CHAPTER VII

WHAT IS NEW IN "THE NEW ECONOMY"? (105)

Compared to the period from 1973 to 1995, the American economy has turned in a
remarkable record for the last four and a half years. Productivity gains,
investment rates, and real wage growth are all higher; unemployment and
inflation are lower; and the expansion has now set an all-time U.S. endurance
record. Increasing confidence that the future of the real economy (106) will
look more like the last four years than the preceding 22 years has led more
analysts and even economists to accept the media label, "The New Economy."
Although slowdowns and recessions will occur at some point, the economy's
trajectory appears to have shifted upward.

The information technology sector has played a critical role in the economic
success of recent years. Businesses across the economy have been investing
heavily in IT hardware and software to harness the potential created by falling
prices and by the increasing capacities of computer processing, storage media
and communications links. Business strategies and even the structures of
companies and industries are being transformed as communication within
companies and among the members of corporate alliances occurs more rapidly,
with more customized information, and with greater security, interactivity, and
timeliness than before. The same quality (or "richness") of communication that
once was limited to a narrow group of close contacts can now be extended to a
much wider "reach" of contacts. (107)

The IT revolution is affecting everyone's life. The advances and spread of IT
are part of the reason why we now have the lowest unemployment rate and fastest
growth in real wages in three decades and the longest expansion on record.
Consumers are making a small but increasing amount of their purchases online
and using the Internet to make more informed purchases offline. IT is also
transforming the way most firms operate. As employers substitute IT for labor,
workers have to develop new skills.

LONG TERM FORECASTS ARE BEING RAISED

The hallmark of the New Economy is higher sustainable growth due to faster
improvement in labor productivity. Recently, most economists have begun to
accept that the U.S. economy can sustain growth at a substantially higher rate
than the 2.5 percent a year average for the 1973 to 1995 period. For example,
the Blue Chip consensus growth forecast released in January of each year from
1996 to 1999 forecast growth for the coming year of 2.3 and 2.4 percent. (108)
In each of those four years, actual growth surpassed 4 percent. (Figure 7.1)
However, this past January, the consensus forecast for 2000 came in at 3.2
percent. Furthermore, the Blue Chip longer term outlook has also shifted
upward. After many years of forecasting 2.45 to 2.7 percent average annual
growth over the coming 10 years, the consensus in the latest forecast shifted
up to 3.1 percent. (Figure 7.2) Since the U.S. labor force tends to grow by
little more than 1 percent per year, the hike in growth forecasts strongly
implies that in the last year Blue Chip economists have raised their
expectations of annual labor productivity growth from roughly 1.5 percent to
about 2 percent.

This more sanguine view of our future economic prospects comes from greater
confidence that the faster labor productivity of the last four years (see
Figure 1.1), based significantly on developments in IT investment, has some
staying power. (109) It is noteworthy that this optimism is still somewhat
conservative, since the labor productivity growth assumed in the ten-year
forecast is still much slower than the recent pace. However, since strong
output growth tends to raise labor productivity growth, Robert Solow has
recently cautioned, probably speaking for many economists, that he "will feel
better about the endurance of the productivity improvement after it survives
its first recession." (110)

IT can support higher rates of labor productivity gains and output growth, so
long as IT innovation and price declines persist, and non-IT industries
continue to invest heavily in IT products and services. Both of these
conditions are expected to persist into the future. Experts in the
semiconductor, computer, storage, and communications industries have expressed
confidence that rapid rates of product innovation and price decline can
continue for at least another decade. Experts in non-IT industries also have
expressed confidence in their capacity to benefit enormously from further
substantial investments in IT.

The prospect of healthier productivity gains over both a medium term and a
longer run has significant implications for our future standard of living and a
range of fiscal issues facing government at all levels. For example, faster
productivity growth translates into more tax revenue, which in turns creates
larger budget surpluses and longer positive balances for trust funds such as
those for Social Security and Medicare. Faster productivity growth also means
lower inflation, reducing the additional costs of COLAs for most entitlement
programs.

IMPLICATIONS OF IT-FOCUSED INVESTMENT FOR

THE BUSINESS CYCLE

The boom in IT investment has implications for the business cycle that go
beyond the impact on underlying trend growth. As Martin Baily, chairman of the
President's Council of Economic Advisers, has noted, the current nine-year-old
expansion has not developed the "geriatric" conditions that we have come to
expect after several years of solid economic growth. In particular, the
improved labor productivity growth (see Table 4.1) has been a "fountain of
youth" for the expansion. As previous postwar expansions matured, labor
productivity and output slowed, inflation rose, real wages stagnated, and
profits declined. The unusual pattern of conditions continuing to improve as
this expansion has aged can be seen clearly by charting the progression of five
basic indicators over the long business expansions of the 1960s, 1980s, and
1990s. (Figures 4.1, 7.3, 7.4, 7.5 and 7.6) Although real wages did continue to grow
throughout the 1960s expansion, recent real wage growth has been even faster
than in the 1960s. Although growth in real profits has slowed in recent years,
by this stage in previous business expansions, profits were declining sharply.

The strong output growth and continued improvements in profits in the current
expansion have, in turn, fueled unusual vigor in real spending for private
investment generally and for research and development in particular. (Figures
7.7 and 7.8)

Much as IT has boosted growth in the expansion, it could have a dampening
effect on the next business slowdown. (111) In the past, a substantial slowdown
or decline in overall demand has led to even greater slowdowns or even declines
in investment as capacity and inventories suddenly became excessive. At some
time in the future, the economy will slow down, squeezing the corporate cash
flow that helps finance new investment and creating involuntary excess capacity
and inventories. While this should curb new investments to expand capacity,
investments in IT should be far less affected. In most industries, IT
investments do not expand capacity; rather, they provide general cost savings,
reduce errors, provide the basis for more prompt and informed decisions, and
increase customer satisfaction. For industries in which IT investments directly
expand capacity to provide services (e.g., finance, real estate, retail) a
slowdown in demand should directly slow IT investment. Because IT investments
are commonly driven by pressures to keep pace with competitors, in terms of
costs and satisfying customer demand for more responsive products, IT
investment should weather a slowdown in demand better than capacity expanding
investments

The spread of IT could also moderate the sharp declines in manufacturing
inventories that occur in recessions. By improving communications with
suppliers and customers, IT has facilitated manufacturers' efforts to limit
their inventory exposure. As a result, durable goods manufacturers have reduced
their inventory ratios from 16.3 percent of annual shipments in 1988 (the
lowest period in the 1982-90 expansion) to just 12.0 percent in the last 12
months. (Figure 7.9)


If U.S. manufacturers of durable goods today held inventories at the 1988
inventory to sales ratio, they would be holding an additional $115 billion in
inventory (Figure 7.10).  The cost savings from reduced inventories takes
several forms. First, there is the average savings of about $10 billion a year
from not having to pay to accumulate as much new inventory in each of the
eleven years. Second, the cumulative $115 billion in funds that would have been
spent for inventory have been used to invest elsewhere or pay down debt. By
this point, the financial benefit of the second effect exceeds the benefit from
the first. Third, the companies are spared the expense of storing and securing
one-third more inventory than they now hold. Fourth, they avoid the inevitable
losses from holding inventories for products that lose favor in the
marketplace. All told, lower inventories were a significant factor in the
sector's $99 billion of profit in 1999 (and in keeping down prices to their
customers).

Adjustments to inventory have aggravated all recent recessions because, as
Figure 7.11 indicates, recessions tend to have bigger declines in output than
in sales. (Sales actually continued to rise during the recessions of 1960 and
1969.) Reductions in inventory accumulation account for the gap between the
change in output and the change in sales. On average, inventory corrections in
the six recessions since 1960 made the change in GDP 1.6 percentage points
greater than the change in final sales. Today's leaner inventories should,
other things equal, cushion the depth of the next recession by narrowing the
gap between declines in output and demand.


                               WHY NOW? WHY HERE?

The U.S. labor productivity boom of the last four years has outpaced not only
its own performance from 1973 to 1995, but also the labor productivity gains of
other major industrial countries in recent years. Since information
technologies and IT prices have been steadily improving since the early 1970s,
why didn't U.S. labor productivity improve sooner? Since IT is readily
available on the world market, why hasn't labor productivity accelerated in
most other industrial countries?

The U.S. macroeconomic environment since the early 1990s has stimulated an
investment boom. Both fiscal and monetary policy have contributed. The 1990s
began with very large budget deficits projected to grow even larger. However,
prudent policies to curb spending and raise revenues were introduced, and the
fiscal picture has reversed. Another reason for the current long boom is that
Federal Reserve policymakers have generally paid more attention to the fact
that inflation has kept on falling, than to traditional concerns that low
unemployment would reignite inflation. Back when the unemployment rate first
reached the once-worrisome range of 5.5 percent to 6 percent, the Fed could
have dampened growth to keep unemployment from falling further. Had they done
so, the United States would not have seen the broad gains in output,
investment, and labor productivity that have occurred.

Sound macroeconomic policies have helped lower unemployment and inflation, but
they cannot account for the recent multi-year doubling of labor productivity
growth. For that, look to more technologically based explanations. For example,
there is the view that fundamental technological changes, from electricity to
IT, take a very long time to generate labor productivity breakthroughs - and
when they do, labor productivity rises very sharply. Comparing the economic
history of electricity and electrical motors to our recent experience with
computers, Paul David and Gavin Wright have documented that labor productivity
in U.S. manufacturing grew less than 1 percent a year from the commercial
introduction of electric motors in the three decades prior to the 1920s, and
then soared to 5 percent per year in the 1920s. (112)

Another explanation uses the model of "recombinant growth" drawn from the
biological sciences. (113) Hal Varian observes that "Every so often innovations
come along that can be broken down into separate parts and recombined to create
a host of new inventions." As businesses bring together different elements in
creative combinations, some flourish while many others are ephemeral. Varian
cites the historical examples of the periods following Eli Whitney's
"uniformity system" to produce muskets, and Edison's invention of the
"invention factory." (114) He also gives the more recent example of integrated
circuits leading to circuit boards for many modern devices and predicts that
"the Web's components - URLs, CGI scripts, HTTP protocols and the HTML
language" provide the basis for another period of recombinant growth. Recent
and now predictable "recombinant growth" includes not only Web components but
hardware innovations that can be creatively taken apart and recombined for
innovative products.

Perhaps most important of all are the broad market conditions that support
innovation. Deregulation has helped drive the development of the largest and
most creative financial markets in the world, including equity markets, credit
markets, and venture capital. Reallocation of resources is facilitated not only
by nimble capital markets but by relatively few barriers to bankruptcy.
Americans also enjoy a lower tax burden, and much more fluid and deregulated
labor markets, than most other countries. Cultural factors probably also
matter, especially the admiration many Americans feel for entrepreneurism and
risk-taking.

PRODUCTIVITY ACCELERATION AND

JOB DISPLACEMENT

Another important issue concerning the dynamics of the New Economy is their
effect on jobs. In an aggregate or macroeconomic sense, the New Economy has
been characterized by strong job and wage growth. With lower inflation and
accommodating monetary policy, unemployment has fallen below 4 percent, the
lowest rate since 1969. The unemployment rate of those with less education and
experience has fallen along with the rates of everyone else, although it
remains higher than those of better educated and experienced workers.
Similarly, with everyone else, workers near the bottom of the ladder in recent
years have enjoyed strong real wage growth.

The effect of the New Economy on jobs at an industry and firm level is more
difficult to analyze. As shown in Chapter V, we can detect some important
effects of IT on IT-related employment, but we can only speculate on the effect
of IT on non-IT related jobs. The number of well-paid jobs in the IT producing
and IT-using sectors is growing rapidly, even as the number of lower-paid
IT-related jobs is shrinking. It is reasonable to assume that IT, by raising
labor productivity, must displace jobs somewhere in the economy. However, there
is no clear evidence about what types of jobs are displaced most rapidly by IT.
A significant percentage of jobs in modern America involve collecting and/or
processing information, and/or making decisions based on information; but some
sectors, such as education and financial services, have a higher proportion of
information-intensive jobs than other sectors. However, all sectors have
information-based functions, such as sales, purchasing and finance, in which IT
investments could displace many current jobs and raise labor productivity.

AFTER SOFTWARE, SHOULD OTHER INTANGIBLE INVESTMENTS ENTER THE NATIONAL 
ACCOUNTS?

Among the statistical issues raised by the New Economy is the significance of
business investments in intangibles. When the Bureau of Economic Analysis (BEA)
recently reclassified software as a form of investment, rather than as business
expenditure or intermediate input, this change substantially increased the size
and growth of IT in our national accounts. Drawing the curtain to reveal a
sector that grew from $28 billion in 1987 to $149 billion in 1999 had a
catalytic effect on economists' perceptions of non-computer aspects of the IT
sector. Much as businesses expect to earn a return on their investments in
software over several years, business spending on intangibles such as training,
workplace reorganization, and consultants can also be viewed as investments
with long-term payoffs.

The work of Erik Brynjolfsson and his coauthors discussed in Chapter IV
strongly suggests that such intangibles are important investments supporting
and complementing tangible IT investments. Not long after BEA recognized
software as investments, Federal Reserve Board Chairman Alan Greenspan urged
that the national accounts go beyond software to include other intangible
investments. (115)

The treatment of business spending on other intangible investments could have
significant effects on a range of measures central to our understanding of the
economy. Since such intangible investment has no doubt been growing faster than
GDP, its inclusion as investments would raise our measure of GDP growth. This
change also would likely improve our ability to account for growth attributable
to specific inputs, and leave less unexplained. (116) Since these intangibles
often complement computer and other IT investments, this change would also help
resolve the paradox of the supernormal returns on computer investments found in
some firm-level studies.

On the other hand, incorporating other intangible investments into the GDP
measure would highlight the limitations of GDP as the almost-exclusive gauge of
longer term growth trends. IT investments tend to have short lifespans and thus
faster depreciation rates than average. As the IT share of investment rises,
depreciation rises faster than GDP. Net Domestic Product (GDP less
depreciation) provides a better indication of sustainable growth. As IT has
become a larger share of total investment, the gap between GDP growth and NDP
growth has widened. In the 1960s, GDP and NDP both grew at the same 4.4 percent
rate. By 1999, however, GDP grew by 4.1 percent, but depreciation was growing
so much faster that NDP grew by only 3.6 percent.

TO SOLVE THE PRODUCTIVITY PUZZLE, BETTER MEASURES OF SERVICE INDUSTRY OUTPUT
ARE NEEDED

As a practical matter, the question of precisely how much IT has contributed to
our stellar economic performance will remain largely a mystery at least until
BEA develops ways of better measuring output in several key IT-intensive
services industries. As noted in Chapter IV, the view that IT has made a large
contribution to labor productivity growth, based on evidence at the
macroeconomic and firm levels, cannot yet be confirmed at the industry level.
As Dale Jorgenson and Kevin Stiroh caution:

The apparent combination of slow productivity growth and heavy computer-use [in
specific service industries] remains an important obstacle for new economy
proponents who argue that the use of information technology is fundamentally
changing business practices and raising productivity throughout the U.S.
economy. (117)

The fact that official measures show flat or declining labor productivity for
several IT-intensive service industries, such as health and business services,
does not mean that labor productivity has not improved in those industries. The
techniques used to measure output in these industries either assume no labor
productivity change or otherwise fail to capture increases in their output
fully.

A case in point is the measurement of output in the banking industry. Until
recently, output in the banking industry was constructed with the same basis
still used for some major service industries - assuming no labor productivity
change - by using labor input growth as a measure for output growth. With its
benchmark revisions released in October 1999, BEA adopted a new method for
measuring bank industry output based on the industry's transaction activities.
As a result, measures of the IT-intensive banking industry now indicate
significant annual labor productivity gains, in contrast to the negative labor
productivity changes portrayed under the old method.

Producing true output measures for all service industries presents a daunting
task. The Bureau of the Census should do more complete surveys of service
industries broken down into more detailed and current categories. Even with
such data, BEA faces difficult conceptual challenges in developing satisfactory
methods for measuring the output of health, legal, business, and other
services. However, BEA has pioneered the use of creative new methods for
measuring the quality, price and output changes for computers, semiconductors,
and certain telecommunications equipment, along with the development and use of
sophisticated methods such as chain-weighted indexes to properly gauge real
output changes in a world with some sharply falling prices. Without these
statistical advances, it would not have been possible to assess the
contribution of IT at the macroeconomic level. (Indeed, the fact that the GDP
accounts of other major industrial countries do not include these advances
makes international growth comparisons very problematic.)

In the absence of more accurate measures of output for IT-intensive services
industries, we cannot rule out the possibility that IT has made a very modest
contribution to labor productivity outside the IT producing sector itself. With
better measures of output for individual service industries' output, we may
learn that IT has contributed strongly to service industry productivity or,
conversely, that IT has not contributed as much to overall labor productivity
improvement as technical change outside of IT, including organizational change.

THE DIGITAL DIVIDE: COMMUNITIES WITH LOW INTERNET ACCESS RATES

Internet access has grown across every group and state in America, but this
growth has been most rapid among those households with higher incomes, more
education, computers at work, white or Asian backgrounds, and headed by persons
age 35 to 50. (118) Serious concerns about other groups that are currently
"falling through the Net" are based on the fact that the Internet is not merely
a place to shop, but also a space where students learn, people find employment,
and communities communicate.

Robert W. Taylor, the director of the Defense Department agency that created
the original Internet in 1969, co-authored a remarkably prescient paper in
1968, "The Computer as a Communication Device," raising concerns about what is
now called the Digital Divide:

For the society, the impact will be good or bad, depending mainly on the
question: Will to be 'online' be a privilege or a right? If only a favored
segment of the population gets a chance to enjoy the advantages . . . the
network may exaggerate the discontinuity in the spectrum of intellectual
opportunity. (119)

In more affluent and better educated communities, Internet access has reached a
critical mass. Students are assigned to do their research on the Web, at home
and not just in the library. Increasingly, job-seekers find job openings on the
Web. Sign-up lists passed around at the PTA or other local organizations
include a column for e-mail addresses, along with name and telephone number. In
each instance, the Internet provides the means for communicating information
critical for students, job-seekers, and members of organizations, that could
not occur as effectively in other ways.

In 1998, 42 percent of all American households had computers at home, and 22
percent had Internet connections at home. Some groups, however, are better
networked. Among the 5.5 million White, Asian, and Pacific Islander families
with incomes of at least $75,000, living in a metropolitan area, headed by
someone with at least a college education and age 30 to 55, 87 percent had
computers at home, and 68 percent had Internet connections. Among households
with these levels of income, education, age and living in a metropolitan area,
Black and Hispanic households were just as likely to have home computers - but
roughly 14 percent less likely to have Internet access at home - as White,
Asian, and Pacific Islander households in the same income, education and age
group. (120)

At the other extreme, the 1.2 million Black and Hispanic urban households with
incomes below $15,000, in which all adults lack a high school diploma or GED,
and headed by someone age 30 to 55, only 7 percent had computers at home and
only 2 percent had Internet service. Among Whites, Asians, and Pacific
Islanders with similar low income, lack of education, and age, 14 percent had
computers at home, and 5 percent had home Internet connections. (121)

Since 1998, more households have obtained computers and Internet access and
alternative points of access, such as state employment commission offices,
public libraries, and community centers and clubs, have expanded. When the
results from a new Census Bureau August survey of households become available
this Fall, we will learn the extent to which different groups have improved
their access to the Web and capacity to create networks on the Internet.

Nonetheless, many Americans - particularly those with less income and education
- are still missing out on the network benefits of the Internet age. And as
more and more everyday activities migrate to the Internet, the gap in
opportunities available to those on either side of the digital divide 
increases.

CONCLUSION

The dynamism of the New Economy presents opportunities and challenges for
almost everyone. IT can offer cost savings, expanded markets, and more intense
competition for private businesses in almost every industry. As employers are
less readily finding workers with appropriate skills, they have had to provide
more training for current employees and to modify technology to match the
skills of available workers. Workers are more readily finding better paid jobs,
but to do so they must often adapt to new technologies. Because many of the
jobs potentially displaced by IT investments now require average or better
education and skills, those displaced may well find new jobs quickly, possibly
with the same employer. The New Economy is expanding the revenues for
government, even as it presents many new and difficult policy issues. Finally,
economists and statistical agencies are now able to obtain better information,
more quickly, but they also have to redesign their frameworks to capture this
fast-changing economy.