The Boom That Concealed a Bust

Although Americans tend to view the past decade as a period of robust growth, the reality, contends economist James W. Paulsen of Wells Capital Management, was far different. The distinguishing characteristic of the U.S. economy in the 1990s, he claims, was not a consumption boom but underlying weakness in demand from consumers, business, and government.

Paulsen advances the provocative thesis that the miracles of the '90s--low inflation, improving productivity, widening profits, surging stock prices, and the longest expansion in history--were actually the result of sluggish growth in U.S. and global demand. What enabled U.S. business to thrive in this environment was the energetic adoption of a number of cost-cutting strategies that went straight to the bottom line.

The most startling aspect of the 1990s, says Paulsen, was the absence of strong "top-line" growth, or sales increases. Among the Group of Seven industrial nations, nominal gross domestic product (a good proxy for an economy's total sales) rose just 4.85% a year--half its rate from 1960 to 1990. In the U.S., nominal GDP grew at a mere 5.54% annual rate, its slowest pace since the Depression, while real growth was no higher than in the 1980s and actually lagged behind the pace of both the low-inflation 1960s and the high-inflation 1970s.

One reason for this slowdown is a sharp decline in advanced nations' demographic growth. Another is a major contraction in overall U.S. debt growth from an average 15% annual increase in the mid-1980s to roughly 5% at last count. Finally, policymakers stopped relying on massive federal outlays and programs to prop up demand.

As it turned out, says Paulsen, weak demand growth proved beneficial in many ways. By curbing inflation, it kept the Fed from hitting the monetary brakes, thus prolonging the expansion and allowing unemployment to reach new lows.

At the same time, it forced companies to cut costs to bolster profits, inspiring such strategies as downsizing, restructuring, and outsourcing. And it accelerated the adoption of productivity-enhancing new technology, which added fuel to the stock market boom.

Paulsen claims the current slowdown has exposed the basic sluggishness of demand growth in advanced nations. The key question, he says, is whether such weakness can once again inspire actions leading to economic strength.

For U.S. business, he sees a mixed outlook. Some strategies, such as restructuring, downsizing, controlling inventories, and using contract workers, have either been exhausted or face diminishing returns, he says. But the ongoing technology revolution could still pay off big once the economy picks up.

For U.S., European, and Japanese policymakers, however, the message is clear. The underlying weakness of global demand due to demographic and other factors suggests that fears of inflation are excessive and that it's time to use both monetary policy and even fiscal policy to promote growth. When online retailing became a reality, many economists saw it as a boon for price-sensitive consumers. As buyers began using shopping engines to check prices at e-tailing sites, they predicted that e-tailers would be forced to lower prices close to their marginal costs to retain customers. They also expected prices to drift lower and the differences between prices to narrow.

In a recent National Bureau of Economic Research study, Karen B. Clay, Ramayya Krishnan, and Eric Wolff of Carnegie Mellon University tested these ideas by examining pricing practices by 32 online bookstores from mid-1999 to January, 2000. They tracked prices of books on The New York Times best-seller list, best-selling computer books, and a random sample of other books.

The results suggest that e-tailing departs significantly from the model of near-perfect competition. While discounts on some books, especially best-sellers, were larger on the Web than in regular stores, e-tailers' prices did not fall over the period studied and price differences did not narrow.

In fact, prices of the Times best-sellers and random titles both tended to rise a bit. Apparently, some e-tailers, under pressure to become more profitable, realized they could lower their discounts and still attract customers.

The results imply that there will continue to be a lot of book price variation on the Web, a fact that should appeal to cost-conscious buyers. And there will also be a wide variety of sellers--many specializing in particular kinds of books or offering services such as book reviews or gift advice that customers may value more than rock-bottom prices. A common view is that U.S. companies in China earn little money there, and that the near-term benefits of trade are totally biased toward China. Not so, says Joseph Quinlan of Morgan Stanley, who notes that greater China (the mainland plus Hong Kong) represents the largest source of income from U.S. affiliates in developing nations.

From 1990 to 1998, reports Quinlan, the number of U.S. majority- or minority-owned subsidiaries in China jumped from 45 to 335, and the number of Chinese workers on their payrolls rose to 180,000. At the same time, surging U.S. direct investment helped lift the total assets of such companies from $2 billion in 1990 to nearly $25 billion by the end of the decade.

The upshot is that greater China accounted for almost 40% of total U.S. foreign affiliate earnings from non-Japan Asia last year. In fact, the $7.1 billion in income it provided to U.S. multinationals topped the earnings they received from Mexico and Brazil combined.

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