The New Economy and Productivity Growth
Economics 115: 11:45 TR
Professor Linda Kamas
January 25, 2005
Cameron Morris
Trung Huynh
Executive Summary
The main findings in this paper are the following:

Productivity is an important economic indicator of our standard of living. There
are three sources that affect productivity growth.

Productivity over the past 30 years has been affected by stagflation due to the oil
shocks, change in demographics, and the IT boom.

The U.S. enjoyed its longest expansion in history as a direct result of IT with
some assistance from globalization, deregulation, and loose fiscal policy.

The “productivity paradox” has been solved due to IT having an effect on
productivity after being introduced to the mainstream in the early 1970s.

There is a correlation between labor productivity and capital deepening. Those
firms with higher IT stock saw productivity increase.

IT has changed the structure of the economy by improving MFP.

The “New Economy” phenomenon is simply an expansion of old economic rules.

European productivity grew at the same pace with U.S with the absence of an IT
boom.

There are some important aspects of the “New Economy” that are often
overlooked.

An historic comparison of the “new economy” to similar events at the end of the
19th century and beginning of the 20th century helps forecast what might happen
in the future.

There is empirical evidence showing declining growth in GDP and IT, but a rise
in productivity.
I. Productivity Defined and Growth History
Productivity, defined as the output per worker, per unit of given input, is one of
the most important economic indicators in that it largely determines the standard of living
in an economy. If productivity remained stagnant, per capita income would also remain
stagnant as total income would only grow proportionally to the workforce. (Council of
Economic Advisors 2004, 52). In contrast, productivity growth causes income per person
to increase and thus, allows society to improve their standard of living through the
purchase of more goods and services at a lower cost. Three main factors determine
productivity growth (Koenig): capital deepening, human capital, and multi-factor
productivity. Capital deepening, the increase in capital per worker, improves
productivity growth by giving workers additional tools and equipment to work with in
order to complete their jobs done more efficiently. However, increasing capital per
worker will not improve productivity unless employees are qualified to use the capital
productively (labor quality). Therefore, the amount of experience and schooling of a
workforce, sometimes referred to as human capital, is a determinant of productivity
growth. A third way to boost the economy is by increasing multi-factor productivity
(MFP), or total factor productivity (TFP), which the BLS defines as those attributes of
productivity growth that cannot be explained by capital deepening and labor quality.
Essentially, MFP or TFTP measures mainly technological progress, which the National
Association for Business Economics (NABE) defines as any advance that allows more
output to be produced with the same amount of labor and capital (Arnold and Dennis 8).
Productivity growth has varied from the early 1970s to 1995 due to cyclical
conditions. After growing 2.8 percent annually from the start of World War II to 1973,
productivity growth slipped to a dismal 1.3 percent (Krugman 57 and Stiroh 1).
Economists have not found an exact source for the decline in productivity, high
unemployment and inflation rates (stagflation). The oil shocks, which raised the real
price of energy by 45 percent between 1973 and 1974, may have caused productivity
growth to fall, but economists are puzzled as to why productivity did not grow back to its
normal rate (Employment Policy Foundation). Edward Denison and Robert Arnold
conclude that other factors besides the oil shocks had a negative effect on productivity.
The introduction of inexperienced baby boomers in the labor force and the high inflation
rate on conducting business transactions are just few of the many factors (Arnold and
Dennis 9-10). Productivity in the 80s remained at around 1.3 percent due to the same
factors Denison and Arnold described, but quickly jumped, recovered, and accelerated as
a result of the IT boom of the 90s.
II. The New Economy Justified
According to the BLS, the U.S. economy experienced the longest economic
expansion in history from March 1991 to March 2001. Real GDP grew at an annual rate
of 4.0 percent, the unemployment rate dropped to 3.9 (with an increase of 20 million
jobs), the budget surplus increased to $124 bilion, and inflation decreased to levels not
seen since 1965 (Council of Economic Advisors 2001, 19-20). The prosperous period
can be partially attributed to globalization, deregulation, and fiscal/monetary policies.
However, rapid improvement in information technology was clearly a major factor in the
economic boom of the late 1990s, causing some economists to conclude that a “new
economy” had emerged. The sustainability of the economy due to IT remains to be a
topic of discussion. Proponents of the “new economy” argue that the production and use
IT fundamentally changed the structure of the U.S. economy, leading to a “…permanent
improvement in growth prospects” (Jorgenson 1).
Due to the surge in information technology investments and the rise in
productivity levels in the late 1990s, many economists and ordinary people were
convinced that a “new economy” in the U.S. had emerged. Computers became more
powerful and cheaper than ever, as a result of Moore’s law (see Chart 1). Firms ceased
the opportunity to invest heavily in IT in hopes of improving profits by increasing
internal efficiencies in production, logistics, and support (see Chart 3 and 4). The
increase in demand for IT caused a chain reaction throughout the whole economy.
Investors saw the possible monetary rewards of investing in the IT sector, causing the
amount of venture capital to increase from $3.4 billion in 1991 to $10.0 billion in 1996.
(U.S. Small Business Administration). With the support of investors, the stock market
had a total return of nearly 200 percent, or 24 percent per year, and the number of
technology firms doubled from 1990 to 1997, as seen in Chart 2 (Council of Economic
Advisors 2001). In 2001, the IT sector accounted for 8.3 of GDP, up from 5.8 in 1990.
As a result of the influx of newly founded IT companies, the unemployment rate
dropped to 4.0 percent by 2000, the lowest since 1965 (see Chart 5). Coupled with the
drop in the unemployment rate and the wealth generated in the stock market, real
disposable personal income increased 3.7 percent annually in 1999 (Council of Economic
Advisors 2000). As expected, the increase in disposable income significantly affected
GDP growth. Accounting for nearly 70 percent of GDP, real personal consumption
expenditures (PCE) grew at a 5.4 percent annual rate, compared to 5.1 percent in the
previous year. Increased disposable income due to the rise in the stock market, the hiring
of more workers, and a low inflation rate of 2.9, were the main forces behind the 4.2
percent growth (seasonally adjusted chained 2000 dollars) in the economy in 1998
(BEA).
Proponents of the “new economy” argue that the structure of the economy has
been altered permanently due to IT. Opponents dismiss the argument by stating that the
power of computers failed to show gains in productivity statistics in the 70s and 80s and
thus, say that the new economy was only temporary. The reason for the “productivity
paradox,” however, was due to computers being introduced in the mainstream.
Companies such as Apple and Microsoft, the most noticeable players in the technology
sector, have only been in existence since then. Computers were not cheap and powerful
enough to work well in a wide range of application (The New Economy Index).
Additionally, the Internet was not a mass medium until the early 90s. New innovations
take time before being fully embraced. Since the lag between introduction and utilization
of information technology is now over, the potential in efficiencies that IT brings is now
being realized by firms.
Efficiencies in manufacturing, distribution, and support were all improved by IT.
Supply-chain and inventory management were streamlined, improving communication
with suppliers, minimizing factory downtime, and increasing product availability to
consumers (see chart 6), according to New York Federal Reserve economist Kevin Stiroh
and the Council of Economic Advisors (Stiroh 2). IT also improved automation
production processes and new product designs, which helped reduce costs significantly
(Council of Economic Advisors 116). Since the benefits of IT were able to be had
inexpensively due to Moore’s Law, firms were inclined to invest in IT to maximize their
internal efficiencies by increasing productivity and lowering costs. Capital deepening of
IT hardware and software reached nearly $2 trillion from 1996 to 2000 (Stiroh 3).
The acceleration of labor productivity from an annual rate of 1.4 percent from
1973 to 1995 to 2.9 percent by 1999 was primarily due to investments in IT (1). “New
economy” economists calculated a relationship between IT investment and productivity
gains across several industries (Council of Economic Advisors and Stiroh 2). Using
1987-99 data on real gross output and full-time-equivalent workers from the BEA, the
New York Federal Reserve found that eight of the ten major sectors in the U.S. economy
saw productivity growth after 1995, as shown in Chart 8 (Stiroh 3). Next, the New York
Fed measured the percentage of IT capital of capital stock invested in the same sectors.
Shown in Chart 9, 20.7 percent of the value of the capital stock in the wholesale trade
sector, for instance, was in IT hardware and software. The analysis shows that firms with
the most IT invested saw the largest productivity increases.
Stiroh also compared the change in average productivity growth from 1987 to
1995 and 1995 to 1999 for industries that produced IT, industries that were IT intensive
(defined as industries with IT capital stock above the 1995 median of 3.8), and industries
that were not. Stiroh found that the IT producing industries saw their productivity
accelerate 3.7 weighted percentage points, while IT intensive industries showed an
average productivity growth of 1.4 weighted percentage points (5). Industries that were
not IT intensive saw productivity increases of only 0.1 weighted percentage points (see
Chart 10).
Although the use of IT (capital deepening), was the main factor behind the
economic prosperity and is therefore, subject to diminishing marginal returns under the
Neoclassical model, MFP or TFP in technology helped increase productivity growth as
well. 1.2 percentage points of the productivity growth between 1995 and 1999 was
attributed to MFP or TFP, of which 0.9 percentage points came from non IT producing
sectors, represented in Chart 11 (Fernald and Ramnath 4; Council of Economic
Advisors). MFP or TFTP grew as a result of government policies that encouraged
competition such as the Telecommunications Act of 1996 and the Research and
Experimentation tax credit. These policies helped R&D spending grow at an annual rate
of 6 percent between 1995 and 1999 (Council of Economic Advisors 2001, 98 and 105).
The increase in MFP or TFP, therefore, meant that employees were also working smarter
with the increase in capital, rather than harder. The increase also means that the
productivity growth experienced was not cyclical, but structural.
The role that IT played in the late 1990s continues to have an impact on
productivity. The structural changes that IT caused continue to raise productivity despite
the recent recession.
Data from the past several quarters showed that productivity grew
at an annual rate of 4.0 percent (Council of Economic Advisors 2004, 51). The 1.2
increase will improve living standards in the coming years by dramatically reducing the
amount of years it takes to double productivity. The continuation of productivity growth
further supports the argument that a sustainable “new economy” has emerged, mainly due
to the improvements in IT.
III. Arguments Against “New Economy”
“Every evolving market economy, our own included, is always, in some sense,
“new”, as we struggle to increase standards of living.” (Greenspan, p2) This was Alan
Greenspan’s response to the question: Is there a New Economy? This statement reflects
the claims made by many dissenting economists that argue that there actually is no “new
economy”. The underlying claim by dissenting economists is that the economy is in a
state of constant change as capital equipment, production processes, financial and labor
market infrastructure and private institutions evolve to become more efficient and
increase overall standard of living. They argue that changes are being made within the
framework of “old” economic rules and that the “new economy” may just be part of a
larger cyclical process similar to events at the end of 19th and beginning of the 20th
century.
Alan Greenspan takes a very clean shot at the “new economy”, he suggests that
the evolution in the economy has more to do with human psychology than IT investment
or any concrete change in economic theory. As humans in a competitive market system
we are always trying to find ways to efficiently fill supply and demand. In the late 90’s
this came in the form of increased IT investment and increased productivity growth.
Greenspan briefly drew a parallel between the tech boom in the late 90’s and the
industrial revolution, noting how both events revolutionized how we did things but they
didn’t take us away from out fundamental competitive market system. Greenspan
maintains that much of the American economic expansion was the result of favorable
expectations, interacting with production and finance to expand rather than implode our
economic processes.
Larry Mishell of the Economic Policy Institute agrees with Greenspan’s claims
that the “new economy” is merely an expanded version of the old economy with
increased technological capabilities, but he points out many problems with current
economic trends. In looking past high productivity growth and astronomical tech
investment Mishell finds several caveats in the system. Our record growth in GDP wasn’t
only caused by increased productivity, it was also caused by increased hours worked, and
as the average number of hours worked went up compensation went down. Gone are
dreams of taking siestas while drowns do work for us, we must now rely on increased
productivity through IT investment and longer hours worked if we want to maintain our
current levels of productivity growth and pay for government disasters such as social
security. What is particularly disturbing is that compensation in the manufacturing sector
(which accounts for 70% of jobs in the U.S.) is lurching down. We are also seeing a
decrease in the gap between low income and middle income levels, the later converging
with the former. These two caveats are driving an increasingly larger wedge between the
rich and the poor. These statistics have been largely overlooked in the hype of the “new
economy” and will surely have adverse effects in the future.
Mr. Mishel also compares the U.S. and European economies in a different light
than many of his counterparts. He points out that in 1999 some European nations had
similar levels of production as the U.S., but that they were not being fueled solely by an
IT boom. During the same period Europe’s multi-factor production was growing at a
faster rate than in the U.S., which shows that either the IT boom hasn’t shook down to all
economic sectors or that IT investment can’t single handedly create sustainable growth
and increase multiple factor productivity. This comparison shows that the “new
economy” isn’t so much as a superior way as a different way of doing things and that it
will not shake the foundation that competitive market lazes-faire economics is based on.
Laurence Meyer, a former member of the Federal Reserve board of governors,
explains improved U.S. economic performance in terms of “new parameters in the old
paradigm”. He attributes U.S. success to an expanded version of very rudimentary supply
and demand rules. Mr. Meyer feels that hear say concerning a new economy is nearly
economists bantering about the future prospects of IT rather than any fundamental
changes that are occurring.
Meyer uses the following economic theory to explain the phenomena of the new
economy:
During the period over which productivity has accelerated, demand has grown
faster than potential supply. The demand effects – to the extent that they are
directly related to the productivity shock – likely reflect the more favorable
investment opportunities, the effect of expected profitability on equity prices and
hence household wealth and consumption, and the effect of the increase in
expected future labor income on current consumption. Demand, it appears,
received an additional boost over this period from a run-up in equity prices that the
higher productivity growth alone could not fully account for.
The balance between supply and demand can be inferred from movements in
utilization rates, specifically in the unemployment rate. When actual output is
expanding at the same pace as potential, the unemployment rate will be stable.
When output growth outpaces the growth of potential, the unemployment rate
declines.
(Meyer, p4)
This analysis clearly explains “new economy” phenomena using “old economy” theory
which shows that the foundation on which our economy functions has not changed
significantly.
The last approach that economists take to disprove the “new economy” is an
historic one. At the end of the 19th century a boom in transport capabilities, mainly
steamboats and railways, ushered in the “first era of globalization”. At the time many
economist felt that these improvements in transport and communications would spurn
sustainable growth which would see developing nations converge with developed
nations, commodity price convergence, and a universal divisions of labor.
Currently most people aren’t even aware that there was a “first era of
globalization”. This is because of the speed in which it fell apart. Within twenty years the
“first era of globalization” had fallen apart in large part due to inadequate trade models,
the great depression, and war. In our present state of globalization IT improvements can
be looked at as the “new” steamboats and railroads. With this in mind we can look at the
current state of affairs and see that we are living in a rather volatile international
community. We aren’t completely aware of the long-term effects IT improvements will
have on trade. The gap between the developed and developing nations is at an all-time
high and we are living in a tumultuous world where the actions of very few nations can
strangle our economy through cutting our oil supply. There are many parallels between
our present condition and the state we were in in the beginning of the 20th century. That
being said, globalization, increased productivity, technological improvements, and
unsustainable high growth might just be part of a larger cyclical process.
IV. Empirical Evidence
Although opponents argue that the recent decline in GDP and IT investment show
that the economy only went through a normal business cycle, there are several pieces of
evidence that suggest that there is, in fact, a “new economy.” Despite the recent
recession, productivity continued to rise at an annual rate of 4.0 percent since 2000 (see
chart 13), according to the Council of Economic Advisors (51). The rise can be
attributed to the increase in MFP or TFTP, which resulted from the IT boom of the 1990s.
The inflation rate has also been stabilized due to the long-term effects of IT on
productivity, which kept labor costs down. The core CPI only grew 1.1 percent during
2003, significantly lower than the 1.9 percent increase in 2002 (100).
Empirical evidence clearly shows that the growth rates in the late 90’s were not
sustainable, suggesting that the economy was merely going through a business cycle.
After achieving GDP growth above 4% for three straight years in the late 90’s the
economy plummeted in 2001 and 2002 with growth rates of 0.8% and 1.9%. Although
GDP isn’t the best indicator of a “new economy” this is still a very significant decrease in
total output. Something more significant to look at is the sharp decrease in IT production
in 2001 and 2002. After producing $500 billion in IT in 2000, the IT industry took a
sharp downward turn in 2001 and 2002 going down to $418 billion and $385 billion. The
40% increase in IT expenditure in the late 90’s was clearly unsustainable and the 20%
decrease in IT expenditure in 2001 may be a sign that the market for current IT products
is saturated. As outlined above, IT driven productivity has not caught on abroad like it
did in the U.S. in the late 90’s, this is another sign that a “new economy” may not exist.
While total output figures suggest that the “new economy” may have been just a
business cycle, productivity figures certainly do not. On the other hand productivity has
continued to rise despite the drop in total output. This may have to do with other factors
such as an increase in hours worked and a delayed effect of IT improvements. Even
though IT expenditure sharply declined firms may still be learning how to get the most
out of their new IT equipment. If this is true then productivity growth would be expected
to falter within a few years. To sustain productivity growth we will have to follow an age
old paradigm “work smarter or work harder”, either through steady improvements and a
renewed commitment to IT investment or an increase in hours worked through some sort
of aggressive flexible work plan.
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