Laurence H Meyer: What happened to the new economy?
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, before the New York Association for Business Economics and The Downtown Economists,
New York, 6 June 2001. Mr Meyer's references have been omitted; please see the Federal Reserve
Board's website (www.federalreserve.gov) for these.
* * *
In 1995, the growth rate of the gross domestic product was close to the prevailing estimate of trend,
the unemployment rate was close to the prevailing estimate of the non-accelerating inflation rate of
unemployment (NAIRU), and inflation was modest. I am reviewing this bit of recent history just to set
the stage for my arrival on the Board of Governors in mid-1996. What did the challenges facing
monetary policy look like, and what did they turn out to be? The contrast is remarkable.
When I joined the Board, the statement I made at my very first Federal Open Market Committee
(FOMC) meeting was that, although economic performance had been very good - perhaps the
firstever soft landing - it would be a challenge to sustain that performance, and we certainly shouldn't
expect it to get any better. Without a doubt, that was my worst forecast.
In fact, as you all know well, the economy's performance did improve, dramatically, over the next four
years. I have often described the ensuing reaction of the FOMC. First, we celebrated. Second, we
gracefully accepted a share of the credit. Third - and in terms of time expended, this swamped all the
others - we struggled to understand why performance had turned out to be so exceptional and what
this explanation implied for the appropriate conduct of monetary policy. In the private sector, I learned
that if you made a bad forecast, clients were more forgiving if, as a result, they ended up richer than
they expected rather than poorer. So we struggled to understand the unexpected performance at the
same time that we were accepting accolades for our contribution to the outcome, if not for our
forecasting acumen.
In my view, monetary policy played a modest but nevertheless important role. First, we contributed to
a very good set of initial conditions as the economy entered 1996 - the soft landing I mentioned. Low,
stable inflation and steady growth facilitated good private decisionmaking and minimized economic
distortions. Second, during the unexpected performance that followed, we adapted policy along the
way, essentially accommodating, or at least not interfering with, the dynamism associated with a wave
of innovation and entrepreneurial activity.
One reason that I am beginning with this nostalgia is to focus on the exceptional performance of 1996
through mid-2000 and take your minds off the more recent travails of the economy. But I certainly
understood that the time would come when monetary policymakers would find it challenging to keep
the economy on a favorable course - as we had been briefly challenged in 1998. Indeed, last October,
I said a transition to slower growth was likely already under way. When I first drafted that talk, I
focused on the two sides of the economy's adjustment to a dramatic acceleration of productivity. The
first I called the bright side. This side pertained to the period when households and businesses were
just waking up to the new, more pleasant range of macroeconomic possibilities. This phase was
dominated by above-trend growth, rising utilization rates, and steady-to-declining inflation. My focus in
October was on what I called the transition to the other side. This is the side that arrives when
productivity growth stabilizes and the temporary demand and disinflationary effects that flowed from
the rising rate of productivity growth begin to dissipate. This period would be characterized by
belowtrend growth, rising unemployment, and, I suspected, some rise in inflation. My editors chided me for a
lack of elegance as well as a lack of symmetry. If I characterized the first side as "bright," they noted, I
should describe the other as "dark." I said, thanks, but no thanks. Fed governors don't talk about dark
sides. In addition, while I saw the risk of a sharper-than-anticipated slowdown, I didn't view the other
side as inevitably "dark." In any case, I wanted to note the positive possibilities - specifically, a benign
outcome.
So I focused on the possibility of another soft landing - though one different from the earlier one. The
soft landing in this case - what I have called a reverse soft landing - would have to be one engineered
by slowing the economy to modestly below trend growth for a period, returning to its potential level of
output from above rather than below. The evidence available at the time simply did not foreshadow the
rapid and dramatic swing from the earlier exceptional performance to flirtation with recession, which
has been accompanied by an equally dramatic change in the national mood - from extraordinary
optimism, indeed exuberance, to the current degree of concern.
Much of the earlier optimism was linked to perceived fundamental changes in the economy, often
summed up by the term "new economy." So the dramatic reversal in at least near-term prospects, and
in the prevailing mood, raises the question: What happened to the new economy? I have chosen this
as the theme for my remarks this afternoon.
As I often do, I will organize my remarks as responses to several questions. First, do we, or did we,
have a new economy? Second, is there is a historical precedent for the recent experience - a boom
associated with a bunching of innovations followed by a period of adjustment in both financial markets
and real investment? Third, returning to the specifics of the current episode, why did the economy
make such an abrupt transition from exceptional performance to sharply lower growth? Fourth,
assuming we were in one to begin with, what happened to the new economy? And, finally, what can
we learn from this experience to help us in meeting the challenges facing monetary policy today?
Let me also remind you, before proceeding further, that the views I am presenting this afternoon on
the economic outlook and challenges facing monetary policy are my own and I am not speaking for
the Board of Governors or the FOMC.
I. Is there, or was there, a new economy?
Is there a "new economy"? I always told my students to answer such questions decisively. I said, "Do
not leave the grader in doubt about whether the answer is (as is the apparent choice here) yes or no."
Indeed, the answer to the question "Is there a new economy?" is (or at least was) very clear: It
depends! It depends on how you define new economy and where you live.
If you use the narrow definition that I prefer and you live in the United States, the answer, I believe is,
yes, we are in a new economy. The narrow definition identifies the new economy with the dramatic
acceleration in productivity tied, to an important degree, to innovations in information technology.
Productivity refers to output per hour, and it is perhaps the single most important determinant of
economic well-being, closely related to real income per capita. But perhaps we should say, we are in a
new economy again - that is, another period, like others over the long span of American economic
history, during which a bunching of innovations has propelled the economy to a higher rate of growth
for a while.
The acceleration in productivity set off complex dynamics. First, it encouraged an investment boom to
take advantage of new profit opportunities provided by technological advances and a consumption
boom in response both to expectations of more-rapid growth of labor income and to the surge in equity
values that reflected optimism about higher earnings growth. Growth soared, not just by an amount
that paralleled the faster growth in supply, but for a while by more, thanks to the simultaneous
consumption and investment booms. As a result, the unemployment rate moved progressively lower.
At the same time, the higher rate of productivity growth meant a lower cost of production for a given
level of wages. That initially boosted profits. But this was quickly followed by a disinflationary virtuous
cycle that allowed the economy to accommodate a progressively tighter labor market without an
increase in inflation.
As income and capital gains soared, tax revenues did too, reinforcing the effects of the 1990 and 1993
tax increases and the restraint on federal spending. In the end, tax revenues increased by more than
could be explained by the higher income growth and the high level of capital gains, but those
developments still played an important role in the dramatic swing from large deficits to burgeoning
surpluses. The swing from deficit to surplus, in turn, kept interest rates lower than they otherwise
would have been by freeing up real resources to sustain the investment boom.
The United States was the only major country in which the dramatic surge in productivity was evident,
so foreign capital flowed in to take advantage of profit opportunities here. The result was a steady
appreciation of the dollar. Again we cannot fully explain the exchange-rate movements with the
changes in the rates of return on bonds and physical capital, but these developments at least played
an important role in the exchange-rate movements. The stronger dollar, in turn, helped contain
inflation and, along with faster growth here than in other industrial countries, contributed to a rising
trade and current account deficit.
II. A new economy again
One of my themes today is that we are in the new economy again. That is, instead of viewing the
current experience 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. My
first task in developing support for this interpretation was to see whether the economic history of the
United States can be viewed as a series of what I will call productivity cycles - meaning relatively long
periods of higher and then lower productivity growth. If this is possible, then I can examine these
cycles for regularities related to investment booms and equity price surges, followed by retrenchments
in investment and corrections in equity values. I should note that whenever I come up with difficult
assignments like this, I immediately turn to our staff to do the heavy lifting and, as usual, they didn't
disappoint.
I have to begin with some disclaimers. First, the pre-World War II data are not as good and not as
detailed as the postwar data, and different researchers put forward competing sets of historical data.
So uncertainty is greater when it comes to dating episodes, comparing amplitudes from one episode
to another, and, especially, going beneath the surface to look at other details of the experience.
Second, the results of the historical tour are intriguing but not definitive. I don't want to oversell, but I
do think some earlier experiences help put recent developments in perspective.
Chart 1 plots the level of labor productivity from 1889 to 2000 and chart 2 presents a summary of
productivity growth over some interesting sub-periods that were judgmentally identified.1 Average
labor productivity growth over the entire period was 2 percent. So we have, of course, periods of
above and below "average" productivity growth. From 1889 to 1995, the duration of the periods shown
in the figures is ten to twenty-eight years, averaging about twenty-one years; leaving out the one short
period, 1917 to 1927, the average duration of the other periods is twenty-four years. Labor productivity
growth during the high-growth periods averaged just about 3 percent a year, compared to just over
1-1/2 percent per year during the slower-growth periods. This is interesting since we have transitioned
from a long period of 1-1/2 percent growth, from 1973 to 1995, to high-end estimates of 3 percent
today. Of course, high-growth periods need not necessarily have similar growth rates; and the same
with low-growth periods. Each episode depends on the character of the innovations in play.
To my eye, the charts suggest a sequence of waves in labor productivity, periods of rapid growth
followed by periods of more sluggish growth. Also looking at a long period of U.S. history, but stopping
before the acceleration in productivity in the second half of the 1990s, and focusing on growth in
multifactor productivity, Professor Robert Gordon of Northwestern University has offered a different
interpretation. He emphasized the "one big wave" of improvement in productivity growth that began in
about 1913 and extended to about 1972, with especially rapid growth during the golden age between
1950 to 1972. He links this rapid growth in this period to the string of important innovations in the late
nineteenth and early twentieth centuries. However one parses the history of productivity growth, the
charts for labor productivity and Gordon's analysis of multifactor productivity suggest that periods of
more rapid productivity growth can be linked, at least loosely, to the pace of innovation.
Although Gordon has, at least in his most recent analysis, reached a similar conclusion about the
dimension and source of the recent productivity acceleration as many others, he has argued that the
computer does not measure up to the great inventions of the past, including electricity, internal
combustion engines, petrochemicals, plastics, pharmaceuticals, and communications. But that seems
to be a more philosophical question - more about the welfare effects of innovations - than one about
the contribution of innovations to measured productivity growth, investment booms and asset bubbles.
In addition, the information technology boom importantly involves improvements to the production
process. Thus, as Paul David and others have noted, the closest parallel to the information technology
revolution might be the introduction of electrical machinery. And, with both the electric motor and
information technology, there was a delay between the time of the innovation and the increase in
productivity growth, as Paul David has documented. At any rate, even if twenty-five years in the future,
we look back on recent developments and conclude that they were not as important as the innovations
earlier in the twentieth century, the recent innovations would still have played a significant role in
boosting measured productivity.
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, as Gordon describes for the period of his 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 some concrete illustrations of this adjustment to
higher productivity growth.2 The first example is the development of the motor vehicle industry and its
contribution to productivity after the First World War. 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 forty-eight stations that
were the first in their states, twenty-seven were out of business by 1924. Later in the decade the
industry grew and stock prices surged, with RCA jumping nearly twenty-fold 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.3
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.
Interestingly, none of our examples overlaps with the golden age. That period seems to be
characterized by a broader range of smaller innovations and perhaps, therefore, did not appear to give
rise to the same frenzy of investment activity or euphoria with respect to valuations.
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.
III. Sustainability and the new economy
Let me now return to the present day and turn to the task of understanding the sharp slowdown under
way and the particular features of recent experience that seem so central to understanding the forces
at work. I refer here to the correction in equity prices and the retrenchment of investment, both of
which are centered on the high-tech area.
As we begin to ask the question, what happened to the new economy, many of you, I expect, may
believe that the answer stands right in front of you. I mean, of course, the view that monetary policy
killed the new economy. So let me begin the story of the slowdown where it started - that is, with
monetary policy.
An important question about the economic performance over the period from 1996 to mid-2000 - and
a question of key importance to monetary policymakers - was whether it was sustainable. To be sure,
if the higher rate of productivity growth continued, growth could remain elevated compared to its
average rate over the previous two decades. But even if the new, higher rate of structural productivity
growth were to persist, could aggregate demand grow faster than the upward-revised rate of increase
in supply, and could the unemployment rate fall indefinitely, without the economy overheating and
inflation rising? In other words, did new-economy forces eliminate the risks of overheating and higher
inflation that were so much a part of the "old" economy? My unambiguous answer was "no." And that
answer was shared by the FOMC, motivating the monetary policy tightening that began in the middle
of 1999.
Given the uncertainties about a sustainable configuration of unemployment, output growth and
inflation, we lacked a precise roadmap of where we needed to go. While we didn't know precisely what
trend growth was, we knew for certain that growth had been persistently above trend - given the
continuing decline in the unemployment rate from 1996 though mid-1999. So it seemed prudent to
slow growth in an attempt to move toward trend and that, I believe, was the intent as monetary policy
began to tighten in mid-1999.
Some, at least, worried about a second set of concerns related to sustainability. Were prevailing equity
valuations sustainable? If not, a correction could occur. Was the high and rising current account deficit
sustainable? If not, the dollar could decline sharply. Was the increase in the ratio of debt service to
income and the low, even negative, personal saving rate sustainable? If not, consumer spending could
slow sharply.
The late Herb Stein, a very wise economist, once said that if something isn't sustainable, it won't
continue! But it is often the case that unsustainable developments do not spontaneously unwind.
Instead, they often reverse or correct only when a change in behavior is triggered by some external
event - for example, a global financial crisis, an unexpected policy development, or an unforeseen
deterioration in broader conditions.
IV. Why such a sharp slowdown?
Why did growth fall more sharply than anticipated and what does this tell us about the new economy?
Sharp slowdowns are often the result of three inter-related and reinforcing developments: a
coincidence of adverse shocks, an unwinding of pre-existing imbalances triggered by the deterioration
in broader macroeconomic conditions, and a collapse in consumer and business confidence.
The economy slowed in part, as I have noted, because monetary policy was committed to such an
outcome. By mid-2000, it appeared that the economy, in response to the cumulative tightening over
the previous year, was slowing toward trend. The Fed stopped tightening and private forecasters were
projecting a "soft landing." By October and November, it appeared that the slowdown was taking
growth modestly below trend. Given the supply-side uncertainties I noted earlier, this outcome also
seemed acceptable. But late in the year, the economy decelerated more sharply and we now know
that growth fell to about 1 percent in the fourth and first quarters and it appears to have remained
sluggish into the second quarter. We did not, however, have the data in hand at the time of the
December meeting to confirm the degree or persistence of the slowdown. The Blue Chip consensus
forecast in December, for example, still projected 3 percent growth over 2001.
The sharper slowdown reflected, in part, the contribution of several additional shocks that reinforced
the effect of the monetary policy tightening. Energy prices rose throughout 1999 and 2000. Oil prices
shot up in the fall and natural gas prices soared late last year just as oil prices began to recede. The
higher energy prices undermined consumers' purchasing power.
As interest rates rose and the economy slowed, lenders became more discriminating about the
creditworthiness of borrowers, reflecting concern about borrowers' ability to service all the debt that
they had accumulated during the earlier period of exceptional performance. The result was increased
interest rates for lower-rated borrowers and tighter underwriting standards at banks. The decline in
equity valuations for high-tech firms, the virtual closing of opportunities for initial public offerings, and
the higher quality spreads for low-rated borrowers naturally hit start-up and new technology firms
especially hard.
Also, equity prices fell sharply, particularly technology stocks - with the NASDAQ now having declined
nearly 60 percent and Internet stocks about 70 percent from their peaks. This is a perfect example of
an unwinding of a pre-existing imbalance - in this case an unsustainable rise in equity values in the
technology sector.
The correction of equity prices presumably reflected, at least in part, a reevaluation of the profitability
of owning and producing high-tech capital and software, a deterioration in the expected earnings of
telecommunications firms, and a reappraisal of the earnings prospects of dot-com firms. These
reassessments of the value of these firms had much to do with earlier developments in the industry
and little to do with monetary policy or the overall slowdown in growth. The frenzy of investment
spending undertaken to take advantage of the investment opportunities arising from advances in
technology resulted in some investments that were successful and others that were not. This is a
second example - one that was perhaps less noticed earlier - of the unwinding of an unsustainable
trend. At any rate, a shakeout in the high-technology area and retrenchment of investment spending
followed.
As demand weakened, inventories accumulated, and firms moved to cut production - not just to a
level supported by the slowdown in demand, but even lower to shed the excess inventories. Inventory
corrections are typically central to the swings in activity that occur during recessions or sharp
slowdowns. The current correction does, however, seem to have a new-economy flavor. Because
information technology provided firms with a more rapid flow of information about current sales and
inventories, they may have responded more quickly to developments. The result might be a sharper
initial decline in production, but with less persistence than otherwise.
Finally, even as forecasters did their best to identify the coincidence of adverse events that was
slowing growth, the economy weakened more than expected. This is also a fairly typical development
- a coincidence of forecast errors in the same direction across many spending categories - during
periods of unusually strong or weak growth. It is often related to sharp swings in business and
consumer confidence - swings that are larger than would have been predicted from the
contemporaneous changes in employment, income, interest rates, and so forth.
V. What happened to the new economy?
So what happened to the new economy? The answer, I believe, 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.
So I think 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 productivity growth.
Some might expect that new-economy developments would make recessions less likely. That is not an
entirely unreasonable presumption. The experience among faster-growing European economies in the
earlier postwar period was that these economies tended to have fewer quarters of declining
output - the sine qua non of a recession as defined in the United States - than was the case in the
slower-growing United States. Now that the United States had become a higher-growth economy
(again), it might be that cyclical episodes would be more likely to be growth recessions and less likely
to be outright recessions. However, in the United States in the 1950s and 1960s - when average
growth rates were about as high as today - the chance of negative-growth quarters was about equal
to the chance in the 1970s and 1980s, when average growth was only half as large.
In addition, to the extent that the high-tech revolution increased the ability of firms to recognize and
respond to changes in demand and quickly remedy unwanted inventory accumulation, the response of
output to demand shocks might be less persistent. On the other hand, it appears that the high-tech
revolution didn't help firms or other forecasters anticipate changes in demand.
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. First, I noted that 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.
VI. Prospects
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 investment spending.
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 a weak first half - but no recession - and
some improvement in the second half, on the way to trend growth 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-know lag in the response of aggregate demand to monetary policy action. Given this lag,
monetary policy could provide