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The Goldilocks Economy, or Why We Don't Need No Stinkin' Interest Rate Hike
It's amazing what a month can do for Mr. Market's perception of reality. Thirty days ago the Dow was sitting at 10,000 contemplating the abyss. While inflation fears and the Y2K uncertainty inspired gold and canned food hoarding. Today, inflation seems tame; the quarter point interest rate hike--if it comes--is discounted in the market and Y2K promises to be the bark that didn't bite. The Nasdaq is up 46% year to date, and the Dow is likely to take another stab at new highs before year's end. So how did we get here? To start with, this was a corporate earnings season to die for. On average, the various technology sectors posted earnings growth of 28% year over year. With the economy in boom mode there's little for a decent bear to hang his hat on, except for the old bear standard of fretting over low equity-risk premiums. Today, the real story is productivity. The More for Less Economy Robert Solow, Nobel laureate in economics, noted a few years back, "you can see the computer age everywhere these days except in the productivity statistics." He was commenting on the slow productivity growth experienced in the US economy through the 1970-80's. The dawn of the digital age was slow going for productivity gains hampered by steep learning curves and expensive equipment, most of which is landfill by now. Low productivity equals high inflation. Increasing productivity means that the cost of goods and services go down and inflation is contained. Of course, measuring productivity isn't as simple in today's information based economy as it was in the industrial age. Back then all you had to do was weigh the ratio of what came in the back door of the factory to the amount of finished product rolling out the front door. The Commerce Department takes quantitative measurements of increases in output but can't consider "qualitative" improvements. How does one measure the productivity increases in a software package? Fortunately, as the economy has heated up in the last few years, so has productivity, with a little help from its cousin, innovation. The world economy is generating more goods, commodities, ideas, and wealth, faster with the same level of input--number of workers, raw materials and time--as before. The blossoming of the Internet and the maturing technologies of computers and software have combined into a synergistic force to propel productivity to new highs. The numbers are downright outstanding. For decades the average growth of productivity in the US economy was about 1.0% per annum, while inflation was killing us. In the 1990's things began to improve. By 1996 the average productivity gain per year had risen to 2.2%. The rate grew to 3.4% in 1998. First half of 1999 it rose to 3.5%. Last week's productivity numbers for the third quarter came in at a striking 4.2% growth. To be fair, critics argue that most of the recent productivity gains are coming from the high tech sectors and changes in the way productivity is measured, not from the "main" economy such as manufacturing. If so, why is inflation so tame? Moreover, high tech is rapidly becoming the mainstream of the economy. US companies have increased their annual investment in information technologies 1400% in the 1990s. During the same period investments in other areas remained unchanged. Half of all US workers will work in intensely computerized and networked jobs by 2006. Worker productivity in the IT sector has been improving at a rate of 10% annual in the 1990s beating the rest of the economy hands down. A better question might be why worry about inflation at all? We are at the bottom of a 12-year period of globally receding inflation. In fact if inflation were much lower the stock markets could start fretting over deflationary pressure, but that's unlikely to occur given the strength of consumer confidence and purchases. Many observers believe that the increases we’ve seen in productivity during the last decade are nothing compared to what is just around the corner. Even the argument that only the high tech sectors have experienced huge productivity gains bodes well for the future. It merely means the gains seen in the bleeding edge IT sectors have yet to ramp up for the rest of the economy, the "late adopters". Even Alan Greenspan acknowledges that "innovations in information technology...have begun to alter the manner in which we do business and create value, often in ways that were not readily foreseeable even five years ago." The Internet If the productivity gains from improvements in manufacturing processes due to computerization is finally yielding big results, the full effect of the Internet is still over the horizon. The Internet, barely beyond the zygote stage of development, represents the beginning of a global economic neural network, which will eventually become as ubiquitous and animated as the air we breath. The paradigm shifts in the way people will work, play, buy, sell, market and deliver products in the near future are now becoming hazily visible. Long ago Venice was built around canals. In the 1950's Los Angeles was built around the strange attractor of the internal combustion engine. The distribution of human populations over the face of the planet during the next century will morph into an optimal shape for the flow of e-traffic in a frictionless Internet based economy. Currently, only about 1% of all US consumer purchases are made on the Internet. However, as much as 50% of some large purchases–-like automobiles-- are researched on the Internet. A bricks & mortar merchant can no longer count on having an isolated market to prey on with arbitrary (or other) price increases. It’s too easy for the consumer to comparison shop or buy online. In fact, the Internet encourages price consciousness in many industries formerly dominated by vendors with high overhead and little competition. Ethan Harris, an economist with Lehman Brothers told the Wall Street Journal that he estimates, "e-commerce, will cut the annual rate of increase in the consumer-price index by half a percentage point by 2002–-a major reduction with inflation running at an annual rate of about 2%." Harris conducted a survey of eight common products, "ranging from pharmaceuticals to clothing. The total basket of goods was 13% cheaper online than offline, including shipping charges. Prescription drugs were 28% cheaper and apparel 38% cheaper." The Journal goes on to point out a study by Erik Brynjolfsson and Michael Smith of the Massachusetts Institute of Technology who found the cost of books and compact disks on the Internet were 9% to 16% less than at your local merchants. We all know the Internet is the "killer app" driving PC sales. Rapidly it's becoming the killer app driving the whole economy too. If only 1% of all retail sales are made online today, how will the productivity/inflation respond to numbers closer to 20% or more within a few years? Even more important than the highly visible retail e-market is the business to business e-transactions going on in relative obscurity. In 1998 $43 billion worth of e-transactions occurred, by 2003 that number will skyrocket to $1.3 trillion, according to Forrester Research. Businesses must adapt to new, more efficient, online models for dealing with customers, retailers and suppliers or fade away, overshadowed by their e-rivals. The phenomena of Internet commerce is so new that little data has been collected or properly analyzed by academics or government. Again, the Wall Street Journal, "Because of the lengthy editing and review process, many university studies of Internet pricing patterns soon to be published are based on data collected in 1997–-ancient history by e-commerce standards." The Commerce Department only began tracking online retail sales this month, don’t look for their reports until next year. Globalism Another reason not to expect inflation any time soon is the nature of a global economy. As markets open around the world, competition and opportunity increase. Most international companies recruit qualified workers globally. As higher education becomes common everywhere, no longer do Americans have a monopoly on the skill sets needed to grow the economy. This is perhaps a primary reason for low wage inflation in the US. Moreover, as trade barriers come down --thanks to diplomatic initiatives like the European Union, GATT (now the WTO) and NAFTA --products can flow efficiently across boarders mitigating inflationary pressures for the importing economy while staving off deflation for an exporting country. The benefits of a globally integrated economy have yet to be fully realized. Likewise, the Internet is still cutting its teeth, while the productivity gains from computerization won't peak in the foreseeable future. No matter which way the short-term monthly economic indicators point, on a broader scale we are in a historical deflationary period. So what is all the fuss about inflation? Why are a small group of old men clinging to an obsolete economic model setting interest rates for the global information economy? These guys are wizened, no doubt, but they probably have spent less time online than the average AOL newbie--55 minutes per day in 1999. My point is, Mr. Greenspan, we don’t need no stinkin' interest rate hike! Your comments are welcomed. |