|BUSINESSWEEK ONLINE : FEBRUARY 14, 2000 ISSUE|
Commentary: The Risk That Boom Will Turn to Bust
Convinced by the longest expansion on record, even skeptical investors and economists are embracing the New Economy--and with it the notion that the U.S. has moved into an era of lower inflation and higher productivity growth. Unfortunately, too many have given in to the temptation to conclude that the New Economy also means the end of the business cycle.
That's wishful thinking. Long-term productivity gains are certainly real and will continue. But nothing about the New Economy rules out business cycles. Quite the contrary: The same forces that propelled the economy to its current heights put it at greater risk of a sharp downturn. Sooner, rather than later, the New Economy boom is likely to be followed by a New Economy bust--a recession and stock market decline that could be much deeper than most people expect.
The reason is simple: This expansion, unlike any previous one, has been mainly driven by the tech sector--software, semiconductors, telecom, and the Internet (chart). These are all what economists call ''increasing-returns-to-scale'' industries. This means they have high initial costs: writing programs, developing Web sites, or laying fiber-optic cables. But once the initial investment is in place, the costs of serving additional customers are relatively low. Such companies perform marvelously in growing economies because their productivity and profits rise as they expand. But on the downside of the cycle, they are hit by the double whammy of fixed costs and falling revenue, making them vulnerable to sharper drops in profits and jobs than traditional industries.
DEJA VU. Such wide swings have always characterized the semiconductor industry, which historically has gone through big boom-and-bust cycles. But now a big swath of the economy shares the same dynamics. What's more, the strength of the tech sector is covering up growing vulnerabilities, including volatile consumer incomes, high debt levels, and increased dependence on foreign money. Once high-tech growth slows--as it almost inevitably will at some point--these weaknesses will feed on each other, setting the stage for a serious downturn.
Such fears may seem fanciful or overblown in the midst of prosperity and an economy that is growing at a rate of almost 6% a year. With the Internet boom coming on the heels of the personal-computer boom, the pace of innovation does not yet seem to be slowing. The global economy is showing signs of picking up, which could give U.S. exports a boost. And Federal Reserve Chairman Alan Greenspan has demonstrated an uncanny ability to navigate uncharted economic waters.
But to many sober economic historians, the current situation is too reminiscent of the economic boom of the 1920s, when inflation was low and productivity was high. Meanwhile, led by the new technologies of the day--automobiles and electronics--the stock market soared. ''There are strong parallels, all of which make me worry,'' says Barry Eichengreen, an economist at the University of California at Berkeley who is a leading expert on both the Great Depression and the international financial crises of the 1990s. ''If you believe history repeats itself, all the ingredients are there for a stock market-led downturn.''
From today's vantage point, it's also striking that the 1920s were marked by a strong belief in the ability of the Federal Reserve Board, which had been founded in 1913 to manage business cycles. ''Our present control of currency is apparently...achieving a stability which is entirely unprecedented,'' Rex Tugwell, a prominent Columbia University economist, wrote in 1927. ''If this stability can be maintained, one of the worst features of the cycle will have been obviated.''
MONETARY MISSTEPS. Yet in the end, this faith in the Fed was misplaced. Economists are now in agreement that a series of bad policy mistakes by the Fed and other central banks turned the stock market crash of 1929 into a prolonged depression. ''We could not have avoided the recession at the end of the 1920s,'' said Peter Temin, an economic historian at the Massachusetts Institute of Technology. ''But with better policy, we could have avoided the Depression.''
The Federal Reserve has certainly learned a lot about managing the economy since then. Nevertheless, the similarities between the 1920s and the 1990s remain. Just as soaring automobile sales helped power the economy to spectacular heights in 1929, so too is information-technology spending driving the economy now. The rate of growth of tech spending has actually accelerated, from 11% in 1997 to 13% in 1998 to 16% in 1999. Little wonder that the price of tech stocks has soared, while the rest of the market has been basically flat.
But with information technology already absorbing almost half of all expenditures on capital equipment, it will be increasingly difficult to maintain the current double-digit rates of growth. Any sustained slowdown in the growth rate of tech spending--say, to 5%--would immediately force a sharp downward revaluation in the price of tech stocks, and perhaps the broader market.
INCOME INSTABILITY. Now even a market crash cannot bring on a recession by itself. But the impact of a steep decline in equity prices will be amplified by the new instability of consumer incomes. It used to be that the trend of real wages and salaries was fairly stable through expansions and downturns. Businesses were reluctant to quickly fire longtime workers or reduce wages.
But now the income of workers has become much more tied to the ups and downs of the economy and the vicissitudes of the market. During the expansion, base salaries have been greatly augmented by bonuses, stock options, and other types of variable compensation. About 8% of the compensation of managers and professionals is now variable, according to Hewitt Associates, up from 4% in 1991. That means labor earnings could actually drop sharply in the next slowdown, making the recession worse.
There are also many more temporary workers who can be released quickly if times turn bad. Almost 3% of the workforce--more than 3 million people--is now employed by employment or temporary-help agencies, double the share at the end of the 1980s. An additional 10% of workers are either independent contractors or temporary workers directly hired by their companies, according to a recent paper by Susan N. Houseman and Anne E. Polivka of the W.E. Upjohn Institute.
The typical household balance sheet is also far more vulnerable to a downturn than it used to be. Households now have 54% of their financial assets tied to the stock market, compared with 28% in 1989. Simultaneously, Americans have taken on far more debt (chart). In particular, margin debt has risen by 62%, or almost $90 billion, over the past year alone, running well ahead of the gains in the market. And mortgage debt now equals 43% of the value of owner-occupied housing, compared with only 30% in 1985. So any significant slowdown in the economy may be accompanied by a wave of mortgage defaults.
''EARNINGS CARNAGE.'' The corporate sector, too, is treading on thin ice. Faced with signs of weakness in demand or profits, the first impulse of New Economy companies is to try to grow their way out of trouble, either by cutting prices or by broadening their offerings. Intel Corp. (INTC) increased capital spending by 60% in 1990 and another 40% in 1991, despite the recession. And when America Online Inc. (AOL) ran into trouble in 1996, rather than cutting back, it went on a campaign to expand its user base and started offering unlimited use for a flat fee. Such a strategy, as it spreads to other companies, can smooth out small business fluctuations and prolong the expansion.
But as economists like to say, there's no such thing as a free lunch. New Economy companies depend on a constant flow of innovation, which means that it's hard to cut research and development spending and capital investment. In addition, they have heavily invested in an information-technology infrastructure that needs to be maintained, even in tough times. So when demand really falls off, companies can start bleeding money. ''The earnings carnage will be really lethal,'' says Stephen Roach, chief economist for Morgan Stanley Dean Witter.
Businesses also run the risk of a funding squeeze that would force them to cut back on capital spending and reduce jobs. In recent years, nonfinancial corporate debt has been rising by more than 10% annually. That hasn't been a problem during the expansion--in fact, in an increasing-returns-to-scale economy, it makes sense to take on debt to fund risk-taking when things are going well. But when the economy slows, the debt burden will become oppressive.
Moreover, the supply of funds for new businesses is likely to dry up in a downturn, as it has in the past. That's no small potatoes, since startups received $45 billion in venture-capital funding in 1999, an amount able to fund the salaries of about 1 million workers. The flow of money from overseas--which totaled a stunning $720 billion over the last year, may dry up as well if U.S. growth slows and the stock market stops rising.
Today, most economists believe that appropriate monetary policy can keep any slowdown in check. The banking system and capital markets, they say, are strong enough to absorb even severe shocks. ''We could be surprised and have a serious recession,'' says Frederic S. Mishkin, a Columbia University economist and former research director for the New York Fed. ''But what I don't see is the kind of situation where the financial system seizes up.'' Adds Temin: ''A great depression like the Great Depression we had before is impossible.''
Still, Temin acknowledges that ''it is not out of the question we could mess up the world economy in a new way.'' Because the economy has never gone through a tech-based recession before, it will be possible for monetary and fiscal policymakers to make big mistakes. The truth is that they still rely on the forecasting models that completely missed the strong growth and low inflation of the 1990s, and there is no reason to expect the models to do any better on the downside. In addition, the monthly and quarterly data available to guide policy are still far too focused on old-line manufacturing. For example, the U.S. Census Bureau publishes detailed figures on durable-goods orders, but not software orders.
PERVERSE POLICIES. Another problem: It is often not obvious in the early stages of a crisis just how bad things will get. After the October, 1929, crash, for example, it took a year for businesses and policymakers to realize that the economy was not going to bounce back. Similarly, after the Asian crisis of 1997, the World Bank greatly underestimated the impact on investment and exports in the affected countries.
Without clear signs of trouble, there is a danger that the Federal Reserve will initially welcome a slowing economy and a declining stock market. The downturn is likely to be accompanied by a falling dollar, which will make imports more expensive and could lead to higher prices. A Fed that is bent on fighting inflation may very will be tempted to raise rates under these circumstances.
Politics, too, may lead the government to adopt perverse policies. For example, economists agree that reducing government spending is absolutely the wrong thing to do in a downturn. Yet both Republicans and Democrats have committed themselves to a balanced budget. If a recession comes and the deficit reappears, there will be political pressure to cut spending. In fact, Presidential candidate Al Gore told BUSINESS WEEK in December that the threat of a budget deficit ''could serve as an opportunity to push much more dramatic reengineering of the way government operates.''
Such mistakes in policy may be more likely than economists care to believe, especially in times of rapid economic and technological change. As much as we try to aim for a recession-free economy, booms and busts may be part of the price of progress.
By MICHAEL J. MANDEL
Mandel is economics editor.
To read a letter to the editor about this story, click here.
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BACK TO TOP
COVER IMAGE: The Boom
How Prosperity Is Reshaping the American Economy
CHART: The Longest Boom Is Going Strong...
CHART: ...Thanks to Higher Productivity
CHART: The Market Soars...
CHART: ...Americans Are Wealthier...
CHART: ...And So Is Uncle Sam
CHART: The Mood Is Upbeat
CHART: Society Benefits...
CHART: ...Though Not All Is Well
TABLE: Origins of the Boom
Clinton: Why the Good Times Keep On Rolling (extended)
ONLINE ORIGINAL: "This Just May Be the Second or Third Inning"
Why the Productivity Revolution Will Spread
CHART: The Investment Leaders
TABLE: Working the Web
ONLINE ORIGINAL: "The Real Killer Legacy Is the Cultural Legacy"
Commentary: The Risk That Boom Will Turn to Bust
CHART: Unbalanced Growth...Rising Debt...
CHART: ...Increased Reliance on Temp Workers...And a Bulging Trade Deficit
CHART: Market Values Are Sky-High...And Margin Debt Is Soaring
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