The Great Bubble Debate
Double, double toil, and trouble; Fire burn, and cauldron bubble.
Federal Reserve Chairman Alan Greenspan worried out loud about stock market bubbles at the recent annual economic "Fed camp" in Jackson Hole, Wyo. In an intellectual tour de force, Greenspan ruminated about the nature and impact of financial bubbles: Measuring overvaluation is an impossible task, and past attempts to prick asset bubbles with higher rates--in the U.S. in the '20s and Japan in the '80s--proved disastrous. He wisely concluded that while stock prices had become an independent force in the economy, the Fed should not use monetary policy to do much about them. Bubbles remain mysterious things, he said--unpredictable and identifiable only after the fact. Is Greenspan right? We believe so, but others disagree.
SIGNS OF TROUBLE?
It all depends on how you view the New Economy. For most of the '90s, mainstream economists rejected the notion of a New Economy. With sustained productivity growth of 2% annually--twice the level of the previous two decades--they have recently become converts. The discussion is no longer about the existence of a New Economy but about what it means for the stock market. We think that an information-based economy generating greater productivity and profitability can probably sustain higher stock market valuations than recent historic norms. Again, others disagree. Here are the two key issues in the bubble debate:
-- Does the New Economy justify sky-high price-earnings ratios, or will it generate a classic stock market bubble? A study called "Bubble Trouble" by HSBC economist Stephen King shows that four modern bubbles--in Britain, Japan, Mexico, and Spain--were associated with low inflation, high productivity, a strong currency, above-average economic growth, and talk of "new eras." Sound familiar? Low price inflation, coupled with robust economic growth, lulled policymakers into keeping monetary policy too easy, too long. Assets inflated, and the bubble burst. According to HSBC, the U.S. is clearly in this kind of bubble. Watch for the pop.
Not so, finds an equally persuasive study, "The IT Revolution and the Stock Market," by Jeremy Greenwood of the University of Rochester and Boyan Jovanovic at New York University. They readily grant that p-e ratios are plenty high. But Greenwood and Jovanovic say the market is simply forecasting higher future output, productivity, and earnings. If that's true, then the sharp runup in stock prices represents a positive estimate about growth in future profits. The info-tech revolution will add value to the stock market for a long time. So high p-e's are justified. Forget the bubble.
-- Is the high-tech, high-productivity revolution confined to a narrow sector of the economy, or is it pervasive, transforming virtually every industry? If the New Economy is Netcentric, then the high p-e's in the broad stock market are way too high, and a bubble exists. But if productivity is rising throughout the economy, then a 31 p-e for companies in the S&P 500-stock index looks more reasonable.
Robert Gordon, a Northwestern University heavyweight economist, argues that nearly all the recent productivity gains have taken place in the computer industry. His figures show virtually no productivity acceleration in the rest of the economy. His research is bolstered by Clayton Christensen, who, in his best-selling book, The Innovator's Dilemma, argues that Old Economy companies invariably get blindsided by disruptive technologies and can't adapt. "The logical, competent decisions of management that are critical to the success of their companies are also the reasons why they lose their positions of leadership." Gordon and Christensen support the view that the New Economy is limited mostly to a narrow sector of the economy, and the stock market as a whole is overvalued. The bubble is here.
But CEOs across America believe Gordon and Christensen underestimate the ability of brick-and-mortar companies to transform themselves into hip New Economy hotshots that can sustain superstock p-e's. Venerable Charles Schwab Corp. has transformed itself into the biggest online discount broker. Gap Inc. is one of the biggest retailers on the Net. Telecom-equipment maker Cisco Systems Inc. may do 78% of its business over the Net, but Ford Motor Corp. has used the Net to boost sales per employee some 25% over five years. Electronic commerce appears to be not only creating new companies but also changing the way Old Economy companies do business. To them, the past is not prologue. And a bubble is not inevitable.
A WIDESPREAD REVOLUTION
BUSINESS WEEK bets that the Information Revolution is probably having a widespread--not a narrow--impact on the economy. But adapting to a new technological base takes time. No one knows how long this Information Revolution will take, or what will happen along the way. That's why there's so much debate about the New Economy, productivity, and bubbles. We believe that stocks warrant higher valuations today than in the past, thanks to the New Economy, but admit to not knowing how much higher. The recent shakeout in Internet stocks shows that investors are also making their own calculatIons.
So feel free to join the bubble debate. For Greenspan's Jackson Hole speech, see the Web site federalreserve.gov; for Greenwood and Jovanovic see www.econ.rochester.edu/Faculty/Greenwood.html; and for Gordon's "Has the New Economy Rendered the Productivity Slowdown Obsolete?" see faculty-web.at.nwu.edu/economics/gordon. The issues are complex. There's reason why Alan Greenspan, in an exceptionally thoughtful and candid moment, decided to worry out loud.