*EPF114 06/26/00
Text: Council of Economic Advisers' Baily on the New Economy
(At OECD he cites continuing importance of competition) (1660)

Even as technology rapidly transforms the global economy, the best national government policies to promote expansion remain the same: competition, openness and flexible labor and product markets, says Martin Baily, chairman of President Clinton's Council of Economic Advisers (CEA).

"The nature and pace of technology are new, but the importance of change is not," Baily said in a June 26 statement at the Organization for Economic Cooperation and Development (OECD) ministers' meeting in Paris.

While the new economy of advanced technology serves the old economy of farmers, manufacturers and service providers, he said, the old economy drives the new economy by creating new demands for hardware and software.

Baily listed important responsibilities for the public sector in the new economy: sound fiscal and monetary policy; protection of intellectual property, workers' rights and privacy; and enforcement of fair trade rules.

Other requirements of the new economy, he said, are good systems for education and worker training.

Following is the text of Baily's statement:

(Note: In the text "billion" equals 1,000 million and "trillion" equals 1,000,000 million.)

(begin text)

The New Economy
Remarks by Martin N. Baily
Chairman, Council of Economic Advisers

Why are we talking about a new economy in the U.S.?

The first reason is that productivity growth has accelerated from about one and a half percent a year 1973-95 to about 3 percent a year 1995-99.

This acceleration is heavily related to technology, both the investment in IT [information technology] hardware and software (i.e., the use of the technology), and also the extraordinary productivity of the industries producing the technology.

Some part of this acceleration is surely temporary, the result of unusual growth in demand, and it is only about four years in duration. But a substantial fraction appears to be structural and hence, potentially, will result in a sustained improvement in productivity performance. Moreover, the signs of information technology as an enabler of business system change have been visible for much longer than just four years.

The second reason is that there has been a dramatic increase in the stock market valuation of U.S. corporations. The rate of increase was 16 percent a year from January 1993 through May of 2000, resulting in nearly $18 trillion of wealth held by shareholders. The increase in market valuation has been oriented to the high-tech sector. NASDAQ and Internet stocks accounted for a large fraction of U.S. market capitalization in March of 2000.

I am not going to comment on whether the market today is overvalued, undervalued or just right. But I note that even if someone (not me) believed that only a half of the growth in the market since '93 were just speculation, there would still have been trillions of dollars of stock market wealth added due to fundamentals.

The third reason is that there are direct signs of acceleration in the accumulation of knowledge and intangible capital, R&D [research and development] spending has soared, so has the number of patents, and the number of trademark registrations. Use of the Internet and the Web is exploding. This type of evidence reflects only the tip of an iceberg, but it all points in the same direction.

Size and Innovation in the New Economy

The increased importance of information and intangible capital results in two countervailing trends with respect to size. There are centrifugal and centripetal forces at work.

First, since information has high fixed costs and low marginal costs of production, there are economics of scale and scope. Large firm size and first mover advantages become important, and the advantages of size are accentuated by globalization.

But at the same time, lower costs of communication and interaction allow small companies to compete by entering a market at a narrow point in the value chain. This can force large companies to outsource activities or downsize, to focus on core competencies. They may choose to globalize on only a sliver of their overall business. As one would predict from the work of Nobel Prize winner Ronald Coase, the boundaries of firms and industries are being changed by developments in IT. In the end, new competition will determine how the boundaries of firms and industries are changed.

One activity being outsourced is technology development. In large companies, burdensome review processes can stifle innovation, in part because innovation undermines existing vested interests within the firm. In the past, lack of financing has provided a barrier to innovation in small firms, but today's venture capital industry, and the active IPO [initial public offering] market, have reduced this barrier and encouraged innovation by small firms. Through stock options, the market has provided tremendous incentives to successful innovators.

Another facilitator of innovation in the U.S. has been access to talent. Higher education provides a flow of new-trained graduates. Immigration has also been important. Twenty-nine percent of the new start-up firms in Silicon Valley 1995-98 had CEOs [chief executive officers] from India or China.

The Interaction of the Old and the New Economies

The new economy is dramatically affecting the old economy. Farmers can use the Internet to check meteorology and soil forecasts based on satellite information. Nurses carry Palm Pilots that contain patient information from all parts of the hospital. Truckers get street directions from the GPS system and are tracked by their companies. They use the Internet to seek out new loads and avoid empty return trips.

These impacts may not always be visible in macro data. Productivity is poorly measured in many old economy industries. And the innovations companies are adopting may not boost market value when industry competitors are all doing the same thing. As Schumpeter noted years ago, excess profits come from innovating ahead of competitors.

The old economy is driving the new economy. The interaction is two-way. For example, a dynamic evolving retail industry is using the new technology to communicate and coordinate its value chain from marketing and design, to customer check out, to transportation, to wholesaling, to purchasing and manufacturing. This creates demand for hardware, software to improve business systems. The same story applies over and over as traditional industries become the customers and end-users for the information sector.

It is appropriate to talk of a new economy. But recall that most of the jobs and most of the GDP [gross domestic product] remain in traditional industries. These are driving the new economy as they themselves are being changed by it.

Policy in the New Economy

1. We know from the macro data that investment has been a major part of the acceleration of productivity. Fiscal discipline and sound monetary policy have been vital parts of the low-interest-rate high-investment U.S. expansion of the 1990s.

2. I mentioned the strong higher education system in the U.S. It is important that students from all backgrounds have the opportunity to take advantage of the system. Moreover, in a world where steelworkers sit at computer consoles controlling giant machines, computer skills are often needed by high school graduates. Companies are looking for workers at all levels that can keep records, understand instructions and solve problems. These are skills that schools must teach in order that workers not be left behind.

3. Right now, some workers are struggling in the new economy. Old skills have become obsolete. Jobs have been lost. To deal with this problem, access to training and retraining is vital, plus a safety net that encourages work, including adjustment assistance and programs such as the Earned Income Tax Credit.

4. The private sector is the heart of the new technology. But at critical points the government has played a central role through support for basic and pre-commercial research. And while the new technologies have prospered in a freewheeling, free-market culture, there are times when government must set rules of the game -- intellectual property protection, international trade rules, privacy, anti-trust policy, labor protections. Government has a key role in the establishment of the infrastructure of the new economy.

5. Finally, however, I want to stress policies toward competition, open markets and change. New firms, new technologies and new business systems are springing up. The nature and pace of technology are new, but the importance of change is not. Studies of manufacturing plants and studies of industries in different countries have revealed that productivity growth depends on the entry of new establishments and firms, the expansion of the most efficient operations and the reduction or closure of the less efficient -- in short, it depends on productive evolution.

To offer an analogy: At 4 degrees Celsius water and ice remain in equilibrium. The proportions of each remain the same. But in actuality the ice is continuously melting and the water is continuously freezing. The apparent equilibrium conceals massive change at the micro level.

Similarly, an economy may appear to be growing steadily. But underneath there is massive change. Jobs are being created mid destroyed. New firms are entering and old firms leaving. New technologies are developed that gain competitive advantage for a period, and then are overtaken.

Policies and regulations that encourage flexible labor and product markets, competition and openness are the policies that support economic evolution and change. These can and must be given a human face. They promote leading edge performance in traditional industries, which, in turn, drive innovation in the new economy.

One final comment on the spread of the new economy to other countries. Many of them have more to gain from the new economy because their traditional industries have not evolved as far, and the potential for performance improvement is greater. But the potential for social disruption is also greater. The adjustment to the new economy may be harder to manage in economies that have traditionally been more tightly regulated.

(end text)

(Distributed by the Office of International Information Programs, U.S. Department of State. Web site: http://usinfo.state.gov)
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