprise inevitably comes. The true test of military

effectiveness in the past has been in the ability of a force

to diagnose the conditions it actually confronts and then

quickly adapt. In the end, it will be our imagination and

agility to envision and prepare for the future, and then to

adapt to surprises, that will determine how the Joint Force

will perform over the next twenty-five years. The agility to

adapt to the reality of war, its political framework, and to

the fact the enemy also consists of adaptive humans, has

been the key component in military effectiveness in the

past and will continue to be so in the future.

3. Quoted in Colin Gray, Another Bloody Century, (London: Penguin

Books, 2005), p. 40.

4 Introduction

the JOE | The Joint Operating Environment 2008

parT i: The ConsTanTs parT i: The ConsTanTs

In the late fifth century BC, Athenian negotiators, speaking to their Spartan competitors,

with whom they were soon at war, staked out their rationale for their refusal to abandon their

position as Greece’s other great power: “We have done nothing extraordinary, nothing contrary

to human nature in accepting an empire when it was offered to us and then in refusing to give it

up. Three very powerful motives prevent us from doing so – security, honour, and self interest.

And we were not the first to act in this way. Far from it.” 4

A. The Nature of War

We cannot predict exactly what kind of war, or for

what purposes, the armed forces of the United States will

find themselves engaged in over the next quarter century.

We can only speculate about possible enemies and the

weapons they will bring to the fight. But we can state

with certainty that the fundamental nature of war will not

change. In a democracy such as the United States, political

aims, pressures, and hesitations have always conditioned

military operations – and will continue to do so. “When

whole communities go to war... the reason always lies in

some political situation.”5 War is a political act, begun

for political purposes. In the twenty-first century war

will retain its political dimension, even when it originates

in the actions of non-state and transnational groups.

The Joint Force will operate in an international

environment where struggle predominates. While the

origins of war may rest on policy, a variety of factors has

influenced the conduct of that struggle in the past and will

do so in the future. The tension between rational political

calculations of power on one hand and secular or religious

ideologies on the other, combined with the impact of

passion and chance, makes the trajectory of any conflict

difficult if not impossible to predict. In coming decades,

Americans must struggle to resist judging the world as if

it operated along the same principles and values that drive

our own country. In many parts of the world, there are

no rational actors, at least in our terms. Against enemies

capable of mobilizing large numbers of young men and

women to slaughter civilian populations with machetes

or to act as suicide bombers in open markets; enemies

eager to die, for radical ideological, religious, or ethnic

fervor; enemies who ignore national borders and remain

unbound by the conventions of the developed world;

there is little room for negotiations or compromise. It

4. Thucydides, History of the Peloponnesian War, trans. by Rex Warner

(London: Penguin Books, 1954) p. 80.

5. Carl von Clausewitz, On War, translated and edited by Michael Howard

and Peter Paret (Princeton, NJ: Princeton University Press, 1976), p. 87.

Thucydides

can become a matter of survival when human passion

takes over. Such a world has existed in recent history – in

World War II on the Eastern Front and on the islands of

the Pacific, in Africa in the Rwandan genocide, and to

some extent in Iraq. In a world where passions dominate,

the execution of rational strategy becomes extraordinarily

difficult.

War more than any other human activity

engages our senses: at times providing a “rush” of fear,

horror, confusion, rage, pain, helplessness, nauseous

anticipation, and hyper-awareness. It is in these vagaries

that imponderables and miscalculations accumulate to

paralyze the minds of military and political leaders. In

the cauldron of war, “It is the exceptional [human being]

who keeps his powers of quick decision intact.”6

There are other aspects of human conflict that

will not change no matter what advances in technology

or computing power may occur: fog and friction will

distort, cloak, and twist the course of events. Fog will

result from information overload, our own misperceptions

and faulty assumptions, and the fact that the enemy will

act in an unexpected fashion. Combined with the fog

of war will be its frictions - that almost infinite number

of seemingly insignificant incidents and actions that

can go wrong, the impact of chance, and the horrific

effect of combat on human perceptions. It will arise

“from fundamental aspects of the human condition and

unavoidable unpredictabilities that lie at the very core of

combat processes.”7

It is the constant fog and friction of war that turn

the simple into the complex. In combat, people make

mistakes. They forget the basics. They become disoriented,

ignoring the vital to focus on the irrelevant. Occasionally,

incompetence prevails. Mistaken assumptions distort

situational awareness. Chance disrupts, distorts, and

6. Carl von Clausewitz, On War, translated and edited by Michael Howard

and Peter Paret (Princeton, NJ: Princeton University Press, 1976), p. 113.

7. Barry D. Watts, Clausewitzian Friction and Future War (Washington,

DC: Institute for National Strategic Studies, 1992), pp. 122-123.

https://us.jfcom.mil/sites/J5/j59/default.aspx Part 1: The Constants 5

parT i: The ConsTanTs parT i: The ConsTanTs

confuses the most careful of plans. Uncertainty and

unpredictability dominate. Thoughtful military leaders

have always recognized that reality, and no amount of

computing power will eradicate this basic messiness.

Where friction prevails, tight tolerances, whether

applied to plans, actions, or materiel are an invitation

to failure – the more devastating for being unexpected.

Operational or logistical concepts or plans that make no

allowance for the inescapable uncertainties of war are

suspect on their face – an open invitation to failure and

at times defeat.

Still another enduring feature of conflict lies

in the recurring fact that military leaders often fail to

recognize their enemy as a learning, adaptive force. War

“is not the action of a living force upon a lifeless mass...

but always the collision of two living forces.”8 Those

living forces possess all the cunning and intractable

characteristics human beings have enjoyed since the

dawn of history.

Even where adversaries share a similar historical

and cultural background, the mere fact of belligerence

guarantees profound differences in attitudes,

expectations, and behavioral norms. Where different

culturescome into conflict,thelikelihoodthat adversaries

will act in mutually incomprehensible ways is even more

likely. Thus, “if you know the enemy and know yourself

you need not fear the results of a hundred battles.”9

The conduct of war demands a deep understanding of

the enemy – his culture, history, geography, religious

and ideological motivations, and particularly the huge

differences in his perceptions of the external world. The

fundamental nature of war will not change.

B. The Nature of Change

If war will remain a human endeavor, a conflict

between two learning and adapting forces, changes in

the political landscape, adaptations by the enemy, and

advances in technology will change the character of war.

Leaders are often late to recognize such changes. Driven

by an inherent desire to bring order to a disorderly,

chaotic universe, human beings tend to frame their

thoughts about the future in terms of continuities and

extrapolations from the present and occasionally the

past. But a brief look at the past quarter century, to

say nothing of the past four thousand years, suggests

8. Carl von Clausewitz, On War, translated and edited by Michael Howard

and Peter Paret (Princeton, NJ: Princeton University Press, 1976) p. 77.

9. Sun Tzu, Art of War, translation by Samuel B. Griffth (Oxford

University), p.84.

the extent of changes that coming decades will bring.

Twenty-fiveyearsagotheColdWarencompassed

every aspect of the American military’s thinking and

preparation for conflict – from the strategic level to the

tactical. Today, that all-consuming preoccupation is

an historical relic. A quarter century ago, the United

States confronted the Soviet Union, a truculent,

intractable opponent with leaders firmly committed to

the spread of Marxist-Leninist ideology and expansion

of their influence. At that time, few in the intelligence

communities or even among Sovietologists recognized

the deepening internal crisis of confidence that would

lead to the implosion of the Soviet Empire. The

opposing sides had each deployed tens of thousands of

nuclear weapons, as well as vast armies, air forces, and

navies across the globe. Soviet forces were occupying

Afghanistan and appeared on the brink of crushing an

uprising of ill-equipped, ill-trained guerrillas. In El

Salvador, a Soviet-backed insurgency was on the brink

of victory.

Beyond the confrontation between the United

States and Soviet Union lay a world that differed

enormously from today. China was only emerging

from the dark years of Mao’s rule. To China’s south,

India remained mired in an almost medieval level of

poverty, from which it appeared unlikely to escape.

To the sub-continent’s west, the Middle East was as

plagued by political and religious troubles as today.

But no one could have predicted then that within 25

years the United States would wage two major wars

against Saddam Hussein’s regime and commit much

of its ground power to suppressing simultaneous

insurgencies in Iraq and Afghanistan.

The differences between the culture and

organization of the American military then and now

further underline the extent of the disruptions with

the past. The lack of coordination among the forces

involved in overthrowing the “New Jewel” movement

in Grenada in October 1983 reminds us that at the time

jointness was a concept honored more in the breach

than observance. That situation led to the Goldwater-

Nichols Act in 1986.

In terms of capabilities, stealth did not yet exist

outside of the research and development communities.

The M-1 Tank and the Bradley Fighting Vehicle were only

starting to reach the Army’s forward deployed units. The

Global Positioning System (GPS) did not exist. The training

ranges of the National Training Center, Twenty-Nine Palms,

6 Part 1: The Constants the JOE | The Joint Operating Environment 2008

Strategic Estimates in the Twentieth Century

1900

If you had been a strategic analyst for the world’s leading power, you would havebeen British, looking warily at Britain’s age old enemy: France.

1910

You would now be allied with France, and the enemy would now be Germany

1920

Britain and its allies had won World War I, but now the British found themselves

engaged in a naval race with its former allies the United States and Japan.

1930

For the British, naval limitation treaties were in place, the Great Depression had

started and defense planning for the next five years assumed a “ten year” rule -- no

war in ten years. British planners posited the main threats to the Empire as theSoviet Union and Japan, while Germany and Italy were either friendly or no threat.

1936

A British planner would now posit three great threats: Italy, Japan, and the worst, aresurgent Germany, while little help could be expected from the United States.

1940

The collapse of France in June left Britain alone in a seemingly hopeless war with

Germany and Italy with a Japanese threat looming in the Pacific. America had

only recently begun to scramble to rearm its military forces.

1950

The United States was now the world’s greatest power, the atomic age had

dawned, and a “police action” began in June in Korea that was to kill over 36,500Americans, 58,000 South Koreans, nearly 3,000 Allied soldiers, 215,000 NorthKoreans, 400,000 Chinese, and 2,000,000 Korean civilians before a cease-fire

brought an end to the fighting in 1953. The main opponent in the conflict would beChina, America’s ally in the war against Japan.

1960

Politicians in the United States were focusing on a missile gap that did not exist;

massive retaliation would soon give way to flexible response, while a small

insurgency in South Vietnam hardly drew American attention.

1970

The United States was beginning to withdraw from Vietnam, its military forces inshambles. The Soviet Union had just crushed incipient rebellion in the Warsaw

Pact. Détente between the Soviets and Americans had begun, while the Chinese

were waiting in the wing to create an informal alliance with the United States.

1980

The Soviets had just invaded Afghanistan, while a theocratic revolution in Iran

had overthrown the Shah’s regime. “Desert One” -- an attempt to free Americanhostages in Iran -- ended in a humiliating failure, another indication of whatpundits were calling “the hollow force.” America was the greatest creditor nation

the world had ever seen.

1990

The Soviet Union collapses. The supposedly hollow force shreds the vaunted IraqiArmy in less than 100 hours. The United States had become the world’s greatest

debtor nation. No one outside of the Department of Defense has heard of the

internet.

2000

Warsaw is the capital of a North Atlantic Treaty Organization (NATO) nation.

Terrorism is emerging as America’s greatest threat. Biotechnology, robotics,

nanotechnology, HD energy, etc. are advancing so fast they are beyond forecasting

2010

Take the above and plan accordingly! What will be the disruptions of the next 25years?

Fallon, and Nellis were just beginning

to change U.S. preparations for war.

Precision attack was largely a matter for

tactical nuclear weapons.

One might also note how

much the economic and technological

landscapes outside of the military

have changed. Economically, in 1983

globalization was in its first stages

and largely involved trade among the

United States, Europe, and Japan. The

tigers of Southeast Asia were emerging,

but the rest of the world seemed caught

in inescapable poverty. Just to give one

example: in 1983 the daily transfer of

capital among international markets

was approximately $20 billion. Today,

it is $1.6 trillion.

On the technological side,

the internet existed only in the

Department of Defense; its economic

and communications possibilities

and implications were not apparent.

Cellular phones did not exist. Personal

computers werebeginning to come into

widespread use, but their reliability was

terrible. Microsoft was just emerging

from Bill Gates’ garage, while Google

existed only in the wilder writings

of science fiction writers. In other

words, the revolution in information

and communications technologies,

taken for granted today, was largely

unimaginable in 1983. A revolution

had begun, but its implications

remained uncertain and unclear. Other

advances in science since 1983, such as

the completion of the human genome

project, nano technologies, and

robotics, also seemed the provenance

of writers of science fiction.

In thinking about the world’s

trajectory, we have reason to believe that

the next twenty-five years will bring

changes just as dramatic, drastic, and

disruptive as those that have occurred

in the past quarter century. Indeed,

the pace of technological and scientific

https://us.jfcom.mil/sites/J5/j59/default.aspx

Introduction 7

parT i: The ConsTanTs

change is increasing. Changes will occur throughout

the energy, financial, political, strategic, operational, and

technological domains. While some change is foreseeable,

even predictable, future joint force planning must account

for the certainty that there will be surprises. How drastic,

how disruptive they might be is at present not discernible

and in some cases it will not even be noticed until they

happen.

The interplay between continuities and disruptions

will demand a joint force that can see both what has

changed and what endures. The force must then have

the ability to adapt to those changes while recognizing the

value of fundamental principles. That can only result from

an historically-minded mentality that can raise the right

questions.

C. The Challenge of Disruptions

Trends may suggest possibilities and potential

directions, but they are unreliable for understanding the

future, because they interact with and are influenced by

other factors. The down turn of Wall Street after the crash

of 1929 might well have remained a recession, but passage

of the Smoot-Hawley tariffs destroyed American trade with

other nations and turned the recession into a catastrophic

global depression. In considering the future, one should

not underestimate the ability of a few individuals, even a

The Fragility of History – and the Future...

The patterns and course of the past appear relatively straightforward

and obvious to those living in the present, but

only because the paths not taken or the events that might

have happened, did not. Nothing makes this clearer than

the fates of three individuals in the first thirty plus years

of the twentieth century. Adolf Hitler enlisted in the 16th

Bavarian Reserve Regiment (the “List” Regiment) in early

August 1914; two months later he and 35,000 ill-trained

recruits were thrown against the veteran soldiers of the British

Expeditionary Force. In one day of fighting the List Regiment

lost one third of its men. When the Battle of Langemark was

over, the Germans had suffered approximately 80% casualties.

Hitler was unscratched. Seventeen years later, when Winston

Churchill was visiting New York, he stepped off the curb

without looking in the right direction and was seriously

injured. Two years later in February 1933, Franklin Roosevelt

was the target of an assassination attempt, but the bullet aimedfor him, hit and killed the mayor of Chicago. Can any onedoubt that, had any one of these three individuals been killed,

the history of the twentieth century would have followed a

fundamentally different course?

single person, to determine the course of events. One may

well predict that human beings will act in similar patterns of

behavior in the future, but when, where and how remains

entirely unpredictable. The rise of a future Stalin, Hitler,

or Lenin is entirely possible, but completely unpredictable,

and the context in which they might reach the top is

unforeseeable.

The interplay of economic trends, vastly

different cultures and historical experiences, and

the idiosyncrasies of leaders, among a host of other

factors, provide such complexity in their interactions

as to make prediction impossible. Winston Churchill

caught those complexities best in his masterful history

of World War I:

One rises from the study of the causes of the

Great War with a prevailing sense of the

defective control of individuals upon world

fortunes. It has been well said, ‘there is always

more error than design in human affairs.’ The

limited minds of the ablest men, their disputed

authority, the climate of opinion in which they

dwell, their transient and partial contributions

to the mighty problem, that problem itself so

far beyond their compass, so vast in scale and

detail, so changing in its aspects – all this must

surely be considered…10

Thus, individuals, their idiosyncrasies, genius,

and incompetence, are major actors in these disruptions.

Perhaps the worst president in American history, James

Buchanan, was followed by the greatest, Abraham

Lincoln. Individuals invariably remain the prisoners of

their cultural and historical frame of reference, which

makes the ability to understand, much less predict, the

actions of other states and other leaders difficult. But

we should not allow this to discourage us from gaining

as deep an understanding as possible of the historical

influences of potential political and military leaders at the

strategic, operational, and tactical level.

Clearly, not all disruptions occur through the

actions of individual leaders. Great events, involving the

overthrow of regimes, the collapse of economic systems,

natural disasters, and great conflicts within or among

states have taken the flow of history and channeled it

into new and unforeseen directions. Such singularities

10. Winston S. Churchill, The World Crisis (Toronto: MacMillan, 1931), p. 6.

8 Part 1: The Constants the JOE | The Joint Operating Environment 2008

are truly unpredictable, except that we can be sure that

they will happen again. They will twist the future into

new and unexpected directions. Here, the only strategy

that can mitigate the impact of surprise is a knowledge of

the past, an understanding of the present, and a balanced

force that is willing and able to adapt.

D. Grand Strategy

As in a building, which, however fair and beautiful the

superstructure, is radically marred and imperfect if the

foundations be insecure -- so if the strategy be wrong, the

skill of the general on the battlefield, the valor of the soldier,

the brilliancy of victory, however otherwise decisive, fail of

their effect.11

Mahan

Future joint force commanders will not make

grand strategy, but they must fully understand the ends it

seeks to achieve. They will have a role to play in suggesting

how the Joint Force might be used and the means necessary

11. Robert Heinl, Dictionary of Military and Naval Quotations (U.S. Naval

Institute Press, 1976), p. 311.

for the effective use of joint forces to protect the interests of

the United States. Thus, their professional, nuanced advice

as military leaders is essential to the casting of effective

responses to strategic challenges.

In the twentieth century the relationship in the

United States between political vision and military leaders

responsible for the execution of policy proved crucial

in winning two world wars and the Cold War. Yet the

dialogue and discourses between those responsible for

casting grand strategy and those responsible for conducting

military operations has always involved tension, because

their perspectives of the world inevitably differ. In the

future, joint force commanders must understand the ends

of strategy in order to recommend the forces required (the

means) to achieve those ends. And policy makers must be

clear as to the strengths, limitations, and potential costs of

theemploymentofmilitaryforces. Therelationshipbetween

ends and means drives the logic of joint operations. Only

clear and unfettered military advice from commanders to

policy makers can provide the understanding required to

employ the Joint Force effectively.

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Engage people with what they expect; it is what they are able to discern and confirms their projection. It settles

them into predictable patterns of response, occupying their minds while you wait for the extraordinary moment

-- that which they cannot anticipate.12 Sun Tzu

Trend analysis is the most fragile element of

forecasting. The world’s future over the coming quarter

of a century will be subject to enormous disruptions and

surprises, natural as well as man-made. These disruptions,

and many other contiguous forces, can easily change

the trajectory of any single trend. The Joint Operating

Environment recognizes that many, if not all, of the trends

and trajectories of the future will be non-linear. But for

the purpose of analysis, it has used a traditional approach

to examine many of the trends and utilized conservative

estimates. For instance, demographically, it has used

estimates from sources such as the U.S. Census Bureau.

Economically, the Joint Operating Environment assumes

growth rates for developed countries of 2.5% and 4.5%

for developing countries, including China. It is in this

manner that this study considers the trends below. In the

final analysis, the value of the trends lies not in accurately

predicting them, but in intuiting how they might combine

in different ways to form more enduring contexts for future

operations. Trend analysis can also help in identifying

some indicators or signposts that one can use to “check”

the path that the world takes into the future and make

adjustments as necessary. Nevertheless, the resource and

strategic implications of even a conservative and linear

rate of increase possess consequences that suggest a dark

picture of the future.

A. Demographics

A good place to begin the discussion of

trends is demographics, because what is happening

demographically today, unless altered by some

catastrophe, has predictable consequences for the

populations of regions and states. Equally important, it

possesses implications for future strategic postures and

attitudes. In total, the world will add approximately 60

million people each year and reach a total of 8 billion

by the 2030s. Ninety-five percent of that increase will

occur in developing countries. The more important

point is that the world’s troubles will occur not only in

the areas of abject poverty, but also to an even greater

12. Sun Tzu, The Art of War, translated and edited by Samuel B. Griffith

(Oxford, 1963), p. 92.

Part II: Trends Influencing the World’s Security

extent in developing countries, where the combination of

demographics and economy permits populations to grow,

but makes meeting rising expectations difficult. Here, the

performance of the global economy will be key in either

dampening down or inflaming ethnically or religiously-

based violent movements.

The developed world confronts the opposite

problem. During the next 25 years population growth

in the developed world will likely slow or in some cases

decline. In particular, Russia’s population is currently

declining by 0.5% annually, and given Russian health

and welfare profiles, there is every prospect that decline

will continue, barring a drastic shift in social attitudes or

public policy. As a recent Center for Strategic International

Studies (CSIS) report suggested, “Russia needs to cope

with a rate of population decline that literally has no

historical precedent in the absence of pandemic.”13 To

Russia’s west, a similar, albeit less disastrous situation

exists. Over all, European nations stopped replacing their

losses to deaths in 2007, and despite considerable efforts

to reverse those trends, there is little likelihood their

populations will significantly increase by the 2030s. This

raises serious concerns about the sustainability of economic

growth in that region. It also has serious implications for

the willingness of European societies to bear the costs

involved in lives and treasure that the use of military force

inevitably carries with it.

Likewise, Japan’s population will fall from 128

million to approximately 117 million in the 2030s, but

unlike the case of Russia this will result not from any

inadequacy of Japanese medical services, which are among

the world’s best, but from the collapse of Japan’s birth

rate. The Japanese are taking serious steps to address their

demographic decline, a fact which explains their major

research and development efforts in the field of robotics as

well as their shift to a capital-intensive economy.

Over the next quarter century, China’s

population will grow by 170 million, but its population

will age significantly because of strict enforcement of

the government’s edict of one child per family. An

13. Center for Strategic International Studies (CSIS), “The Graying of the

Great Powers,” (Washington, DC), p. 7.

the JOE | The Joint Operating Environment 2008

Demographics:

Population by Age

• Eight billion people in the world by 2025 (2 billion more than today).

• Nearly all growth in the developing world.

• Absolute decline in Europe, Japan, Russia, and Korea.

• The U.S. will add 50 million people by 2025 (unique among the developed Countries

of the world).

World Population Pyramids

A population pyramid is a demographer’s tool used to

track the size and age composition of a country or group.

Each bar represents an age group in four-year increments

(youngest at the bottom) with males on the left and

females on the right. The pyramids above show projected

populations of selected countries in the 2030 time frameand the width of each pyramid is to scale. Thus, we see

a 2030 Yemen that rivals Russia in terms of population.

Developed countries generally show a typical “inverted”

pattern with dramatic declines in the raw numbers ofyouth relative to the retired. This pattern of decline will be

difficult to manage as most welfare systems in the developed

world are based on an assumption of moderate population

growth. Developing countries such as Nigeria and Yemen

illustrate how the population pyramid in fact got its name,

and are typical of fast-growing countries with large multi-

children families. The effects of China’s one-child policy are

clear, especially when compared to fast-growing India. The

United States occupies a middle position among states, with

a large, yet relatively stable population.

Source: U.S. Census Bureau

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additional demographic

factor, which may impact

on Chinese behavior, is the

choice of many families to

satisfy that limitation with

a male child. How the

resulting imbalance between

young males and females

will play out by the 2030s in

China’s external and internal

politics is impossible to

predict, because there are

few historical analogues.

Nevertheless, there are some

indications of an increasing

predilection to violence

among Chinese youth, while

there have been exuberant displays of nationalistic

feeling among the young in response to criticisms of

China’s behavior in Tibet.

By the 2030s the U.S. population will climb

by more than 50 million to a total of approximately

355 million. This growth will result not only from

births in current American families, but also from

continued immigration, especially from Mexico and

the Caribbean, which will lead to major increases in

America’s Hispanic population. By 2030 at least 15%

of the population of every state will be Hispanic in

origin, in some states reaching upwards of 50%. How

effective Americans prove in assimilating these new

immigrants into the nation’s politics and culture will

play a major role in America’s prospects. In this regard,

the historical ability of the United States to assimilate

immigrants into its society and culture gives it a distinct

advantage over most other nations, who display little

willingness to incorporate immigrant populations into

the mainstream of their societies.

India will grow by 320 million during the next

quarter of a century. The tensions that arise from a

growing divide between rich and poor in a nation

already driven by a multiplicity of races and religions

could seriously impact on its potential for further

economic growth. Exacerbating tensions will be the

divide between the sub-continent’s huge middle class

and those in the villages mired in poverty, as well as the

divide between Muslims and Hindus. Nevertheless,

India’s democratic system gives some latitude for

political changes to accommodate society’s poor.

The continued population growth across the

Middle East and in Sub-Saharan Africa has only

recently begun abating, but not fast enough to forestall a

demographic crisis, where economic growth fails to keep

pace with population growth. In areas of abject poverty,

continued growth among the youth has significance for

the employment of U.S. forces called upon to feed the

starving and mitigate the suffering. Where economic

growth fuels but does not satisfy expectations, the

potential for revolution or war, including civil war, will

be significant.

Even as the developing world copes with its youth

bulge, the developed world will confront its acute aging

problem. By the 2030s the number of elderly people

in developed countries will double. In Japan there will

be 63 elderly for every 100 workers, with Europe not

far behind with 59 per 100. The United States will

be slightly better off with 44 elderly per 100 workers.

Even China will see its ratio of elderly to working

population double (from 12 to 23 per 100 workers)

as a result of better diet and improved medical care.

Such demographic trends will make it less likely that

nations in the developed world will sacrifice their youth

in military adventures, unless extraordinary threats

appear. Regions such as the Middle East and Sub-

Saharan Africa, where the youth bulge will reach over

50% of the population, will possess fewer inhibitions

about engaging in conflict.

Around the world, humanity is on the move,

with Muslims and Africans moving to Europe, ethnic

Chinese moving into Siberia, Mexicans and other

12 Part II: Trends Influencing the World’s Security the JOE | The Joint Operating Environment 2008

Latin Americans moving north to the United States

the inequality of rich and poor. In some worst-case

and Canada, and citizens of the Philippines and India

scenarios, they portray the rise of resentment and

providing the labor and small commercial backbones

violence throughout the world as a direct result of

of the economies of the Gulf States. Equally important

globalization. Not surprisingly, the future is likely to

are the migrations occurring in war torn areas in Africa

contain both good and bad as globalization accelerates

in areas like the Sudan, Somalia,

the pace of human interaction and extends its reach.

Darfur, Rwanda. Such migrations

disrupt patterns of culture, politics,

and economics and in most cases

carry with them the potential of

further dislocations and troubles.

Everywhere, people are

moving to cities. Skilled workers,

doctors, and engineers are leaving

the undeveloped world as fast as

they can to make a living in the

developed world. Increasingly,

these global diasporas connect

through the internet and telephone

to their home countries. Often,

the money they send back to their

families forms major portions of the

local economies back in their home

communities.

B. Globalization

For the most part, the

developed world recognizes that it

has a major stake in the continuing

progress of globalization. The same

can be said for those moving into

the developed world. Nevertheless,

one should not ignore the histories

and passions of popular opinion

in these states as they make their

appearance. One should not confuse

developed world trappings for an

underlying stability and maturity

of civil societies. A more peaceful

cooperative world is only possible if

the pace of globalization continues.

In particular, this means engaging

China and other nations politically

and culturally as they enter into the

developed world.

The critics of globalization

often portray its dark side in

Lessons from the History of Globalization

How can one best define globalization? Some might delineate it in terms of increased

international trade, limited restrictions on the movement of peoples, and light regulation on the

flow of capital. At least that was how politicians and pundits defined it at the start of the twentieth

century. At that time, Europeans did not require passports to travel from one country to another on

the continent, a situation restored only in the late 1990s. By 1913 the value of international trade

as a percentage of world GDP had reached a level the global economy would not replicate until

the last decade of the twentieth century. The economies of the United States and the German Reich

were expanding at unheard of rates. Western merchants were queuing up to supply China’s teeming

masses, as that country opened its markets for the first time in centuries. Furthermore, the largest

migration – and a peaceful one at that – in history was taking place, as 25 million Europeans left

home, most immigrating to the United States.

The world also saw technological and scientific revolutions unequaled in history, which

in turn spawned revolutions in travel and communications. Travel across the Atlantic was now

a matter of days rather than weeks or months. Telegraph cables linked the continents for near

instantaneous communications. Railroads allowed travelers to cross continents in days rather

than months. The internal combustion engine was already impacting on travel by land, while

the appearance of the aircraft in 1903 suggested even greater possibilities. A complex web of

international agreements, such as the International Postal Union and the International Telegraph

Conventions, welded these changes together. Again as with today, many were not content to leave

the direction of the new world order to governments. In the first decade of the century activists

formed 119 international organizations and 112 in the second decade.

For much of humanity, this was a time of hope and optimism. As early as the mid-

nineteenth century, John Bright, a British industrialist, argued that “nothing could be so foolish as

a policy of war for a trading nation. Any peace was better than the most successful war.” In 1911

a British journalist, Norman Angell, published a work titled The Great Illusion, which became an

international best seller. In it, he argued the expansion of global commerce had changed the nature

of wealth, which no longer would depend on control of territory or resources.

For Angell, the belief that military strength was the basis for security represented a dangerous

illusion. As for war itself, it represented a futile endeavor incapable of creating material wealth,

while putting much at risk. His arguments boiled down to a belief that the interlocking networks

of global trade made war impossible. In 1913, he published an improved edition to even greater

acclaim. Yet, within a year the First World War had broken out. The result of that conflict in

political and economic terms was to smash globalization for the next seventy years. Angell had

been right about the absolute destructive effects of modern war. He had been wrong about human

nature and its passions.

Why is this important? Because these same arguments have regained currency. For

many, particularly in the West, the interlocking trading and communications networks of the

twenty-first century with their benefits have made war, if not impossible, then at least obsolete.

Accordingly, any future war would cost so much in lives and treasure that no rational political

leader would ever pursue it. The problem is that rationality, at least in their terms, does not exist

in much of the world outside Europe, the United States, and Japan. Saddam Hussein managed to

invade two of Iraq’s six neighbors in the space of less than ten years and sparked three wars in the

period he ruled. The first of his wars against Iran resulted in approximately 250 thousand Iraqi

deaths and half a million Iranian dead, while his wars against his own people killed upwards of 100

thousand. In historical terms, globalization is not the norm for human affairs.

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The processes propelling globalization over the

next two decades could improve the lives of most of

the world’s population, particularly for hundreds of

millions of the poorest. Serious violence, resulting from

economic trends, has almost invariably arisen where

economic and political systems have failed to meet

rising expectations. A failure of globalization would

equate to a failure to meet those rising expectations.

Thus, the real danger in a globalized world, where

even the poorest have access to pictures and media

portrayals of the developed world, lies in a reversal or

halt to global prosperity. Such a possibility would lead

individuals and nations to scramble for a greater share

of shrinking wealth and resources, as occurred in the

1930s with the rise of Nazi Germany in Europe and

Japan’s “co-prosperity sphere” in Asia.

Admittedly, some will also be left behind

by globalization, either through the misfortunes of

geography, culture (much of sub-Saharan Africa),

or design (North Korea and Burma). Many of these

nations will be weak and failing states and will require

an international array of economic, diplomatic, and

military resources to establish or sustain stability.

In a globalized world of great nations, the

United States may not always have to take the lead in

handling the regional troubles that will arise. By the

2030s, every region of the world will likely contain

local economic powers or regional organizations capable

of leadership. In any case, the United States will often

find it prudent to play a cooperative or supporting

role in military operations around the world. In most

cases the assisting of, or intervention in, failing states

will require a cooperative engagement between the

United States and regional powers. Again, the skills of

a diplomat in working with other people and military

organizations from different cultures must be in the tool

kit of commanders, staffs, and personnel throughout the

Joint Force.

C. Economics

Using a base line of 2.5% growth for the

developed world and 4.5% growth for the developing

world, including China and India (a figure that grossly

understates the present growth trajectory of these two

nations), the world economy would double by the

2030s from $35 trillion to $72 trillion. Global trade

would triple to $27 trillion.

Given these projections, those living in extreme

poverty would fall from 1.1 billion to 550 million, while

those living on $2 a day would fall from 2.7 billion to 1.9

billion. Currently, only six countries in the developing

world possess populations of over 100 million people

and a GDP of at least $100 billion (China, Russia,

India, Indonesia, Brazil, and Mexico). By the 2030s

Bangladesh, Nigeria, Pakistan, the Philippines, and

Vietnam will have joined that group. Thus, in terms

of the developing world alone, there would be 11 states

with the population and the economic strength to build

military forces possessing the ability to project significant

military power in their region.

As more young enter the work force, the

developing world will need to increase employment by

nearly 50 million jobs per year. China and India alone

need to create 8 to 10 million jobs annually to keep pace

with the numbers entering the work force every year. If

economic growth suffices to provide such employment,

it would go far to reduce international tensions and

the endemic troubles inherent in youth bulges. While

poverty has rarely been a driving force for revolutionary

movements and wars, rising expectations often have.

And in a world covered by media reports and movies from

around the globe, rising expectations will increasingly

be a driving force of politics, war, and peace, however

The disparity between Growth and GDP

14 Part II: Trends Influencing the World’s Security the JOE | The Joint Operating Environment 2008

The Volatility of Trends

Economic estimates rest on trend lines easily disputed both in the present and the future. For instance, were one to employ the same

methodology used to compute the chart on the previous page in 1935, to predict future national GDPs in 1955, the results would be off by an

order of magnitude. This chart presents the equivalent of a central scenario. Nevertheless, a word of warning is in order. In 1928 most economists

would have given far rosier prospects for the American and world economies. Four years later, they would have given a far darker picture. That

is the nature of change in economics as well as in very other human endeavor. Wide variations in either direction are not just feasible – they are

likely.

As the Joint Operating Environment goes to print the world is in the midst of the worst economic crisis since the Great Depression.

While the final resolution is not yet in sight, the authors are of the opinion that the proactive measures taken by world governments (adding huge

amounts of liquidity, recapitalizing the financial system and purchasing bad assets) will ensure that a global economic meltdown will not occur.

Yet, it is almost certain that there will be a rather nasty global recession of indeterminate length. Recessions, while painful, are part of the natural

business cycle and are unlikely to have a major impact on the trends outlined in this document.

Nevertheless, the long-term strategic consequences of the current financial crises are likely to be significant. Over the next several

years a new international financial order will likely arise that will redefine the rules and institutions that underpin the functioning, order, and

stability of the global economy. There is one new watchword that will continue to define the global environment for the immediate future –

interconnectedness.

Until a new structure emerges, strategists will have to prepare to work in an environment where the global economic picture can change

suddenly, and where even minor events can cause a cascading series of unforeseen consequences.

well individual economies may perform.

In contrast, real catastrophes may occur if

economic growth slows or reverses either on a global

scale or within an emerging power. Growing economies

and economic hopes disguise a number of social ills and

fractures. The results of a dramatic slowdown in China’s

growth, for example, are unpredictable and could

easily lead to internal difficulties or aggressive behavior

externally. That is precisely what happened in Japan in

the early 1930s with the onset of the Great Depression.

Even within the most optimistic economic scenarios,

there will be major areas of the world left behind – the

bottom billion. Between now and the 2030s, many

of these areas will likely lie in sub-Saharan Africa and

the Middle East (excluding the oil boom countries).

Although both regions have maintained impressive

growth rates over the past several years, those rates have

not been sufficient to decrease unemployment.

If economic stability and growth continue

unabated up to the 2030s, there would be sufficient

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global resources to provide support for failing and

failed states --that is, providing the political will is

there. A broken economy is usually a harbinger of

social collapse and anarchy, or ruthless despotism.

Neither is attractive, but if the United States chooses

to intervene in such situations, political and military

leaders should keep in mind that they should only

insert professional military forces if they are willing

to sustain and inflict casualties which could result on

both sides, as the experiences of the intervention in

Somalia in 1993 underline.

A central component of America’s global

military posture is its massive economic power. This

power is predicated on a financially-viable, globally

connected domestic economy. Should this central

feature of American power be weakened, it is highly

likely that military capabilities will be diminished or

otherwise degraded as a result.

D. Energy

To meet even the conservative growth rates

posited above, global energy production would need

to rise by 1.3% per year. By the 2030s, demand

would be nearly 50% greater than today. To meet that

demand, even assuming more effective conservation

measures, the world would need to add roughly the

equivalent of Saudi Arabia’s current energy production

every seven years.

Unless there is a major change in the relative

reliance on alternative energy sources, which would

require vast insertions of capital, dramatic changes

in technology, and altered political attitudes toward

nuclear energy, oil and coal will continue to drive

the energy train. By the 2030s, oil requirements

could go from 86 to 118 million barrels a day

(MBD). Although the use of coal may decline in

the Organization for Economic Cooperation and

Development (OECD) countries, it will more than

double in developing nations. Fossil fuels will still

make up 80% of the energy mix in the 2030s, with

oil and gas comprising upwards of 60%. The central

problem for the coming decade will not be a lack of

petroleum reserves, but rather a shortage of drilling

platforms, engineers and refining capacity. Even were

a concerted effort begun today to repair that shortage,

it would be ten years before production could catch

up with expected demand. The key determinant here

would be the degree of commitment the United States

and others would display in addressing the dangerous

vulnerabilities the growing energy crisis presents.

That production bottleneck apart, the potential

sources of future energy supplies nearly all present their

own difficulties and vulnerabilities as shown here:

None of the above provides much reason for

optimism. At present, the United States possesses

approximately 250 million cars, while China with its

immensely larger population possesses only 40 million.

Non-Organization of Petroleum Exporting Countries (OPEC) oil:

New sources (Caspian Sea, Brazil, Colombia, and new portions of

Alaska and the Continental shelf) could offset declining production

in mature fields over the course of the next quarter century. But

without drilling in currently excluded areas, they will add little

additional capacity.

Oil Sands and Shale: Production from these sources could increase

from 1 MBD to over 4 MBD, but current legal constraints, such

as U.S. law forbidding importation of oil from Canada’s tar sands,

discourage investment.

Natural Gas: Production from this energy source could increase to

the equivalent of 2 MBD, with half coming from OPEC countries.

Biofuels: Production could increase to approximately 3 MBD–

equivalent, but starting from a small base, biofuels are unlikely

to contribute more than 1% of global energy requirements by the

2030s. Moreover, even that modest achievement could curtail

the supply of foodstuffs to the world’s growing population, which

would add other national security challenge to an already full

menu.

Renewable: Wind and solar combined are unlikely to account for

more than 1% of global energy by 2030. That assumes the energy

from such sources will more than triple, which alone would require

major investments.

Nuclear: Nuclear energy offers one of the more promising

technological possibilities, given significant advances in safety

since the 1970s. In particular, it could play a major role in

replacing coal–fired plants, and a greater supply of cheap electricity

could encourage electric–powered transportation. Nevertheless,

expanding nuclear plants confronts considerable opposition

because of public fears, while the disposal of nuclear waste

remains a political hot potato. Moreover, construction of nuclear

power plants in substantial numbers will take decades.

OPEC: To meet climbing global requirements, OPEC will

have to increase its output from 30 MBD to at least 50 MBD.

Significantly, no OPEC nation, except perhaps Saudi Arabia,

is investing sufficient sums in new technologies and recovery

methods to achieve such growth. Some, like Venezuela and

Russia, are actually exhausting their fields to cash in on the

bonanza created by rapidly rising oil prices.

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Although the world depends on oil, existing capacities and the

development of existing reserves cannot keep up with demand.

Massive investments in enhanced oil recovery techniques, non-

conventional oil reserves such as oil shale, and large scale new

finds will be required to meet anticipated future oil demand.

The Chinese are laying down approximately 1,000

kilometers of four–lane highway every year, a figure

suggesting how many more vehicles they expect to

possess, with the concomitant rise in their demand for

oil. The presence of Chinese “civilians” in the Sudan

to guard oil pipelines underlines China’s concern for

protecting its oil supplies and could preview a future

in which other states intervene in Africa to protect

scarce resources.

In summary:

To generate the energy required worldwide by the 2030s would

require us to find an additional 1.4 MBD every year until then.

During the next twenty-five years, coal, oil, and natural gas

will remain indispensable to meet energy requirements. The

discovery rate for new petroleum and gas fields over the past two

decades (with the possible exception of Brazil) provides little

reason for optimism future efforts will find major new fields.

At present, investment in oil production is only beginning to

pick up, with the result that production could reach a prolonged

plateau. By 2030, the world will require production of 118

MBD, but energy producers may only be producing 100 MBD

unless there are major changes in current investment and drilling

capacity.

By 2012, surplus oil production capacity could entirely

disappear, and as early as 2015, the shortfall in output could

reach nearly 10 MBD.

To avoid a disastrous energy crunch, together with the economic

consequences that would make even modest growth unlikely, the

developed world needs to invest heavily in oil production. There

appears to be little propensity to consider such investments.

Although as oil prices increase, market forces will inexorably

create incentives. But the present lack of investment in this area

has created major shortages in infrastructure (oil rigs, drilling

platforms, etc.) necessary for major increases in exploration and

production.

The implications for future conflict are

ominous. If the major developed and developing states

do not undertake a massive expansion of production

and refining capabilities, a severe energy crunch is

inevitable. While it is difficult to predict precisely what

economic, political, and strategic effects such a shortfall

might produce, it surely would reduce the prospects for

growth in both the developing and developed worlds.

Such an economic slowdown would exacerbate other

unresolved tensions, push fragile and failing states

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World oil Trade Choke poinTs

OPEC nations will remain a focal point of great-power interest. These nations may have a vested interest

in stymieing production increases, both to conserve finite supplies and keep prices high. Should one of the

consumer nations choose to intervene forcefully, the “arc of instability” running from North Africa though to

Southeast Asia easily could become an “arc of chaos,” involving the military forces of several nations.

OPEC nations will find it difficult to invest much of the cash inflows that steadily rising oil prices bring. While

they will invest substantial portions of such assets globally through sovereign wealth funds – investments that

come with their own political and strategic difficulties – past track records, coupled with their appraisal of their

own military weaknesses, suggests the possibility of a military buildup. With the cost of precision weapons

expected to decrease and their availability increasing, joint force commanders could find themselves operating

in environments where even small, energy-rich opponents have military forces with advanced technological

capabilities. These could include advanced cyber, robotic, and even anti-space based systems.

Finally, presuming the forces propelling radical Islam at present do not dissipate, a portion of OPEC’s windfall

might well find its way into terrorist coffers, or into the hands of movements with deeply anti-modern, anti-

Western goals, movements which have at their disposal increasing numbers of unemployed young men eager to

attack their perceived enemies.

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further down the path toward collapse,

and perhaps have serious economic

impact on both China and India. At

best, it would lead to periods of harsh

economic adjustment. To what extent

conservation measures, investments

in alternative energy production, and

efforts to expand petroleum production

from tar sands and shale would mitigate

such a period of adjustment is difficult

to predict. One should not forget that

the Great Depression spawned a number

of ferocious totalitarian regimes that

sought economic prosperity for their

nations by ruthless conquest, while Japan

went to war in 1941 to secure its energy

supplies.

One other potential effect of an energy crunch

could be a prolonged U.S. recession which could lead

to deep cuts in defense spending (as happened during

the Great Depression). Joint force commanders could

then find their capabilities diminished at the moment

they may have to undertake increasingly dangerous

missions. Should that happen, adaptability would

require more than preparations to fight the enemies of

the United States, but also the willingness to recognize

and acknowledge the limitations of America’s military

forces. The pooling of U.S. resources and capabilities

with allies would then become even more critical.

Coalition operations would become essential to

protecting national interests.

E. Food

Two major factors drive food requirements: a

growing global population and prosperity that expands

dietary preferences. While food shortages still occur

today, they are more likely to reflect politically-inflicted,

rather than natural causes. Several mitigating trends

could diminish the possibility of major food shortages.

For starters, any slowdown in the world’s

population growth may reduce overall demand for food

and thus ease pressure to expandand intensify agriculture.

On the other hand, increased animal protein use in

countries with rapidly rising income levels is placing

considerable pressure on the world’s food supply, since

animal production requires much greater input for

calories produced. Opposition to genetically modified

foods is dissipating. As a result, there is a reasonable

chance of sparking a new “green revolution” that would

expand crop and protein production sufficiently to meet

world requirements. The main pressures on sufficient

food supplies will remain in countries with persistently

high population growth and a lack of arable land, in

most cases exacerbated by desertification and shortages

in rainfall.

In a world with adequate global supply but

localized food shortages, the real problems will stem

from how food is distributed. How quickly the world

reacts to temporary food shortages inflicted by natural

disasters will also pose challenges. In such cases, joint

forces may find themselves involved in providing lift,

logistics, and occasionally security to those charged with

relief operations.

Natural disease will also have a say in the

world’s food supply. The Irish potato blight was not an

exceptional historical event. As recently as 1954, 40%

of America’s wheat crop failed as a result of black-stem

disease. There are reports of a new aggressive strain of

this disease (Ug99) spreading across Africa and possibly

reaching Pakistan. Blights threatening basic food crops

such as potatoes and corn could have destabilizing effects

on nations close to the subsistence level. Food crises have

led in the past to famine, internal and external conflicts,

the collapse of governing authority, migrations, societal

collapse, and social disorder. In such cases, many people

in the crisis zone may be well-armed and dangerous,

making the task of the Joint Force in providing relief

that much more difficult. In a society confronted with

starvation, food becomes a weapon every bit as important

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as ammunition.

Access to fish stocks has been an important

natural resource for the prosperity of nations with

significant fishing fleets. Competition over access to

these resources has often resulted in naval conflict.

Conflicts have erupted as recently as the Cod War (1975)

between Britain and Iceland and the Turbot War (1995)

between Canada and Spain. In 1996, Japan and Korea

engaged in a naval standoff over rocky outcroppings

that would establish extended fishing rights in the Sea

of Japan. These conflicts saw the use of warships and

coastal protection vessels to ram and board vessels, and

open conflict between the naval forces of these states.

Over-fishing and depletion of fisheries and competition

over those that remain have the potential for causing

serious confrontations in the future.

F. Water

As we approach the 2030s, agriculture will likely

remain the source of greatest demand for water worldwide,

accounting for 70% of total water usage. In comparison,

industry will account for only 20%, while domestic usage

will likely remain steady at 10%. Per unit harvest yield,

developed nations are more efficient than developing

nations in using available water supplies for agricultural

irrigation and use far less than the 70% average. Improved

agricultural techniques could further increase the amount

of land under irrigation, and increase yields per unit of

water used.

In short, from a global perspective, there should

be more than sufficient water to support the world’s

population during the next quarter century. However, in

Projected Water Scarcity in 2025

Economic water scarcity

Not estimated

Approaching physical

water scarcity

Little or No water scarcity

Physical water scarcity

Physical Scarcity: Physical access to water is limited, or sources of water

overused and overmanaged, leading to serious water scarcity downstream.

Economic Scarcity: A population does not have adequate financial or

political means to obtain adequate sources of water.

SOURCE: International Water Management Institute

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some regions the story is quite different. The Near East and

North Africa use far more than the global average of 70%

of available water dedicated to irrigation. By the 2030s, at

least 30 developing nations could use even more of their

water for irrigation.

In recent times, the increasing unreliability of an

assured supply of rainwater has forced farmers to turn more

to groundwater in many areas. As a result, aquifer levels are

declining at rates between one and three meters per year.

The impact of such declines on agricultural production

could be profound especially since aquifers, once drained,

may not refill for centuries.

Within a quarter century, water scarcity could affect

approximately 3 billion people.

One should not minimize the prospect of wars

over water. In 1967, Jordanian and Syrian efforts to dam

the Jordan River was a contributing cause of the Six-Day

War between Israel and its neighbors. Today, Turkish dams

on the upper Euphrates and Tigris Rivers, the source of

water for the Mesopotamian basin, pose similar problems

for Syria and Iraq. Turkish diversion of water to irrigate

mountain valleys in eastern Turkey already reduces water

downstream. Even though localized, conflicts sparked by

water scarcity easily could destabilize whole regions. The

continuing crisis in Sudan’s Darfur region, now spreading

to Chad, is an example of what could happen on a wider

scale between now and the 2030s. Indeed, it is precisely

along other potential conflict fault lines that potential crises

involving water scarcity are most likely.

Whether the United States would find itself

drawn into such conflicts is uncertain, but what is certain

is that future joint force commanders will find conflict

over water endemic to their world, whether as the spark

or the underlying cause of conflicts among various racial,

tribal, or political groups. Were they called on to intervene

in a catastrophic water crisis, they might well confront

chaos, with collapsing or impotent social networks and

governmental services. Anarchy could prevail, with armed

groups controlling or warring over remaining water, while

the specter of disease resulting from unsanitary conditions

would hover in the background.

The latter is only one potential manifestation of

a larger problem. Beyond the problems of water scarcity,

will be those associated with water pollution, whether from

uncontrolled industrialization, as in China, or from the

human sewage expelled by the mega-cities and slums of

the world. The dumping of vast amounts of waste into the

world’s rivers and oceans threatens the health and welfare

of large portions of the human race, to say nothing of the

affected ecosystems. While joint forces rarely will have

to address pollution problems directly, any operations in

polluted urban areas will carry considerable risk of disease.

Indeed, it is precisely in such areas that new and deadly

pathogens are most likely to arise. Hence, commanders

may be unable to avoid dealing with the consequences of

chronic water pollution.

G. Climate Change and NaturalDisasters

The impact of global warming and its potential

to cause natural disasters and other harmful phenomena

such as rising sea levels has become a prominent—and

controversial—national and international concern. Some

argue that there will be more and greater storms and

natural disasters, others that there will be fewer.14 In

many respects, scientific conclusions about the causes and

potential effects of global warming are contradictory.

Whatever their provenance, tsunamis, typhoons,

hurricanes, tornadoes, earthquakes and other natural

catastrophes have been and will continue to be a concern

of joint force commanders. In particular, where natural

disasters collide with growing urban sprawl, widespread

human misery could be the final straw that breaks the back

of a weak state. In the 2030s as in the past, the ability

of U.S. military forces to relieve the victims of natural

disasters could help the United States’ image around the

world. For example, the contribution of U.S. and partner

forces to relieving the distress caused by the catastrophic

Pacific tsunami of December 2006 reversed the perceptions

of America held by many Indonesians. Perhaps no other

mission performed by the Joint Force provides so much

benefit to the interests of the United States at so little cost.

H. Pandemics

One of the fears haunting the public is the

appearance of a pathogen, either man–made or natural,

able to devastate mankind, as the “Black Death” did in the

Middle East and Europe in the middle of the fourteenth

century. Within barely a year, approximately one–third of

Europe’s population died. The second-and third-order

effects of the pandemic on society, religion, and economics

14. Kerry Emanuel, Ragoth Sundaraarajan, and John Williams, “Hurricanes and

Global Warming,” Bulletin American Meteorological Society, March 2008, pp. 347367.

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were devastating. In effect, the Black Death destroyed the

sureties undergirding Medieval European civilization.

It is less likely that a pandemic on this scale will

devastate mankind over the next two decades. Even though

populations today are much larger and more concentrated,

increasing the opportunities for a new pathogen to spread,

the fact that mankind lives in a richer world with greater

knowledge of the world of microbes, the ability to enact

quarantines, a rapid response capability, and medical

treatment, suggests that authorities could control even the

most dangerous of pathogens. The crucial element in any

response to a pandemic may be the political will to impose

a quarantine.

The rapid termination of 2003’s Severe Acute

Respiratory Syndrome (SARS) pandemic does provide hope

that current medical capabilities could handle most pandemic

threats successfully. In the five months after initial reports

from East Asia in February of an atypical respiratory disease,

medical authorities reported more than 8,000 cases in 30

different countries. The disease itself was highly contagious

and life-threatening: almost 10% of reported cases died.

However, once doctors identified the disease, the combined

efforts of local, national, and international authorities

contained it. Newly reported cases increased rapidly in

March and April 2003, peaked in early May, and thereafter

rapidly declined.

The SARS case suggests that the risk of a global

pandemic is not as great as some fear. That does not mean

that it is nonexistent. A repetition of the 1918 influenza

pandemic, which led to the deaths of millions world-wide

would have the most serious consequences for the United

States and the world politically as well as socially. The

dangers posed by the natural emergence of a disease capable

of launching a global pandemic are serious enough, but

the possibility also exists that a terrorist organization might

acquire a dangerous pathogen.

The deliberate release of a deadly pathogen, especially

one genetically engineered to increase its lethality or virulence,

would present greater challenges than a naturally occurring

disease like SARS. While the latter is likely to have a single

point of origin, terrorists would seek to release the pathogen

at several different locations and it would spread faster. This

would seriously complicate both the medical challenge of

bringing the disease under control and the security task of

fixing responsibility for its appearance.

The implications for joint forces of a pandemic

as widespread and dangerous as that of 1918 would be

profound. American and global medical capabilities would

soon find themselves overwhelmed. If the outbreak spread

to the United States, the Joint Force might have to conduct

relief operations beyond assisting in law-enforcement and

maintaining order when legal prerequisites are met, as

currently identified by the National Strategy for Pandemic

Influenza. Even as joint force commanders confronted an

array of missions, they would have to take severe measures

to preserve the health of their forces and protect medical

personnel and facilities from public panic and dislocations.

Thucydides captured the moral, political, and psychological

dangers that a global pandemic would cause in his description

of the plague’s impact on Athens: “For the catastrophe was so

overwhelming that men, not knowing what would happen

next to them, became indifferent to every rule of religion or

of law.”15

I. Cyber

Perhaps the most important trend in the area of

science and technology is the continuing information

and communications revolution and its implications.

Although many pundits have touted the ability of

information to “lift the fog and friction of war,” such

claims have foundered on the rocks of reality.

Key to understanding information technology

in the 2030s is the fact that the pace of technological

change is accelerating almost exponentially. Because most

individuals tend to view change in a linear fashion, they

tend to overestimate what is achievable by technology in

the short term, while dramatically underestimating and

• An iPod today can hold some 160 gigabytes of data, or

160,000 books. The iPod of 2020 could potentially hold

some 16 terabytes of information – essentially the entire

Library of Congress.

• Connectivity to the home (or node in military networks)

grows by 50% a year. Therefore by 2030, people will have

about 100,000 times more bandwidth than today.

• The computing capacity available to the average home

will be a computer that runs at a rate of one million

times faster than a computer today (2.5 petabytes vs. 2.5

gigabytes). A typical home computer would be capable of

downloading the entirety of today’s Library of Congress (16

terabytes), in 128 seconds – just over two minutes’ time.

The technical capacity of the telegraph in 1900, was some

2 bits per second across continental distances, meaning

that same Library of Congress would have required a

transmission time of 3,900 years.

15. Thucydides, History of the Peloponnesian War, trans. by Rex Warner

(London: Penguin Books, 1954) p. 155.

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thethe JOE

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The JThe Joint O

oint Ooint Operating E

perating Eperating Envir

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onment 2008onment 2008

discounting the power of scientific and technological

advances in the long term.

If the pace of technical advances holds true,

greater technological change will occur over the next

twenty years than occurred in the whole of the twentieth

century. In many ways the world of 2030 will be nearly

as strange as the

world of 2000

would have been

to an observer from

1900. The advances

in communication

and information

technologies

will significantly

advance the

capabilities of

the Joint Force.

Nevertheless, those

same advances

will be available

to America’s

opponents and

they will use those

advances to attack,

degrade, and disrupt

communications

and the flow of

information. Indeed, our adversaries have often taken

advantage of computer networks and the power of

information technology not only to directly influence

the perceptions and will of the United States, its

decision-makers, and population, but also to plan and

execute savage acts of terrorism. It is also essential that

joint forces be capable of functioning in an information-

hostile environment, so as not to create an Achilles’ heel

by becoming too network dependent.

J. Space

In 2007 the Chinese used an interceptor missile to

destroy a satellite in space. In that single act, they made

clear their belief that space was a potential theater of conflict

and that they aimed to possess the capability to fight in that

environment. As with the profusion of inexpensive precision

weapons, technological advances and increasing wealth will

place the ability to conduct military operations in space

within the reach of an increasing number of players.

Over the past several decades the United States

has enjoyed an unchallenged dominance over the dark

realm beyond the atmosphere. However, the increasing

proliferation of launch and satellite capabilities ,as well as the

development of anti-satellite capabilities, has begun to level

the playing field. Other countries are leveraging the benefits

of space for both commercial and defense applications,

and the United States

already confronts

increased competition

over its use. This will

increasingly be the case

over coming decades.

The implications are

clear: the Joint Force is

going to have to be in a

position to defend the

spaced-based systems

on which so many of

its capabilities depend.

As well, the Joint Force

must anticipate the

inevitable attack and

know how to operate

effectively when these

attacks degrade those

systems.

K. Conclusion

The previous discussion outlined just some of the

trends that are likely to influence the security environment

for the next quarter century. These individual trends,

whether they adhere to predictions or not, will combine

together in ways to form more broad and robust contexts

that will define the world in which the Joint Force will

operate in the future. By understanding the trends

and resultant contexts, joint force leaders have a way to

appreciate their implications, and to identify some key

indicators to watch along the way. This provides a means

of assessing our assumptions and predictions, and our

progress towards building and operating the Joint Force

to meet the future. What follows then is a discussion of

the contextual world of the 2030s.

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Contexts of conflict and war are the environment created by the

confluence of major trends. Contexts illuminate why wars occur and

how they might be waged .16

Colin Gray

A. Competition and CooperationAmong Conventional Powers

Competition and conflict among conventional

powers will continue to be the primary strategic

and operational context for the Joint Force over

the next 25 years. For the purpose of the Joint

Operating Environment, a “conventional power” is an

organization that is governed by, and behaves according

to, recognized norms and codes – conventions. Such

institutions may be political (the state), financial,

judiciary, business and economic, academic, and

many more. Conventions may include the Geneva

Convention, the Law of Armed Conflict, United

Nations Resolutions, National and International Law,

international trade agreements, diplomatic alliances,

monetary and banking conventions, and many more.

These are groups that are broadly recognized as being

legitimate actors, behaving according to broadly

recognized rule sets.

The state will continue to be among the most

powerful conventional institutions. It has become

popular to suggest that the era of states is coming to

an end. In fact states, in one form or another, have

been the order of most of human affairs since the dawn

of history in almost all cultures. The chaos in places

such as Somalia, Sierra Leone, Afghanistan, and Iraq,

where the state’s structure has been dysfunctional for

periods of time, is further testimony to the utility of

a working state.

This is not to say that states will not vary from

culture to culture, region to region. As well, the state

will undoubtedly change in response to the influences

of politics, geography, migration, economics and

other factors. But though it will mutate and adapt to

the international environment’s changing conditions,

16. Colin Gray, “Sovereignty of Context”, Strategic Studies Institute, (2006)

the state will continue to survive as a centralized

mechanism through which power is organized and

which provides the internal and external security

required by its citizens. Some aspects of globalization,

and the related rise of non-state powers, will pose

difficulties to states in their efforts to preserve their

status, but the state will endure as a major power

broker into the 2030s.

In the next 25 years, the relative balance of

power between states will shift, some growing faster

than the United States and many states weakening

relative to the United States. The variables that

affect the growth of states range from wars, to the

effectiveness of political leaders, economic realities,

ideological preconceptions, and ethnic and religious

forces. All will to one extent or another influence

the course of future events. Recognizing that reality,

present trends suggest that the era of the United States

as the sole superpower may be coming to an end. The

charts on page 25, highlighting potential growth in

various nations between 2008 and the 2030s, suggest

much about the nature of the emerging international

arena.

While China’s rise represents the most

significant single event on the international horizon

since the collapse of the Cold War, it is not the only

story. Steady, if not rapid economic growth appears

to be the norm for much of the world over the coming

decades, provided sufficient energy remains available

to fuel that growth. Russia and India are both likely

to become richer, although Russia’s strength is fragile,

resting as it does on unfavorable demographic trends, a

single-commodity (oil) economy, and a lack of serious

investment in repairing its crumbling infrastructure.

As the figures at right suggest, based on a GDP per

capitabasis,anumberofcountrieswillbeabletofieldlarger

conventional militaries over the course of coming decades.

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Source: Institute for Defense Analyses

Indeed, the story around the globe is one of substantial

potential rearmament. While the rise of Nigeria, Turkey,

Brazil, Vietnam, and Egypt may not be as dramatic as

what is happening in South and East Asia, their increasing

power is and will be remarkable. Admittedly these nations

will likely not be able to field globally deployable forces,

but they are in a position to build military forces which

could either stabilize or destabilize their regions and could

significantly challenge the ability of the United States to

project military force into their area.

The critical issue will lie in national will. What has

mattered most in the past has been the intent and national

goals of states. In the 1930s, the democracies of Western

Europe and the United States possessed the economic

strength to crush Hitler’s Germany, but lacked the will to

rearm – they refused to see the threat. Today, many of these

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same countries make up the European Union and could

field forces as large and capable as those of the United

States, but again they lack the will. Since the end of the

Cold War, many European nations have engaged in what

could be classified as disarmament. The great question

confronting Europeans is whether this trend will continue,

or whether some impending threat – an aggressive and

expansionist Russia, the internal stress of immigration, or

radical Islamic extremism – will awaken them.

It is also conceivable that combinations of regional

powers with sophisticated regional capabilities could band

together to form a powerful anti-American alliance. It is

not hard to imagine an alliance of small, cash-rich countries

arming themselves with high-performance long-range

precision weapons. Such a group could not only deny

U.S. forces access into their country, but could also prevent

American access to the global commons at significant

ranges from their borders.

Not all conventional organizations will be states.

Many transnational organizations will also behave

according to a recognized set of conventional rules. Samuel

Huntington describes the activity of these groups in this

way:

Transnational organizations try to ignore [sovereignty]. While

national representatives and delegations engage in endless debate

at U.N. conferences and councils, the agents of transnational

organizations are busily deployed across the continents, spinning

the webs that link the world together.17

In this environment, the U.S. must strive to use

its tremendous powers of inspiration, not just its powers

of intimidation.18 How America operates in this world

of states and other conventional powers will be a major

factor in its ability to project its influence and soft power

beyond the long shadow cast by its raw military power.

It will remain first among equals due to its military,

political and economic strengths. But in most endeavors

it will need partners, whether from traditional alliances

or coalitions of the willing. Thus, the United States will

need to sharpen its narrative about the unique vision we

offer to the world and to inspire like-minded partners

to strive and sacrifice for common interests. Alliances,

partnerships, and coalitions will determine the framework

in which joint force commanders operate. This will require

17. Samuel Huntington, quoted in Joseph Nye (with Robert Keohane),

Power in the Global Information Age: From Realism to Globalization.

(London, 2004) p. 172.

18. John Hamre, President, Center for Strategic and International Studies.

(June 2007)

diplomacy, cultural and political understanding, as well as

military competencies. Here, the example that Dwight

Eisenhower displayed as overall commander of Allied

Forces that invaded Europe is particularly useful for future

U.S. military leaders.

B. Potential Challenges andThreats

1. China

Source: Department of Defense

The Sino-American relationship represents

one of the great strategic question marks of the

next twenty-five years. Regardless of the outcome –

cooperative or coercive, or both – China will become

increasingly important in the considerations and

strategic perceptions of joint force commanders.

The course that China takes will determine

much about the character and nature of the twenty-

first century -whether it will be “another bloody

century,”19 or one of peaceful cooperation. The Chinese

themselves are uncertain as to where their strategic path

to the future will lead. Deng Xiaoping’s advice for

China to “disguise its ambition and hide its claws” may

represent as forthright a statement as the Chinese can

provide. What does appear relatively clear is that the

Chinese are thinking in the long term regarding their

strategic course. Rather than emphasize the future

strictly in military terms, they seem willing to see how

their economic and political relations with the United

States develop, while calculating that eventually, their

growing strength will allow them to dominate Asia and

the Western Pacific.

History provides some hints about the

challenges the Chinese confront in adapting to a

world where they are on a trajectory to become a great

power. For millennia, China has held a position of

cultural and political dominance over the lands and

people on its frontiers that has been true of no other

civilization. The continuities of Chinese civilization

19. The title of Colin Gray’s book on the future of war in the twenty-first

century.

26 Part III: The Contextual World the JOE | The Joint Operating Environment 2008

reach back to a time when the earliest civilizations in

the Nile and the Mesopotamian valleys were emerging.

But those continuities and the cultural power of

China’s civilization have also provided a negative side:

to a considerable extent they have isolated China from

currents and developments in the external world.

China’s history for much of the twentieth century

further exacerbated that isolation. The civil wars

between the warlords and the central government

and between the Nationalists and Communists, the

devastating invasions of the 1930s and 1940s by the

Japanese, and the prolonged period of China’s isolation

during Mao’s rule further isolated China.

Yet, one of the fascinating aspects of China’s

emergence over the past three decades has been its

efforts to learn from the external world. This has not

represented a blatant aping nor an effort to cherry pick

ideas from history or Western theoretical writings on

strategy and war, but rather a contentious, open debate

to examine and draw lessons from West’s experience.

Two historical case studies have resonated with the

Chinese: the Soviet Union’s collapse and the rise of

Germany in the late nineteenth and early twentieth

centuries. These case studies, written in a series of

books, were also made into documentary films and

form one of the most popular shows on Chinese

television.

In the case of the Soviets, the Chinese have

drawn the lesson that they must not pursue military

development at the expense of economic development

– no traditional arms race. That is the path Deng

laid out in the late 1970s and one which they have

assiduously followed. Indeed, if one examines

their emerging military capabilities in intelligence,

submarines, cyber, and space, one sees an asymmetrical

operational approach that is different from Western

approaches, one consistent with the classical Chinese

strategic thinkers.

There are interesting trends in the People’s

Liberation Army (PLA). The Party has ceded

considerable autonomy to the military, allowing the

PLA’s generals and admirals to build a truly professional

force, rather than one constantly hobbled by the party’s

dictates. This has led to a renaissance in military

thinking; one that draws not only from the classics of

Chinese writings, but on an extensive examination of

Western literature on history, strategy, and war. The

internal consensus seems to be that China is not yet

strong enough militarily, and needs to become stronger

over the long term. But the debate also extends to

issues on China’s strategic and operational choices:

Should it be offensive or defensive? Should it have a

continental or maritime focus, or a mixture of the two?

How can the PLA best protect the nation’s emerging

global interests?

Above all, the Chinese are interested in the

strategic and military thinking of the United States. In

the year 2000, the PLA had more students in America’s

graduate schools than the U.S. military, giving the

Chinese a growing understanding of America and its

military. As a potential future military competitor,

China would represent a most serious threat to the

United States, because the Chinese could understand

America and its strengths and weaknesses far better than

Americans understand the Chinese. This emphasis is

not surprising, given Sun Tzu’s famous aphorism:

Know the enemy and know yourself; in a hundred

battles you will never be in peril. When you are

ignorant of the enemy, but know yourself, your

chances of winning or losing are equal. If ignorant

both of your enemy and of yourself, you are certain

in every battle to be in peril.20

In the Second World War and the Cold War,

victory by the allies was achieved in part by the thorough

understanding of their opponents, who remained

relatively ignorant of the United States and its strengths.

The Chinese are working hard to ensure that if there is a

military confrontation with the United States sometime

in the future, they will be ready.

In regard to a potential military competition

with the United States, what is apparent in Chinese

discussions is a deep respect for U.S. military power.

There is a sense that in certain areas, such as submarines,

space, and cyber warfare, China can compete on a near

equal footing with America. One does not devote the

significant national treasure required to build nuclear

submarines for coastal defense. The emphasis on

nuclear submarines and an increasingly global Navy

in particular, underlines worries that the U.S. Navy

possesses the ability to shut down China’s energy imports

of oil – 80% of which go through the straits of Malacca.

As one Chinese naval strategist expressed it: “the straits

of Malacca are akin to breathing itself -- to life itself.”

20. Quoted in Robert Debs Heinl, Jr., Dictionary of Military and Naval

Quotations (Annapolis, MD, 1967), p.320.

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21

Thinking About China’s Potential Military Power

If GDP alone directly translated into military power, in the 2030s China would have the capacity to afford military

forces equal or superior to current U.S. capabilities. And while one must temper such calculations by per capita measures,

even by conservative calculations it is easily possible that by the 2030s China could modernize its military to reach a level

of approximately one quarter of current U.S. capabilities without any significant impact on its economy. There are some

important historical excursions to keep in mind.

First, throughout the Cold War the United States sustained military spending levels, as a percentage of GDP, at

about twice current levels, or roughly 8% of GDP, without damaging the economy. If China increased spending to the

same level that the United States maintained for decades during the Cold War (8% of GDP) and if U.S. defense spending

remained steady as a percent of GDP, China would spend an amount equal to roughly half of America’s outlays for defense.

During that period, the Soviet Union proved that a nation can maintain substantially higher rates of military

spending for some time before serious economic consequences ensue – the Soviet Union’s collapse was due more to the

nature of its economic system than to defense expenditures. A similar effort by China could see the Chinese equal U.S.

defense expenditures for a multi-decade period. Such an effort would quickly come to the attention of Western analysts,

but to what effect? Historically, a more obvious massive military buildup such as that taken by Nazi Germany in the years

before the Second World War, did not incite the Western powers to respond.

Chinese writers on military and strategic subjects

seem to be in agreement that there is a window of opportunity

that will last out to the 2020s, during which China can focus

on domestic economic growth and expanded trade with the

world to make it a truly great power. China is investing

significantly in human and physical capital. Indeed, skilled

Chinese engineers, technicians, and scientists are deeply

involved in scientific discovery around the world, and in

building the infrastructure upon which its future prosperity

21. Christopher Pherson, “Meeting the Challenge of China’s Rising Power,”

Carlisle Papers in Security Strategy, July 2006.

and global integration might be built. Above all, however,

the Chinese are objective about their own weaknesses as well

as strengths and prospects for the future.

What then are the potential courses that

China might follow? The challenges that Chinese

leadership confronts at present are enormous, and an

unsuccessful China is perhaps more worrisome than a

prosperous one. A serious global economic down turn

might force China in dangerous directions, as was the

case with the Japanese in the 1930s. On the other

28 Part III: The Contextual World the JOE | The Joint Operating Environment 2008

hand, China is confronting major internal problems

that could have an impact on its strategic course.

Urbanization, pollution on a monumental scale, water

shortages, and the possible responsibility to protect

a growing ethnic diaspora, in places such as Siberia

or Indonesia, represent realities the leadership cannot

easily dismiss. Over the course of its history, internal

stability along with the threat of foreign invasions have

represented the twin political and strategic challenges

that Chinese governments have confronted. Moreover,

as recent events in Tibet suggest, tensions between the

minorities and the central government in Beijing have

been building. Yet with China’s approach to strategy,

there is considerable sophistication in the leadership’s

understanding of its internal problems.

Taiwan is a wild card, but even here the picture

is not clear. A reunification might bring with it the

spread of democratic ideals to the mainland and

a weakening of the Party’s grip on an increasingly

educated and sophisticated population.

Source: Washington Times

Russian tanks in Georgia

2. Russia

Russia’s future remains as uncertain as its past

has been tragic. From one of the world’s most populous

nations with a bright future in 1914, given its natural

resources and rapid growth, the world has watched that

potential dissipate and then collapse in the catastrophes

of World War I (3-4 million military and civilian dead),

civil war (5-8 million), man-made famines (6-7 million),

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purges (2-3 million), and World War II

(27 million), accompanied by sixty years

of “planned” economic and agricultural

disasters. The 1990 implosion of the

Soviet Union marked a new low point,

one that then-President Vladimir Putin

decried as “the greatest geopolitical

catastrophe of the century.”

With the collapse of the Soviet

Union, Russia lost the lands and

territories it had controlled for the

better part of three centuries. Not only

did the collapse destroy the economic

structure that the Soviets created, but

the weak democratic successor regime

proved incapable of controlling the

criminal gangs or creating a functioning

economy. Moreover, the first attempt

by the Russian military to crush the

rebellion in Chechnya foundered

in a sea of incompetence and faulty

assumptions. Since 2000, Russia has

displayed a considerable recovery based

on Vladimir Putin’s reconstitution of rule

by the security services -a move most

Russians have welcomed -and on the

influx of foreign exchange from Russia’s

production of petroleum and natural

gas. How the Russian government

spends that windfall over the long term

will play a significant role in the kind of

state that emerges.

The nature of the current

Russian regime itself also carries

significant concerns. To a considerable extent its leaders

have emerged from the old KGB. Thus, their education

and bureaucratic culture have inculcated them with a

ruthlessness that recalls their predecessors, but without

their ideological fervor. This suggests that the strategic

perspectives of the regime and its zero-sum focus on

security bear watching.

At present, Russian leaders appear to have chosen

to maximize petroleum revenues without making the

long-term investments in oil fields that would increase oil

and gas production over the long term. With its riches in

oil and gas, Russia is in a position to modernize and repair

its ancient and dilapidated infrastructure and improve

the welfare of its long suffering people. Nevertheless, the

current leadership has displayed little interest in such a

course. Instead, it has placed its emphasis on Russia’s great

power status. For all its current riches, the brilliance of

Moscow’s resurgence, and the trappings of military power,

Russia cannot hide the conditions of the remainder of the

country. The life expectancy of Russia’s male population,

59 years, is 148th in the world and places the country

somewhere between East Timor and Haiti.

Perhaps more than any other nation Russia has

reason to fear the international environment, especially

considering the invasions that have washed over its

lands. There are serious problems: in the Caucasus

with terrorists; in Central Asia where the stability of the

new oil-rich nations is seriously in question; and in the

30 Part III: The Contextual World the JOE | The Joint Operating Environment 2008

east where the Chinese remain silent, but increasingly

powerful, on the borders of eastern Siberia. In 2001,

Russia and China agreed to demarcate the 4,300

mile border between them. However, demographic

pressures across this border are increasingly tense

as ethnic Russians leave (perhaps as many as a half-

million in the 2000-2010 time frame, or 6% of the

total population) and ethnic Chinese immigrate to the

region. Estimates of the number of ethnic Chinese in

Siberia range from a low of about 480,000 (or less than

six percent of the population) to more than 1 million

(or nearly 12%). Russia must carefully manage this

demographic transition to avoid ethnic tensions that

could erupt into a cross border conflict with China.

Russia is playing a more active, but less

constructive role across the Black Sea, Caucasus, and

Baltic regions. Russian involvement in each of these

areas has its own character, but they have in common

a Russia that is inserting itself into the affairs of its

much-smaller neighbors. In each, Russia plays on

ethnic and national tension to extend its influence in

its “near abroad.”

In the Caucasus region, especially Georgia and

its Abkhazian and South Ossetian provinces, Russia has

provided direct support to separatists. In other cases,

such as the conflict between Armenia and Azerbaijan

or in the Trans-Dnestrian region of Moldova, Russia

provides indirect support to keep these conflicts

simmering. These conflicts further impoverish areas

in dire need of investment and productive economic

activity. They lay astride new and vulnerable routes to

access the oil of the Caspian Basin and beyond. They

encourage corruption, organized crime, and disregard

legal order and national sovereignty in a critical part

of the world. In the future, they could exacerbate the

establishment of frameworks for regional order and

create a new “frontier of instability” around Russia.

Indeed, while many of its European neighbors

have almost completely disarmed, the Russians have

begun a military buildup, in part to redress the

desperately lean years of the 1990s, when the collapse of

the post-Soviet economy devastated its military forces.

Since 2001, they have quadrupled their military budget

with increases of over 20% per annum over the past

several years. In 2007, the Russian parliament, with

Putin’s enthusiastic support, approved even greater

military appropriations through 2015. Russia cannot

recreate the military machine of the old Soviet Union,

but it may be attempting to make up for demographic

and conventional military inferiority by modernizing

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its nuclear forces, including warheads, delivery

systems, and doctrines. It is also exploring and fielding

strategic systems based on what it terms “new physical

principles” including novel stealth and hypersonic

technologies. With their vast and increasingly capable

nuclear arsenal, the Russians remain a superpower in

nuclear terms, despite their demographic and political

difficulties.

One of the potential Russias that could emerge

in coming decades could be one that focuses on

regaining its former provinces in the name of “freeing”

the Russian minorities in those border states from

the ill-treatment they are supposedly receiving. The

United States and its NATO allies would then confront

the challenge of summoning up sufficient resolve and

deterrence to warn such a Russia off.

At present there is a dangerous combination

of paranoia -some of it justified considering Russia’s

history -nationalism, and bitterness at the loss of what

many Russians regard as their rightful place as a great

power. It was just such a mixture, along with a series

of unfortunate events that drove Nazi Germany on its

ill-thought-out course.

3. The Pacific and Indian Oceans

The rim of the great Asian continent is already

home to five nuclear powers: China, India, Pakistan,

North Korea, and Russia. Furthermore, there are three

threshold nuclear states, South Korea, Taiwan, and

Japan, which have the capacity to become nuclear powers

quickly. While the region appears stable on the surface,

political clefts exist. There are few signs that these

divisions, which have deep historical, cultural, and

religious roots, will be mitigated. China and Korea

hold grudges against Japan. Neither China nor Japan

have forgotten the seizure of what they regard as their

legitimate territory by the Russians. If one includes

the breakup of the British Raj in 1947-1948, India

and Pakistan have fought three brutal wars, while a

simmering conflict over Kashmir continues to poison

relations between the two powers. The Vietnamese

and the Chinese have a long record of antipathy, which

broke out into heavy fighting in the late 1970s. And

China’s claim that Taiwan is a province of the mainland

obviously represents a flashpoint.

Geographically, there are a number of areas in

dispute. The continuing dispute between India and

Pakistan over Kashmir is the most dangerous, in this

Source: globalsecurity.org

case between two nuclear armed powers. The Chinese

have backed up their claims to the Spratleys, which

Vietnam and the Philippines also claim, with force.

The Kurile Islands, occupied by the Soviets at the end

of World War II, remain a contentious issue between

Russia and Japan. The uninhabited islands south of

Okinawa are in dispute between Japan and China, both

obviously drawn to the area by the possibility of oil.

Much of the Yellow Sea remains in dispute between

the Koreas, Japan, and China, again because of its

potential for oil. The straits of Malacca represent the

most important transit point for world commerce, the

closure of which for even a relatively short period of

time would have a devastating impact on the global

economy.

There is at present a subtle, but sustained

military buildup throughout the region. India could

more than quadruple its wealth over the course of the

next two decades, but large swaths of its population

will likely remain in poverty through the 2030s. Like

China, this will create tensions between the rich and

the poor. Such tension, added to the divides among

its religions and nationalities, could continue to have

implications for economic growth and national security.

Nevertheless, its military will receive substantial

Part III: The Contextual World the JOE | The Joint Operating Environment 2008

upgrades in the coming years. That fact, combined

with its proud martial traditions and strategic location

in the Indian Ocean, will make India the dominant

player in South Asia and the Middle East. Like India,

China and Japan are also investing heavily in military

force modernization, particularly with an emphasis

in naval forces that can challenge their neighbors for

dominance in the seas surrounding the East and South

Asian periphery. The buildup of the navies by the

powers in the region has significant implications for

how the United States develops its strategy as well as

for the deployments of its naval forces.

4. Europe

The European Union has solidified Europe

economically to a degree not seen since the Roman

Empire. For the next quarter century, Europe will

exercise considerable clout in economic matters. The

Union’s economy as a whole by the 2030s will likely

be greater than that of the United States. From a

security standpoint, the NATO alliance will have

the potential to field substantial, world-class military

forces and project them far beyond the boundaries of

the continent, but this is currently a relatively unlikely

possibility.

The massive disarmament that occasioned

Europe’s shift to a “post-conflict” mindset as a reaction

to the end of the Cold War will eventually halt, but

many European nations have already largely disarmed.

The fact that at present only few Europeans have been

willing to place their forces in harm’s way in support

of the NATO commitment in Afghanistan to any

significant extent indicates that many Europeans

question the idea that lethal military force has a

significant role to play in international affairs

Perhaps this will change with the recognition

of a perceived threat. The next 25 years will provide

two good candidates: Russia and continued terrorism

fueled by global Islamic extremism. Russia has already

been discussed. The Baltic and Eastern European

regions will likely remain flashpoints as a number of

historical issues such as ethnicity or the location of

national boundaries, that have in the past led to conflict,

continue to simmer under the surface. Russian efforts

to place the gas pipeline to Western Europe through

the Baltic rather than through Eastern Europe suggests

a deliberate aim to separate the Central and Western

European NATO countries from the Baltic and Eastern

European members of NATO.

Continued terrorist attacks in Europe might

also spark a popular passion for investing in military

forces. Should violent extremists persist in using this

tactic to attack the European continent with increasing

frequency and intensity, there might a response that

includes addressing this threat on a global scale rather

than as an internal security problem.

5. Central and South America

Themilitaryproblems that ariseinSouthAmerica

and Central America will likely arise from within.

Many currently plague the continent, particularly drug

cartels and criminal gangs, while terrorist organizations

will continue to find a home in some of the continent’s

lawless border regions.

Nevertheless, South America’s improving

economic situation suggests the region could be in a

better position to deal with these problems. Brazil, in

particular, appears set on a course that could make it

a major player among the great powers by the 2030s.

Chile, Argentina, Peru and possibly Colombia will

also most likely see sustained growth, if they continue

prudent economic policies.

The potential major challenges to the status quo

at present are Cuba and Venezuela. The demise of the

Castros will create the possibility of major changes in

Cuba’s politics. The future of Venezuela is harder to read.

The Chavez regime is diverting substantial amounts of

its oil revenues to further its anti-American “Bolivarian

Revolution,” while at the same time consolidating his

regime’s hold on power by distributing oil wealth to his

supporters. By trying to do both it is shortchanging

investments in its oil infrastructure, which has serious

implications for the future. Unless its current regime

changes direction, it could use its oil wealth to subvert

its neighbors for an extended period while pursuing anti-

American activities on a global scale with the likes of

Iran, Russia, and China, in effect creating opportunities

to form anti-American coalitions in the region.

[mawilson 2,133]

Thanks AJ - very interesting read!

Edited January 16, 2009 by mawilson

[Welshcookie 17]

gee aj, this is the first time you're ever gonna hear this, but yours (copy and paste) is longer than his.

Thanks AJ - very interesting read!

You have superman reading eyes!!

[w¡n9Nµ7 §£@¥€r 123]

gee aj, this is the first time you're ever gonna hear this, but yours (copy and paste) is longer than his.

Thanks AJ - very interesting read!

You have superman reading eyes!!

i expect mawilson has already read the beige book

[mawilson 2,133]

Thanks AJ - very interesting read!

You have superman reading eyes!!

My evil plan was to quote his entire article and add the above one-liner, but the system

wouldn't let me do it.

[Peikko 1,575]

The beige book? The 'little red book' for conservative atheists?

[w¡n9Nµ7 §£@¥€r 123]

Thanks AJ - very interesting read!

You have superman reading eyes!!

My evil plan was to quote his entire article and add the above one-liner, but the system

wouldn't let me do it.

remove a few lines until it does.

The beige book? The 'little red book' for conservative atheists?

you cant possibly not know.

[Peikko 1,575]

Clairvoyance should never be confused with omnipotence A.J

Why is it called the 'beige' book? That's so, washed out...