Now that the stock market is apparently going through an overdue correction, a long-running economic debate has flared anew. Is there really a "New Economy"? Or is it just wishful thinking by Wall Street hypesters and a few economic renegades? This is no mere academic flapdoodle, for it goes to the heart of a crucial issue: how fast the U.S. economy can grow without triggering inflation.
When the stock market started falling this autumn, the I-told-you-so traditionalists came out of the woodwork to attack the New Economy concept--even though some of them have been consistently wrong in their forecasts for the past three years. Unable to explain what's going on and wedded to deeply flawed statistics and models, many traditionalists find it easier to set up straw men and knock them down.
Here's straw man No.1, from our esteemed colleagues at The Economist: The new thinking in America, "verging on claptrap," says that the "old economic laws have been repealed and that America's stock markets can therefore keep on growing indefinitely at their present rate." Well, nonsense. Nobody I know says anything of the sort. The economic laws are intact, though the trade-offs may have shifted.
Straw man No.2 comes from columnist Robert J. Samuelson, writing in The Washington Post. Normally astute, Samuelson attacks the New Economy thusly: "We have not created permanent economic bliss." Well, of course not. Who ever said we had?
Since BUSINESS WEEK has written sympathetically about some New Economy thinking, permit me a rebuttal. Let's begin with some basic definitions. First, here's what the New Economy isn't: It does not mean inflation is dead. It does not mean we'll never have another recession or that the business cycle is extinct. It does not mean the stock market is destined to shake off the correction and rise forever, like some beanstalk growing to the sky. It does not mean the financial turmoil in Asia won't affect the U.S.
So if the New Economy is not economic nirvana, what is it? How do we know it exists? Do the skeptics have a case?
GLOBAL SHIFT. By the New Economy, we mean two broad trends that have been under way for several years. The first is the globalization of business. Simply put, capitalism is spreading around the world--if not full-blown capitalism, at least the introduction of market forces, freer trade, and widespread deregulation. It's happening in the former communist countries, in the developing world of Latin America and Asia, and even in the industrialized West--with economic union in Europe and North America's free-trade agreement. For the U.S., this means international trade and investment play a much greater role in our economic life than before. Twenty years ago, exports and imports made up 17% of our economy. Today, they account for 25%.
The second trend is the revolution in information technology. This one is all around us--fax machines, cellular phones, personal computers, modems, the Internet. But it's more than that. It's the digitization of all information--words, pictures, data, and so on. This digital technology is creating new companies and new industries before our eyes. Here's a statistic that should amaze you: In Silicon Valley alone, 11 new companies are created every week. Not all succeed, obviously. But enough do. Last year, on average, a Silicon Valley company went public every five days, minting dozens of new millionaires in the process.
All of this entrepreneurial energy is transforming Corporate America. You can argue about whether there is a New Economy, but there sure as hell is a new business cycle. Housing and autos used to drive the U.S. economy. Now, information technology accounts for a quarter to a third of economic growth. And remember, this is an industry that pays very good wages. And it is an industry, bless its heart, in which prices actually fall every year. How's that for noninflationary growth? Furthermore, information technology affects every other industry. It boosts productivity, reduces costs, cuts inventories, facilitates electronic commerce. It is, in short, a transcendent technology--like railroads in the 19th century and automobiles in the 20th.
These two broad trends, globalization and information technology, are undermining the old order, forcing business to restructure. If you want to compete in global markets or take advantage of rapid technological change, you have to move quickly--and that means getting rid of layers of management. Technology makes it possible: Put a PC on everyone's desk, network them together, and you don't need so many middle managers. The result: a radical restructuring that is making us more efficient.
These trends can combine in powerful ways to raise Americans' standard of living, create jobs, spur entrepreneurial effort--and do all this without boosting inflation. To the believers in the New Economy, we have here the magic bullet--a way to return to the high-growth, low-inflation conditions of the 1950s and 1960s. Forget 2% real growth. We're talking 3%, or even 4%. Forget double-digit inflation and the natural rate of unemployment. We're talking stable prices. Forget hopelessness in the developing world. We're talking about raising living standards in India and Brazil.
FIELD TEST. How is this possible? First of all, globalization opens new markets for our goods and services. At the same time, global competition helps to keep at least some prices in check. As trade barriers fall, cheaper goods are available around the world. Cheaper labor, too, whether you're talking about software programmers in Russia or textile workers in China. The cheaper goods prompt people to buy more of them, and workers everywhere get the chance to share in economic growth. The result is increased global demand and a supply explosion that helps keep costs down for both labor and products. While this is happening, the information revolution is spurring capital spending and renewed efficiency.
O.K., it sounds great. But is it real? This is where things get tricky. A lot of the evidence for the New Economy is anecdotal. If you talk to business executives, they'll tell you they can't raise prices but that they don't have to. Why? Because they're getting productivity increases sufficient to pay wage increases and still boost profits.
Such talk is automatically suspect. After all, executives may know their own industries, but they usually lack a macroeconomic overview. Besides, many well-paid execs want eagerly to believe that their high-flying stock prices demonstrate their managerial genius in cutting costs and raising productivity.
But when executive after executive in industry after industry tells you the same thing in convincing detail, attention must be paid. This is the sort of thing that economists don't pick up quickly in their models or statistics--and often reject as mere anecdote. But such changes are precisely what journalists are often first to observe. As the late Washington Post publisher Phil Graham noted, journalism is often "the first draft of history."
Furthermore, there is at least some empirical evidence to back up the reportage. One clue is the coexistence of low unemployment and low inflation. Until a couple of years ago, most economists thought that if unemployment fell below 6%, inflation would start rising. They even had a graph to explain it: the so-called Phillips curve.
Well, here we are--well into the seventh year of an economic expansion, with unemployment under 5% and growth averaging 4% over the past 12 months. And guess what? Inflation isn't rising. It's falling. In the third quarter, GDP inflation was running at an annual rate of only 1.4%. Something is going on that traditional economists can't explain. So, defending their turf, they have become the leading skeptics.
In their view, if there really is a New Economy, it should be showing up in the overall productivity statistics. That is, if technology and globalization are boosting efficiency, productivity growth should be increasing at a faster rate than it was, say, 10 or 20 years ago. But according to government statistics, productivity has been increasing only about 1% a year for the past two decades. It was over 2% a year in the 1950s and 1960s. In other words, the stats show productivity getting worse, not better. Therefore, the noninflationary speed limit of the economy, skeptics say, is just 2% or so--1% from productivity growth, 1% from labor-force growth. The rest is wishful thinking. If you try to grow at 3% or 4% for more than a little while, traditionalists say, you'll end up with more inflation and an economic downturn.
NEW MATH. The New Economy gurus counter by saying the statistics are simply not capturing what's going on. We know how to measure the output of widgets in the Old Economy. But we don't know how to measure output in a high-tech service economy. We don't know the value of a cellular phone or fax machine that costs less today than it did a year ago. In fact, these advances would actually show up as a decline in GDP unless the statistics are properly adjusted. But they're not. We do know inflation is overstated--by about one percentage point. That, plus other known statistical problems, suggests that both real GDP growth and the productivity rate are about one point higher than the official numbers tell us. In short, the New Economy is here right now, believers say.
And finally, they argue, we have the most powerful gauge of all telling us that something profound is going on: the stock market. Even with the recent correction, the market has more than quadrupled since the 1987 crash. In the past three years alone it has doubled. Sure, the market has boomed partly for demographic reasons--baby boomers and their 401(k) accounts--and partly because of the inflow of funds from other countries. But the market has boomed mainly because conditions have been perfect for corporate profits and thus for stocks--decent growth and low inflation. In its wisdom, the market got it right. Millions of decisions, by millions of people every day, provided the most accurate measure of what was happening in the underlying economy--even if there is a 10% or 20% correction.
WAGE SQUEEZE. The skeptics are quick with their rebuttals. Yes, there is a lot of money going into information technology. Yes, there's more globalization. Yes, the stock market has soared in the wake of rising profits. But none of this means there's a productivity revolution powering a New Economy. Rather, they say, all those profits are coming out of the hide of labor.
This is a hard argument to dismiss. It's true that wages have been stagnant for a long time. Only in the past year or two have they started increasing beyond the rate of inflation. If that continues, skeptics claim, say goodbye to rising profits, a rising stock market, and your so-called New Economy.
Furthermore, the skeptics say, we have been remarkably lucky. Oil prices have remained stable. The shift to managed care has restrained medical costs. The strong dollar has kept inflation down by reducing the prices of our imports. The end of the cold war has enabled us to slash military spending. A conservative tide has enabled us to balance the budget. And the U.S. has been remarkably free of external shocks.
So which is it? Are we just lucky to have a temporary confluence of events that have combined to produce decent growth and low inflation? Won't the Phillips curve reassert itself in higher unemployment or higher inflation?
Or is there a New Economy operating that allows faster growth, with all its benefits, without reigniting inflation?
I vote for the New Economy, properly defined. Even though we haven't ended the business cycle, outlawed recession, or banished inflation, the business cycle really has changed. It is powered more these days by technology and trade. And this may well enable us to grow faster than before without renewed inflation. Perhaps the 4% rate of the past 12 months is too high--enough to justify interest-rate hikes by the Federal Reserve if things don't slow. But the 2%-to-2 1/2% speed limit is probably obsolete. In an era of stronger productivity growth, which may just now be starting to show up in statistics, the speed limit for the U.S. economy is probably 3% to 3 1/2% a year.
If that doesn't sound like much, remember, it is a 50% improvement over what the Old Economists deem possible. Think of it this way: If we had listened to the skeptics and held growth to a 2 1/2% rate over the past 18 months, we would have given up $150 billion in economic output. The unemployment rate would have been half a percentage point higher, putting 750,000 people out of work. Thanks to the magic of compounding over time, a speed limit one point higher is indeed something to crow about. And that's what the New Economy means--nothing more, nothing less.