THE WASHINGTON TIMES - April 9, 2001

End of the New Economy?

by Peter Morici

Although positive reports from Alcoa and Dell Computer were newsmakers and market movers this week,

announcements of disappointing corporate profits and layoffs have become routine over the past few months. As

economic growth slipped to a meager one percent annual rate, stocks have been in freefall. Despite Thursday´s

sharp bounce, market bears continue to roar as the Dow recently experienced its worst week in 11 years, while

the NASDAQ, down about 60 percent from its peak last year, fell to levels not seen in 29 months.

This is not merely idle chat for economists and market pundits: Americans now have 60 percent of their savings

and investment in the stock market – double the ratio in 1982 – and crumbling stock prices represent a loss of real

wealth.

What happened to the New Economy? Can we get it back?

At the center of the new economy were advances in telecommunications, microelectronics, software, and

management practices. These created new products and unleashed innovations in the workplace and corporate

supply chain that raised potential productivity growth to levels not seen since the 1960s.

Better products and productivity resurrected American competitiveness. From 1989 to 1998, exports accounted

for 25 percent of U.S. growth, more than double the historical norm.

A flexible labor market kept wages from rising too fast. Even as businesses expanded and unemployment fell, many

firms cut costs by streamlining management and production. Released workers joined even more rapidly growing

firms and new enterprises. Immigrants – from engineers to janitors – filled gaps in the labor supply.

Meanwhile, a strong dollar and falling oil prices kept import prices low. Foreign competition pressured businesses to

boost productivity – embracing new technologies and upgrading workers´ skills rather than raising prices to

increase profits and wages.

In turn, investments in technology fueled profits among leaders such as General Electric, Dell, Intel, and Microsoft,

creating the optimism necessary to finance start-ups through venture capital and stock offerings.

All of this permitted economic growth greater than 4.5 percent and low inflation for four years through the middle

of 2000, plus soaring stock valuations.

Unfortunately, forces beyond the control of policy-makers, and some missteps, deflated the economy and the

stock market. The Asian crisis and continuing malaise in Japan slowed U.S. export growth and increased imports

after 1997. Oil exporting nations agreed to cut production, and oil prices began rising in early 1999. From July

1997 to January 2001, therefore, the annual trade deficit grew from $83 billion to $400 billion, creating a drag on

demand for domestic goods and services equal to nearly four percent of GDP.

Moreover, large government surpluses also can constrain domestic demand, and just as the trade deficit began

ballooning in 1997, the federal budget swung from deficit to surplus. In FY 2001, it may reach $265 billion. At

current levels, the combination of the trade deficit and budget surplus reduces domestic demand by about six

percent.

Furthermore, in June 1999, the Federal Reserve, concerned about inflation, began raising interest rates.

Unfortunately, rate increases in March and May 2000 had much of their effect after the slowdown had begun.

Growth slowed from 5.6 percent in the second quarter of 2000 to 2.2 and one percent in the third and fourth

quarters. Instead of braking an accelerating economy, these rate hikes helped push a besieged economy over the

edge. Growth in corporate profits slowed, business investment dropped, and productivity growth fell.

Since January, the Federal Reserve has cut interest rates three times. Unfortunately, a time-tested lesson of

economics is that monetary policy can choke a recovery but cannot easily ignite one. Lower interest rates will not

cause consumers to spend much more; Americans already spend almost everything they earn.

Flagging investment is resistant to rate cuts – corporate managers need to see more sales and profits on the

horizon before they will trade in old computers or add new capacity.

Fiscal stimulus is needed. The congress and president must spend more or give some of the budget surplus back

to taxpayers.

Although we can quarrel about how much of the surplus should be devoted to spending versus tax cuts, it is not

surprising that the president and Democratic leaders are debating the size and focus of a tax cut, not whether we

should have one.

Unfortunately, the president´s tax plan will not give the economy the immediate boost it needs. Of the $1.6 trillion

proposed, a significant share is earmarked for ending the estate tax by 2011, and most income tax rate cuts

would be phased-in through 2006.

Meanwhile, the $60 billion tax rebate proposed by some Democrats pales by comparison to the $665 billion drag

created by the trade deficit and budget surplus.

To avoid recession, tax relief should be accelerated. Writing every taxpayer a rebate check, compressing the

timetable for the president´s tax cuts, or some combination of both approaches makes good sense.

Importantly, the fundamentals for rapid growth remain in place – namely, technological advances and a

resourceful work force. If the country is to get back on track, the Congress and president will likewise have to

show some creativity and flexibility.