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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 measured productivity.

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 value.

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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