Destination Unknown | Reelin' And Rockin' Aboard The Bear Market
Express: The Ride Nationwide | The Magical, Mysterious High- Technology
Economy: Now You See It, Now You Don't
25 March 2001
The San Diego Union-Tribune
It seems almost daily that another major corporation announces
declining profits and layoffs. Adding to the public angst, the Dow
Jones industrial average a week ago just suffered its worst week in 11
years, and the NASDAQ composite is off 63 percent from its peak a year
ago. Because Americans now have 60 percent of their savings and
investment in the stock market -- double the ratio in 1982 -- those
statistics represents a loss of real wealth.
What happened to the fabled "New Economy" that was supposed to be our ticket to paradise? And how can we restore its luster?
The economic boom of the past decade has been remarkable. During an
unprecedented expansion of the U.S. economy, we experienced four years
of growth averaging more than 4.5 percent, unemployment falling to a
21-year low, and stocks soaring to record valuations -- all this
without much inflation.
Restoring the magic will depend importantly on understanding the
conditions that made the boom possible and the policies that helped
Despite the casual rhetoric often reported in the media, the U.S.
economy is not, nor is it likely to be in 2001, in full-fledged
recession -- defined as two consecutive quarters off declining economic
growth. But rather than haggle over semantics, it is important to
recognize that a weakened American economy is more vulnerable to risks
in the global economy. For example, the cumulative weight of Japan's
decade-long economic woes are beginning to take their toll on the U.S.
economy. American companies and the stock market are likely to
experience more pain before recouping lost gains.
At the center of the new economy were synergies generated by advances
in telecommunications, microelectronics, software, and management
practices. These unleashed innovations in the organization of work and
the corporate supply chain, as well as a torrid pace in the
introduction of new products and services. Together, these raised the
sustainable level of productivity growth to levels not seen since the
The avalanche of new products and higher productivity resurrected
America's international competitiveness. Led by the high-technology
sector, exports accounted for 25 percent of U.S. gross domestic product
growth from 1989 to 1998, more than double the historical norm.
A flexible and high-powered labor market also kept wages from rising.
Even as businesses expanded and unemployment fell, many firms boosted
productivity by streamlining factories and management bureaucracies.
Released workers joined even more rapidly growing firms and new
At the same time, a tight labor market taught businesses the value of
being good employers and, in particular, the virtue in training workers
at all levels to upgrade their skills and prospects. In addition,
immigrants -- ranging from computer programmers to food service workers
-- helped fill gaps in the domestic labor supply.
Meanwhile, a strong dollar and falling oil prices helped keep import
and energy prices low. Moreover, competition from imports pressured
domestic firms to find new ways to boost productivity and encouraged
businesses to embrace new technologies and methods, and to upgrade the
skills of their workers rather than raise prices to grow profits and
finance wage increases.
Finally, investments in technology to boost productivity fueled rapidly
growing profits among leaders such as General Electric, Dell, Intel,
and Microsoft, thus creating the optimism necessary to attract
financing to start-up enterprises through venture capital and initial
Unfortunately, forces beyond the control of U.S. policy makers, as well
as some policy missteps, deflated the economy and the stock market over
the last year. The Asian economic crisis, continuing malaise in Japan,
and the rising value of the dollar significantly slowed the growth of
U.S. exports and increased American purchases of foreign products after
1997. Moreover, oil exporting nations agreed in 1998 to cut production,
and the price of oil began rising in early 1999. From July 1997 to
December 2000, therefore, the annual trade deficit grew from less than
$83 billion to $396 billion, creating a drag on domestic demand for
goods and services equal to about four percent of GDP.
In addition, while the end of large federal budget deficits is cause
for celebration, it is important to recognize that large government
surpluses can constrain the demand for goods and services just as large
trade deficits do.
It was a matter of considerable consequence, therefore, that the U.S.
trade deficit began ballooning in 1997 at the same time that the
federal budget swung from deficit to surplus. By FY 2000, the budget
surplus had reached $237 billion, and in FY 2001 it is expected to
reach $265 billion. At current levels, the trade deficit and budget
deficit together place a drag on domestic demand in excess of six
percent, and this could easily grow much larger in the months ahead.
As we moved through 2000, other structural constraints were also coming
to bear. Federal government policies to reduce pollution through
greater reliance on natural gas for electricity generation, coupled
with limits on development of domestic oil and gas, created a tight
natural gas market. Misadventures in deregulation created a shortage of
electricity-generating capacity in California, with important
consequences for other western states.
To compound matters, the Federal Reserve, alarmed by rising prices,
raised interest rates six times from June 1999 to May 2000.
Unfortunately, it was chasing inflation that monetary policy cannot
catch. Most of the price increases were caused by: the tightening grip
of the foreign oil cartel coupled with the limited supply of domestic
energy; health care costs, which are fairly unresponsive to interest
rates and the pace of economic expansion; and one-time events, such as
the impact of the tobacco settlement on cigarette prices.
The last two interest rate increases came in March and May 2000, so
that much of their effect occurred after the slowdown had begun. In
2000, GDP growth slowed from 5.6 percent in the second quarter to 2.2
percent in the third quarter and 1.1 percent in the fourth quarter.
Instead of braking an accelerating economy, these rate increases helped
push a besieged economy over the edge. Growth in corporate profits
slowed, business investment dropped, and productivity growth fell
As for the stock market, while it may be irrational and overly
exuberant at times, it has proved clairvoyant since last March.
Investors recognized that slower-growing corporate profits did not
justify high valuations for established companies. A slowing economy
meant many young companies -- importantly, those financed by stock
sales -- were unlikely to turn a profit soon and would need to sell
more stock just to stay open. When stocks began sliding, investors were
anticipating what ultimately happened in the real economy.
In response, the Federal Reserve has announced three interest rate cuts
totaling 150 basis points since the start of the year. Unfortunately,
we are relearning one of the oldest lessons of economics: monetary
policy can choke a recovery but it cannot easily ignite one. Lower
interest rates will not cause consumers to spend much more money --
Americans already spend almost everything they earn. Moreover, flagging
investment is fairly resistant to rate cuts, because corporate
decision-makers need to see more sales and profits on the horizon
before they will trade in three-year-old computers for new ones or add
expensive new capacity. And while lower rates can accelerate exports by
weakening the dollar, it won't happen this time, because conditions in
Japan and elsewhere in Asia make a weaker dollar and an export boom
This time, fiscal policy must come to the rescue. Congress and the
president must agree either to spend more of the budget surplus or give
some of it back to taxpayers to spend for themselves.
Before writing your congressman to ask for a new bridge, however, it is
important to recognize that federal taxes are now at a record peacetime
high as a share of GDP and are only one-half percentage point less than
their 1944 wartime record. Although we can quarrel about how much of
the surplus should be spent on worthwhile public purposes and how much
should be sent back to the people, it is not surprising that the
president and Democratic leaders are debating the size and focus of a
tax cut rather than whether we should have one at all.
Unfortunately, the president's tax cut plan will not give the economy
the boost it needs. Of the $1.6 trillion, a significant share is
earmarked for ending the estate tax, but individuals spared taxes on
estates greater than $675,000 are not likely to run out and buy
additional Ford Explorers or computers.
Furthermore, because the Bush plan calls for cuts in income tax rates
in 2001, 2003, 2005 and 2006, a good deal of the $958 billion slated
for income tax relief will not find its way into taxpayer pockets and
consumer spending right away.
To get the economy moving again, tax relief should be accelerated. In
particular, it would be better to compress the schedule for income tax
cuts, even if this required reducing the ultimate size of rate cuts or
limiting estate-tax reductions to stay within a total tax package the
president and Congress could accept. Further, cuts could be considered
after the next election cycle if conditions warrant.
Importantly, the fundamentals are still in place for rapid productivity
growth and the opportunities that creates. These fundamentals include
continuing advances in new technologies and the very flexible and
resourceful American work force.
Congress and the president need to show some creativity -- and
flexibility, also -- to get the economy and the country back on track.
Peter Morici is a senior fellow at the Economic Strategy Institute in Washington, D.C.