The Internet Economy
When you drive a car at 90 mph, you get to your destination faster--but even a pothole in the road can turn into a disaster. That, in a nutshell, sums up the dilemma of the U.S. economy these days.
There is no doubt that the U.S. is in the midst of one of the greatest capital-spending and stock market booms in history. Business spending on equipment, adjusted for inflation, has increased 60% during the last four years, a rate matched only by the best stretch of the 1960s. The stock market is up by an astounding 160%.
The gaudiest numbers, of course, belong to Internet companies such as eBay Inc. and Yahoo! Inc., whose stock gains during the past year inspire either visions of easy wealth or, from the sidelines, plain old envy--or revulsion at the excesses of greed. Despite dropping by 20% since Jan. 29, the Chicago Board Options Exchange Internet Index is still up some 200% just since September, 1998.
WINNOWING OUT. But these figures are only a measure--and an imprecise one--of a larger phenomenon. Like the railroad boom of the 1890s and the automobile-driven expansion of the 1920s, which also produced surging markets, the Internet boom stems from the addition of a whole new stratum of industry to the economy. The rush to adapt Internet technology to all sorts of purposes and to create the hardware and software to take the Web everywhere is spurring a tremendous surge in growth, investment, and new business creation.
In the long run, this commitment of resources will produce a new industrial base that will flourish in the future. Just as the auto makers of the 1920s became the giants of the 1950s and 1960s, today's outpouring of innovation is creating the companies that will generate growth in the E-commerce era.
DEAD ENDS. But such investment-led expansions that occur when new technologies are emerging will inevitably come to an end--often in ugly ways. Somewhere along the way there is a brutal sorting out of winners and losers. The survivors consolidate and thrive. But many companies that lead the boom disappear; once-promising innovations turn out to be dead ends. And much of the stock market value created in the boom simply evaporates, as investors realize what makes business sense and what doesn't. The sorting-out process often triggers disruptions in the rest of the economy as well.
The pattern from history is clear. In the 1920s, for example, the single biggest force for growth was the tripling of auto production, along with a similar expansion of capacity in related industries such as steel, rubber, and highway construction. The Standard & Poor's index for carmaker stocks more than quintupled between 1925 and the spring of 1929. During the same period, the market as a whole rose 144%.
But when auto sales hit their peak in April, 1929, that signaled the end of the boom time for the autos--and the rest of the economy. In the next four years, carmakers' stock prices dropped as far and as fast as they had risen. A few big players such as General Motors Corp. survived and even continued to be profitable, but many others, such as Auburn, Franklin, and Pierce Arrow, disappeared in the following years, along with most of the money of the people who invested in them.
Eventually, something similar will happen to the Internet-led boom as well. There have already been a series of scary, if brief, plunges in Net shares, most recently in early February.
Many on Wall Street would welcome a revaluation of Internet shares to more sustainable levels. But if such a move triggers a pause in the investment boom, the economy could suffer. The tech sector now looms so large in the economy that overall growth could falter. The labor market, for example, has become increasingly dependent on job growth in New Economy industries such as software, communications, and consulting. BUSINESS WEEK calculations show that New Economy industries are adding jobs at a 3.7% rate, twice as fast as the rest of the economy (chart). These well-paid jobs have helped fuel a strong rise in consumer spending--but when the boom pauses, many workers may find themselves unpleasantly surprised by layoffs and falling incomes. The result will be to remove one of the major props from economic growth.
The other worrisome factor is that, with profits sluggish, companies have been taking on a mountain of debt to finance capital spending. That means when the boom ends, some companies may have a tougher time weathering a slowdown. According to Securities Data Co., about $650 billion in investment-grade corporate debt was issued in 1998, up 39% from the previous year. High-yield debt was up about 29%. By contrast, new equity issuance has been about flat, at just under $120 billion per year. True, with rates low, much of the new borrowing went to refinance existing debt. Nevertheless, nonfinancial corporate debt outstanding rose by 11%, the fastest rate since the mid-1980s.
For now, despite the gyrations in tech stocks, there is no sign that the Internet-infotech boom is slowing yet. Business spending on computers and communications equipment rose at a strong 14% rate in the fourth quarter. According to a new report from the Semiconductor Industry Assn., global chip sales in the fourth quarter increased by 10.5% over the third quarter, after falling for most of 1998.
UP AND UP. Indeed, the performance of the economy keeps confounding skeptical economists. The latest good news: On Feb. 9, the Bureau of Labor Statistics announced that productivity rose at a 3.7% rate in the fourth quarter, the fastest rate in three years. Forecasters who had been predicting 2% growth in gross domestic product for 1999 are now revising their estimates to 3% or more.
The gains in productivity point up one of the advantages of U.S.-style capitalism: the ability to move human and financial resources to the cutting edge of the economy quickly. From that point of view, the stratospheric rise of many Internet stocks reflects precisely what is supposed to happen. Drawn by the possibility of big gains, investors are willing to fund a wide variety of new companies, greatly accelerating the pace of innovation. And even if most of the start-ups fail, the net result is to move the economy forward at a faster pace.
Equally important, the massive market capitalizations of companies such as Amazon.com Inc. and America Online Inc. are a wake-up call for existing businesses, forcing them to reorient their spending and hiring to cope with the rise of the Internet. That explains much of the surge in capital spending and borrowing that's now taking place. The Internet companies themselves have little debt, but the same is not true of their suppliers and competitors.
Some of the biggest borrowers were telephone companies, which were investing in new infrastructure and capacity. In 1998, for example, rapidly expanding Frontier Corp., a Rochester, N.Y.-based telephone company, boosted long-term debt by 44%, to $1.3 billion. Barnes & Noble Inc., facing tough competition from Amazon.com, was forced to increase long-term debt by more than 50% during the last two years to expand and keep up.
Are disruptions in the offing? Almost certainly. But there's no denying that high speed innovation and investment have left the U.S. in far better shape than it was just a few years ago.