Commentary: The Boon behind the Bubble
By Michael J. Mandel
Like a film running backward, many of the corporate giants that grew quickly to prominence in the 1990s are shrinking at an even faster rate. Icons of the New Economy, such as WorldCom, Enron, and Global Crossing, are disappearing in a haze of bad accounting. Corporate America is being forced to issue restatement after restatement, signaling that much of the earnings booked in recent years were manufactured rather than real. And the stock market is languishing: The Standard & Poor's 500-stock index is down 17% since the start of the year.
Taken together, these problems are leading many economists to wonder if the New Economy boom was, in the end, simply a bubble, overhyped by the press and by Wall Street, and that many of the gains of the 1990s will disappear as quickly as Enron Corp. collapsed.
Fear not. There's plenty of substance left in the financial markets and the economy even as the froth disappears. While some sectors--notably telecom and utilities--have cratered, the overall S&P 500 index has more than doubled since the beginning of 1995, when the productivity gains from tech spending first became visible and stock prices took off. That translates into an annual return of 10.2%. Moreover, virtually every indicator of economic health is sturdier now than in 1995. In particular, real wages, business-capital spending, and productivity growth are all much higher than they were seven years ago despite the 2001 recession.
The combination of boom followed by bust has left America better off than when it started. That may seem like cold comfort to investors who can't forget the money they've lost in the market over the past couple of years. But the evidence supports the basic premise underlying the New Economy--that investment in information technology, combined with corporate restructuring, can substantially boost productivity and economic performance. Moreover, it suggests that the U.S. economy should be capable of another round of solid growth.
All this, of course, assumes that the stock market and the economy have bottomed out, which is no sure thing. Another terrorist attack or the discovery of major financial problems at more big companies could send the market into another tailspin. And the economy, while clearly recovering, is vulnerable to a double-dip: Consumer confidence was off 3.5% in June, there's scant evidence yet of a sustained recovery in the labor market, and the dollar is down sharply against the yen and euro.
It's also true that, in some cases, it has taken considerable time to unwind the excesses of an out-of-control investment boom. Example: The aftershocks of the mid-'80s oil bust in Oklahoma and Texas continued to be felt for years. And more than a decade after Japan's stock market started to slide in 1990, the nation still has not recovered from its post-bubble hangover.
For now, though, it appears that the U.S. is coming out of its investment boom in far better shape than Japan did. Despite the financial markets' dips and spikes, about half of the stocks in the S&P 500 have produced average annual returns in excess of 10% since the beginning of 1995. Even the tech-heavy Nasdaq turned in an annual return of 8.3% over that stretch.
Out in the real world, moreover, the economy is doing just fine. Inflation-adjusted wages are up 13% over the past seven years--the best jump in three decades and a boon for most Americans. Inflation, outside of food and energy, is only 2.5%, down from 2.9% in 1995. And productivity growth over the past three years is still running at a 3.1% rate--far faster than the 1.5% seen in the first half of the 1990s and the entire 1980s.
Indeed, productivity growth has been so strong that it can withstand even expected downward revisions in the economic data. At the end of July, the Commerce Dept. will issue revised estimates for the past couple of years that could reduce 2000's reported gross domestic product and productivity growth by as much as a percentage point. But even if that happens, the three-year productivity growth rate will still be a very solid 2.7%.
The strength of productivity gains is the best way to tell if the boom was justifiable exuberance about new technology or a mass suspension of rational thinking. Historically, speculative bubbles are followed by a period of weak productivity growth and low investment as businesses find themselves stuck with low returns from their capital outlays. Japanese companies, for example, invested heavily in new machinery during the golden years of the late 1980s. But this capital spending never paid off: After the boom ended, output per worker in Japan rose at less than 1% annually for the first half of the '90s. In effect, the spending was wasted.
In contrast, U.S. companies generated big productivity gains even while the economy was in recession last year. That's highly unusual, and it suggests that the info-tech investments of the 1990s are finally paying off, though perhaps with a longer lag than expected. That has implications for future spending as well: As companies see the benefits of their past investments, they'll be more willing to put money into similar projects, especially if profits start to rebound in the second half of the year.
In truth, though, companies never really stopped spending. Despite the Nasdaq's bad performance and Silicon Valley's gloom, business spending on IT gear and software is about 75% higher today than it was in early '95, according to the Commerce Dept. Even shipments of nondefense communications equipment--the hardest-hit sector--are up by about 40% over the past seven years.
These gains are reflected in the financial reports of the leading tech companies, which show just how much the demand for technology has increased. For all their current problems compared with the height of the boom, Intel (INTC ) and Sun Microsystems (SUNW ) have about doubled their 1995 sales, while Microsoft's (MSFT ) revenues have more than quadrupled. And Cisco Systems Inc. (CSCO ), despite having absorbed a disastrous inventory write-off in 2001, reported sales in the latest quarter of almost $5 billion--more than eight times its sales of $581 million in the first quarter of calendar 1995. That's a striking increase in growth, even if much of it came through acquisitions.
Surprisingly, these tech companies have held on to much of the stock gains they have racked up since 1995 despite the massive plunge in tech equities over the past couple of years. Adjusted for stock splits, the share prices of both Microsoft Corp. and Cisco have risen by almost 600% since 1995, or at about a 29% annual rate. The stocks of Sun Microsystems Inc. and Intel Corp. did a bit worse, with about a 20% annual gain over the same period. Overall, S&P's information-technology index rose by 125%, which translates into an 11% annual rate of return. Spectacular? No, but it's nothing to sneeze at.
The other pillar of the New Economy, financial services, has also stood up well. The boom of the 1990s was built in large part on the ability of businesses to raise cheap capital and the increased participation of individual Americans in the financial markets. That pumped up financial stocks, which collectively almost quadrupled in value from 1995 to the peak of the market in 2000.
Given the bear market and the general distrust of Wall Street and Corporate America these days, one might expect that a lot of these gains would have dried up. But the combination of low interest rates, the housing boom, and the continued flow of new corporate bonds has meant that the financial sector has prospered. Financial companies have actually added 24,000 jobs over the past year, and profits are close to record levels.
As a result, the S&P's financial-services index is down by only 18% from its early 2001 peak. All told, the sector has shown a 17% annual return since 1995, with financial-services companies some of the biggest gainers of the past seven years, reflecting the increasing importance of the financial sector in the economy. The share price of Capital One Financial Corp., the credit-card company, is up almost 1,000% since the beginning of 1995, while Lehman Brothers Inc. is up about 700%.
Even financial companies that have taken heat for bad behavior are holding their own. Take Merrill Lynch & Co. (MER ), which was publicly pilloried by New York State Attorney General Eliot Spitzer for producing misleading analyst recommendations and for conflicts of interest. At $37 a share, Merrill's stock is worth half what it was at the end of 2000. Nevertheless, it's more than four times higher than the split-adjusted $9 a share it traded for at the beginning of 1995, when the stock market boom started.
That's not to say the U.S. economy didn't develop some real excesses in 1999 and 2000. Dot-com mania, especially toward the end, was clearly unconnected to economic or business realities. In telecom, the combination of deregulation and overconfidence in new technology sent telecommunications stocks first spiraling upward and then plunging.
There were other bubbles, too. Like telecom, the electric- and gas-utility industry was hardly all it was cracked up to be by its promoters--call it the "Enron bubble." Deregulated just as the boom hit, many utilities also went through a spending-and-borrowing spree. And they engaged in financial engineering to make stodgy companies look more like high-powered earnings machines. Of course, energy trading and all the other attempts to dress up utilities turned out to be no more than smoke and mirrors.
Right now, most media and investor attention is focused on uncovering the wrongdoing that permeated some companies and industries in the 1990s--and finding ways to prevent it in the future. That's as it should be. But it helps to remember that even after a two-year bust, the New Economy has left most American consumers, investors, and companies in better shape than they were in when the boom started.
Mandel covers the economy from New York.