BUSINESSWEEK ONLINE : OCTOBER 9, 2000 ISSUE
COVER STORY

Commentary: The Case for Optimism


The longest economic expansion in American history will eventually come to an end. Corporate spending on computers will wane. The golden touch of venture capitalists and other New Economy money mandarins will fade. But an Internet Depression? An economic catastrophe big enough to rival the Great Depression of the 1930s or Japan's Great Stagnation of the 1990s? That would require the economic equivalent of a Perfect Storm. And I wouldn't bet on it.

Michael J. Mandel's dark predictions of economic woe and policy ineptitude in The Coming Internet Depression rest on a series of worst- case assumptions. Unlike most economists, Mandel rightly recognizes that fast growth in a high-tech economy helps keep inflation low. Intense, perhaps unprecedented levels of competition prevent companies from raising prices. And management burns the midnight oil figuring out ways to run their businesses more efficiently by investing huge sums in high-tech gear and reorganizing the workplace. Productivity growth is currently so strong that unit labor costs are actually declining, even though the economy is at full employment.

Now, here's Mandel's ingenious twist that is key to his doleful outlook. Prices will soar when high-tech investment falls off sharply, venture-capital financing dries up, and the economy slows. No longer threatened by entrepreneurial rivals, companies will hike prices to shore up their earnings. The Fed, frightened that inflation is taking off, will tighten monetary policy. The economy will slump further, high-tech investment will plummet, the stock market will tumble, prices will rise further, the Fed will tighten again, and so on, in a vicious cycle that ends in depression.

THE FINAL CUT. But hold on. Just because faster economic growth is a force for price stability doesn't mean slower economic growth is inflationary. On the contrary, we can expect falling demand to force companies to hold down prices. What's more, global forces work in the same direction. Already, competition from goods manufactured cheaply in China by both local companies and foreign multinationals is putting downward price pressure on Japanese and American rivals. Japan is in the grips of a deflationary spiral. U.S. discount retailers are expanding into Europe and undercutting the Continent's established merchants. The Internet, with its promise of enormous efficiencies, is constantly expanding its reach. Management at General Electric ( GE), Charles Schwab ( SCH), Wal-Mart ( WMT), and other brand-name companies are spending billions restructuring their global operations around the World Wide Web. And they'll continue to shell out for greater efficiencies, even as the economy slows. ''Technology spending would be the last thing we would cut,'' says Hardwick Simmons, president and CEO of Prudential Securities Inc.

No doubt about it, the Fed does make mistakes. But the Fed is an institution scarred by the inept policies it pursued during the 1920s and '30s and frightened by the enormous missteps of the Japanese monetary authorities in the '80s and '90s. Remember, against the conventional wisdom of academic economists, the Fed placed a cautious bet that the positive impact of the computer revolution was showing up as higher productivity--and won. The Fed isn't infallible, but it is well-equipped to stave off economic Armageddon.

What's more, the New Economy is remarkably resilient. The long expansion has been periodically punctuated by stomach-churning upheavals, including the 1994 Mexican peso crisis, the collapse of Asia's emerging markets in 1997, and the 40% collapse in the Nasdaq Composite Index from its March high through the late spring. The economy's ability to weather severe shocks largely reflects an astonishing increase in the efficiency and flexibility of the economy's key markets. ''Labor, capital, and product markets are increasingly adept at adjusting to shifts in demand, technology, and the various shocks emanating from the global economy,'' says Mark Zandi, chief economist at consultants Economy.com Inc.

Take labor. Companies are pursuing a variety of strategies to turn fixed labor costs into a variable expense. A quarter of all employees now keep schedules with varying work hours and work times, up from one-sixth a decade ago. Already, as of 1998, three-quarters of all companies used performance bonuses, about one-half offered profit sharing, and over one-third provided stock options, according to a Federal Reserve survey. Similarly, business is quick to respond to changes in the supply and demand for goods and services. Thanks to just-in-time and materials-resource management techniques, inventories are at a record low of two times sales, compared with three times sales two decades ago.

MASS EXODUS? Mandel's depression scenario requires that investors turn skittish and abandon the market en masse. But investors are smarter than that. For years, a vocal group of economists and Wall Street seers warned that the U.S. stock market was a dangerous ''bubble,'' especially considering the stratospheric valuations of dot-com companies. When the dot-com bubble burst, they warned, the crash would take both the New and the Old Economies down. Well, the Bloomberg Internet index is down 36% year-to-date, and many employees at dot-com startups hold worthless stock options. So where is economic catastrophe?

Yes, the stock prices of business-to-consumer Internet companies are getting hammered, but equity valuations in the Internet-equipment sector are still strong. Venture-capital firms and angel investors may be rejecting many dot-com proposals these days. But they are still willing to put money into biotech ventures that discover and analyze genes, for example, or software startups with dazzling new programs for managing the flood of digital information.

The technological revolution is still in its infancy, and several huge advances are just starting to take shape. Interactive television. Net-based medical care, or ''e-health.'' Global wireless Internet services. These are giant industrial shifts, which take time to mature, and require progress in core technologies. Fortunately, researchers can collaborate on the Net to speed the pace of development. And that very process breeds fresh innovations--many of which promise further efficiency gains. Software companies, for example, are reinventing themselves as so-called application service providers, leasing their programs over the Net, and thus reducing delays, technical glitches, and costs for the customer. In Japan, which is ground zero for the wireless Internet, a whole new business category known as mobile e-commerce has been built around cell phones that surf the Net.

Economic disasters are fascinating. Some of the most fabled stories in economics are financial bubbles that ended in economic hardship, from America's railroad-building boom in the late 1860s and early 1870s to the Roaring Twenties and the Great Depression. But this bull market hasn't been a bubble. It has been a reflection of the New Economy. Right now, investors are reasonably knocking down stock prices, struggling to divine whether the economy will glide gracefully into a more moderate growth pattern, or, thanks to higher oil prices, endure a harder landing. Curl up with The Perfect Storm if you want a good read, but don't bet your portfolio that its economic equivalent will happen.

By Christopher Farrell
Contributing Editor Farrell was an early proponent of the New Economy thesis.

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