April 20, 2002

Is the "New Economy" a Fad?

Is the "New Economy" a Fad?

by Lawrence H. Summers and J. Bradford DeLong

A year ago the "new economy" was seen by many as having repealed the laws of economic gravity: stock prices, productivity, and employment were to go ever up and never to go down. NASDAQ’s crash and the worldwide slowdown have caused many to think that the much vaunted "IT revolution" was just another speculative bubble.

How important, then, will the technological revolutions in data processing and communications be in the long run? Can we really speak of a "new economy" and what does it portend? No one has a crystal ball and predictions are apt to be wrong. Nevertheless, we believe that the long-run economic impact of the "new economy" is likely to be very large indeed.

Some technological innovations change our lives but have no lasting effect on the economy as a whole. The revolution in illumination is a good example. In 1800, an American household spent 4% of its income on candles, lamps, oil, and matches. It now spends less than 1% and consumes more than a hundred times as much artificial illumination. The real price of light fell by a thousandfold over the past two centuries, yet we do not speak of the "illumination revolution," or of a "new economy" based on streetlights and fluorescent office and store lights.

For a technological change to revolutionize the whole economy, as steam power and electricity did, its effect must not be local, but must radiate across much of the economy, so that the demand for new products grows more rapidly than the decline in their prices. Only then can we speak of a "new economy" because only then does the share of the new sector’s products in total expenditure grow, with high productivity growth in the new sector translated into productivity growth for the entire economy.

Armed with this observation, let’s look at the impact of the changes in data processing and communications. Note first the phenomenal growth of productivity in the new sector. By the late 1950s there were roughly 2000 computers in the world and their processing power averaged 10,000 machine instructions per second. There are now 300 million computers in the world, with processing power averaging several hundred million instructions per second – a four-billion-fold increase in the raw automated computational power, an average annual rate of growth of 56%!

There is every reason to believe that this pace of productivity growth will continue for decades. More than a generation ago Intel’s co-founder Gordon Moore noticed that improvements in semiconductor fabrication allow for a doubling of the density of transistors on a chip every eighteen months. The scale of investment needed to make what is known as "Moore's Law" hold has grown exponentially along with the density of transistors and circuits, but "Moore's Law" remains in force, and engineers see no immediate barriers that will bring the process of improvement to a halt anytime soon.

Rapid technological progress brings fast falling prices. As prices fall, IT products, unlike light, are ever more in demand because this explosion of technology has profound consequences for how we organize production across the whole economy. Computers, switches, cables, and software are general-purpose technologies, hence demand for them is likely to be extremely elastic.

Indeed, each successive generation of falling prices appears to produce new uses for computers and communications equipment, thus increasing demand and increasing their salience in the economy as a whole. The early, very expensive, computers performed complicated and lengthy arithmetic operations. Their use was at first limited to the military, and was then extended to America’s Census Bureau which also needed to perform lengthy calculations.

Only later did it become clear that the computer was good for much more than repetitive calculations at high speed. The computer was also an organizer. American Airlines used computers to create its automated reservations system and insurance companies automated their back office sorting and classifying.

Subsequent uses included computer-aided product design. In this and other applications, the computer functions as a "what-if machine": it creates models of what would happen if the airplane, the molecule, the business, or the document were to be built up in a particular way. It thus enables an amount and a degree of experimentation in the virtual world that would be prohibitively expensive in the real world.

Indeed, the process has come full circle: today’s complex designs for new semiconductors would be impossible without automated design tools. Progress in computing depends upon Moore’s law; and the progress in semiconductors that makes possible the continued march of Moore's law now depends upon progress in computers and software!

As computer power continued increasing, the use of computers expanded to new applications. Production and distribution processes are being transformed, not just through robotic auto painting or assembly, but also through such things as scanner-based retail inventory control and robot-guided hip surgery. Computers burrowed inside conventional products and became embedded systems. They became interconnected in what we call the world wide web: a distributed global database of information accessible through a single global network. Paralleling the revolution in data processing has been a similar revolution in data communications capacity.

There is no sign that the domain of potential uses has been exhausted. Indeed, we used to live in an economy in which the canonical source of value was an ingot of iron, a barrel of oil or a bushel of wheat. We are moving to an economy in which the canonical source of value is a gene sequence, a line of computer code, or a logo. Goods are increasingly valued not for their physical properties but for weightless ideas. What you know matters more than how much you can lift.

Thus, unless Moore's Law ceases to hold or the marginal usefulness of computers and communications equipment rapidly declines, the economic importance of the IT sectors will not shrink, but grow. Rapidly falling prices and extremely elastic demand will produce its rapidly-growing share of overall economic expenditure. Posted by DeLong at April 20, 2002 12:14 PM | TrackBack

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