Christopher J. Waller

In this article, I discuss the performance of the U.S. economy in 2000 and draw some inferences as to what will happen in 2001. In short, the U.S. economy should continue growing but at a slower rate than has been observed over the last two years as the Federal Reserve’s interest rate hikes finally take a bite out of the economy. In the second half of this article, I discuss the microeconomic and macroeconomic impact of the ‘new economy’. While the microeconomic impact has been dramatic, with regards to important macroeconomic data, the new economy appears to be more style than substance

Introduction

It is almost impossible these days to pick up a business magazine that does not contain an article on how computers and information technology led to the creation of a ‘new’ U.S. economy. The fact that the U.S. economy has seen sustained and robust economic growth for the last nine years in conjunction with the explosion of the Internet has lead many to conclude that the Internet is responsible for the performance of the U.S economy. In this article, I first examine the performance of the U.S. economy in 2000 and then try to shed some light on what the computer revolution has done for the U.S. economy and what it has not done.

The U.S. Economy in 2000

GDP

In 2000 the U.S. economy continued expanding at annualized rates of 4.8%, 5.6% and 2.7% respectively for the first three quarters of 2000. The significant drop off in the third quarter numbers have led many to believe that the six interest rate hikes undertaken by the Federal Reserve in 1999 and early 2000 have finally begun to slow down the U.S. economy. The Federal Reserve’s willingness to keep rates unchanged since this past summer show that it believes that its actions will accomplish the task of slowing down the economy without crashing it. However, one quarter’s numbers do not a recession make — recall that second quarter growth in 1999 was only 2.5% but was followed by 5.7% and 8.3% third and fourth quarter growth rates respectively. This is the reason the Federal Reserve has not changed its bias away from ‘tightening’ (raising interest rates) to neutral as some expected they might at the November FOMC meeting.

Inflation

Dramatically rising oil prices have started to have an impact on the U.S. economy. The CPI inflation rate for all categories over the period 1999:10-2000:10 was 3.45% compared to 2.5% for the same time period the year before. However, excluding food and energy, the CPI inflation rate for 1999:10-2000:10 was 2.5% compared to 2.1% for the same time period the year before. So while we saw a significant increase in the inflation rate for 2000, a major component of that inflation was accelerating food and energy prices. The key thing to keep in mind with oil price increases is that they will most likely stabilize, albeit at a much higher price level per barrel, and once that happens the growth rate of prices will fall significantly. Consequently, the key is not to overreact to rising oil prices since they will only have a short-term affect on the U.S. inflation rate. Only bad monetary policy can turn this temporary effect into a longer permanent affect on the inflation rate, as occurred in the 1970s.

Unemployment, Wages and Productivity

The U.S. unemployment rate stayed steady in 2000 hovering around 4.0% for most of the year. This has lead to continued concern that labor markets are extremely tight and that further increases in aggregate demand for goods will manifest itself in the form of rising wages which will in turn be passed on by firms to consumers in the form of higher goods prices. However, to date we have not seen that because wage increases have reflected increases in labor productivity growth. Productivity growth allows firms to produce at lower costs and pass those cost savings along to customers thus putting downward pressure on prices even though workers are being paid more. In 1999, non-farm business real hourly labor compensation grew at 2.7% and productivity grew at 2.9%. But for the first three quarters of 2000, real hourly compensation has increased -02, 2.2, and 3.2% respectively while productivity has grown at annualized rates of 1.9, 6.1, 3.8% respectively. Thus, productivity growth has far outpaced real wage increases in 2000. The question is whether it will continue to do so in 2001. Given that productivity growth has been rising during the 1990’s, it is reasonable to expect it to continue in the near future.

Government Surpluses and the National Debt

The fiscal discipline imposed by Congress in the early 1990s has continued to show up in the data. In 1996, the federal government ran a deficit of $107 billion whereas the surplus in 2000 is estimated at $237 billion. The surplus has been used to buy back privately held government debt over the last few years. The amount of privately held government debt was $3.847 trillion at the end of 1997, while that number had fallen to $3.69 trillion by the third quarter of 2000. However, there has been a large increase in government debt (a half a trillion dollars) held by agencies and trusts from $1.656 trillion at the end of 1997 to $2.19 trillion by the middle of 2000. Of course most of this accumulation is by the Social Security Trust Fund. Since it is not allowed to hold any assets in its portfolio other than U.S. government debt, the large Social Security surpluses have been used to buy government debt over the last three years.

Financial Markets

The stock market started the year on a high note but by the beginning of April 2000, the financial battlefield was littered with the corpses of Nasdaq billionaire wannabes. After peaking around 11,500 the DJIA has fallen to around 10,600 (at the time this article was written) with substantial volatility during the year. The Dow actually rose back to around 11,500 but then crashed down and at one point closed below 10,000. The bubble in the Nasdaq appears to have burst. By March of 2000 the Nasdaq had risen to over 5000 as financial market gamblers continued to enter the market in the hopes of striking it rich. However, as in all casinos, the gamblers’ wealth eventually gets wiped out. The Nasdaq had fallen all the way to 3000 by November 2000 and in the process, wiping out an entire year’s worth of capital gains. While technology may be the driving force in the economy, the market has had a rough year determining the long-term value of the firms developing and using it.

Exchange Rates and International Trade

Besides the rapid increase in oil prices, the biggest international surprise of 2000 was the continuing fall of the euro against the dollar. At its inception on January 1, 1999, the euro’s value was 1.17 dollars per euro. By late 2000, it had fallen to 0.86 dollars per euro. This created considerable concern for Europe since the fall of the euro makes U.S. imports more expensive and thus raises their domestic inflation rate. For the U. S., this of course hurts exports of goods to Europe. Since the European Central Bank’s mandate is to produce price ‘stability’ (near zero inflation), the falling euro has forced them to try and stop its fall by intervening in currency markets to buy euros and sell dollars. Unfortunately, despite two currency market interventions to raise the value of the euro, to date those efforts have not been very successful. A weak euro will continue to hurt U.S. exports to Europe and increase imports from Europe. The general strength of the dollar around the world is reflected in the continuing rise in the U.S. current account deficit, which increased by one-third over the period 1999.II-2000.II (from $78.9 billion to $106.14 billion). In addition to a worsening relative trade position in goods and services, the current account has also worsened due to large capital inflows over the last two years as foreign citizens continued buying both ‘old’ and ‘new’ U.S. economy stocks rather than their own domestic financial assets.

Interest Rates

In the first half of 2000, the Federal Reserve continued raising interest rates in its attempt to slow down the U.S. economy, head off inflation and burst the equity bubble that appeared to be occurring in financial markets. Despite claims that ‘new’ economy firms were immune to interest rate changes, the Nasdaq bubble finally burst as it became clear that rising interest rates raise the cost of capital for all firms, even ‘new’ economy firms. By mid-June, the Fed stopped raising rates and opted to take a wait and see attitude in order to assess how much of an effect the previous six rate hikes were having. However, the FOMC committee did not change its policy bias away from tightening. No rate hikes occurred during the latter half of 2000 and are unlikely to occur in the first few months of 2001 unless the economy resumes speed or inflation accelerates.

Summary and Outlook

The U.S. economy appears to be in good shape heading into the new millennium (for those of us who are sticklers for correct dating procedures). The economy appears to be slowing a bit in response to the Federal Reserve’s tightening over the last 18 months. Inflation still appears to be under control despite the significant increases in oil prices over the past year. If inflation backs down a bit, the Federal Reserve will most likely adopt a neutral or loosening bias in its attitude towards interest rates. It is unlikely that unemployment will fall much more but unless the economy slows down dramatically, it should remain stable or increase slightly. The trade deficit will continue to worsen as it always has for the last decade but the federal government trade surplus should continue to rise since a strongly divided government will produce very few changes in taxes or spending at the federal level over the next year. In short, as long as major oil disruptions or wars do not erupt in the Middle East, the U.S. economy should continue on its upward but slower path.

The New Economy

It appears to be an inescapable truth to the business media that, as we have entered a new millennium, the U.S. has become a ‘new’ economy. We have witnessed a nine-year expansion with robust growth rates and very little inflation. This expansion of the economy coincided with the rise of the Internet as an important feature in almost everyone’s lives. It is this correlation with the rising economy and exploding technology has created a new economy. However, having the media pundits declare something is true and determining if it is true is another matter (as our recent presidential election proved).

This is too vague of a definition for an academic economist. Consequently, I will try and outline what I think is ‘new’ about the new economy and what is not new about the new economy.

The New Economy at the Microeconomic Level

At their most fundamental level, markets match buyers and sellers together so that they can trade and extract some ‘surplus’ from the trade (either profits or happiness from consumption). How well this matching works depends on the transaction costs associated with trading. Transaction costs are determined by many factors such as the number of buyers and sellers (market thickness), the frequency of trading, how easy it is to be matched with another trader, the quantity and quality of information that each trader has and, finally, the ease of switching trading partners.

Therefore, what the ‘new’ economy does is allow us to expend fewer resources on the process of trading and put those resources towards more valuable uses for the production and consumption of goods and services. By lowering the costs of trading, new markets can arise that otherwise could not function due to thin markets, specialized matching or the lack of sufficient information about potential trading partner. Consequently, the ‘new’ economy not only allows existing goods and services to be traded more efficiently but it also creates markets for new goods and services.

The New Economy at the Macroeconomic Level

What does this all mean for the macroeconomy? Lower transactions costs means lower costs of production. Thicker markets mean more buyers and the ability to produce in larger volumes and exploit economies of scale. Both of these effects mean greater efficiency, greater labor productivity and greater production of output. Furthermore, since buyers have more choices of sellers to buy from, competition forces sellers to pass along the cost savings in the form of lower prices to consumers. So the new economy should produce three notable macroeconomic effects: 1) above average output growth, 2) lower prices and 3) above average growth in labor productivity.

Rather than relying on ‘new’ economy explanations for the growth in GDP in the 1990’s, one way to explain the steady rise of the GDP growth rate during the 1990s is by simply noting that the unemployment rate fell dramatically. In June 1992, there were over 10 million unemployed workers in the U.S.; in November 2000, there were 5.5 million unemployed workers. It should not be surprising that if close to 5 million workers find jobs that we will see dramatic increases in output and high output growth rates. But it does not mean that those workers are high tech workers who have been somehow magically transformed by the Internet into high productivity workers. In fact, upon inspection of industry level data, the only place where we see dramatic and consistent increases in labor productivity is in the computer industry itself.

Conclusions

So what are to conclude from this? Everyday we see how computers and the Internet have transformed our lives in numerous ways at the microeconomic level. But at the macroeconomic level, we are still looking for evidence that the economy has profoundly changed as a result of the rise of computers and the Internet. It brings to mind Nobel laureate Robert Solow’s famous comment that we see computers everywhere but in the productivity data. Maybe it will take another decade for the full fruits of this ‘new’ economy to show itself in the macroeconomic data (economic historians point out that it took over 20 years for electricity to fully impact the production sector). But until it does reveal itself, the best we can say about the ‘new’ economy is that, up till now, it is more style than substance.

This document is a © of CBER, Center for Business and Economic
Research, located at the University of Kentucky, Gatton College of Business and Economics.