Requiem for the New Economy


MIT economist Paul Krugman travels ahead in time to report on the presidential election of 2000:

Like every presidential election in the past 20 years, last week's contest was driven largely by economics--specifically, by public dismay over the economy's recent performance. What is strange about the near-hysterical public mood is that objectively, things aren't really that bad. Unemployment is nowhere near as high as in the early 1980s, and most forecasters think the economy either has already bottomed out or will do so in the near future. Yet the public is furious and bitter; it feels betrayed. Why?

The answer, surely, is that people feel that they had been led to expect better. Just a couple of years ago it was virtual dogma among business economists and the media that we had entered a new era, that of the so-called New Economy--an economy that would grow at unprecedented rates thanks to the magic of digital technology, that would no longer be subject to the vagaries of the business cycle, that would never again find its ability to expand hobbled by inflationary pressure. Even Alan Greenspan cautiously endorsed the New Economy doctrine. As belief in that doctrine spread, the stock market soared to dizzying heights, and the strength of the market only reinforced the sense of millennial optimism.

Yet even three or four years ago it was obvious to anyone who thought about it that there were, to say the least, some major problems with the whole New Economy idea. Conventional economic measures showed no sign at all of an increase in the economy's potential growth rate. From the middle of 1994 to the middle of 1997, real GDP grew at an annual rate of 2.8%; over the same period the unemployment rate fell from more than 6% to less than 5%. Since unemployment can't fall indefinitely, this suggested that the economy's long-run sustainable growth was considerably less than 2.8%--perhaps no more than 2%. And with a growth rate of not much more than 2%, inflation of less than 3%, and long-term interest rates of more than 6%, it was hard to see how profits could possibly grow fast enough to justify the level of stock prices.

The response of the New Economy enthusiasts to such dismal calculations was to insist that a dramatic acceleration of productivity growth had changed the rules.

There was not a shred of statistical evidence for such an acceleration--but the statistics, the enthusiasts insisted, were missing the real story. And wasn't the combination of unexpectedly low inflation and high profits proof that something had changed for the better? Critics pointed out in vain that low inflation and high profits could be entirely accounted for by slow growth in wages--and that while workers had been cautious about demanding wage increases, this restraint could not be expected to last as labor markets became ever tighter.

The New Economy crowd also seemed to have failed to grasp the seemingly technical but actually crucial point that official measures of productivity, GDP growth, and inflation are not independent of one another. If productivity is understated by the official data, so is growth--by exactly the same amount. Even if there was unmeasured productivity growth, there was no reason to think that the economy could grow faster than it was already growing.

In short, the New Economy doctrine made no sense at all, and without that intellectual justification there was no way to regard the great stock market boom as anything other than a bubble. Yet as long as inflation stayed low and the market continued to rise, skeptical voices were ignored.

So strong was the desire to believe, in fact, that even when inflation did begin to accelerate over the course of 1998, the general response was denial. The pundits and the business press insisted it was only a statistical blip. Even Greenspan seems to have been unwilling to face the facts--or perhaps to face the howls of outrage he knew would greet any rise in interest rates. And so the Fed waited until the evidence that inflation was back was unmistakable to everyone (except a few hundred die-hard Wall Street gurus).

By that time, it was impossible to manage a soft landing. When the markets woke up to reality, they panicked. And as millions of people watched their fortunes dwindle, they began cutting back with a vengeance: consumer spending spiraled downward. By late last year the Fed--alas, minus Greenspan, who averted the possibility of impeachment by resigning of his own accord--was backpedaling, frantically cutting interest rates in an effort to reverse the slump.

All signs point to an incipient recovery, and unemployment is unlikely to rise above 8%. But while the economic havoc could have been worse, the political fallout was devastating. Prosperity had been an essential lubricant of the Washington political process during the good years. A hot economy had allowed Congress and the President to offer a little bit to everyone. Once the good times stopped rolling, ideology ran rampant: Republican radicals demanded sweeping tax cuts and a return to the gold standard, while Democratic radicals demanded massive public works programs and import quotas. Moderates were caught in the crossfire. The result was a strange and ugly campaign.

The good news is that the U.S. economy remains fundamentally sound. Our ever resilient private sector is ready to bounce back; all it really needs are calm, sensible policies at the top. The big question is this: Can we really count on sensible policies from President-elect Perot?

--Paul Krugman

Originally published, 11.10.97