TCS Daily

Rationally Exuberant

By Arnold Kling - August 8, 2002 12:00 AM

The ultimate irony of the stock market decline of the past two years is that it occurred at a time when long-skeptical economists have come around to the view that the "new economy" story that fueled much of the rise appears to be true. Using Moore's Law, leading professional economists are painting an optimistic picture of economic growth in the coming decade.

In 1987, Robert Solow wrote an article in the New York Times Book Review in which he said, "You can see the computer age everywhere but in the productivity statistics." For over a decade, this view held up within the profession.

Recently, however, the consensus has moved in the opposite direction. Brad DeLong writes, in a paper called Productivity Growth in the 2000's, that "[economists] nearly all agree that the cause of the productivity speed-up of the 1990s lie in the information technology sector."

What happened between 1987 and 2002 to change professional economists from skeptics to believers in the new economy? Why did computer-driven productivity growth become apparent in the late 1990's when it was not visible earlier?

A Bigger Deal

The answer is that in fifteen years, computers have become a much bigger deal in the economy as a whole. As this chart shows, information technology investment relative to GDP grew from less than 2 percent in 1987 to 6 percent today. Also, keep in mind that in 1987 the state-of-the-art microprocessor was the Intel 386. In fifteen years of progress from 1985 to 2000, the standard microprocessor went from the 386 with 275,000 transistors to the Pentium 4 with 42,000,000 transistors.

Economist William Nordhaus even says that Moore's Law may understate the progress of computing. His measures suggest that since 1980 the cost of computing has fallen at an average rate of 80 percent per year.

This tremendous increase in computing power, combined with the sharp increase in spending on information technology, coincides with a doubling of the rate of productivity growth, from 1.3 percent in 1973-1995, to 2.7 percent since then. A reasonable estimate is that something like half the increase in productivity growth can be attributed to information technology investment.

The Case for Optimism

It is not 1987 any more. The information technology sector is significant today. Starting from today's high baseline of computing power, further extrapolation of Moore's Law leads to remarkably optimistic forecasts. For example, Nordhaus predicts that by 2025 we will see "petacomputers, tiny machines with memory, storage, and computing capacities that are roughly a million times greater than today's personal computers and cost $1 or less. Such devices will be intelligent, essentially free, essentially weightless, and small enough to fit unnoticeably into your shoe or under your skin."

DeLong says that with the high rate of information technology investment and the continued operation of Moore's Law, the only way that we can see a productivity slowdown is for the social return on information technology investment to drop to zero. In other words, as long as we do not become completely unable to figure out new uses for better computing technology, the power of that technology will be felt in future productivity growth.

In fact, DeLong argues that there are reasons to expect the social return on information technology investment to remain high, or even to increase. He cites economic historian Paul David, who studied the impact of the introduction of the electric motor. David, who found that most of the productivity gains came decades after the technology was developed, theorizes that it takes time for knowledge of technology to spread widely enough so that technology is used effectively.

As long as inventors and entrepreneurs can come up with new uses for information processing power, we can be assured of a high rate of productivity growth, which is the key variable in the economy. The case for an optimistic economic forecast is compelling.

What Could Go Wrong?

DeLong's analysis indicates that the biggest potential threat to this "new economy" scenario would be for a large sector of the economy to become "productivity resistant," meaning that it is unable or unwilling to take advantage of better information technology. I think of the music industry as a potential example. Obviously, growth will not take place if you have the power to outlaw innovation.

DeLong points out that the institutional underpinnings of the information economy probably will differ from those of an industrial economy, just as the institutional underpinnings of an industrial economy differed from those of an agricultural economy. He points out that "Optimistic views of future macro productivity growth assume that government will - somehow - get these important micro questions right."

It could be that the corporation as an institution is not as economically useful as it was 50 years ago. In that case, even though GDP will grow, the share of GDP accounted for by corporations could decline. If so, then people who try to participate in the new economy by investing in corporations could be disappointed.

Rational Exuberance?

Economists did not buy the "new economy" story in 1996. It was economist Robert Shiller who coined the term "irrational exuberance." Even today, some economists continue to expect price-earnings ratios for stocks to revert to low historical levels. DeLong appears to be among these, even though his economic catch-phrase is slouching towards utopia.

However, the "new economy" story is that price-earnings ratios should be higher than historical averages, because those averages cover periods of lower economic growth. The "new economy" story justifies higher price-earnings ratios, and the cumulative impact of Moore's Law has made that story plausible to economists.

Although there are downside risks to the new economy scenario, there is upside potential as well. Nanotechnology and/or biotechnology could become even more important sources of growth than Moore's Law. The stock market may be depressed, but economists are veering toward rational exuberance.



TCS Daily Archives