The New Economy: How Real Is It?
Does the New Economy exist? Not long ago, with growth strong and markets booming, the answer seemed an obvious yes. But then came the bust. In the first half of this year, output grew at an annual rate of just 1%--and there's still a chance of an outright recession. Many pundits have left the New Economy for dead. Now they're talking about the "Bubble Economy."
Not so fast. We think that there really is a New Economy, properly defined, and that it's here to stay. In our view, the wild excesses of the late 1990s and the stock market plunge of 2000-2001 combined to obscure a fundamental change in the structure of the U.S. economy. The New Economy was never about the end of the business cycle. Recessions can still occur. Nor was it about price-earnings multiples rising to the ionosphere. It was--and is--about an economy capable of growing more rapidly without inflation than it did during the long slump of 1973 to 1995, because of technology-driven increases in productivity, the world's best financial system, and the unleashing of entrepreneurial energies through deregulation.
Looking ahead, we're cautious about the immediate future. But we remain optimistic about the two- to three-year outlook, which is the time horizon for this Special Double Issue. Since the middle of the 1990s, labor productivity--the output per hour of work--has grown at a rate of 2.4% annually, even after the latest downward revisions. These gains are likely to continue, though probably at a slightly slower pace. At the same time, immigration is helping to expand the labor force. Put those together, and the U.S. can most likely sustain annual gross-domestic-product growth of around 3.5%. That's a healthy contrast with the period of 1973 to 1995, when GDP growth averaged 2.8%. Moreover, it's safely below the overheated 4%-plus growth of the late 1990s--and right in line with the average for the 20th century as a whole, when America experienced the greatest increase of wealth in world history. Other nations seem to agree. They're betting on the long-term strength of the U.S. economy by investing in American assets ranging from Treasury bills to new auto plants.
In contrast, the short term isn't so pretty. Those who thought the New Economy meant good times forever have been mugged by reality. Along with being faster-growing, the New Economy is more exposed to the forces of volatility. The tech investment cycle has extreme ups and downs. Innovation, once funded by fairly stable corporate research-and-development budgets and government grants, is whipsawed by fluctuations in financing from venture capitalists and initial public offerings. And deregulation exposes once-insulated businesses like phone and electric companies to the unpredictable forces of competition. Even globalization may add to volatility, if it means tech investment goes cold all over the world instead of in different countries at different times, as before.
Overall, the good news outweighs the bad. So far, it looks likely that the U.S. economy will manage to skirt a recession this year, if just barely. The outright bust has been confined to a few sectors, such as Internet companies and telecom-equipment makers. Even though the slump in capital spending subtracted almost 2 percentage points from economic growth in the second quarter of 2001, the overall economy still managed to grow a bit. A rapid series of interest-rate cuts by the Federal Reserve has buoyed consumer spending and housing, and there is likely to be at least one more. Lower rates have offset the hit to consumers from the tech-induced decline in their stock market wealth. In short, the new sources of volatility haven't been severe enough to drag the entire economy into recession.
The timing of a full rebound boils down to when businesses resume serious investing in new plants and equipment. Right now, they're reluctant to buy new gear because they have plenty on hand from the last capital-spending binge. Industry is using just 77% of its capacity, the lowest rate since 1983. Companies are filling orders out of inventory instead of new production. David A. Wyss, chief economist at Standard & Poor's, which like BusinessWeek is a unit of The McGraw-Hill Companies, says this business cycle is similar to those of the 1950s: Capital spending was the first component of GDP to slump and will be the last to recover.
WAVE OF INNOVATION. The best bet: Capital spending will finally come back strong sometime next year. With inventories running low, companies will need new equipment and software. Plus, some of the gear they already have will be outmoded. In the cutthroat business world, companies can't afford to keep using out-of-date equipment even if it still has years of serviceable life. Equipment that lowers costs will be in demand. With capital spending back on track, the economy should reach full strength a year from now, if not sooner. The latest survey of 50 economists by Blue Chip Economic Indicators pegs GDP growth at 1.8% this year and 3% next year, with the annualized growth rate reaching 3.5% by the second half of 2002.
The next expansion may well look different from the last one, with a new complement of companies leading the charge. Pharmaceutical and biotech companies are likely to expand rapidly, riding the wave of innovation that results from the unraveling of the human genome. As for info tech, expect a mixed bag. It's hard to see who's going to sizzle by making slightly faster routers or stringing yet more optical fibers across prairies and oceans. What consumers and businesses want now are systems that produce immediate, concrete benefits. Computing on demand, for instance, is supposed to make computing as easy as turning on a water tap. Instead of running its own complicated info-tech shop, a business pays by the month to use hardware and software maintained by an outside specialist. A promising new generation of collaborative software from companies such as MatrixOne (MONE ), Agile Software (AGIL ), and Logistics.com eliminates bottlenecks in supply chains through information sharing. And wireless still holds promise: Pretty soon, experts say, cell phones and the Internet will go together like peanut butter and jelly.
New Economy skeptics have a more pessimistic view of the future because they have a gloomier reading of the past. They say much of the equipment and software bought in the late 1990s went to waste. And they argue that recent downward revisions of historical GDP data solidify their case that the profit and productivity surge of the period was not as strong as first believed. When the history books are written, they say, the boom will turn out to have been largely a bubble.
CRITICAL MASS. No denying, there was plenty of froth. But the boom was founded on something real. In the 1990s, corporate investment in information technology finally hit critical mass. Computers became a big enough share of the nation's capital stock to raise overall productivity and growth significantly. A study last year by Federal Reserve economists Stephen Oliner and Daniel Sichel concluded that half of the acceleration in labor productivity improvement of the late '90s came from equipping workers better--"capital deepening," as it's called.
Not only is there more computing power than ever before, it's also improving at a faster rate. Harvard University economist Dale W. Jorgenson dates the acceleration to November, 1995, when Intel Corp.'s product cycle for its microprocessors shrank from three years to two with the early introduction of the Pentium Pro. Intel (INTC ) has kept up the pace since, most recently with its Itanium processors for servers and workstations--its first that chew on 64 bits of data at once.
Build it and they will (eventually) come. Bill Martin, chief economist of UBS Asset Management's London-based Brinson Partners, points out that falling prices for info technology have predictably led to rising volumes since at least as far back as 1971. Paul A. David, an economist on the faculties of Oxford and Stanford universities, thinks there are still giant opportunities for gains in productivity and consumer welfare from electronic commerce between businesses, from cheaper and better information appliances, and from telecommuting. "If the current technological wave does represent a third Industrial Revolution, the upturn in productivity growth could last for a couple of decades or more," write London-based economists Darren Williams and Richard Reid of Schroder Salomon Smith Barney in their new report, Back to the Future.
Computers and telecommunications are general-purpose tools. That means they'll continue to grow in importance, because they'll be put to uses that nobody today can imagine. J. Bradford DeLong, an economic historian at the University of California at Berkeley, points out that electric power gave U.S. industry an annual horsepower increase from 1880 to 1930 of less than 10% a year. In contrast, since the late 1950s, the total computational power of the world has risen about 84% a year. Even if you assume that a lot of the computing power wasn't harnessed, that's a sonic-boom rate of increase. And performance is continuing to improve even during the slump. A temporary excess of cheap and excellent technology is not the worst kind of problem a society could have.
True, long-term optimism has to be tempered by concern about the current slump. In the New Economy, the ups and downs of the tech cycle affect the overall economy much more than in the past. In the late '90s, info-tech investment grew like wildfire--at an inflation-adjusted annual rate of 20% from 1995 through 2000. Business and consumer spending on information technology accounted for one-quarter to one-third of economic growth during most of the period. Now it's subtracting from growth. In the first half of this year, IT investment fell at an annual rate of 6%. And the tech downturn isn't over. From April to June, new orders for nondefense telecom equipment fell by more than 25%.
HIGHLY SENSITIVE. The tech cycle is being exacerbated by the reliance of tech outfits on funding from venture capital, initial public offerings, and junk bonds. All three are highly sensitive to the overall mood of the financial markets. In the boom years, that was all to the good: The amount of venture capital rose from $3.5 billion in 1990 to $104 billion last year, according to Thomson Financial Securities Data's Venture Economics unit. Beyond being sources of money, VCs sit on startups' boards, help them find suppliers and customers, and redo their business plans when circumstances change. Economists Samuel S. Kortum and Josh Lerner of Harvard Business School estimate that a dollar of venture capital produces three to five times more patents than a dollar of corporate R&D spending.
But now, tech companies that need money, especially startups, are getting the door slammed in their faces. Says Geoffrey Y. Yang, a partner in Redpoint Ventures, a venture-capital firm in Menlo Park, Calif.: "We went from a period where the cost of capital was basically zero to a period now where the cost of capital for the most groundbreaking ideas is nearly infinite." Yang is proud to have put seed money into TiVo Inc. (TIVO ), a now-struggling company that makes it easy for busy people like Yang himself to save TV programs on a digital recorder. "I think of TiVo up there with the microwave in terms of how it's changed my life," says Yang. "But I doubt we would invest in a company like that today as a startup. Which is a pity." Yang fears that "normal conditions" won't return in the tech sector until late next year or early 2003.
No wonder people are moping in Silicon Valley. But each time the U.S. tech sector falls into a trough, new technologies and companies emerge to lead it forward again. And it could happen sooner than the pessimists fear. The two keys to recovery will be innovation and cost-effectiveness. Alan Greenspan, to name one influential observer, remains optimistic. "By all of the evaluations we can make," he told the Senate Banking Committee in July, "we are only partway through a technological expansion."
It may take some time for Wall Street to overcome its fear and share Greenspan's good mood. Says Henry Kaufman, a New York-based investment manager and economic forecaster: "People took such a beating. You've got to wipe out those memory banks."
But investment will snap back. With more modern software and equipment, American workers will be able to produce more goods and services with less effort--the very definition of higher productivity. Even now the economy continues to grow, keeping the longest expansion in U.S. history intact. The New Economy lives. It's a good bet that sometime next year, the U.S. will once again enjoy sustainable, noninflationary, and brisk economic growth.
By Peter Coy