... later ...
So what's the problem? This turbocharging of innovation depends on easy access to capital. But risk capital is very sensitive to the economy and the stock market. The IPO market closes almost immediately in response to market turmoil, and venture-capital funding typically follows the market, with a lag of about a year or so.
For example, venture financing dropped sharply in the years following the 1987 crash. From 1987 to 1991, venture capital fell by more than 50%. Over the same period, first-round financing for new companies--that is, companies that
had never gotten venture capital before--fell 75%. Many small high-tech startups turned to large Japanese companies for money.
Even the most experienced venture capitalists grow more cautious when financial conditions turn tight. In 1990, for example, Tim Draper, a leading venture capitalist, told The Scientist magazine that venture capitalists are ''not going to fund a couple of people coming out of Stanford [University] as easily as they would have in 1983. Instead, they're going to wait until these people have succeeded for a while.''
A similar venture-capital pullback could happen again if tech stocks go into a sustained decline. Venture capital won't fall overnight--right now, many venture-capital funds are flush with money from investors who want to get a
share of the recent sky-high returns. But eventually, when the market goes down and venture returns diminish, investor interest will wane as well. And fewer companies would be funded, for smaller amounts. This drought would have
pervasive effects throughout the economy:
-- Innovation and productivity. Many new products are still in the pipeline, notably in the wireless area. Nevertheless, without continual pressure from aggressive startups, the U.S. will lose much of the accelerated leap from idea to
market that characterizes the New Economy.
How important would this be? New figures from the Bureau of Labor Statistics (BLS) show that more than half of the productivity gains in 1995-1998 came from accelerated technological change. No one knows how much of that is
driven by risk capital, but consider this: Almost all the truly successful new tech companies in recent years were funded by venture capital and IPOs.
-- Business investment. During the second half of the 1990s, capital spending rose at an annual rate of 11%, far faster than forecasters predicted. In large part, this reflected the falling cost of investment goods over the past five years. Meanwhile, the Internet and other new technologies meant that companies had to invest to keep up with competitors, even if there was no obvious payoff.
When the tech cycle turns down, spending on information technology and the Internet will still offer big benefits. But as innovation and the economy slow, it will become harder to justify upgrading computer and telecom systems as often. It will become more difficult to justify investments without a clear payoff.
If the economy slows enough, even companies that still believe in the benefits of information technology will be forced to make cuts. It's a simple matter of arithmetic--tech spending now makes up 40% of business investment spending, so it will be hard to protect (chart, page 180). Indeed, tech represents 63% of nontransportation equipment spending. There is no other place to trim.
-- Inflation. In the early stages of the tech downturn, the economy will paradoxically become much more inflation-prone. Labor and product markets will still be tight, so as productivity growth slows and investment falls off,
companies will not be able to absorb wage increases without raising prices. And large companies will have less reason to restrain themselves from raising prices because they will have less fear of competition from startups.
The slowing of innovation will also directly boost inflation. In the second half of the 1990s, rapidly falling prices for software and information technology sliced
about a half-percentage point from inflation. As innovation slows, it's likely that tech prices will fall at a slower rate.
-- Employment. This is going to be a Palm Pilot recession. Almost 60% of the new jobs generated between 1995 and 2000 were managerial or professional jobs, and those will be hit hard by the tech cycle downturn.
The first wave has already come this year, as struggling dot-coms have laid off almost 17,000 workers, according to outplacement firm Challenger, Gray & Christmas. As innovation slows, fewer people will be needed to create new
products and companies, leading to job cutbacks at high-tech firms. The layoffs will eventually stretch from the telecoms to the software makers to the consulting firms.
Particularly vulnerable will be the floating workforce of temporary workers, independent consultants, free-lancers, programmers, and Web designers-for-hire who have thrived in the boom. As of early 2000, such employees of temp firms
made up a much larger 2.7% of total jobs, up from 0.6% in 1981. And that number doesn't include independent contractors or temporary workers directly hired by companies, who according to the BLS make up at least an additional 6% of the workforce. These people will find that companies have a lot less need for them when growth slows down.
-- The stock market. In the New Economy, the stock market is an essential part of the tech cycle, rising and falling with the overall economy. Add in rising inflation and a slump in business investment, and it's likely that stocks will plunge
sharply when the tech cycle turns down.
All this may seem excessively dire. After all, a wave of new technology could stimulate demand, just as the Internet did. Moreover, even if a downturn does start, most economists have an almost religious faith in the power of the central
bank to prevent it from going too far. It is widely accepted that if the economy ever seemed about to fall off the edge, the Fed would cut interest rates sharply.
But this sanguine conclusion assumes that policymakers will be able to recognize when the tech cycle turns down and draw the correct conclusions about how to react. In fact, policy mistakes are more likely when an economy is in flux and the
old institutions and rules don't fit anymore.
For example, economic historians now agree that the Fed's tight money policies in the late 1920s and early 1930s turned a garden-variety stock-market crash and recession into the Great Depression. Similarly, an extended series of
mistakes by the Bank of Japan transformed the stock-market decline of 1990 and 1991 into a depression. And pressure from the International Monetary Fund to raise interest rates greatly worsened the Asian crisis of 1997. In all these
cases, policymakers failed to recognize the true nature of the dangers they faced.
It's important to note that the economists who tell you today not to worry about a deep recession are exactly the same people who completely missed predicting the tech-driven boom of the 1990s, as well as the 1997 Asian crisis. Even after the crisis started, forecasters badly underestimated how bad it would be.
In the case of the New Economy, the real question will be how the Fed reacts when faced with a slowdown in productivity growth and the corresponding increase in inflation. On an intellectual level, economists in Washington and on Wall Street concede the importance of computers and the Internet. But with the exception of Fed Chairman Alan Greenspan and a few others, most economists
have not fully embraced the New Economy. Such echno-pessimists will welcome a productivity slowdown as a return to normalcy. There will be a tendency to view a downturn--even a steep one--as the natural response to the
excesses of the 1990s. Their response to a recession will be to let the economy fall back to what they consider a ''sustainable'' level of output.
Indeed, there may be broad calls for the Fed to raise rates if the dollar starts to plummet. The U.S. economy has become dependent on foreign capital flows, with 23% of investment being funded from abroad (chart, page 176). This money
has been drawn to the U.S. by the high returns, and a tech slowdown could send foreign investors rushing for the door, especially since it would hit the tech-driven U.S. economy harder than others. The result could be a sharp devaluation of the dollar that would make it hard to cut rates.
Nevertheless, the correct response to a tech cycle downturn and a productivity slowdown is to lower interest rates as soon as possible. If the Old Economy was an automobile, the New Economy is an airplane. In an auto, if anything
unexpected happens, the natural and correct response is to put on the brakes. But just as an airplane needs a certain airspeed in order to stay aloft, so the New Economy needs fast growth for high-risk investment in innovation to be
worthwhile.
Just as pilots learn how to deal with a stalled and falling plane by the counterintuitive maneuver of pointing the nose to the ground and accelerating, policymakers have to learn how to go against their instincts by cutting rates when
productivity slows and inflation goes up. That's the only way to keep from crashing.
After an unprecedented expansion, it's tempting to believe it will go on indefinitely. But the New Economy has never been about sunny skies forever--and it's time to start thinking about what happens when the storm comes.
Adapted from The Coming Internet Depression: Why the High-Tech Boom Will Go Bust, Why the Crash Will Be Worse Than You Think, and How To Prosper Afterwards (Basic Books). Copyright 2000 by Michael J. Mandel
By Michael J. Mandel
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.
EDITORIALS Are We Headed for a Tech-Led Recession?
Economic crises are tough to predict. Economists don't have a good track record, and neither do the markets. Despite the difficulties of looking ahead, Business Week Economics Editor Michael J. Mandel, a longtime champion of the
New Economy, has decided to take the risk. In a new book, The Coming Internet Depression, and in this week's cover story, adapted from the book, he makes a worrisome prediction: There's a good chance the U.S. is on the road to
a downturn, and that downturn could turn nasty, brutish, and long if economic policy stumbles.
It's a worst-case scenario, and it will happen only if all the trends turn sour and all the mistakes are made--the economic equivalent of the Perfect Storm. But because the warning comes from someone who has long been an optimistic
believer in the New Economy, it deserves a very careful look.
Mandel and Business Week were among the first to recognize the New Economy, explain it, and understand its implications. Conventional economic indicators missed it, but reporting on the ground by Business Week's reporters
and editors suggested that something new was happening--that technology had assumed a pivotal role in the U.S. economy and would lead to unprecedented, productivity-driven growth. Business Week said the expansion would ultimately end, and it predicted that there would be bumps along the road. But now Mandel's argument goes much further.
The thesis is difficult to prove. As Mandel himself says, the downside of the tech cycle is uncharted territory--we've never seen the aftermath of a New Economy tech boom. But if he's right, we need to be alert to the warning signs and get
ready to make the crucial policy moves.
Vulnerable Venture Capital
Mandel's argument turns in part on what he calls one of the great financial breakthroughs of the 20th century: the venture-capital fund. Venture capitalists gave about $60 billion to startups and young companies last year, and in the first half of this year, their funding was running at about a $100 billion annual rate. Along with that came the use of initial public offerings, which allow venture
capitalists to cash out and recycle their returns into new enterprises. These developments gave cutting-edge technologies the financial muscle to challenge even the largest and most entrenched Old Economy companies.
But there's a downside to this financing mechanism: The pace of innovation is now tied to the growth of the economy and the rise of the stock market. Drops in the market and economic slowdowns are likely to lead to less funding of startups and a consequent slowdown in innovation. And that's where the cycle begins to feed upon itself, according to Mandel. Less innovation means less productivity growth,
a tendency for inflation to rise, and pressure on companies to raise prices. Those developments, in turn, threaten to further slow the economy and depress the market, leading to a pernicious downward economic spiral.
The early warning signs of this spiral would include a simultaneous fall in tech stocks and tech spending, a slowdown in the rate of price declines for technology
goods, and a decline in venture-capital financing and IPOs.
That's enough to create a painful recession, but Mandel argues that something more is needed to turn that into a depression. And that is a major misstep in monetary policy.
Most historians now agree that such a mistake was a key factor in the Great Depression. In 1931, when the economy was already reeling, the Federal Reserve, worried about the flow of gold out of the country, raised interest rates
sharply. That crushing blow helped send both the U.S. and the global economy into a depression. Similar mistakes were made in Japan in the early '90s and during the Asian financial crisis in 1997.
Pressure on the Fed
And the same mistake could happen again. Foreign investors have pumped more than $3.3 trillion into U.S. financial and business assets since 1995. If the country slips into a technology recession, accompanied by inflation and a falling stock market, overseas investors will want to get out, putting further downward pressure on the dollar. The Fed will find itself under great pressure to defend the
currency by raising rates--precisely the move that could worsen any recession.
It's not a smart move, but domestic politics and economists who never believed in the New Economy might force the Fed's hand. Many economists, fearful of aggravating inflation, would oppose cutting rates even if the economy is in a
slump.
Whether an economic slowdown will lead to inflation is a matter of debate. Competition from goods made in Asia would continue to put downward pressure on U.S. prices, even in a tech slump. And the Fed, under Chairman Alan Greenspan, has accepted the premise of the New Economy and acted
accordingly. If Greenspan is at the helm when a slowdown hits, he will likely provide the proper guidance. But others at the Fed might behave differently in the years ahead.
We are nowhere near the point where we can say with any certainty whether a sharp Internet recession awaits us. But there is reason for concern. The Nasdaq is now down about 28% from its high. In the first half of 2000, the price of
technology products increased for the first time since 1991. Revenue growth in tech and telecom is expected to slow from 17% this year to 11% in 2002. Global computer, networking, and software spending may rise 10.1% next year, down
from 10.4% this year. Growth in PC sales will fall from 17% this year to 12% in 2001. Some of the key indicators of an Internet recession are in place.
We remain optimistic. Business Week's reporting suggests that the boom in innovation and investment will continue. But Mandel correctly points out where the dangers lie. It's important to keep a sharp lookout for the warning signs of what could become an economic Perfect Storm if economic policy turns perverse. |
