Commentary Magazine

Crash or Boom?

For an economist these days, it is difficult even to attend a cocktail party without being asked whether we are, indeed, living in a new economy. (The next query—peculiar to New York—is “Where do you think the price of co-ops is headed?”) Though the question may be posed for personal reasons, the answer one gives to it is far more consequential than whether bulls or bears will end up with the last laugh and the fattest IRA’s.

Private gains or losses, however vital they may be to the individuals involved, and however interesting to the television channels that cover the markets around the clock, or the newsletters that combine financial analysis with “human interest” stories on the size of houses in Silicon Valley, are, in most instances, of no concern to public policy. But as Robert J. Shiller of Yale argues in his recent book, Irrational Exuberance,1 in addressing the gyrations and, to some, astonishing levels of today’s stock market we are not dealing merely with private winners and losers, but rather with “an important national—indeed international—issue”:

All of our plans for the future, as individuals and as a society, binge on our perceived wealth, and plans can be thrown into disarray if much of that wealth evaporates tomorrow. The tendency for speculative bubbles to grow and then contract can make for very uneven distribution of wealth. It may even cause many of us, at times, to question the very viability of our capitalist and free-market institutions.

As the title of his book suggests, Shiller himself concludes that the current level of the stock market is, in fact, irrationally high, being the result of “wishful thinking on the part of investors” rather than of a “consistent estimation of real value.” And that conclusion implies in turn that we are still living in the old, familiar economy—the one in which share values can become inflated by periodic outbreaks of speculative fervor and in which trouble, inevitably, lies in wait.

In this assessment, Shiller is hardly alone. Among the spate of new books on our current economic situation, there is no dearth of authors warning of “unfettered speculation,”2 of a market fated to crash,3 and of bubbles that will surely burst like past bubbles in the markets for tulips,4 or Mississippi land,5 or British trading rights in the South Seas.6 Nor is Shiller alone in foreseeing not just a temporary setback in the financial markets but, as he puts it, “a poor long-run outlook for the stock market” in general.

Others, however, emphatically disagree, assuring us that the financial markets remain the best place to stash money for the long term7 and that “Tomorrow, stock prices could immediately double, triple, or even quadruple and still not be too expensive.”8

Shiller and those who think as he does are certainly right about one thing: if the bursting of speculative bubbles does involve more than a redistribution of income from losers to winners (which is not at all certain), and if (as Edward Chancellor argues in Devil Take the Hindmost) the ameliorative tools available to government are inadequate in a world of rapid currency movements, derivatives, and other relatively new trading instruments, then the implications are profound. To put it bluntly, investing Social Security funds in the stock market, a proposal now under lively debate, would then become a sure route to impoverishing the elderly. On the other hand, if history teaches us that “stocks hold the key to enriching the lives of all peoples everywhere” (Jeremy Siegel), and if the future of the stock market is buoyant (James Glassman and Kevin Hassett), then we most certainly should “save” Social Security by arranging for all of us to participate in what truly is a new economy.



Are we or are we not, then, living in that new economy? Unfortunately, the best answer to this question is Clintonesque in character: it depends on what the meaning of “new” is. Certainly there are companies that differ in their corporate style from what we have been accustomed to. And certainly there is a class of entrepreneurs who seem to differ from old-style executives in more than their taste for Dockers trousers—tending, for example, to be more suspicious of government intervention in economic affairs, more libertarian in their social outlook, greener in their positions on environmental issues, more likely to manage their own philanthropic activities, and less committed to either political party. But those who speak of a new economy have something much more sweeping in mind. For the investors among them, encouraged by thirty-something brokers, “new” means, essentially, financial markets in which share prices are certain to rise over the long term and in which temporary declines, even precipitous ones, are only so many “buying opportunities.” For others, it means an economy so dynamic, with a Federal Reserve Board possessed of such powerful and finely calibrated instruments, that we need never again see a significant downturn. In short, “new” means an economy in which there is only one escalator, and it is marked “up.”

In those particular senses of “new,” it is safe to say that we are not living in a new economy. We have not seen our last hair-raising drop in stock prices, or what one author (Janet Gleeson) calls “terrifying vacillations in markets”—even if, at the moment, it seems to take more to stand investors’ hair on end than it once did. The defanging of several Asian “tiger” economies, the sudden realization that the Mexican economy and its currency were shored up by unsustainable levels of debt, even the phrase “irrational exuberance” tumbling from the lips of Alan Greenspan, the chairman of the Fed, have caused markets all over the world to drop like stones. (In the last of these cases, as Shiller records, the plunge spread from Wall Street to Japan, Hong Kong, and Germany; on the day after Greenspan’s public musing, London’s market followed suit.)

Nor have we seen our last recession. Businessmen will, from time to time, misestimate consumers’ appetites for their goods and services, produce too much, and then, in the face of soaring inventories, contract output and cut back on investments and workforces. Government officials will commit errors—mistiming a change in tax rates, misreading a growth hiccup as a major slowdown, failing to raise interest rates before the inflation genie escapes the bottle, loading American companies with regulations whose costs outweigh the gains in efficiency from investment in new technologies, and so forth. And then there are such things as wars, oil-price shocks, and the like—in short, what British Prime Minister Harold Macmillan once famously said he feared more than anything else in the world: “events, dear boy, events.”

It is true that we know better how to use the tools available to us in order to prevent a recession from cascading into a 1930’s-style depression. In 1907, it took a private citizen, J.P. Morgan, to assume the role of a nonexistent central bank in order to stem financial panic. A few decades later, it took a major depression, and its mishandling by the Federal Reserve, before policy-makers learned what Walter Bagehot, the distinguished British economist, knew in 1873: “the best way for the bank or banks who have the custody of the bank reserve to deal with a drain arising from internal discredit is to lend freely.”9

Today, Alan Greenspan has taught everyone just how effective a remedy that can be. When the U.S. stock market tanked in October 1987, and when, ten years later, the so-called Asian crisis seemed likely to roll over the world’s economies, Greenspan brought matters to a swift resolution by easing the money supply—so swiftly in the latter case that he astonished even George Soros, the world’s most famous currency speculator, who had seen in the Asian “crisis” a herald of the downfall of capitalism itself.10

Still, merely possessing antidepression and anti-bubble-bursting tools is not enough; one has to know how and when to use them. Although Greenspan manifestly does, there is more art than science in his management of monetary policy, and others have not been so successful. Nor will Greenspan, when he retires, have left us with a durable institutional arrangement to compensate for the loss of his special genius, which means that the risk of policy error continues—and that is nothing new.



But if the “new economy” resembles the old economy in that we remain vulnerable to downturns both in financial markets and in the “real” economy, that is not the end of the story, or even its most important part. For there are many things about our present situation—five things in particular—that really do seem new. These developments began to take shape in the 1980’s or a bit earlier, and each of them has to do with the structure of the American economy.

First, until Michael Milken came along, the ownership and the control of America’s large corporations were two separate matters. For the managers, this was a cozy arrangement, giving them a tenure as secure, and as initiative-numbing, as that of any university professor. Rarely did the failure to maximize efficiency and innovation lead to even a threat of forced retirement.

All this changed when Milken found a way to finance the efforts of a class of entrepreneurs who had previously been denied access to long-term credit, and the rest, as they say, is history. Corpocrats who failed to increase the value of the enterprises they had been charged with running now found their companies taken over by Milkenfinanced predators who eliminated both them and the waste they had tolerated. Even more importantly, those same predators took a fresh approach to industries like television news (Ted Turner was an early Milken client) and communications (McGraw Cellular relied on Milken for its start).

Milken himself paid dearly for his assault on the corporate establishment. As John Steele Gordon puts it in The Great Game, he “came to ruin as a financier because he lacked J.P. Morgan’s sense of limits and of the strength of the forces arrayed against him.” But his legacy has been an enduring one: a leaner and meaner American corporate structure, focused on maximizing shareholder value by investing in efficiency-enhancing capital goods, shedding unnecessary layers of management, and welcoming rather than shunning innovation.

A second new element is the tax structure bequeathed to us by Ronald Reagan and only somewhat perverted by his successors. If investment and innovation require incentives, so does hard work. But high marginal tax rates—government appropriation of an undue portion of incremental profits and wages—act as a disincentive to both investment and work. By reducing those rates, Reagan increased the rewards of risk-taking and effort. In no small measure, the willingness of venture capitalists and Internet entrepreneurs to take the all-or-nothing chances associated with developing technologies can be attributed to Reagan’s understanding of what is required to induce the gales of creative destruction that are so essential to the health of capitalism.

A third new feature is really an extension of an older one: greater reliance on competition and free markets to allocate resources among alternative uses. Jimmy Carter started, and Ronald Reagan finished, the deregulation of large swathes of the American economy: airlines, banks, electric utilities, gas companies, trucking, communications. Suddenly, airlines could fly to the destinations that they, rather than some federal regulator, felt would most appeal to travelers—and cut fares if they chose. Dynamic companies like Enron could create new markets in natural gas, bandwidth capacity, and a variety of energy and other products. Electric companies could begin to build smaller, lower-cost power plants in an effort to woo customers from rivals once protected against such raids by their friendly government regulator. Truckers were given the freedom to fill their eighteen-wheelers on inbound as well as outbound trips, and to range over the entire country in pursuit of business.

This newly competitive system, it is important to add, has been actively protected by the Justice Department’s (often unpopular) antitrust division. Thanks to this activism, which recently reached its apex in the Microsoft case, fledgling firms, and the investors to whom they look for venture capital, know that they will not be denied access to markets by a powerful company that can crush others by tying a competing product to one in which it already possesses monopoly power.

Fourth on the list is a new devotion to free trade. This is not to say that protectionism is dead: hard-pressed industries—steel, oil, textiles, and others—often ask for and sometimes get insulation from international rivals. But, by and large, trade is freer than it has ever been. This means that American consumers can count on foreign competition to keep the prices of cars, T-shirts, sneakers, clothing, and other goods at reasonable levels. And the fact that there are ample supplies of workers in the world to meet the needs of these consumers enables the American economy itself to continue expanding without triggering inflation. (Of course, foreign competition based on a “cheap” labor supply puts some American workers in a worse position to bargain for and receive higher wages: hence, their impulse to protectionism.)

Free trade, it must be remembered, is not confined to goods and services or the free movement of capital. It includes, as well, free movement of that other resource, labor. And there is no doubt that the world’s workers are moving, sometimes legally, sometimes clandestinely, to where the opportunities are. For America, this means an augmented supply of labor to empty bedpans, build factories, and satisfy the demand for high-tech personnel.

Fifth, ownership. In 1952, a mere 4 percent of Americans owned stock By 1997, 40 percent of American adults had some sort of ownership stake in the nation’s corporations. Today, the Fed estimates that some 50 percent of Americans are shareholders.

These new capitalists are not all wealthy. Far from it: according to the Fed, the number of stock-owning families with annual incomes in the $25,000-$49,000 range has recently increased by 50 percent. (In the words of the Wall Street Journal‘s Paul Gigot, “The workers of the world are uniting, but not the way Karl Marx imagined.”) This suggests the formation of a much broader political constituency in favor of such market-oriented policies as reduced marginal tax rates and freer trade, which will in turn enhance the durability of the Milken-created revolution.



In combination, these five factors make for a more flexible, more competitive, more innovative—and more productive—economy. And I have not yet mentioned what many would regard as the very heart of the new economy, namely, the revolution in information technology (IT).11 This requires a separate discussion, but one that will take us back to the run-up in the financial markets and its connection, if any, with the “real” economy.

Don Listwin, the executive vice-president of Cisco Systems, an information-technology company whose growth rate can only be described as breathtaking, is one of many who argue that the Internet has repealed all the old rules on how we do business, dealing a card so high and wild (to paraphrase the balladeer Leonard Cohen) that we will never need to deal another. The old economy, Listwin recently told the Wall Street Journal, consisting of buildings and plants and trucks, was and remains vulnerable to such variables as interest rates and oil prices. New-economy companies that are “in the business of delivering intellectual property” are, by contrast, in a wholly different position. “[0]il and interest [rates] aren’t on the radar screen. . . . If there’s a slowdown, that isn’t going to affect us—customers will just squeeze old-world assets even harder.”

Is this true? Here once again we have acknowledged gurus taking opposite positions, with Jack Welch, the CEO of General Electric and possibly the most admired corporate executive in the country, stating flatly that “There is no new economy. It’s the same old economy with new technology.” Perhaps the best way to adjudicate the matter is to examine what is different about overall economic performance in recent years, and then to identify its proximate causes—apart, that is, from the influence of the five structural changes listed above.

The most obvious difference has to do with the behavior of the stock market—more precisely, with the relation of share prices to earnings. Simply put, investors are now willing to pay more for every dollar of earnings than ever before. Indeed, they are willing to lavish billions on companies, mostly in the IT sector, that have never shown a penny of profit and will not soon do so. The flip side of these new valuations is that the cost of raising capital has also come down. It is now easier and cheaper both for established companies and for startups to obtain equity capital, which in turn makes it easier and cheaper for these companies to invest in research and new technologies.

Not for long, however, according to Shiller and others of the “irrational-exuberance” persuasion. In a marked departure from the theory that markets rapidly process all available information, allowing investors to assign rational values to shares and other assets, a new school of thought, known as “behavioral finance,” draws on what Shiller calls the “potent insights” of psychology, history, sociology, and demography to determine whether investors are indeed behaving rationally and hence whether markets are functioning efficiently. The answer: they are not. In the view of Andrei Shleifer, a leading academic member of this school who has written still another of the many books spawned by our period of unparalleled prosperity and intense interest in share prices, “Investors’ deviations from the maxims of economic rationality turn out to be highly pervasive and systematic.”12 It follows that when reason is restored, and fundamentals reassert themselves, share prices will fall—a lot.

But the problem with this entire line of thinking is that its truth or falsity can only be judged after the fact (if then). Consider an investor who buys shares in loss-making because he accepts the premise that the costs of amassing a huge customer base will one day be justified by even larger sales of books, CD’s, drugs, and other products. No analysis of Amazon’s—or the market’s—“fundamentals” would justify such a decision. But until we learn whether Amazon begins to turn fabulous profits or runs out of cash—two opposite scenarios now being predicted by different Wall Street analysts—we will not know whether this investor was behaving rationally or irrationally. And even if he loses his bet, that would not necessarily warrant characterizing his behavior as irrational—wrong, but not irrational.

The same goes for Internet stocks in general. I cannot say whether those gambling that current prices will rise are more likely to win their gamble than those, the so-called “shorts,” who are gambling that prices will fall. Boyan Jovanovic and Peter Rousseau, two scholars of economic history, have reminded us recently in the Wall Street Journal that it might have seemed irrational to buy stock in the Radio Corporation of America at its 1929 price of $114 per share, a high to which it had risen from a low of $1.50 in 1920. But after crashing to $2.50 in 1932, RCA shares were eventually bought out by GE in 1986 at more than twice their “irrational” 1929 price. Other such examples abound.

We are left, then, with the limited conclusion that, thanks largely to the advent of IT, the prices of shares no longer bear the relationship to earnings that they once did. But this does not tell us whether we are experiencing a temporary aberration—“the combined effect of indifferent thinking by millions of people” (Shiller)—or a permanent lowering of the cost of capital in response to a major shift in how our economy works. To this latter possibility we may now turn.



It was once thought that the “real” economy could grow at an annual rate of something like 2 percent without triggering inflation. If it grew faster than that, especially at a time when unemployment stood at 6 percent or lower, labor and industrial capacity would come into short supply, employers would bid up wage rates and other input costs, and inflation would take off. (Some economists have always quarreled with this analysis, but that is another matter.)

But data are beginning to suggest that just as share prices have broken out of their historic relationship to earnings, so the economy has proved able to produce more goods and services without running into inflationary bottlenecks. Productivity is now soaring, having increased from a rate of about 1.4 percent per year in 1974-1990 and a bit higher than that in 1990-1994, to 2.6 percent or higher for the years 1996-1999. Inflation is in check, even though unemployment is running at a mere 4 percent.

Of course, some would say that employers are wringing more output from an increasingly limited workforce during an up-phase of the business cycle; when the economy slows, the rate of increase in productivity will likewise recede. But the evidence supports an alternative interpretation—namely, that the economy’s speed limit has permanently increased, and that growth of, say, 4 percent per year or even higher is attainable with an unemployment rate of under 4 percent, making it possible to give workers higher and higher wages without unleashing significant inflation. (In the twelve-month period ending this past June, hourly compensation rose by 4.7 percent but productivity rose even faster, by 5.2 percent, driving unit labor costs down.)

Once again, information technology plays a large (but not the only) part, for the massive investment in this technology has helped make the increase in productivity possible. IT helps companies purchase goods more efficiently by using the Internet to engage in business-to-business (“B2B”) commerce. It lowers costs both to sellers and buyers by enabling a company like Enron to set up markets that allow the purchase of otherwise unused time on broadband communications systems, the National Transportation Exchange to connect buyers and sellers of unused trucking capacity, airlines to peddle otherwise empty seats to bargain-hunting travelers, and businesses in general to hold down inventories. And the effects may be spreading: according to a recent Wall Street journal report, a new study by the economists Dale Jorgenson and Kevin Stiroh argues that improved productivity has come not just from the IT sector but from “noninformation-technology” industries as well; that the improvement is not due merely to cyclical factors; and that our higher-than-historic growth rates can be sustained.



And yet, and yet. Acknowledging all these trends, I would still side with Lawrence Meyer, a governor of the Federal Reserve Board, in insisting that, however new certain aspects of our economy may be, we should not “encourage a disrespect for the old rules.” Yes, productivity is increasing more rapidly than in the past. Yes, an unemployment rate consistent with low inflation is now around 4 rather than 6 percent. And yes, the economy seems able to grow more rapidly without triggering inflation. The old relationships have indeed shifted; but that does not mean they have disappeared.

Other things being equal, the more calories you consume, the fatter you get; but as you get older, it takes fewer calories to add more weight. So too with the economy. Increased productivity may make it possible for wages to rise faster than before without forcing employers to raise prices, but a relationship still exists among wages, labor costs, and consumer prices. We are certainly better off under the new set of relationships than we were before, but we would be wise to temper our enthusiasm with an awareness that the only thing that is permanent in economic affairs is the unattainability of perfection.

Long ago, John Maynard Keynes spoke of the importance of “animal spirits” in driving the economy. As his biographer Robert Skidelsky tells it,13 Keynes believed that “the future yield of capital assets is incalculable, [and] . . . that had the capital equipment of the world depended on cool calculations of prospective yield, it would never have been built.” Faced with inevitable uncertainty, entrepreneurs must rely on the virtues associated with enterprise—courage and recklessness being the most prominent among them. Thrift, wrote Keynes, “is not enough by itself to build cities or drain fens. . . . It is enterprise which builds and improves the world’s possessions. . . . If enterprise is asleep, wealth decays.”

This may provide a clue, and a way of drawing together the various strands of a maddeningly elusive subject. Perhaps because Ronald Reagan’s tax reforms increased the rewards for risk-taking; perhaps because Michael Milken and his band of non-establishment predators cleared away the corpocracy clogging the capitalist system; perhaps because, thanks to new technologies, we have somehow launched a cycle of rising productivity to finance still further innovations and still greater productivity; perhaps because besting our ideological enemies has bred in us a rush of confidence and swagger; or perhaps because we have been just plain lucky, we seem to have a new economy. If that is what you want to call it.



1 Princeton University Press, 312 pp., $27.95.

2 Edward Chancellor, Devil Take the Hindmost: A History of Financial Speculation. Farrar, Straus & Giroux, 386 pp., $25.00.

3 John Steele Gordon, The Great Game: The Emergence of Wall Street as a World Power, 1653-2000. Simon & Schuster, 319 pp., $25.00.

4 Mike Dash, Tulipomania: The Story of the World’s Most Coveted Flower & the Extraordinary Passions It Aroused. Crown, 273 pp., $23.00.

5 Janet Gleeson, Millionaire: The Philanderer, Gambler, and Duelist Who Invented Modern Finance. Simon & Schuster, 304 pp., $24.00.

6 Peter M. Garber, Famous First Bubbles: The Fundamentals of Early Manias. MIT, 175 pp., $24.95.

7 Jeremy J. Siegel, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies. McGraw Hill, 1998 (second edition).

8 James K. Glassman and Kevin A. Hassett, Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market. Crown, 288 pp., $25.00.

9 Bagehot’s Lombard Street: A Description of the Money Market (1873) has recently been reissued. John Wiley, 1999.

10 George Soros, The Crisis of Global Capitalism, Public Affairs (1998). In a forthcoming book, Soros reportedly admits he was wrong.

11 See also Francis Fukuyama’s review of Telecosm by George Gilder on page 65 of this issue—Ed.

12 Inefficient Markets: An Introduction to Behavioral Finance. Oxford, 224 pp., $60.00 cloth ($19.95 paper).

13 “Two Stories of Investment,” in Financial Crises, a series published in the UK by the Social Market Foundation, January 2000.


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