Dollars and Sense, March/April 2000
As the stock market soars to ever greater heights, the voices proclaiming a "new economy" are becoming louder and more numerous. According to this chorus, computer technology and the Internet have created a qualitatively different economy. This new economy is not bound by the same physical constraints as the old industrial economy. New ways of doing business and organizing the workplace are creating possibilities that were unimaginable just a decade ago. As a result, the new economy can sustain more rapid rates of productivity and GDP growth than would have been possible in prior decades. In addition, the new technologies allow the economy to sustain lower rates of unemployment without inflation than had previously been the case. In short, the new economy is rapidly propelling the nation and the world into an new era of prosperity.
Is the New Economy New?
Much of the argument for the new economy rests on assertions about the wonders of the new technology that are largely subjective. Clearly computer technology and the Internet allow us to do many things that were not previously possible. But this is not the first time that technology has changed our lives or the economy. The real question is the quantitative impact of the latest set of technological innovations compared with prior breakthroughs. But, before examining the numbers directly, it is worth taking a moment to try to put the current set of innovations in some historical context.
Starting with the most evident breakthrough, the Internet is a great medium that allows for instant, virtually costless, communication between large numbers of people anywhere in the world. It clearly presents a qualitative breakthrough over previous modes of communication. But, this sort of breakthrough is not without precedent. Television, beginning in the late forties, allowed people in most parts of the nation to instantly receive news and entertainment in their living rooms. As we all know, it has radically altered peoples lives in the last five decades, as most families now spend several hours each day watching television. Radio played a similar role two decades earlier.
In terms of allowing two way communication, however great the advantages of the Internet, the telephone was surely a much larger breakthrough over pre-existing means of communication. Prior to the existence of telephones, it could take hours to just get a simple message across town. An even earlier innovation, the telegraph, can also arguably match or exceed the importance of the Internet. Before the telegraph was invented, information could only be transmitted as fast as people could travel. By land, this meant on horseback, by sea, on steamboat. The telegraph allowed for instant communication instead of the days or even weeks that were previously needed.
New technology has also been applied to other areas of the economy. In particular, much has been made of the potential for bioengineering to revolutionize medicine. As scientists learn more about human genes, they hope to be able to develop cures to everything from cancer and AIDS to flu and the common cold. In addition, this technology offers the potential to permanently improve the quality of life for future generations, as undesirable genes are removed or over-ridden. According to proponents of genetic engineering, it will allow our children to be taller, smarter, more athletic, and more attractive than we were.
Whatever, the real potential of these technologies might be, and ignoring the ethical issues they raise, it is not obvious that the significance of these breakthroughs is greater than the medical breakthroughs made by earlier generations of researchers. The polio vaccine almost completely removed the threat of a disease that could cause a child's trip to a swimming pool to lead to paralysis or even death. Two decades earlier, penicillin was discovered. Prior to that point, simple infections often led to serious illness or death. The current generation of medical technologies has far to go before it has achieved the same revolutionary impact on people's lives as these earlier medical breakthroughs.
The last hundred years have seen many innovations that have radically altered people's lives. In addition to the breakthroughs in communication and medicine mentioned earlier, there are many other innovations (e.g. the automobile, airplane, modern sewage treatment facilities, refrigeration) that have transformed life in very fundamental ways. The Internet and other new technologies may rank among these innovations, but they are not in any obvious way a qualitatively different or more important development than the major innovations of prior decades.
How Does the New Economy Measure Up?
Since there is little basis for the claim that the technological innovations of the current period are qualitatively different than the technological breakthroughs of previous eras, we can turn to economic data to see whether there is quantitative evidence of a "new economy." The standard measures that economists look to are rate of the growth of the overall economy, or gross domestic product (GDP); the rate of growth of productivity -- the amount of GDP produced in each hour of work; and the rate of real wage growth.
However, before directly discussing this evidence, it is worth dispelling one myth about the old economy. One of the undeniably positive developments of the last few years has been the decline in the unemployment rate to levels not seen since the late sixties. The overall unemployment rate has fallen to just over 4.0 percent. Just five years ago, there was near unanimity among the nation's leading economists that the unemployment rate could not fall below 6.0 percent without setting off an inflationary spiral. When the unemployment rate falls, workers are in a better position to get wage increases. When wages start to rise more rapidly this can cause prices to rise more rapidly. Higher prices will in turn lead workers to demand higher wages. The conventional wisdom among economists was that this spiral kicked off when the unemployment rate fell below 6.0 percent.
The unemployment rate has been below 6.0 percent since the middle of 1994. It has been below 5.0 percent for two and a half years. During this time the inflation rate has actually fallen slightly. The new economy advocates see this as compelling evidence of a new era where the economy can sustain low rates of unemployment without inflation.
There is a simpler explanation: the nation's leading economists were wrong. While lower rates of unemployment always imply more inflationary pressure than higher rates of unemployment (holding everything else equal), there never was much reason to believe that an inflationary spiral would be triggered if the unemployment rate fell below 6.0 percent, or any other level. There was no widely accepted theoretical reason why the economy should have a trigger point rate of unemployment, or "non-accelerating inflation rate of unemployment (NAIRU)," where inflation endlessly accelerates out of control if the unemployment rate falls lower. The evidence for this view was very limited, relying on the few post-war expansions where the unemployment rate at least temporarily fell to relatively low levels. In each of these cases there were compelling alternative explanations for the increases in inflation. For example, the huge commitment of resources to the Vietnam War surely added to inflationary pressures in the sixties independently of the rate of unemployment. Similarly, the thirty percent fall in the value of the dollar in the late eighties created substantial inflationary pressures, quite apart from the impact of a brief period of relatively low unemployment.
There have been structural changes in the last two decades that have reduced workers' bargaining power. Weaker unions, deregulation of major industries like trucking and telecommunications, the increased use of non-standard work arrangements like temporary and contract workers, and the growing importance of international competition all have had the effect of putting downward pressure on wages. Largely, as a result of these changes there has been a significant redistribution from wages to profits over the course of this business cycle. But, it does not follow that in the absence of these changes there would have been spiraling inflation in the nineties. In any case, if the main innovation of the new economy is a restructured labor market that depresses wage growth, it does not have much to offer most of the population.
But the final score on the new economy must rest on its ability to produce more rapid increases in growth and productivity than the old economy. By this measure, the evidence is mixed at best. The rate of GDP growth over this business cycle has averaged 3.0 percent a year, exactly the same the as the cycle from 1979 to 1989. This rate falls below the 3.2 percent growth rate from 1969 to 1979, and well below the 4.4 percent growth rate from 1959 to 1969. There is no evidence of a new economy is this data.
The economy's performance over the business cycle looks somewhat better when focusing on productivity growth. The 1.9 percent average growth rate over this cycle is up significantly from the 1.4 percent rate of the eighties. Still, this only brings productivity growth back to its average rate during the seventies, and leaves it well below the 2.9 percent rate of the sixties. Furthermore, changes in measurement have added approximately 0.2 percentage points annually to the rate of productivity growth. This leaves productivity growth in the nineties behind the seventies and far behind the sixties when a consistent measurement technique is used.
The Bubble Years
New economy advocates can point to a considerably brighter picture in the last four years. Since 1995 GDP growth has averaged 4.0 percent, while productivity growth has averaged 2.5 percent. While this doesn't quite match the performance of the sixties, it is in the same ballpark. But, it is dangerous to draw broad conclusions based on the economy's performance over a relatively short period. This warning is especially appropriate at present, since the economy's growth during this period has been based on two unsustainable trends, an exploding trade deficit and a soaring stock market.
The trade deficit is the amount by which the value of the goods and services the United States buys from other nations exceeds the total value of goods and services that we sell to other nations. Most industrialized nations do not run trade deficits, since they sell more to the rest of the world than they buy. However, the United States has consistently run a trade deficit for the last quarter century.
Usually this deficit has been relatively small, but in the last four years it has grown from 0.8 percent of GDP to more 3.0 percent of GDP, a gap of more than $300 billion a year. This means that the United States economy has not been producing enough to meet its demand. Instead it is relying on foreign economies and borrowing to fill the gap. In effect, over the last four years consumption in the United States has been allowed to grow by 2.2 percent more than would have otherwise have been the case if the trade deficit had remained constant.
If the trade deficit continues to grow at this rate it will hit an almost unimaginable 6.0 percent of GDP by 2005. Even if the trade deficit stabilizes at this level, the nation's foreign debt will reach 60 percent of GDP by 2010, a level of indebtedness completely without precedent for a major industrial nation. Few, if any, economists would dare make such a prediction.
Eventually, the rise in the trade deficit will have to be reversed. This means that consumption growth in the United States will have to increase less rapidly than growth of the overall economy. As a practical matter this will be accomplished through a large fall in the value of the dollar, which will decrease the nation's ability to purchase imports and increase domestic inflation. It is not clear how the economy will respond to this sort of shock.
The second unsustainable trend is the run-up in the stock market. Over the last decade, stock prices have risen by 350 percent while corporate profits have increased by just 150 percent. As a result, the ratio of stock prices to earnings per share vastly exceeds past records. At current price to earnings ratios and projected rates of earnings growth from agencies like the Congressional Budget Office (CBO), the return on stocks will not even be able to match the return from government bonds, unless the price to earnings ratio rises still further.
CBO projects that corporate earnings will grow only about 1.0 percentage point more rapidly than the inflation rate over the next decade. While some fast growing companies will clearly do much better than this, many others will perform much worse. When examining the market as a whole, it is only necessary to examine the aggregate growth of profits, and almost no economists have projections of profit growth very different from the ones produced by CBO.
If profits are barely growing, then the only way that stock returns can continue to be good is if stock prices continue to rise more rapidly than corporate earnings. No one has yet produced a coherent argument explaining how the ratio of share prices to corporate earnings can rise indefinitely. A further rise in the price to earnings ratio would simply set the stage for an even larger collapse when the inevitable adjustment eventually occurs.
In short, the stock market is a classic bubble. It is every bit as "new" as the tulip bulb mania in Holland in the 17th century or the South Sea Bubble in England at the beginning of the 18th century. While the bubble inflates, the economy looks goods, since the surge in stock prices creates massive amounts of wealth, which leads to growth in consumer demand. In addition, the fact that many workers, especially higher paid workers, can be paid in stock options that may ultimately prove worthless helps relieve supply constraints on the economy.
The current situation can be compared to one in which $10 trillion of counterfeit money ($35,000 for every person in the country) entered into the economy. As long as people were willing to accept this money for payment for goods and services, it will provide considerable stimulus to the economy. Once it is recognized that the money is counterfeit, the situation will be very different.
How or when the stock market collapses remains to be seen. It is likely that the crash will coincide with a sharp decline in the value of the dollar, further complicating the economic picture. It is virtually certain that the crash will produce a wave of bankruptcies and lawsuits, as investors attempt to reclaim some of their losses from the people who gave them bad advice or misleading information. It may take a considerable period of time to get the economy back in order. If the nation can continue to experience rapid economic and productivity growth in the wake of this collapse, then we will have evidence of a new economy. Until then, the evidence suggests that the new economy is nothing more than an old-fashioned bubble.
BOX: The New Economy In the Eyes of Its Prophet
Management consultant Peter Drucker is one of the nation's leading new economy gurus. A recent interview included some typical comments. For example: "Global markets, which are growing at more than twice the rate of domestic markets, intensify the pressure to cut costs, thereby creating wealth for society at large...In a transparent marketplace, when everyone knows everyone's price, the price of everything trends downward. Consider the magnitude of all this: Instead of causing prices to rise, economic growth is actually propelling them lower."
It would really be quite new if firms decided to lower their prices because they were selling to a global market rather than a domestic market. Competition places downward pressure on prices regardless of its origins. In an era where mega-mergers are the order of the day, it is not clear that the competition has necessarily intensified. A major piece of evidence pointing in the opposite direction is that corporations have managed to significantly increase their profit margins in the last decade. It is also worth noting that Federal Reserve Board Chairman Alan Greenspan appears to have missed this new relationship between more rapid economic growth and falling prices. He is trying to slow the economy to reduce inflationary pressures.
At another point in the interview, Drucker comments that: "Inventories, which once triggered or prolonged recessions, are not just declining but in many places evaporating...Long-term, wealth can only increase in a dematerializing economy." Whatever the future may hold, the economy has not dematerialized just yet. According to the most recent data, the value of the nation's inventories is close to $1.4 trillion. Even in a 9 trillion dollar economy, this volume of inventories still makes a difference. In fact, in some ways the economy seems to be re-materializing. Amazon.com's biggest investment in 1999 was building a series of huge warehouses across the country.
Finally, Drucker celebrates the fact that in the new economy, decision making is no longer controlled by monolithic corporations rather it is done by "untold number of small firms and individuals." Microsoft, AOL-Time-Warner, and Dell, among others, are betting otherwise.
BOX: Productivity -- The Source of Wealth
Productivity, the average value of the goods and services produced in an hour of output, is the main determinant of a nation's wealth. It is a better measure than GDP because it takes account of the time people spend at work. If everyone started working sixty hours a week, GDP would rise because people are working more hours. But, most people would probably not consider themselves better off, since they would have little time left to be with their families or do anything else other than work. As productivity increases through time, workers have the option to either have more income and work the same number of hours, or to keep the same amount of income, but to work fewer hours. To a large extent in the United States workers have done the former. There has been little or no reduction in the length of the average workweek or work year over the last decade.
By contrast, in Europe and now Japan, workers are increasingly getting the benefits of increased productivity in more leisure time. Thirty five hour workweeks are becoming the standard in the western Europe. In most countries workers also get five to six weeks of vacation each year. Since the typical worker puts in so much less time on the job in western Europe, these nations appear much poorer than the United States if the measure used is GDP per capita. But, if the measure is GDP per hour of work, most of these nations are approximately even with the United States.