Are We Headed for a Tech-Led Recession?
Economic crises are tough to predict. Economists don't have a good track record, and neither do the markets. Despite the difficulties of looking ahead, BUSINESS WEEK Economics Editor Michael J. Mandel, a longtime champion of the New Economy, has decided to take the risk. In a new book, The Coming Internet Depression, and in this week's cover story, adapted from the book, he makes a worrisome prediction: There's a good chance the U.S. is on the road to a downturn, and that downturn could turn nasty, brutish, and long if economic policy stumbles.
It's a worst-case scenario, and it will happen only if all the trends turn sour and all the mistakes are made--the economic equivalent of the Perfect Storm. But because the warning comes from someone who has long been an optimistic believer in the New Economy, it deserves a very careful look.
Mandel and BUSINESS WEEK were among the first to recognize the New Economy, explain it, and understand its implications. Conventional economic indicators missed it, but reporting on the ground by BUSINESS WEEK's reporters and editors suggested that something new was happening--that technology had assumed a pivotal role in the U.S. economy and would lead to unprecedented, productivity-driven growth. BUSINESS WEEK said the expansion would ultimately end, and it predicted that there would be bumps along the road. But now Mandel's argument goes much further.
The thesis is difficult to prove. As Mandel himself says, the downside of the tech cycle is uncharted territory--we've never seen the aftermath of a New Economy tech boom. But if he's right, we need to be alert to the warning signs and get ready to make the crucial policy moves.VULNERABLE VENTURE CAPITAL
Mandel's argument turns in part on what he calls one of the great financial breakthroughs of the 20th century: the venture-capital fund. Venture capitalists gave about $60 billion to startups and young companies last year, and in the first half of this year, their funding was running at about a $100 billion annual rate. Along with that came the use of initial public offerings, which allow venture capitalists to cash out and recycle their returns into new enterprises. These developments gave cutting-edge technologies the financial muscle to challenge even the largest and most entrenched Old Economy companies.
But there's a downside to this financing mechanism: The pace of innovation is now tied to the growth of the economy and the rise of the stock market. Drops in the market and economic slowdowns are likely to lead to less funding of startups and a consequent slowdown in innovation. And that's where the cycle begins to feed upon itself, according to Mandel. Less innovation means less productivity growth, a tendency for inflation to rise, and pressure on companies to raise prices. Those developments, in turn, threaten to further slow the economy and depress the market, leading to a pernicious downward economic spiral.
The early warning signs of this spiral would include a simultaneous fall in tech stocks and tech spending, a slowdown in the rate of price declines for technology goods, and a decline in venture-capital financing and IPOs.
That's enough to create a painful recession, but Mandel argues that something more is needed to turn that into a depression. And that is a major misstep in monetary policy.
Most historians now agree that such a mistake was a key factor in the Great Depression. In 1931, when the economy was already reeling, the Federal Reserve, worried about the flow of gold out of the country, raised interest rates sharply. That crushing blow helped send both the U.S. and the global economy into a depression. Similar mistakes were made in Japan in the early '90s and during the Asian financial crisis in 1997.PRESSURE ON THE FED
And the same mistake could happen again. Foreign investors have pumped more than $3.3 trillion into U.S. financial and business assets since 1995. If the country slips into a technology recession, accompanied by inflation and a falling stock market, overseas investors will want to get out, putting further downward pressure on the dollar. The Fed will find itself under great pressure to defend the currency by raising rates--precisely the move that could worsen any recession.
It's not a smart move, but domestic politics and economists who never believed in the New Economy might force the Fed's hand. Many economists, fearful of aggravating inflation, would oppose cutting rates even if the economy is in a slump.
Whether an economic slowdown will lead to inflation is a matter of debate. Competition from goods made in Asia would continue to put downward pressure on U.S. prices, even in a tech slump. And the Fed, under Chairman Alan Greenspan, has accepted the premise of the New Economy and acted accordingly. If Greenspan is at the helm when a slowdown hits, he will likely provide the proper guidance. But others at the Fed might behave differently in the years ahead.
We are nowhere near the point where we can say with any certainty whether a sharp Internet recession awaits us. But there is reason for concern. The Nasdaq is now down about 28% from its high. In the first half of 2000, the price of technology products increased for the first time since 1991. Revenue growth in tech and telecom is expected to slow from 17% this year to 11% in 2002. Global computer, networking, and software spending may rise 10.1% next year, down from 10.4% this year. Growth in PC sales will fall from 17% this year to 12% in 2001. Some of the key indicators of an Internet recession are in place.
We remain optimistic. BUSINESS WEEK's reporting suggests that the boom in innovation and investment will continue (page 168). But Mandel correctly points out where the dangers lie. It's important to keep a sharp lookout for the warning signs of what could become an economic Perfect Storm if economic policy turns perverse.