- The Washington Times - Friday, June 23, 2000

It is great to see that Alan Greenspan has come back to planet Earth to acknowledge that the Internet economy and the related boom in productivity-enhancing technology investment really is a good thing after all. This was the gist of his recent speech to New York business economists.

Last winter, however, the Fed chairman was singing a different tune. He argued then that technology-driven productivity increases actually had a dark side. Rising productivity, higher profits and strong stock prices, you see, are really inflationary.

This baffled roughly 100 million American investors who were enjoying the wealth- and job-creating benefits of the stock market bull. But Mr. Greenspan repeatedly asserted that productivity-driven stock market wealth is really a bad thing because it led to "excess demand" and inflation. Too many people working, producing, prospering and consuming. Got it?

Now the Jekyll and Hyde central banker is apparently returning to the healthy side of his economic schizophrenia, the side he initially emphasized in various speeches during 1998 and 1999. Borrowing from my favorite dead economist, Joseph Schumpeter, the new new Mr. Greenspan told economists last Tuesday that "Our economy is benefiting from structural gains in productivity that have been driven by a remarkable wave of technological innovation."

This is not the place to compare and critique the literary merits of "Dr. Jekyll & Mr. Hyde" creator Robert Louis Stevenson vs. technology growth-model creator Joseph Schumpeter. They're both important authors. Of the two, I would rather have Mr. Greenspan be more fluent in the works of Schumpeter, the eminent technologist. Though Stevenson's other great work, "Treasure Island," did have an upbeat and optimistic ending.

But let us return to Mr. Greenspan. He told the New York economists that "What differentiates this period from other periods in our history is the extraordinary role played by information and communications technologies… . The effect of these technologies could rival and arguably even surpass the impact the telegraph had prior to and just after the Civil War." Imagine that.

Much of Mr. Greenspan's text was taken from the Commerce Department's excellent new study titled "Digital Economy 2000," prepared by Undersecretary Robert J. Shapiro, an innovative New Democrat who serves under the free trade and pro-business Commerce Secretary William M. Daley, recently tapped to become Al Gore's campaign chairman.

This report argues for new era economic prosperity driven by falling technology prices, rising productivity and "cheaper and rapidly increasing electronic connectivity." This year the number of people with Internet access will reach an estimated 304 million people worldwide, up nearly 80 percent from 1999.

As investment in information technology equipment and software more than doubled over the past four years, IT contributed about 30 percent to overall economic growth and roughly 75 percent to the record expansion of business investment. Meanwhile, computer prices in the digital economy, which fell by 12 percent yearly between 1987 and 1994, accelerated to a 26 percent rate of decline during 1995-1999.

The falling prices of IT goods and services have reduced overall U.S. inflation during the past five years by roughly one-half of 1 percent yearly, from 2.3 percent to 1.8 percent. Of course, technology deflation has coincided, indeed, one might even say caused, the better than 4 percent rate of economic growth during this period.

Both the Greenspan speech and the Commerce Department digital economy report draw heavily from an internal Federal Reserve report, "The Resurgence of Growth in the Late 1990s: Is Information Technology the Story?," by Stephen D. Oliner and Daniel E. Sichel.

Messrs. Oliner and Sichel believe the new economy has significantly increased productivity growth, mainly in response to surging IT investment. This process is called "capital deepening," where the amount of capital rises in relation to the amount of labor hours.

(Economics 101 students will recognize the old K/L ratio. When capital rises faster than labor work, productivity heightens.)

The Fed economists show the ratio of the capital stock of computer hardware to hours worked increased, on average, by 16.3 percent annually in the 1991-95 period, and 33.7 percent per year since 1996. Capital deepening in computer software also grew at double-digit rates, with a similar effect in communications equipment investment.

As a result, unexpectedly rapid U.S. productivity has provided a booster-rocket for the economy that has unleashed rapid growth and suppressed inflation. Output-per-hour has advanced by nearly 3 percent annually over the past four years, compared to only a growth of only 1.4 percent during the prior two decades. Non-financial corporate productivity is increasing by nearly 4 percent yearly, manufacturing productivity by more than 6 percent.

In other words, the Internet economy is more important than the Fed. More IT investment has retooled the economy and the work force. Output, productivity, profits and stock prices go up. Inflation goes down.

It is comparable to a supply-side tax-cut that expands the economy's potential to grow. Not a one-time effect, but a recurring effect (from spillovers and applications) that leads to increasing returns to risk capital and production scale.

Stanford economist Paul Romer calls it the new law of increasing returns. It replaces the old law of diminishing returns. Mr. Romer, and the spirit of Joseph Schumpeter, combine with the optimistic economic growth model of Arthur Laffer: an unbeatable combination.

If only the Fed would leave well enough alone. Mr. Greenspan's recent speech could put him back on the Internet economy growth track, but it is hard to know for sure. Can we count on him to be the good Dr. Jekyll? Or must we fear that he will return as the bad Mr. Hyde?

The Fed's newest Malthusian, Phillips Curve-NAIRU (non-accelerating inflation rate of unemployment) chief proponent of the forces of darkness, Laurence Meyer, believes the nation's 4 percent unemployment rate must rise to more than 5 percent in order to prevent inflation. Think of him as Mr. Hyde.

If the Meyer/Hyde view prevails, U.S. workers will lose about 2 million of their jobs during the next year or so, as overkill interest rate increases terminate jobs, reduce labor force participation, and move the economy into a growth recession, or worse.

All for a buggy-whip austerity theory that is empirically unproven. Indeed, the evidence disproves the Phillips Curve model. Silicon Valley is winning big over the people's republic of Cambridge, Mass. If anyone cares to notice.

So will the Fed change its stripes? Is Mr. Greenspan making a statement that the tightening cycle is over? Will he stand down the Meyer-led Gang of Three austerity campaign? Will Dr. Jekyll put a stake in Mr. Hyde's hide?

Let us all try to stay optimistic on this. At least over the longer term, there's no stopping the Internet economy. Sometimes, however, in the short run, fact can often be worse than fiction.

Lawrence Kudlow is chief U.S. investment strategist and chief U.S. economist at ING Barings LLC.



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