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How "New" Is Today's Economy?

J. Bradford DeLong

Professor of Economics, University of California at Berkeley,
and Research Associate, National Bureau of Economic Research

July 15, 1998; Version 1.0; First Draft
August 18, 1998; Version 2.0; Second Draft

An edited version of this is forthcoming in the Wilson Quarterly. I want to thank Hal Varian, Larry Summers, Steve Lagerfeld, and especially Michael Froomkin for helpful discussions.

A. Introduction

At the end of the twentieth century legions of the powerful--politicians, intellectuals, journalists, business leaders, and visionaries--made what can only be called pilgrimages to a spot in California between San Francisco Bay and the Pacific Ocean, some forty miles south of San Francisco: Silicon Valley.

In the past the powerful had made similar pilgrimages. In the 1830s and 1840s Alexis de Tocqueville (reprinted 1991), Benjamin Disraeli (reprinted 1993), and Friedrich Engels (1844) were among the pilgrims who journeyed to Manchester, England, to see the shape of the future emerging from the factories (and the smog, and the slums) of the rising British cotton textile industry.

In the 1920s the pilgrims traveled to Detroit, to see Henry Ford's assembly lines and the extraordinary upward leap in productivity that turned automobiles from luxuries into commodities within the reach of the bulk of American families. The revolution of mass production of Detroit may have driven an even bigger change in human conditions of life than the original industrial revolution of Manchester: Aldous Huxley (reprinted 1989) wrote in _Brave New World_ of a future in which people dated years from the production of the first Model-T Ford, and in which the key problem facing governments was how to brainwash people so that they would consume enough to keep the economy near full employment.

In all three cases people went on pilgrimage to see the future--the industrial future, in Manchester; the mass-production future, in Detroit; and the microelectronic future, in Silicon Valley. The pilgrims invariably came away convinced that new technologies had created a fundamentally different future--a new society, a new culture, and a new economy.

But what, exactly, is "new" about this particular "new economy" that awaits us in our future? Each pilgrim to Silicon Valley seems to bring back a slightly different report. Many of the reports are simply wrong. Some see as brand-new phenomena patterns of entrepreneurship and enterprise that are in fact quite old--and do so because they fail to view Silicon Valley from a long enough historical perspective. Some fail to understand the most important fact about economic growth: that ever since the industrial revolution there have always been new industries, new inventions, and new commodities. of the measurement of economic growth.

Nevertheless, when all is said and done, there is something to the idea that we live in a "new economy"--just as there was something in the air in the past in Manchester or Detroit. What is new is not the extraordinarily rapid pace of invention and innovation: there is always, or rather for the past two hundred years there has always been, some leading sector or other the pace of invention and innovation has been extraordinarily rapid. What is new is not that our standard of living is growing faster than official statistics suggest: for at least a century our official statistics have been understating rates of economic growth because official statisticians don't have the information to adequately understand leading sectors.

What is--or rather might be--substantial in the idea of a "new economy" is that the information age may see the breakdown of those underpinnings of scarcity and control over commodities that supported economists' belief that the market system was a good social mechanism for guiding production and distribution. Economists preach that the Invisible Hand of the market will carry us all to wealth, luxury, and utopia as long as the government is smart enough to protect property rights, enforce contracts, and tweak the system around the edges to deal with "externalities." Such reliance on competitive markets has, by and large, proven a good bet in the past. But it rests on principles--that commodities are excludible (easy to control), rival (scarce and expensive to society to make use of), and transparent (easy to identify)--that may not be true when the information age arrives.

That would be a new economy indeed, but one very different from the picture currently being painted.

B. Leading Sectors

The first dimension of "newness" of today's economy--the one that strikes almost all observers immediately, and leads to breathless descriptions of technological revolution-is the sheer speed of technological progress in the semiconductor and the semiconductor-derived industries. _Business Week's_ Stephen Shepard (1997) writes of how information technology and the computer- and network-driven international integration of business are:

...the magic bullet--a way to return to the high-growth, low-inflation conditions of the 1950s and 1960s. Forget 2% real growth. We're talking 3%, or even 4%. Forget double-digit inflation and the natural rate of unemployment...

The "undermining of the old order..radical restructuring that is making us more efficient" have left traditional analysts of the economy in the dust: "unable to explain what's going on... wedded to deeply flawed statistics and models."

From his post at _Wired_, Executive Editor Kevin Kelly (1997) writes of the new economy as a:

...tectonic upheaval... [driven by] two stellar bangs: the collapsing microcosm of chips and the exploding telecosm of connections....tearing the old laws of wealth apart.... As the size of silicon... shrinks... costs...become cheap and tiny enough to slip into every... object we ephemeral package... your chair, each book, a new coat, a basketball.... Soon, all manufactured objects, from tennis shoes to hammers to lamp shades to cans of soup, will have embedded in them a tiny sliver of thought...

Since the early post-World War II invention of the transistor, the onrush of invention, innovation, and industrial expansion in information technology has been constant and rapid (see Hanson (1982)): transistors, integrated circuits, microprocessors, and now entire-computers-on-a-single-chip and the high-speed worldwide networking of potentially every computer within reach of a regular or a cell phone. Year after year Moore's Law (named for Intel Corporation co-founder Gordon Moore) continues to prove itself: the density of silicon-on-a-single-chip doubles (and thus the cost of silicon circuits to consumers halves) every eighteen months or so (see Saxenian (1996)). Moore's law has been at work since the early 1960s. It will continue until--at least--the middle 2000s.

Observers note the enormous fortunes made on the stock market by founders of startup corporations that have never turned a profit: how intenet bookseller is seen by the stock market as worth as much as established bookseller Barnes and Noble. Observers see how last year's high-end products are this year's mass-market products, and will be obsolete and sold for scrap within two more years (see Kelly (1997)).

Hence this vision of this "new economy": a vision of never-ending cost reductions driven by technological innovation, "learning curves," "economies of scale," "network externalities," and "tipping points." In the old economy you made money by selling goods for more than they cost: in the new economy you make money be selling goods for less than they cost--and relying on the learning curve to lower your costs next year. In the old economy you boosted your company's stock price by selling valuable goods to customers: in the new economy you boost your company's stock price by giving away your product to customers--and relying on network externalities to boost the price you can charge for what you have to sell next year. In the old economy the first entrant often made big mistakes that followers could learn from and avoid: it was dangerous to be first into a market. In the new economy the first entrant that passes a tipping point gains a nearly unassailable degree of market dominance.

And there are pieces of the world that fit this vision of the "new economy" very well. Think of the fortune of Bill Gates. Think of the rapid and steady price declines of silicon chips. Think of the rocket-like rise of new companies that did not exist a decade ago to prominence in the stock market. Think of the rise of companies that did not exist three decades ago--like Intel--to industrial prominence

But, somewhat paradoxically, it is along this marveled-at dimension that our economy today is perhaps the least new. For what this particular set of returning pilgrims to the future are describing are the standard economic dynamics of a "leading sector," of a (relatively narrow) set of industries that happen to be at the center of a particular decade's or a particular generation's technological advance. There have been such leading sectors well over a hundred years. Manchester was the home of the leading sectors of the 1830s. It was the Silicon Valley of its day--and saw the same creation of large fortunes, the plummeting of product prices, and the sudden growth of large enterprises.

Every leading sector goes through a similar process. Consider the automobile. The average car purchased in 1906 cost perhaps $52,640 of 1993 values (Raff and Trajtenberg (1997)). By 1910 the price had dropped to $39,860--while the "quality" of the average car had jumped by at least 31 percent. By the time the heroic, entrepreneurial age of the American automobile came to an end during World War I, an average car cost 53 percent less in inflation-adjusted dollars than and was at least twice as much car as in 1906: 4.2 times as much car for the (inflation-adjusted) dollar as a mere decade before.

This does not match the pace of innovation found in semiconductors recorded to Moore's Law--which generates at least a 32-fold, not a four-fold, increase in value over a decade. But it is in the same ballpark, especially once one recognizes that the tremendous improvements in semiconductors have not been matched by many of the other components that make up microelectronics products.

Thus a citizen of the late nineteenth century would not have had to wait for our age in order to see the "new economy." In order to be astounded by how the best of products got cheaper and more reliable every year, he or she would only have had to go to Detroit, and be astounded by the pace of technological progress in the automobile manufacturing industry. During the 1920s magazines like the _Atlantic_ would publish articles claiming that mass production made not just for greater efficiency or higher productivity but "a better world" and demanded the rapid creation of a "Fordized America" (see Hounshell (1984)).

The automobile industry is not alone: other industries have had similar transformations during their times as leading sectors. For example, my wife and I have a small dining room, with a small four-bulb chandelier. But should we go to Monterey for the weekend and leave the dining room light on, by the time we return our dining room will have consumed--in our absence--as much in the way of artificial illumination as an average pre-1850 American household consumed in a year. It cost them about five percent of their household income in candles, tapers, and matches. Because of the technological revolutions that made possible the cheap generation and transmission of electricity, it costs us so little that we cannot see it in our Pacific Gas and Electric bill (Nordhaus, 1997).

Silicon pilgrims have made an elementary mistake. They grew up with the goods of the industrial revolution--from automobiles to washing machines, railroads to container ships to airplanes to radios. They remember these goods from their childhood, and see them today in much the same form as they existed thirty or more years ago. So they assume that such "industrial" goods must have always existed, that the pace at which they changed must have always been glacial. But we have had a succession of productivity revolutions in leading sectors since the start of the industrial revolution: that's why it's called the industrial revolution--it kicked off the process of staggered sector-by-sector economic transformation of which Silicon Valley is today's instance.

The economy cycles through a number of leading sectors: textiles, transportation, construction, textiles again, watches and jewelry, telegraphs, construction again, telephones, transportation again, household utilities, household appliances, broadcasting, textiles and apparel, and medical care-all before the microelectronics revolution. It will continue to cycle through different leading sectors in the future, long after the pace of technological change in microelectronics has slowed down.

So how would pilgrims returning from Silicon Valley change their vision of the future after recognizing that much of what they have seen are the more-or-less standard economic and technological dynamics of a leading sector? I believe that they would change their mind in at least four areas:

C. Growth and Measurement

A second (and somewhat overlapping) set of pilgrims have returned from Silicon Valley believing that the economy could grow much faster than it has over the past generation. They believe that the technological revolutions of microelectronics are having a large and positive impact on our standard of living, and could be having a larger and more positive impact if only those managing our economy would recognize the importance and enormous benefits of this postindustrial revolution in telecommunications and computers.

This group returns from Silicon Valley to announce that growth in productivity and living standards is (or could be) back to the rapid pace of the first post-World War II generation between 1945 and 1973. The post-1973 productivity slowdown was a profound shock to America. It caused a stock market crash in the mid-1970s. It meant that government promises of future benefits that had been based on assumptions that tax revenues would continue to rise at their pre-1973 rate could not be fulfilled. It made false the basic American assumption that each generation would find itself living significantly better than its parents' generation, with bigger houses, better jobs, and markedly easier lives.

But today new economy advocates announce that because of microelectronics and telecommunications the productivity slowdown is over, and that economic growth can return to the pace of the period before 1973. Many good things will follow: real wages and living standards will grow rapidly, the Federal Reserve will be able to expand the money supply more rapidly without generating higher inflation, and the stock market will continue to boom because the high value of today's stock market is perfectly justified by the high profits to be made in the "new economy."

Thus Newt Gingrich opines that better technologies should give us an economy that can year after year generate measured economic growth of 4 or 5 percent without rising inflation, instead of the 2.5 percent per year in growth in measured GDP calculated by the tight-fisted central bankers at the Federal Reserve. Stephen Shepard (1997) writes of how information technology is a "transcendant technology" that affects everything: "boosts productivity, reduces costs, cuts inventories, facilitates electronic commerce." The "statistics are simply not capturing what's going on" because of the way the Department of Commerce collects and processes data: "we don't know how to measure output in a high-tech service economy."

As best as I can tell, this group of returning pilgrims seems to have failed to recognize the importance of the word "measured" in the phrase "measured economic growth." Their pilgrimage has led them to the belief that true economic growth is higher than measured economic growth. And they are right: there are a large number of statistical and measurement problems built into our official economic statistics that together imply that "true" economic growth is faster than "measured" economic growth by one percentage point per year or so.

But what this group of returning pilgrims fails to see that this understatement of growth and improvement of livings standards is a lot older than today's "new economy." Our government's official statistical system was little, if any, better at measuring growth in the network-television-and-superhighways economy of the late 1950s or the automobiles-and-appliances economy of the late 1920s than it is today. For more than fifty years national income accountants at the Commerce Department have known that estimates of gross domestic product grossly underestimate the economic benefits from the inventions and innovations of leading sectors. Yet the national income accountants have continued to follow their established procedures because they lack the information to do a better job, and would rather report numbers that they can count reliably rather than numbers that are based on guesswork. It is likely that the problems of measurement today are somewhat bigger than in the past: Moore's law tracks productivity growth that is even faster than that of previous leading sectors. But they are not of an entirely different order of magnitude

So the correct answer seems to have two parts: First, that improvements in living standards and economic growth are faster than standard statistics suggest (at least for the middle class: it is harder to get excited about $29.99 a month unlimited internet access and cellular phones if you are on food stamps). Second, that the productivity slowdown is not over, that growth in real wages and in living standards is not back to its pre-1973 pace, and that the stock market is unlikely to continue to boom--for back before 1973 the American economy possessed faster growth in measured GDP and roughly the same gap between "true" and "measured" growth, because for nearly a century before 1973 the Department of Commerce has had similar problems estimating the economic benefits from previous leading sectors that it has estimating the benefits from telecommunications and computers today.

Economic growth is more rapid than official statistics tell us. But the productivity slowdown is still there: still a shock to American expectations about the magnitude of economic progress. And just because measured growth is lower than real growth does not mean that the economy could be growing faster than it is.

How would we tell if economic growth was too slow? How would we tell if inappropriate policies were hobbling the rate of economic progress? One guide would be the rate of investment: are bad economic policies stealing capital that should be going to expand the productive capacity of the economy. While you can argue that the budget deficits of the 1980s hobbled economic growth by crowding out investment, the budget deficits of the Reagan and Bush administrations are now gone.

If businesses formed long-term ties with their workers, and believed that worker loyalty to the firm should be matched by firm loyalty to the worker (as in today's Japan), it would be hard to figure out if the economy was growing as fast as it could. But we live in an economy in which firms have little if any loyalty to their workers, and have a duty to shareholders to fire workers whenever doing so increases profits. So if productive capacity were growing faster than production, businesses would be firing workers on a large scale: unemployment would be rising as firms used technology to economize on workers.

Yet there are no signs of any persistent rise in unemployment. The labor force as a share of the adult population is a record high: it is not that large numbers of discouraged workers are masking massive underemployment. Unemployment remains constant--a good indicator that the economy is growing at the sustainable rate of growth of its productive potential--when measured real GDP grows at some 2.5 percent per year (see Blinder (1997); Krugman (1997)).

D. The New Economy

Nevertheless, such a complete debunking of the "new economy" is not completely satisfactory. Pilgrims do return speaking of visions that cannot reflect reality. Much political-economic discussion of the new economy does result from basic confusion between measured and true rates of growth. Much of the hype is the same hype that always surrounds the firms in a leading, technologically-dynamic sector--whether Edison General Electric in the 1880s or the Radio Corporation of America in the 1920s.

But the pilgrims have seen something.

First, although what many of the pilgrims have been seeing is the standard pattern of activity and change found in a leading sector, this particular leading sector of our day is a large and rapidly-progressing leading sector. The pace of productivity improvement in telecommunications and microelectronics does appear faster than in most--if not all--leading sectors of the past.

For an example from telecommunications, look at the creation and spread of network television throughout America beginning in the 1950s. Network television dominated and in some ways still dominates American culture, occupying in its heyday perhaps a fifth of the average American's leisure hours. But obody ever paid a cent to receive network television. So its product received--and still receives--a value of zero in the national income and product accounts.

The salaries and profits of the networks, of the production studios, of the actors, of the advertising managers, and of the commercial makers do appear--but they appear as a cost of the production of the goods being advertised, not as an increase in the economic value produced. The growth of broadcast television increased the size of the denominator in productivity calculations, but not the size of the numerator. Each worker who moved into the network television industry (broadly defined) decreased officially-measured productivity.

For an example from network computing, look at the internet: a source of entertainment and information that does not (or does not yet) rival network television, yet shows the same pattern. People pay a toll to telephone companies and to internet service providers in order to access the network. But then the overwhelming bulk of information is free, and is likely to remain free simply because the internet makes information so cheap to distribute and anyone who tries to charge will find their audience going elsewhere. Once again the national income accountants at the Department of Commerce are, when they estimate real GDP, subtracting one-tenth of a percent from American productivity for each one-tenth of one percent of the labor force employed creating and maintaining the world wide web.

Second, this particular leading sector may indeed have broader consequences in the very long run than other leading sectors in the past. Previous leading sectors have revolutionized the conditions of life of relatively small segments of the labor force. For example, the automatic loom of the nineteenth century bankrupted those who wove cloth in their homes--the handloom weavers--and transformed the weaving business from one in which the entrepreneur rode from village to village dropping off yarn and collecting cloth to one of factories and steam engines. But it left the conditions of life of others largely unchanged, save that clothes became much, much cheaper.

Today's leading sectors, however, might--but might not--radically change the conditions of life of nearly everyone: those who use information to direct enterprises (managers), who process information in their jobs (white-collar workers), and who use information to decide what to buy (consumers) (Cairncross (1997)).

Moreover, "information" might have to be defined very broadly. As Danny Quah of the London School of Economics puts it, when you think of a typical "information good" you should think of a pair of Nikes. The Nikes may not look like an information good: they look like a pair of shoes, made of leather, cloth, and plastic rather than of bits of information. But what does the consumer see when he or she looks at or wears the Nikes? They are shoes, yes, but more important to the consumer--the source of more value, utility, satisfaction--is that the Nikes are a symbolic link to the basketball star Michael Jordan. This desire for symbolic links to those we admire and respect is very human, and modern information and telecommunications technologies enable the Nike Corporation to mass-produce such symbolic links to Michael Jordan. Some people read biographies or articles or accounts of games. Others wear shoes. Thus Nike is perhaps an information-economy company.

But why should the fact that today's leading sectors revolutionize the production and distribution of information make a difference? Why is information special?

Information is special because the invisible hand of the market may do a much poorer job at arranging and controlling the economy when most of the value produced is in the form of information goods. For the past two hundred years reliance on competitive markets to produce economic growth and prosperity has, by and large, proven a good bet. But the invisible hand of the market does a good job only if three preconditions are met (see DeLong and Froomkin (1997)): the typical commodity must be excludible, so that its owner can easily and cheaply keep others from using or enjoying it without his or her permission; the typical commodity must be rival, so that if I am using it now, you cannot be; And the typical commodity must be transparent: purchasers must know what they are buying.

Now non "information good" commodities take the form of single physical object--hammers, cars, steaks--and are rival and excludible by nature. If I am using my hammer, you are not. The process of distribution made transparency straightforward as well: if I am buying this car from this showroom, I can see it, touch it, drive it, and kick it before writing the check.

But if a commodity is not "excludible"--if I the owner cannot block you from using it if you have not paid for it--then my relationship to you is not the relationship of seller to buyer, but much more that of a participant in a gift exchange: I give you something, and out of gratitude and reciprocity you give something back to me. Think of an economy run like a public radio pledge drive. It doesn't work very well--the revenue raised is a small fraction of the value gained by consumers--and the process of collecting the revenue is very annoying.

If a commodity is not "rival," then the market will not set its price correctly. If my using it does not keep you from doing so, then there is a sense in which its price should be zero: things should cost only if they use up scarce resources. But no producer can make a profit selling a commodity at a price of zero. Only a producer with substantial market power can keep the price of such a commodity up, and so if the typical commodity is non-rival then we can expect monopoly to become the rule rather than the exception in the structure of industry.

If a commodity is not transparent, then markets may fail completely. Think of a private individual trying to buy health insurance: the insurance company responds with: "Why do you want this? You must be sick in an expensive way. It raises the price until only the truly and expensively sick want to try to buy insurance, and the market breaks down. Yet information goods are by their nature non-transparent: if you know what the piece of information is that you are buying, then you already have it.

Thus if these three conditions are not met, there is reason to think that the Invisible Hand will not work well.

Words distributed in electronic form (and, with improvements in scanner technology, words distributed in books and magazines as well) are becoming non-excludible. Information goods are by definition non-transparent: if you know what the piece of information is that you are buying, you don't need to buy it. Software is becoming non-transparent as well: when you purchased Microsoft Word or Wordperfect for the first time did you fully realize that you were committing yourself to a long-run path of upgrades and file-format revisions? Computerized words, images, programs are nonrival: the file doesn't know whether it is the second or the two-thousandth copy of itself.

How far will this process extend? Will it confine itself to a relatively small set of e-goods, or will it extend to cover the rest of the economy as well? We do not really know.

It is possible that we are looking forward to an information-age economy in which the gap between the productivity level that our technologies could deliver and the productivity level that our market economy produces grows increasingly large. It is possible--although how likely we do not know--that in an information-age economy the successful businesses will not be those that focus on making better products but those that focus on how to induce consumers to pay for what they use. It is possibel that in an information-age economy firms that can exert intellectual property rights will charge greatly excessive prices for what they know, thus limiting demand.

In such a world the tasks of government regulators would become infinitely more difficult. The very nature of the commodities produced would be undermining the supports that the market economy needs in order to function well. The role of the government would then be one of shoring up these supports: doing whatever it could to create a simulacrum of market competition and to try to restore the profitability of useful innovation. For if we want to continue to rely on the invisible hand of the market, and if the nature of commodities no longer guarantees that the goods sold are excludible, rival, and transparent, then the economic system will function well only insofar as the government can change the rules of the game in order to make people act as if the valuable commodities in the economy are still excludible, rival, and transparent.

The antitrust division of the Justice Department might become the most important branch of the government, as it tries to keep the structure of industry as competitive as possible.

This vision of the future information-age economy--if it should develop, and I cannot now estimate the probability that it will--would certainly be a new economy. But this new economy that we may see in the future has nothing to do with the image of the new economy that we hear about today.



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My earlier critique of Kevin Kelly: Old Rules for the New Economy, in REWIRED

Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax

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