The hype about the new economy is over. But the economic effect is real – and lasting. Laura Tyson examines the reasons for substantially higher productivity growth in the US than in Europe or Japan over the past few years, the sustainability of that growth and its implications for the global economic outlook –

After a surprisingly strong start, the US economy slowed sharply during the second half of 2002, buffeted by a sharp summer sell-off in equity markets, a crisis of investor confidence triggered by a handful of spectacular corporate scandals, and rising uncertainty about the timing and costs of US military action in Iraq.

Faced with a toxic combination of weak demand, excess capacity, limited pricing power and low share prices, US companies concentrated on cutting costs, rather than on increasing capacity.

With capital spending stagnant, the US economy relied on the strength of consumption spending for its forward momentum. But as the year wore on, there was mounting concern about the sustainability of consumption demand.

How long could – or would – the US consumer continue to increase spending, despite significant losses in pension values, mounting debt, increasing job insecurity and heightened geopolitical risk?

The most pessimistic among the economic forecasters looking at this nasty brew concluded that the US was headed for a double-dip recession and possibly even several years of stagnation.

And since the global economy had developed an unhealthy dependence on the US as its primary engine of growth during the 1990s, this outlook had sombre implications for the global economy as well. Indeed, the US economy outperformed both the European and Japanese economies throughout 2002 and is expected to do so in 2003, too.

Surprising strength

Economic history books are likely to describe 2002 as a year characterized by a major correction – or collapse – in global equity markets, a sharp, synchronized slowdown in an increasingly interdependent global economy, and mounting criticism of the US form of capitalism for its slack corporate governance and desultory ethics.

But historians are also likely to record another noteworthy feature of the US economy, namely that productivity growth showed surprising strength, providing additional evidence of the beneficial effects of the information technology (IT) revolution on long-term living standards.

In 2002 the new economy hype evaporated, along with the equity values of technology companies, but the payoff from the IT revolution persisted.

From the mid-1990s, output per hour in the US economy grew at an annual rate of more than 2.5%, compared with a rate of roughly 1.5% during the preceding two decades. Through the year ending in the third quarter of 2002, despite an anaemic pace of economic growth, productivity in the non-farm business sector increased at slightly more than 5%, one of the largest advances in the past 30 years.

Investing in efficiency

A growing body of evidence shows that most of the increase in productivity since the mid-1990s was the result of capital deepening – that is an increase in capital per worker – driven by a doubling in the pace of investment in information technologies by US companies.

Across sectors, there was a strong correlation between investment in information technologies and an improvement in productivity growth, with the most IT-intensive sectors enjoying the largest productivity gains.

There is also evidence of a marked improvement in efficiency – that is, productivity gains over and above those attributable to higher levels of capital per worker – primarily in the IT-producing sector itself during the second half of the 1990s.

The fact that productivity growth remained strong even as capital investment swooned between 2000 and 2002 suggests that US firms responded to weak demand and harshly competitive conditions by reorganizing their production processes to realize efficiency gains from their substantial previous IT investments.

This interpretation is consistent with both historical and firm-level evidence showing a substantial lag between investment in new technologies and the full realization of their productivity-enhancing effects.

It is also consistent with surveys reporting that even towards the end of 2002 many US companies believed that they still had a considerable way to go to exploit the full efficiencies of their IT equipment.

Intriguing evidence that US firms have not yet fully adapted their operations to the latest technology is also provided in a recent study measuring the gap between the productivity potential of leading-edge capital and the average productivity of the current capital stock. This gap is estimated to be quite wide, indicating significant productivity payoffs to technology upgrades.

While US productivity growth unexpectedly increased in the mid-1990s, Europe’s unexpectedly fell. During the past six years the growth of real GDP per hour worked declined in France, Germany and the UK, while increasing in the US. After nearly two decades during which productivity growth was roughly comparable in the US and Europe, this divergence is understandably a source of concern in Europe.

It is particularly puzzling in light of the fact that productivity levels in these European economies remain significantly lower than the US level.

The literature on the cross-country convergence of productivity levels suggests that Europe should have enjoyed faster productivity growth as it caught up with the front-runner.

Moreover, the US managed to pull ahead in the productivity growth race even as it enjoyed much faster employment growth than the European economies, and absorbed millions of relatively unskilled workers into production.

What explains the divergence in productivity growth rates in the US and Europe since the mid-1990s?

A recent study finds a correlation between changes in IT investment and changes in productivity growth rates during the 1990s, suggesting that lower IT investment rates were partly responsible for slower productivity growth in Europe.

Another study comparing Europe and the US shows a significant pick-up in productivity growth rates in IT-using sectors in both manufacturing and services in the US and a decline or stagnation in productivity growth rates in comparable sectors in Europe between the first and second half of the 1990s.

The sectors producing IT equipment in both Europe and the US enjoyed a significant improvement in productivity growth over this period. But the US productivity growth rates in these sectors were higher, and overall US productivity growth benefited from the fact that IT output accounts for a larger share of total manufacturing output in the US than in Europe.

About one-third of the difference in the productivity growth rates of France and Germany on the one hand and the US on the other is explained by the smaller contribution of the IT sector to overall output in the European economies.

Competition is key

Recent industry and firm studies by the McKinsey Global Institute conclude that competition is a key determinant of productivity growth and that competitive intensity in product markets is considerably weaker in Europe and Japan than it is in the US.

When competitive intensity is high, companies are forced to seek greater efficiencies by investing in new technologies. Thus a lower level of competitive intensity is one of the reasons for the lower rates of IT investment and the slower diffusion of IT technologies in Europe compared with the US.

This conclusion is also supported by another recent cross-country study by scholars at the board of governors of the Federal Reserve, who find that both regulatory constraints on employment practices and regulatory barriers on start-ups discouraged investment in IT and hence dampened productivity growth in the European economies during the 1990s.

In a recent book combining both theory and empirical evidence, William Baumol, a noted microeconomist, argues that competitive intensity is the most important driver of innovation and productivity growth.

Competition compels firms to make innovation a regular feature of their activities, rather than a specialized function of their R&D; or strategic departments.

Such findings have an important policy lesson for the European economies. Continued deregulation of their product and labour markets is likely to foster more competition, an increase in IT investment and an uptick in the growth of productivity and living standards.

The hype about the new economy is over.

It was never realistic to assume that the revolution in IT technologies was going to end the business cycle or break the link between equity values and expected future earnings streams. But it was reasonable to predict that, like previous technological revolutions, the IT revolution would usher in a period of higher productivity growth.

So far, the evidence from the US economy over the past seven years confirms this prediction. And the outlook for productivity growth remains bright.

Since most experts believe that the power of information technologies will continue to grow at an astonishing pace over the next few years, it is likely that the acceleration in productivity growth will persist for some time. This is the real payoff of the new economy revolution.

Laura D’Andrea Tyson
Laura D’Andrea Tyson became London Business School’s first female dean in January 2002. She had previously been dean of the Haas School of Business at the University of California at Berkeley and, before that, professor of economics and business administration at the University of California. Dr Tyson served in the Clinton administration from January 1993 to December 1996.