Venture capital won't fall overnight--right now, many venture-capital funds are flush with money from investors who want to get a share of the recent sky-high returns. But eventually, when the market goes down and venture returns diminish, investor interest will wane as well. And fewer companies would be funded, for smaller amounts. This drought would have pervasive effects throughout the economy:
-- Innovation and productivity. Many new products are still in the pipeline, notably in the wireless area. Nevertheless, without continual pressure from aggressive startups, the U.S. will lose much of the accelerated leap from idea to market that characterizes the New Economy.
How important would this be? New figures from the Bureau of Labor Statistics (BLS) show that more than half of the productivity gains in 1995-1998 came from accelerated technological change. No one knows how much of that is driven by risk capital, but consider this: Almost all the truly successful new tech companies in recent years were funded by venture capital and IPOs.
-- Business investment. During the second half of the 1990s, capital spending rose at an annual rate of 11%, far faster than forecasters predicted. In large part, this reflected the falling cost of investment goods over the past five years. Meanwhile, the Internet and other new technologies meant that companies had to invest to keep up with competitors, even if there was no obvious payoff.
When the tech cycle turns down, spending on information technology and the Internet will still offer big benefits. But as innovation and the economy slow, it will become harder to justify upgrading computer and telecom systems as often. It will become more difficult to justify investments without a clear payoff.
If the economy slows enough, even companies that still believe in the benefits of information technology will be forced to make cuts. It's a simple matter of arithmetic--tech spending now makes up 40% of business investment spending, so it will be hard to protect. Indeed, tech represents 63% of nontransportation equipment spending. There is no other place to trim.
-- Inflation. In the early stages of the tech downturn, the economy will paradoxically become much more inflation-prone. Labor and product markets will still be tight, so as productivity growth slows and investment falls off, companies will not be able to absorb wage increases without raising prices. And large companies will have less reason to restrain themselves from raising prices because they will have less fear of competition from startups.
The slowing of innovation will also directly boost inflation. In the second half of the 1990s, rapidly falling prices for software and information technology sliced about a half-percentage point from inflation. As innovation slows, it's likely that tech prices will fall at a slower rate.
-- Employment. This is going to be a Palm Pilot recession. Almost 60% of the new jobs generated between 1995 and 2000 were managerial or professional jobs, and those will be hit hard by the tech cycle downturn.
The first wave has already come this year, as struggling dot-coms have laid off almost 17,000 workers, according to outplacement firm Challenger, Gray & Christmas. As innovation slows, fewer people will be needed to create new products and companies, leading to job cutbacks at high-tech firms. The layoffs will eventually stretch from the telecoms to the software makers to the consulting firms.
Particularly vulnerable will be the floating workforce of temporary workers, independent consultants, free-lancers, programmers, and Web designers-for-hire who have thrived in the boom. As of early 2000, such employees of temp firms made up a much larger 2.7% of total jobs, up from 0.6% in 1981. And that number doesn't include independent contractors or temporary workers directly hired by companies, who according to the BLS make up at least an additional 6% of the workforce. These people will find that companies have a lot less need for them when growth slows down.
-- The stock market. In the New Economy, the stock market is an essential part of the tech cycle, rising and falling with the overall economy. Add in rising inflation and a slump in business investment, and it's likely that stocks will plunge sharply when the tech cycle turns down.
All this may seem excessively dire. After all, a wave of new technology could stimulate demand, just as the Internet did. Moreover, even if a downturn does start, most economists have an almost religious faith in the power of the central bank to prevent it from going too far. It is widely accepted that if the economy ever seemed about to fall off the edge, the Fed would cut interest rates sharply.
But this sanguine conclusion assumes that policymakers will be able to recognize when the tech cycle turns down and draw the correct conclusions about how to react. In fact, policy mistakes are more likely when an economy is in flux and the old institutions and rules don't fit anymore.
For example, economic historians now agree that the Fed's tight money policies in the late 1920s and early 1930s turned a garden-variety stock-market crash and recession into the Great Depression. Similarly, an extended series of mistakes by the Bank of Japan transformed the stock-market decline of 1990 and 1991 into a depression. And pressure from the International Monetary Fund to raise interest rates greatly worsened the Asian crisis of 1997. In all these cases, policymakers failed to recognize the true nature of the dangers they faced.
It's important to note that the economists who tell you today not to worry about a deep recession are exactly the same people who completely missed predicting the tech-driven boom of the 1990s, as well as the 1997 Asian crisis. Even after the crisis started, forecasters badly underestimated how bad it would be.
In the case of the New Economy, the real question will be how the Fed reacts when faced with a slowdown in productivity growth and the corresponding increase in inflation. On an intellectual level, economists in Washington and on Wall Street concede the importance of computers and the Internet. But with the exception of Fed Chairman Alan Greenspan and a few others, most economists have not fully embraced the New Economy. Such techno-pessimists will welcome a productivity slowdown as a return to normalcy. There will be a tendency to view a downturn--even a steep one--as the natural response to the excesses of the 1990s. Their response to a recession will be to let the economy fall back to what they consider a "sustainable" level of output.
Indeed, there may be broad calls for the Fed to raise rates if the dollar starts to plummet. The U.S. economy has become dependent on foreign capital flows, with 23% of investment being funded from abroad. This money has been drawn to the U.S. by the high returns, and a tech slowdown could send foreign investors rushing for the door, especially since it would hit the tech-driven U.S. economy harder than others. The result could be a sharp devaluation of the dollar that would make it hard to cut rates.
Nevertheless, the correct response to a tech cycle downturn and a productivity slowdown is to lower interest rates as soon as possible. If the Old Economy was an automobile, the New Economy is an airplane. In an auto, if anything unexpected happens, the natural and correct response is to put on the brakes. But just as an airplane needs a certain airspeed in order to stay aloft, so the New Economy needs fast growth for high-risk investment in innovation to be worthwhile.
Just as pilots learn how to deal with a stalled and falling plane by the counterintuitive maneuver of pointing the nose to the ground and accelerating, policymakers have to learn how to go against their instincts by cutting rates when productivity slows and inflation goes up. That's the only way to keep from crashing.
After an unprecedented expansion, it's tempting to believe it will go on indefinitely. But the New Economy has never been about sunny skies forever--and it's time to start thinking about what happens when the storm comes.
Adapted from The Coming Internet Depression: Why the High-Tech Boom Will Go Bust, Why the Crash Will Be Worse Than You Think, and How To Prosper Afterwards (Basic Books). Copyright 2000 by Michael J. Mandel
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Carl
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