NEW ECONOMY WILL PICK UP AGAIN -- WITH HIGHER PRODUCTIVITY
By Laurence H. Meyer
Laurence H. Meyer is a governor of the U.S. Federal Reserve
NEW YORK -- We are in the new economy -- again. That is, instead
of viewing the ups and downs of the information economy 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 -- 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 also suggests a sequence of
waves in labor productivity, with periods of rapid growth followed by
periods of more sluggish growth.
The closest parallel to today's information technology revolution might
be the introduction of electrical machinery. 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,
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 story may be that of one
big wave, 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 World War I. 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
twentyfold 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.
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 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.
The story is that 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
Some might expect that new-economy developments would make recessions
less likely. However, 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.
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
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 no
recession -- and some improvement on the way to a growth trend 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.
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, though we are unlikely
to see a repeat of the unsustainable rise in equity prices or frenzied
pace of investment, at least for a time. The events of the past year are
likely to linger in the minds of many.
It is always important to learn or relearn valuable lessons from
experience. Recent developments have taught or retaught us a number of
such lessons. Equity prices can go down as well as up. Firms need profits
to survive. Business cycles happen. And although we cannot always anticipate
or counter these developments perfectly, monetary policy remains a potent
tool to aid economic stabilization and maintain low inflation and thereby
to promote long-term sustainable growth.
(c) 2001, Laurence H. Meyer. Distributed by the Los Angeles Times
Syndicate International, a division of Tribune Media services.
For immediate release (Distributed 8/15/01)