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Why High Tech May Rally

Tech investment is still slumping, as companies cut back on spending during the recession. Moreover, many analysts are predicting that the tech doldrums will continue well into 2002.

Nevertheless, there's at least one indicator that suggests tech investment may revive faster than expected. The positive sign: The price of computers, adjusted for quality and computing power, has plummeted at a 34% annual rate over the past six months. By contrast, in the year before that, computer prices fell at only a 17% rate. Similarly, the price declines in telecom equipment have accelerated since spring.

By themselves, these price declines won't create a new boom, given how much companies spent on technology in the 1990s. But they are good news for tech investment. Historically, tech sales accelerate when the price of computing power is dropping fastest, since companies are more likely to invest when they can get more computer for less money. This dynamic reflects not just lower prices but also faster innovation.

For example, the information-technology spending spree of the 1990s started in 1995, which is precisely when the quality-adjusted price of computers began dropping like a stone. Indeed, leading economists, such as Dale W. Jorgenson of Harvard University, argue that it is this fall in computer prices that triggered the New Economy investment boom and productivity surge.

By contrast, during times of slow price declines, new purchases of information-technology equipment often flag, as computers and communications gear seem like less of a bargain. During the late 1980s, a period of relatively weak growth in technology spending, the price of computers fell at only a 9% rate.

It may be coincidence, but the current tech slump started in the second half of 2000, at a time when computer price declines slowed dramatically. And over that full year, the price of the broad category of information technology gear, including communications equipment, barely fell at all. One possible reason is that demand was so strong that capacity utilization in high-tech manufacturing reached a mighty 89%, giving tech companies the mistaken belief they could keep prices high.

Now, of course, the lack of demand is forcing big price cuts. And judging by the past, that may eventually make tech purchases more appealing to buyers. The explosion of global trade in the postwar era is usually attributed to the lowering of tariffs and other trade barriers. But a recent paper by David L. Hummels, an economist at Purdue University, suggests that there may be another reason for globalization: the dramatic reduction in the time that freight spends in shipment. New security measures that slow down the passage of goods across borders may therefore have a much bigger impact on trade than expected.

Hummels points out that 50 years ago, all overseas trade went by ship. Since then, the use of air freight for high-value, time-sensitive goods has soared. Moreover, the shift to containers has substantially reduced the average transit time of ocean-shipped goods.

Hummels argues that time in transit is a big impediment to trade. And faster transport makes it possible to outsource high-tech goods, such as computers, which typically travel by air. "If you manufacture computers to order, you can't do it if the computer is going to be on a boat for four weeks," he says.

By examining trade patterns, Hummels calculates that reducing time in transit by one day is equivalent to reducing the price of the product by 0.8%. Thus, the shift from a 20-day ocean shipment, the average today, to a one-day air shipment, for example, is equivalent to cutting roughly 15% from the price of a product.

Hummels' research implies that post-September 11 security could impose a big cost. For example, suppose security checks on incoming goods add a day to shipping. With manufactured imports running at over $800 billion dollars per year, the extra day is equivalent to $7 billion in added costs. "You could be talking about very serious expenses if goods are subject to even minimal scrutiny on the way in," says Hummels. An imponderable of this recession is how corporations will deal with their heavy debt loads. Since the downturn started in the first quarter, nonfinancial corporations have issued new bonds by the truckload, driving up their total debt by $137 billion. By contrast, during the 1990-91 recession, nonfinancial corporate debt rose only $5 billion.

Optimists argue that this time, companies were able to take on new debt and refinance old debt at low interest rates, making it less worrisome. Indeed, interest paid is less than 4% of nonfinancial corporate output, compared with 6% during the last recession.

Nevertheless, new data from the Federal Reserve Board raise questions about corporate balance sheets. Nonfinancial corporate debt as a share of net worth now stands at 59%--a record level. Moreover, that's up from 54% a year earlier, the biggest four-quarter jump ever. By comparison, the ratio of debt to net worth at the end of the 1990-91 recession was only 51%.

The high level of debt compared to net worth reduces the financial cushion of companies and makes them more vulnerable to unexpected shocks. For example, if inflation falls more sharply than expected and companies can't raise their prices, that debt will be harder to repay.

Spotting vulnerabilities in a financial system ahead of time is never easy. But it would be more reassuring if Corporate America was not borrowing quite so much.

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