The Emerging Lessons of the New Economy

CAMBRIDGE: Debates about the New Economy have raged for years, yet preliminary conclusions are now possible. The New Economy, built on advances in information technology (IT), is real, and is reshaping global industry and services, increases in US productivity in recent years being the clearest demonstration. Simultaneously, the stock market valuations associated with the New Economy are unreal, in the sense that they reflect more of a speculative bubble than fundamental valuations. A third conclusion is that like many technologies, adoption and diffusion of information technologies depends not just on private market forces, but on government. The US, which portrays itself as the bastion of free enterprise, is pursuing the IT revolution through a concerted "industrial policy" as well as through market forces. Other countries should also adopt national strategies to accelerate the uptake of the new technologies.

The reality of the New Economy is best captured in the data on economic growth and productivity in the US, where the New Economy is most advanced. Until about five years ago, American economists bemoaned a "growth slowdown," a downturn in productivity growth beginning in the 1970s. Studies seemed to show that the computer revolution had contributed little to improvements in productivity. Economic historians warned that it takes many years for new technologies to show up in actual improvements in industrial productivity, which was true for past major technological leaps. By the mid-1990s, those predictions were proving correct. Productivity growth began to soar, from around 1.5% per year, to around 3% per year. Higher productivity growth in turn resulted in an acceleration in GDP growth, from around 2.5% per year during 1990-96 to more than 4% per year since 1997.

The deserved enthusiasm for the real economy translated into an undeserved enthusiasm for the stock market prices of IT-based enterprises. There is a big difference between productivity growth and profits, and this basic point was largely ignored by market enthusiasts. Even though productivity gains are likely to be substantial, most benefits will accrue to consumers in the form of lower prices, or to workers in the form of higher wages relative to prices, rather than to firms in the form of higher profits. This is because of a basic aspect of internet technology: freedom of entry of new firms, and therefore the very high contestability of markets. Yes, early movers in internet technology such as, the electronic bookseller, will maintain an advantage, but that advantage is likely to remain modest, since the potential entry of competitors will keep profit margins low. In fact, even as Amazon increased its revenues in recent years, it sustained losses. Recent reversals in the US stock market, quickly transmitted around the world, are the first glimmers that market participants are waking up to these basic facts.

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