Date created:24 June 2002
Last modified: 24 June 2002
Maintained by: John Quiggin
John Quiggin

Even the old is new again

Australian Financial Reviee

6 June 2002

Whenever a boom is longer or stronger than seems reasonable, the idea of a 'New Economy' is advanced to explain it. The continuing economic recovery in the Unisted States looks more and more at odds with the economic reality of a chronic current account deficit, nonexistent household savings, and declining corporate profits, now being stripped of the accounting fictions that boosted them during the late 1990s. As a result, not one but three different 'New Economy' stories are doing the rounds.

The most prominent version of the New Economy is still the late-90s claim that developments in the technology of computing and telecommunications have fundamentally transformed economic activity. The persistence of this claim in the 21st century is a stunning illustration of the natural human reluctance to admit that a beautiful idea can be killed by an ugly fact.

The ugly fact is that the Internet is merely an incremental advance over previous methods of doing business by phone, fax and mail. It is not, as its advocates suggested, a revolutionary innovation. Even more plausible New Economy ideas, such as the idea that electronic data change could rationalise the inventory chain, have been refuted by experience. The ups and downs of the US economy over the past year have been, for the most part, a standard inventory cycle, leaving more fundamental imbalances like the current account deficit unresolved.

The second New Economy idea is that, thanks to financial innovation, corporate and household debt levels that would have been dangerous in the past are now sustainable. Today's big financial innovation is the securitization of mortgages and other, previously illiquid, forms of debt. This, it is said, a massive increase in the price of houses and other assets. Hence, it is suggested, consumer demand can provide a path to continued prosperity, even with household savings at record low levels, and corporate credit being extended to the point where 'junk' is a generous rating. If anyone believes this, I can offer them a securitized slice of a bridge in Brooklyn at a very competitive price.

The third New Economy story, also popular in Australia, is the claim that economic liberalisation has made the economy more flexible, and therefore more capable of surmounting economic shocks. The Australian version of the story focuses on microeconomic reform, tariff reductions and so on. In the US, attention is focused either on the supposed inherent dynamism of the flexible US economy or on the restructuring of employment relationships arising from the mass layoffs of the early 1990s.

The idea that a flexible economy can respond smoothly to economic shocks sounds appealing, but is contradicted by the evidence. Capitalist economies were more liberal in the 19th century than they are today, but still experienced regular depressions and recessions. Radical free-market reforms did nothing to insulate New Zealand from the Asian crisis.

The US recovery is better viewed as an illustration of the power, but also of the limitations, of countercyclical macroeconomic policy. One of the most expansionist monetary policies ever seen in the United States has been supplemented, particularly since September 11, by expansionary fiscal policy. A projected budget surplus of nearly $200 billion (2 per cent of GDP) has been replaced by a rapidly growing deficit.

Countercyclical macroeconomic policy smooths the impact of short-lived shocks. It can also provide breathing space in which to undertake structural reforms. But fiscal and monetary stimulus is a drug that must be used with care if habituation and addiction are to be avoided. If a temporary recovery is used as a reason for dodging necessary reforms, it may do more harm than good in the long run.

Japan provides a cautionary example. When the property and sharemarket bubble of the 1980s was pricked, expansionary fiscal policy provided a breathing space, in which the problems of the banking sector might have been addressed. But instead of fixing the underlying problems, the economy was kept afloat with more and more doses of fiscal and monetary expansion. Now these policies have reached their limits, and the reforms have barely begun.

At present, there is little sign that the need for reform in the United States has been recognised. Capital markets are resisting even such modest reforms as proper accounting for the cost of executive stock options. The overvalued US dollar is seen as a symbol of national strength Households are being encouraged to borrow and spend. The longer the necessary adjustments to these policies is delayed, the greater will be the eventual pain.

Professor John Quiggin is a Senior Research Fellow of the Australian Research Council, based at the Australian National University and Queensland University of Technology.

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