TCS Daily

Create, Destroy, Repeat

By Kevin Hassett - June 28, 2002 12:00 AM

The past few weeks have seen puzzling pairings of economic releases and market responses. The latest June data have suggested that consumers are happily spending away again in the early summer, and even the lowly manufacturing sector has begun to turn around. And the stock market? Down again.

Undoubtedly, a good deal of the market pessimism is associated with very real risks. News of WorldCom, Enron, Tyco, dirty bombs, a possible war with Iraq, and the conflict between India and Pakistan threatens both our near-term peace and our prosperity. But underneath this fear has been the continued absence of the kind of good news about profits that we normally see in a recovery. What is going on?

We at the Digital Greenbook have been spinning the data for months to almost no avail, but our crack team of econometricians has finally happened upon a story that holds up under fairly close scrutiny, so here goes.

The problem is that the dollar has been unusually strong for several years, and that has caused a very real manufacturing shakeout. While the dollar has weakened slightly lately, there still may be significant room for more negatives. If so, profits in the aggregate may well continue to be disappointing.

Here's why. First, the price of the dollar relative to other currencies is set in a global marketplace. When the demand for dollars is high, the price goes up, and vice versa. The demand for dollars will be high when Americans produce something that foreigners want to buy. In recent years, there have been two types of products that have generated massive foreign demand: U.S. financial assets and U.S. high tech software and equipment. When foreigners are lapping up U.S. financial assets, the dollar appreciates, and that makes U.S. goods more expensive in foreign markets. Accordingly, a key side effect of soaring U.S. equity markets was a concomitant decline in the demand for many U.S. products. Since everyone wanted to purchase shares in, it became much harder to sell them sparkplugs.

For products, a key factor driving external demand is productivity growth. If U.S. firms get very good at producing a product relative to foreign producers, they can capture a large share of the foreign market for goods. In the high-tech sector, which includes patented pharmaceuticals, the U.S. has no equal, and, according to Northwestern University economist Robert Gordon, productivity growth in these sectors has been extraordinary. The problem is, if you are a sparkplug manufacturer, and you happen to live in a country that is generating enormous foreign demand for your currency because of high tech developments and financial flows, then the demand for your product gets axed through no fault of your own. This is exactly the story that has lead to many sob stories for American industry.

Indeed, in the most recent boom period, growth in productivity was unusually skewed. A few industries produced a huge share of the productivity growth, putting upward pressure on exchange rates, while the majority of industries treaded water. How much pressure? A recent study by the National Bureau of Economic Research concluded that a 1 percentage point increase in productivity increases the value of a country's currency by 5 percentage points! With productivity growth in the U.S. averaging well above 3 percentage points over the past few years, a tremendous pressure was put on the exchange rate.

How does the story end? As firms that are no longer productive at world prices gradually go bankrupt, a natural weakening of the dollar will occur. This, in turn, will allow marginal industries to regain the upper hand, and once again capture large foreign markets -- pushing the dollar back up. And those that survive will, in the long run, likely benefit from the presence of the high tech industry. Better prepared workers with clever ideas that will allow firms to use computers to gain a cost advantage will help even the lowest tech firms capture competitive advantage.

The lesson of this episode is simple. If large productivity advances occur in narrow industries, a sharp cycle of creative destruction will ensue. As a firm, it pays to keep an eye on the aggregate productivity numbers. If you are not keeping up, and your firm receives a healthy share of its revenue from exports, you better lean on your managers to find productivity enhancing strategies. The alternative is bankruptcy. In the new economy, you have to run faster to keep up.



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