THIS INVESTMENT BOOM GIVES THE ECONOMY RUNNING ROOM
Bruce M. Sieben certainly knows a good deal when he sees one. As director of telecommunications for financial-services giant Merrill Lynch & Co., Sieben recently replaced Merrill's entire New York voice, data, and fax network with the latest technology. The price: one-third of what the original network cost five years earlier.
Merrill is not alone. For large corporations and small home offices alike, fax machines, modems, and computer networks are becoming faster, more powerful, and perhaps most important--cheaper. Phone companies are buying ever-increasing amounts of central office switching and transmission capacity for ever-decreasing prices. Indeed, the fast-dropping price of communications equipment is driving the Internet boom, the coming expansion of two-way video services to the home, and the entire web of new services and connections that is known as the Information Superhighway.
SERIOUS ERRORS. But search as you may, there's no trace of this broad-based price decline in the government's official price numbers. Instead, unable to keep up with rapidly changing technology, the government is reporting that the price of communications equipment has actually risen by some 7% since 1989. By comparison, BUSINESS WEEK estimates that the true price decline was about 35%.
The government's overestimate is leading to serious errors in the two key elements that determine the inflation outlook. First, the overall rate of inflation over the past year is far lower than what the government is reporting. Second, and no less important, the level of private investment in equipment is far higher than official numbers show. Higher investment makes it easier for the economy to grow without hitting bottlenecks that would cause inflation.
According to the government's numbers, investment in communications equipment is now running at a rate of $67 billion annually in 1987 dollars. But adjusting for the true decline in prices shows that companies are, in fact, buying far more telecommunications equipment than the official statistics now indicate--$50 billion worth more a year. So huge is the outlay for telecom equipment that the adjustment would boost the economy's total spending on equipment by about 10% and raise net equipment investment from 2.8% to 3.4% of gross domestic product. That's by far the highest level in the last 40 years.
Moreover, the new analysis shows inflation to be much less of a threat than previously believed. Accounting for the drop in price of telecom equipment would chop three-tenths of a percentage point off inflation over the past year. That would bring the rate of inflation, as measured by the gross domestic product deflator, down to only 1.6%, the lowest level since 1963. With numbers such as these, interest-rate hikes make the Federal Reserve look more overzealous than ever.
There's ample evidence that high-tech communications gear is getting cheaper by an average of about 10% a year. For example, take digital switches, the nerve centers of today's telephone systems. These are essentially special-purpose computers that allow a phone company to connect one phone with any other and to provide special services such as call waiting. Starting around 1990, regional telephone companies such as Ameritech Corp. began negotiating more effectively for lower prices from switch suppliers such as AT&T and Northern Telecom Ltd. "The price per line for central-office switching dropped very substantially," says Howard Wallace, senior consultant for Arthur D. Little Inc. in Cambridge, Mass.
Northern Business Information, a unit of McGraw-Hill Inc., estimates that the price per line to install a digital switch dropped from $277 in 1989 to $140 today, a 50% decline over five years. But that's not what the U.S. government says: The Bureau of Labor Statistics reports the price of digital switches rose by 3.1% over the same period.
The price declines are even more dramatic for fiber-optic cables, which use light waves to provide high-capacity, long-distance links. Just a few years ago, the cost of a mile of fiber cable, plus the associated electronics, was sky-high. But the price per unit of transmission capacity for fiber optics has been dropping by 40% a year, estimates Nim K. Cheung of Bellcore, the research arm of the regional telephone companies. That's as fast as the prices of computers are falling. "The semiconductor industry and the light wave industry are on the same track," says Timothy J. Regan, director of public policy for Corning Corp., the world's largest maker of optical fiber.
The upshot of these price declines is that telephone companies, cable-TV companies, and large corporations are building much more data, voice, and picture transmission capacity at a lower price. For example, Ameritech, the Chicago-based regional telephone company, boosted its purchases of fiber-optic cable by 60% in 1993 compared with 1992, while paying only 10% more.
You don't have to be a telephone company to benefit from the falling price of communications equipment. Take the ubiquitous fax machine, which has become an essential part of almost every business. The price of a basic fax machine has dropped 75% over the past five years, notes Casey Dworkin, general manager of Personal Technology Research, a market-research and consulting firm in Waltham, Mass. Cellular telephones, too, have been plummeting in price, pulled down by the "same silicon improvements that have been driving the computer industry," says Rick Bean, an associate partner at Andersen Consulting.
And consider teleconferencing, the rapidly growing technology that enables companies to hold long-distance meetings without flying people around the country. In 1989, a teleconferencing system capable of handling groups of 8 to 12 people cost about $80,000. Now, a comparable system costs some $40,000, according to Personal Technology Research.
In some cases, improvements in technology mean that companies can buy much more transmission capacity for the same amount of money. Modems are the devices computers use to pump data through telephone lines. Five years ago, a modem that transmitted data at 2,400 bits per second cost about $200. Today, it's possible for the same money or less to get a modem that transmits at 9,600 bits per second--four times the capacity. This translates directly into substantially lower telephone bills for businesses.
The price of almost every piece of communications equipment has been dropping. Even the humble desk telephone costs 10% less than it did five years ago. "The general trend has been quite a continuous reduction in price. I can't think of a single exception," says Eli M. Noam, a telecom expert at Columbia University's Institute for Tele-Information. Adds Sieben of Merrill Lynch: "The unit cost of telecom equipment has been consistently trending downward at about 10% each year."
How did these pervasive price declines evade the attention of the price mavens at the Bureau of Labor Statistics, where the government's price numbers originate? The reason, in part, is that the BLS has trouble tracking prices in industries with fast-changing technologies. "There are major problems with the government's ability to measure the impact of new products and quality improvements," says Michael J. Boskin of Stanford University, who was head of the Council of Economic Advisers under George Bush. "Our statistical system has a difficult time keeping up."
Still, that's not the whole story behind the government's oversight. The BLS does in fact have a special technique, "hedonic pricing," that allows it to adjust price numbers to take account of improvements in the quality and speed of products. Hedonic pricing has been used by the BLS to measure computer prices since 1985. Indeed, the price index for computers and office machinery shows a decline of about 12% annually over the past five years.
But the BLS has not used hedonic pricing for communications equipment, even though telecom gear and computers share the same underlying technology. Why not? The reason, in part, is simply lack of money. The government's statistical agencies have barely enough resources to keep up with the current data, much less mount new statistical initiatives. Equally important, however, the government's statisticians were misled by the long-standing torpor of the telecom equipment market, where prices didn't start dropping in earnest until the late 1980s. That's when the full effects of deregulation and the 1984 AT&T breakup were felt. In effect, the government was right seven years ago to pay little attention to communications equipment, but it's making a major mistake today.
BUSINESS WEEK's estimate of a 35% decline in prices over the past five years may be conservative. In arriving at its figure, BUSINESS WEEK estimated that 60% of communications investment goes for high-tech gear, which is dropping in price by about 10% annually, or roughly the same rate of decline as computers. The other 40% of communications equipment was assumed to be rising in price at the original rate the government reported. In fact, the data suggest that an even larger share of spending was concentrated in high-tech equipment.
The revised numbers have profound consequences for the most important problem facing economic policymakers today: How fast can the economy grow without triggering inflation? Pessimistic economists believe that over the long run, the economy can sustain only a 2.5% growth rate. Optimistic forecasters, by contrast, estimate that the U.S. can manage growth rates that are as high as 3.5%.
NEW OUTLOOK. The pessimists argue that net investment remains at historically low levels, and it is investment in new plants and equipment that ultimately determines growth. The published numbers say that the pessimists have a good case: Net of depreciation, equipment investment over the past two years has averaged mnly 1.6% of GDP, according to the government, barely higher than the postwar average of 1.5%. That's not enough to put the economy onto a fast growth track.
But measure the price of communications equipment more accurately, and the whole outlook for the economy changes. Companies are, in fact, buying more and better equipment for the same money, so net investment is soaring. And it's investment in new capacity that increases the economy's long-term growth rate.
It's all too easy to accept the government's published numbers on prices and investment as holy writ. And judging by its actions in boosting interest rates, the Federal Reserve seems to be doing just that. But in the face of the greatest telecommunications boom in history, the Fed would do well to take another look at what American business is actually doing.Michael J. Mandel in New York