One of the pillars of the ‘new economy’ thesis, popular at the beginning of this decade, was that the traditional business cycle would be flattened and the economy could grow faster without producing inflationary pressures, so central banks did not have to put on the brakes.
Mentioning the ‘new economy’ will meet lots of laughter these days, but in a way, its main thesis played out with a rather surprising exactitude. However, it also contained the seeds of its own destruction, as the consequences for asset markets (like the stockmarket) have been rather stark.
In the end, the business cycle was not eliminated but its dynamic was changed pretty comprehensively, its main dynamic now comes from increased instability in asset markets, which, ironically, are at least in part a consequence of the forces the ‘new economy’ unleashed. The question how should central banks respond is answered differently in different parts of the world, a most interesting experiment.
Let’s quickly revisit some of that ‘new economy‘ thinking (now sufficiently aged to make a detached assessment possible). Which economic forces did it identify as contributing to a flattening of the business cycle? To be able to explain that you have to realize that inventory fluctuations are a prime mover of the business cycle. When demand (for goods and services) growth falters, inventories of unsold goods pile up, and production is reduced as a result.
When production is reduced enough, it’s called a recession (two quarters of reduced production, to be more precise). Also, reduced production needs fewer workers, unemployment goes up. Now, would it not be a terrific idea if we would be able to reduce those inventory fluctuations that are at the heart of producing recessions?
Here a few prime candidates:
- so called supply chain management software and collaborative practices (like ‘just-in-time’ inventory management) between suppliers would reduce the need for inventories
- the ‘new’economy is increasingly dominated by the service sector, which doesn’t produce any inventories at all (if you’re not convinced, try producing, say, haircuts in advance)
So, production can be more smooth, and there will be reduced need for large, sudden adjustments of production in relation to demand. But what causes fluctuations in demand in the first place?
It’s one of the best kept public secrets that the prime culprit with respect to sudden falls in demand in the ‘old’ economy were central banks. Invariably, they intervened at the towards the top of the business cycle, as spare capacity started to run out, workers became scarce and their bargaining position enhanced, so inflationary pressures started to build up.
Inflation is like fire, prevention is a lot better than having to cure it, which is why central banks, at least the more competent ones like that paragon of monetary stability, the German Bundesbank, started to put on the breaks when the party was only just getting started, an action that was not universally admired.
Under the ‘new’ economy, this would not have happen nearly as often if indeed at all. Why? Well, because the forces of the new economy made labour (and capital) more productive, increasing the pace at which the economy could grow without causing inflationary pressures to build up, or so was the thinking.
Which are these forces that increased the speed limit of the economy? Basically, the information and communication technology (ICT) revolution. Workers armed with shiny new (connected) computers, the web, robots, software (like enterprise resource planning ERP stuff) enabling organizations to run more smoothly and efficiently, the works.
There is something of a timing problem. Productivity figures only showed increased growth from the second half of the nineties, however, computers have been around for quite some time. In the words of a famous economist, “computers were everywhere but in the productivity figures.”
It was perhaps a question of critical mass (and connecting computers only occurred on a grand scale after Mark Andreessen (not Al Gore) wrote Mosaic, the internet browser that brought the internet to the masses. Almost certainly more important is that it took most organizations a long time to figure out how to actually take advantage of all that shiny new stuff (there are plenty of examples of failure here).
So, the basic tenet of the ‘new economy’ is that the economy can grow faster and with less ups and downs. While once growth curves snaked their way upwards at a rather pedestrian way, the new economy offered a rapid, smooth ride into heaven.
Also investor heaven, which is why we write this article in the first place. If the economy can grow faster and inflation and the business cycle are a shadow of their intimidating past, this has consequences for asset prices in general and the stockmarket in particular. And consequences for central banks how to deal with this new reality. We’re living in the midst of them.