Book Adaptation: The Next Downturn

The Old Economy business cycle is giving way to a New Economy tech cycle driven by financial markets


High oil prices, a weak euro, early signs of slower tech growth, a jittery stock market: People are starting to worry how much longer this almost 10-year-old economic expansion can last. In this adaptation from his new book, The Coming Internet Depression, Economics Editor Michael J. Mandel explains why America's tech-driven boom may end with a steep decline.


Since 1995, the U.S. economy has turned in a staggering performance. Growth has averaged a heady 4.4%, unemployment has fallen to near 4%, and inflation, outside of food and energy, has declined. Perhaps most important, productivity has been rising at an annual rate of 2.8%, harkening back to the economic golden age of the 1960s. Even the biggest skeptics concede that something has changed.


The question now is what will follow the boom. The conventional wisdom is that the Information Revolution has smoothed out the business cycle. A computerized supply chain allows real-time monitoring of inventories, so production never gets too far ahead of sales. The combination of soaring productivity and intense competition keeps inflation in check, so the Federal Reserve Board can afford to let growth roll without raising rates much. Thus, the most pessimistic predictions call for only a mild recession--and even that is several years off.


But the New Economy is more than a technological revolution, it's a financial revolution as well--and that makes today's economy far more volatile than most realize. Just as forecasters seriously underestimated the growth potential of the U.S. economy in the 1990s, they are underestimating the possibility of a steep decline in the near future.


Every economic era has its own unique curse. What's happening is that the Old Economy business cycle, led by housing and autos, is being replaced by the New Economy tech cycle, driven by technology and the financial markets.


The upside of the tech cycle, as we have seen in recent years, is a long, low-inflation boom, with soaring tech spending, rapid innovation, and a buoyant stock market. But when the tech cycle turns down--as it inevitably will--the result could be a deep and pervasive downturn. Technology spending will flatten out, innovation will slow, and the stock market will slide sharply. Hit hardest will be the New Economy workers, companies, and stocks that prospered the most in the expansion of the 1990s.


EXPLOSION. The tech cycle is rooted in the very heart of the New Economy. The U.S. boom has been driven by an unprecedented explosion of ''risk capital,'' led by venture-capital funds and initial public offerings. Here, for the first time, is a set of financial institutions devoted to systematically finding and funding innovation. Here, for the first time, is a marketplace in which entrepreneurs with bright ideas can actually get enough money to challenge existing companies. Here, for the first time, is an economy, as Treasury Secretary Lawrence H. Summers has said, ''in which entrepreneurs may raise their first $100 million before buying their first suits.'' This is what makes the New Economy new.


If technology is the engine for the New Economy, then finance is the fuel. Over the past 10 years, venture-capital funding has swelled from about $5 billion annually to an annual rate of around $100 billion today. Such New Economy powerhouses as Cisco (CSCO), Netscape (AOL), Amazon.com (AMZN), Yahoo! (YHOO), eBay (EBAY), Commerce One (CMRC), and Ariba (ARBA) could grow explosively, in part because they received venture-capital funding in their early days, and could expand quickly by drawing on the broader stock market.


Without access to capital, the Internet Age would have arrived, but much more slowly. Online businesses would have been created, but often as subsidiaries of existing companies with markets to protect. E-commerce, too, would have arrived, but much more slowly. And the U.S. would have had a half-New Economy rather than a whole one.


The availability of financing and the opportunity to get rich from a new idea drives innovation at a faster pace. And faster innovation, in turn, drives productivity growth higher, lowers inflation, and accelerates investment. This is why America has benefited more than any other industrial country from the technological revolution. Countries such as Germany and Japan have access to the same technology as the U.S., but they have lagged behind because they have been unable to match the risk-taking capabilities of the American financial markets.


But the New Economy brings new problems. When the next downturn starts, the virtuous cycle of the 1990s could start going in reverse. Instead of a rising stock market generating more funds for financing innovation, a falling market will reduce the risk capital for new startups. That will lead to slower technological innovation and productivity growth, depressing the stock market further. Investment will fall, inflation will rise, and so, too, will unemployment.


If the Fed cuts interest rates aggressively in response to the unfolding tech downturn, then it could be relatively mild and short. But if policymakers dawdle and don't quickly move to counteract falling asset prices and slowing tech demand, then the downturn could morph into something deeper and more sinister: an Internet Depression. Such a depression would start in tech and devastate the entire economy. And while government safety nets would prevent the 25% unemployment rates and shuttered factories that characterized the Great Depression of the 1930s, things could still get very ugly.


Unfortunately, the odds of a bad policy mistake are too high for comfort. There is still widespread disagreement about the nature of the New Economy, making errors more likely. The slower productivity growth and higher inflation that will accompany the tech downturn will make it more difficult to muster support for rate cuts. And a tech slowdown centered in the U.S. will trigger an exodus of foreign money, driving down the dollar and putting pressure on the Fed to raise rates.


MOMENTUM. The tech downturn will not happen overnight. A powerful economy like the U.S. possesses enormous reserves to carry it through setbacks. Venture-capital firms have built up tremendous financial reserves. And long booms create a psychological momentum that is tough to break, since investors learn to ''buy on the dips.'' Even if the stock market turns out to have peaked in early 2000, it could take another two years or more until the economy conclusively falls into a slump.


Moreover, the long-term trends still favor information-technology industries, investment, and jobs. The automobile industry was hit hard by the Great Depression but still dominated the postwar economy. Similarly, the high-tech industries face short-term pain but will continue to lead growth over the long run.


And the new ways for raising risk capital are clearly a potent boost for growth. The Old Economy marshaled the forces of the financial markets to support investment in physical capital. The New Economy marshals financial resources to support innovation--and that's a big difference.


The modern stock and bond markets were developed in the 1800s to funnel large sums of money to capital-intensive industries such as railroads, utilities, and large industrial enterprises. But capital markets and banks have no good way of financing small, innovative companies. The risks of providing money to a startup with no track record and no collateral are too high, the odds of success too low.


The American-style system of risk capital developed to fill this vacuum. The first venture-capital firm, American Research & Development, was founded in 1946, but for many years venture capital was too small to be economically significant. In 1988, the peak year for venture capital in the 1980s, the amount dispersed was about $5 billion. By comparison, total U.S. spending on research and development (R&D) in that same year was $134 billion.


NO SUBSTITUTE. But now venture capital has increased to the point where it rivals R&D as a funding source for innovation. In the first half of 2000, venture capital is running at an annual rate of about $100 billion, or 40% of all money spent on R&D (chart, page 174). The impact of venture capital may be even larger than these numbers show. One 1998 study calculated that a dollar of venture capital stimulates three to five times more patents than a dollar of corporate R&D spending.


Venture capital is no substitute for systematic R&D investment by corporations trying to improve their existing products or develop new ones. Nor does venture capital replace basic research, which has no immediate profit-making application. Almost by definition, basic research must be funded outside the market system, by governments and universities.


But when it comes to getting new ideas to market quickly, venture capitalists have a big advantage. For one, they are single-minded in pursuit of profits. Venture capitalists are not hobbled by the need to protect existing products and markets, as big companies are. Nor do they need to worry about national security or political considerations, as government funding agencies do. The result: Money is directed toward the ventures with the highest expected payoffs. That's a good recipe for speeding up innovation.


The availability of capital for startups creates new competitors in virtually every industry: telecom, health care, insurance, financial services, utilities, real estate, media, grocery stores. Existing players are forced to adopt innovations at an accelerated pace--whether they want to or not. They have to invest more to keep up, and they have to hold down prices to compete.


For example, in June, 1999, the threat of E*Trade Group (EGRP), the low-cost Internet broker, forced Merrill Lynch & Co. (MER), the largest brokerage firm in the country, to start an online service that let customers trade for a flat fee of $29.95 per transaction. That was much less than most of them had to pay before.


Or look at the race to map the human genome. The Human Genome Project--funded with government and nonprofit money--had originally set a leisurely date of 2005 for delivering the human genome sequence. But under pressure from a private venture-funded competitor, the Project was forced to move up its schedule several times. In the end, most of the human genome was announced in spring, 2000, years faster than expected.


And consider the case of Netscape Communications and Microsoft Corp (MSFT). Netscape's August, 1995, IPO created a well-funded competitor that forced Microsoft to move away from its own proprietary online service and instead pour resources into developing its own Web browser, which it then bundled with Windows. This likely accelerated Microsoft's move to the Internet.


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 techno-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