A New Economy Again
Laurence Meyer is governor of the US Federal Reserve
Board. This article is part of the Global Economic Viewpoint series NPQ
produces for the Los Angeles Times Syndicate International.
New York - We are in the new economy again. That
is, instead of viewing the current experience as unique, it is probably
better understood as a replay of earlier historical episodes in which
a bunching of technological innovations ushered in periods of high productivity
growth. Indeed, the economic history of the United States can be viewed
as a series of productivity cycles-meaning relatively long periods of
higher and then lower productivity growth.
These cycles generate regularities related to investment booms and equity
price surges, followed by retrenchments in investment and corrections
in equity values.
The historical evidence suggests a sequence of waves in labor productivity,
periods of rapid growth followed by periods of more sluggish growth.
The closest parallel to the information technology revolution might be
the introduction of electrical machinery. And, with both the electric
motor and information technology, there was a delay between the time of
the innovation and the increase in productivity growth. Even if 25 years
in the future, we look back on recent developments and conclude that they
were not as important as the innovations earlier in the 20th century,
the recent innovations would still have played a significant role in boosting
Given the productivity resurgence of the late 1990s-and the patterns evident
in the historical data-I believe that the recent data should be interpreted
as part of another high-growth wave following a low-productivity-growth
period. If I am right, then the critical question is, what forces underlie
the high- and low-productivity periods? I don't want to exaggerate my
ability to provide a definitive answer, but the recount period of one
big wave may have been a "happy coincidence of innovations."
That is, high-productivity periods reflect the influence of a bunching
of technological innovations. Low-growth periods reflect the productivity
performance in the absence of bunching or with considerably less of it.
What are the regularities associated with periods of higher productivity
growth? Not surprisingly, investment in the sectors in which the innovations
are taking place surges, and the stock prices of firms in these industries
soar. Also excesses tend to emerge, at least in these industries, followed
by corrections. The excesses and corrections generally involve both valuations
of firms and investment in the innovating industry. After the initial
frenzy of investment spending to take advantage of the new opportunities,
the industries sometimes become overcrowded, or at least profitability
is significantly diminished for a while, resulting in failures of many
firms and a retrenchment in investment.
Several examples of important innovations provide concrete illustrations
of this adjustment to higher productivity growth.
The first example is the development of the motor vehicle industry and
its contribution to productivity after the First World War.
Investment in motor vehicle production surged in the 1910s and early 1920s.
Share prices soared. General Motors' share price, for example, increased
5,500 percent from 1914 to 1920. By the early 1920s the industry had become
overcrowded. It appeared clear at this point that the auto companies would
be unlikely to meet the overblown profit expectations that had prompted
both the pace of investment in the industry and the surge in equity valuations
for auto firms. Share prices plummeted, with GM losing two-thirds of its
Radio is a very interesting case study. It took a long time to develop
a successful business model for this innovation. The early innovators
focused on point-to-point communication, and it took considerable time
to move to a business model in which the advertisers would pay for programming.
This pattern seems analogous to the struggle for a viable business model
for the Internet. Broadcast radio developed in the early 1920s, but many
innovators did not survive. Of the 48 stations that were the first in
their states, 27 were out of business by 1924. Later in the decade the
industry grew and stock prices surged, with RCA jumping nearly 20-fold
from 1923 to 1929. Share prices fell during the Depression, but, unlike
stock prices in many other industries, RCA's share price did not return
to its pre-Depression peak for about three decades, suggesting that its
earlier price represented a bubble.
Other examples also illustrate excesses associated with new technologies.
The development of electric utilities was another important source of
productivity gains in the 1920s. Expansion and consolidation considerably
boosted efficiencies in the industry during that decade, although signs
of excess capacity were not evident. On the other hand, share prices of
these firms soared, with a stunning run-up late in the decade. Share prices
collapsed in the Great Depression, but again did not return to the pre-Depression
peaks until the mid-1960s, suggesting again the possibility that a bubble
had developed in the earlier period.
Finally, we consider the airline industry. After Lindbergh's 1927 transatlantic
flight, airline stocks soared, and many companies rushed into the business.
Stock in a company called Seaboard Air Lines took off even though it was
just a railway company, a phenomenon analogous to that of adding a dot-com
suffix to company names in the late 1990s.
Interestingly, none of our examples overlaps with the golden age. That
period seems to be characterized by a broader range of smaller innovations
and perhaps, therefore, did not appear to give rise to the same frenzy
of investment activity or euphoria with respect to valuations.
In the examples above, innovations generally resulted in investment booms
in the innovating sector but not always in the broader economy. The innovations
often seemed to result in bubbles in valuations in the innovating sector,
but this did not necessarily dominate the equity valuations for the entire
economy. After a period, the innovating sector often experienced a shakeout
or retrenchment, though that didn't always dominate the macrodynamics
of the entire economy. Nevertheless, in the examples in which booms were
followed by retrenchments, the sector in question made important contributions
to productivity long after the shakeout.
So what happened to today's new economy? The answer,
I believe, is that we are still in the new economy (again). The shape
of the slowdown has the new economy written all over it, just as the shape
of the earlier expansion did. We could say that the new economy has suffered
an old economy disease-if not a full-fledged recession, at least a close
relative, a growth recession-as a result of the developments I just described.
A growth recession refers to a period of below-trend growth during which
the unemployment rate rises. But that misses the distinctive features
of the current slowdown.
We turned from a period in which all the forces operating on the economy
were lined up to produce exceptionally favorable performance to a period
when the economy must adjust to some of the imbalances that built up in
the earlier period. Our job as monetary policymakers is to try to ensure
that the adjustment is not too jarring. But there has been pain. Many
investors are understandably unhappy at their loss of wealth. So much
of what had been accumulated in a few years has quickly disappeared, almost
as mysteriously. In addition, many firms have gone bankrupt and others
will, especially some of the riskier ventures in the technology sector.
But these patterns seem to have historical precedent in the corrections
of both equity values and investment that follow, after a lag, the transition
to a period of higher productivity growth.
Some might expect that new-economy developments would make recessions
less likely. That is not an entirely unreasonable presumption. The experience
among faster-growing European economies in the earlier postwar period
was that these economies tended to have fewer quarters of declining output-the
sine qua non of a recession as defined in the US-than was the case in
the slower growing United States. Now that the US had become a higher
growth economy (again), it might be that cyclical episodes would be more
likely to be growth recessions and less likely to be outright recessions.
However, in the US in the 1950s and 1960s-when average growth rates were
about as high as today-the chance of negative-growth quarters was about
equal to the chance in the 1970s and 1980s, when average growth was only
half as large.
In addition, to the extent that the high-tech revolution increased the
ability of firms to recognize and respond to changes in demand and quickly
remedy unwanted inventory accumulation, the response of output to demand
shocks might be less persistent. On the other hand, it appears that the
high-tech revolution didn't help firms or other forecasters anticipate
changes in demand.
There is no guarantee that a higher growth economy is less vulnerable
to recessions. Indeed, I believe that the new-economy developments that
have raised sustainable growth might also, at least initially, have made
economic performance more volatile.
First, I noted that the adjustment to a higher rate of productivity growth
might bring a temporary surge in output, on top of the higher average
growth rates, while at the same time lowering the rate of inflation. Such
a remarkable performance, while bound to be temporary, nevertheless could
easily encourage unsustainable expectations. Hence, the attempt to take
advantage of new-economy forces prompted such a frenzy of investment activity
that many bad, as well as good, investment decisions were made. Bad investments
result in some firms going out of business and others suffering temporarily
depressed profitability and therefore curtailing further expansion for
a while. And, in part because the profit opportunities of new technology
firms were so difficult to gauge, exuberance took valuations to levels
that proved to be unsustainable.
Two sets of new-economy forces
are likely to be especially important in determining the severity of the
slowdown. The first is the length of the adjustment period required to
complete the shakeout and absorb any excess capacity resulting from the
high-technology investment boom. The second is the time it takes for the
accumulation of investment opportunities arising from the continued flow
of innovations to lead to a revival of investment spending.
With respect to households, it appears inevitable that the decline in
equity valuations will result in a negative wealth effect; as a result,
growth in consumer spending is likely to remain below the pace of increase
in income for a while. This will, over time, partially reverse the earlier
decline in the saving rate. The other related key will be the degree to
which declines in consumer confidence, perhaps under the influence of
a softer labor market, undermine consumer spending.
The consensus forecast remains quite optimistic. It calls for a weak first
half-but no recession-and some improvement in the second half, on the
way to trend growth next year. One reason for a relatively optimistic
assessment of recovery is that monetary policy has eased promptly and
aggressively to support aggregate demand. To date, this easing has had
only a little effect on aggregate demand. That is not a statement about
the lack of potency of monetary policy, only about the well-known lag
in the response of aggregate demand to monetary policy action. Given this
lag, monetary policy could provide limited support for the economy during
the period when weakness was developing.
But the response to the cumulative easing to date should begin to mount
in the second half and continue to build in 2002. Moreover, if expectations
in futures markets are borne out, energy prices should be moving lower.
In addition, fiscal stimulus is on the way.
But the key to the strength and rapidity of the recovery will be the balance
between the working off of excesses associated with new-economy forces
that built up in 1999 and early 2000 and the renewal of investment as
new-economy opportunities continue to accumulate.
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