Is The New Economy Dead?

By John Greenwald

It was fun at first, admit it--watching those bratty dotcom billionaires, oops, millionaires--ha!--thousandaires squirm as their cyberpriced stocks came screaming back to earth and their dotcoms disappeared overnight. But then something else dawned. It wasn't just kids from Stanford taking it on the chin. It was us. Suddenly, warning lights are flashing. In recent weeks, everyone from mighty Intel--whose microchips power 80% of the world's computers--to lumber and housewares seller Home Depot has signaled a sharp drop in profits, leading nervous investors to pummel their stocks.

To that growing disquiet add the recurrence of warfare and terrorism in the Middle East last week. Result: a full-fledged panic on Wall Street. By the time the rout ended, the Dow Jones average had plunged 379 points on Thursday and the tech-heavy NASDAQ index stood at its lowest level of the year. Though both markets rebounded on Friday, that did little to dispel the underlying unease that the economy may be a Ford Explorer speeding along on Firestones.

Much of that feeling stems from concerns that the thing that got us here--the vaunted New Economy--was looking like a big Sony Betamax that had promised a revolution it could not deliver. The New Economy is supposed to be frictionless, tied as it is to the ultra-productive cyberworld of computers, broadband networks and the Internet, and cosseted by low inflation and low interest rates. But nobody told that to OPEC. Or to Arafat. And if the New Economy is rewinding, what will become of the economic expansion that had already started grinding down after an unprecedented 10-year run?

Such questions could hardly be more pressing for a nation that is entering the home stretch of a presidential election. For Al Gore, the New Economy-led prosperity is by far the strongest selling point on his resume. Voters nervous about their economic future can be dangerous, as the Republican candidate's father will be the first to tell you.

Today's economic risks may be the greatest in recent years. If the U.S. is unlucky, rising inflation, higher interest rates and slower spending could whip up what economist David Wyss calls "a perfect storm" that could turn the soft landing the Federal Reserve is trying to engineer into an outright recession sometime next year. Wyss, chief economist for Standard & Poor's, still expects a gentle slowdown that would lower growth from nearly 5% at present to a more sustainable 3.5% in 2001. But he also sees a 1 in 4 chance of a slump. "Bad things," he warns, "can happen to new economies."

Fed Chairman Alan Greenspan showed few such signs of concern last week. As Wall Streeters reached for airsick bags, he calmly flew to Boston for a long-scheduled session with fellow bankers. Greenspan believes U.S. economic fundamentals are solid. Fed vice chairman Roger Ferguson told TIME, "The economy is cooling from its unsustainable pace of earlier this year, but recent data certainly don't suggest a dangerous slowdown."

If things are so good, why has Wall Street been doing so poorly, especially now that America has become a nation of stock traders? An explanation is that Wall Street has exchanged its traditional role of follower of economic trends for that of economic pacesetter. Consider the way that the dotcom mania showered wealth on every jaunty entrepreneur with the gleam of an idea but not a clue about earnings. In the past, the stock market would rarely show its checkbook to a start-up sans profits. And now that Wall Street has been burned, the fear is that the current stock pullback could leave even companies with real potential starved for cash--thereby stifling innovation.

That's the risk foreseen by Michael J. Mandel, Business Week's economics editor, in a new book darkly titled The Coming Internet Depression. According to Mandel, any failure by the Fed to counter such a cash shortage by slashing interest rates could send the economy into a harrowing free fall. Though government safety nets would prevent a repeat of the Great Depression of the 1930s, he writes, "things could still get very ugly."

But that's not very likely. The U.S. appears to be witnessing something richer and more varied than either New Economy enthusiasts or dotcom alarmists have envisioned: the rapid--if still painful and uneven--merging of the old and new economies. That's evident from deals as complex as America Online's proposed $120 billion acquisition of Time Warner (the corporate parent of this magazine) or as simple as the act of buying a Pokemon video game or a bedding set from K Mart's website, BlueLight.com "What we're seeing," says Garth Saloner, a professor of e-commerce at Stanford's business school, "is the diffusion of technologies that were popularized by the dotcoms into traditional companies."

Viewed in that fashion, the New Economy is nothing more than a fancy term for the basic infrastructure that allows consumers and companies across the globe to shop, work and play at Internet speed. In New York City, for example, travel agencies routinely farm out chores like updating frequent-flyer miles to online boutiques as far away as India. "All our activities from consumption to production are unalterably changed," says Allen Sinai, chief global economist for Primark Decision Economics. "In that sense, the New Economy is for real, and it's here forever."

The immediate payoff, according to many economists, has been a boom in productivity that has raised America's once barely detectable gains in output per hour of work to a robust 5% in 1999. That permitted the economy to grow at an unbelievable 8.3% annual pace in last year's final quarter while inflation stayed comfortably below 3%. "The New Economy," Sinai notes, "creates efficiencies and lowers the cost of everything we do."

And that efficiency includes, it turns out, funding new businesses and laying waste to those that disappoint. On Wall Street, day traders and fund managers continue to smart over this year's natural--even desirable--bursting of the speculative tech-stock bubble. "The Internet really turbocharged everything," says Marshall Acuff, chief equities analyst for Salomon Smith Barney. "It was the infinite expectations for the Internet that pushed excitement to the ultimate level."

Amid the frenzy, the market awarded astronomical valuations to dotcom companies that had never made a dime--and paid an unheard of 100 to 200 times earnings for true New Economy leaders like Cisco or Sun Microsystems or Dell Computer, whose stocks have since plunged some 50%. "The current growth rate of earnings won't support stocks with high valuations," says Hugh Johnson, chief investment officer for the investment firm First Albany. "That's why technology stocks are coming down so sharply."

Yet the technology sector as a whole, like the rest of the economy, remains financially vibrant. Sinai estimates that earnings for U.S. tech companies will grow a healthy 18% a year for the next three to five years. While that would pale in comparison with the phenomenal 25%-to-30% annual increases the companies have chalked up since 1995, it would be more than enough to lead the economy.

Tell that to the countless dotbombs that have suddenly vaporized. Gazoontite.com an online and off-line dispenser of air purifiers, hypoallergenic stuffed toys and all things sneeze-and-wheeze related, has snuffled into Chapter 11 bankruptcy court. Scour, the troubled Web entertainment site backed by Hollywood superagent Michael Ovitz, filed last week to reorganize itself under Chapter 11.

The relentless setbacks have left normally ebullient Silicon Valley dazed and chastened. Among the phrases that venture capitalist Danny Rimer no longer wants to see in business plans are "losses for the next five years" and "recent business school graduates"--which now look suspiciously like the preamble to failure.

Even growing companies have shut down in the face of VC disdain and looming cash shortages. Three weeks ago, Kibu.com a start-up that had made healthy inroads in the teen-girl market by building a cyberchat "hangout," shocked analysts by closing while it still had a healthy bank balance. The reason? Kibu was unlikely to be "valued appropriately"--in other words, stupefyingly overvalued--by a market that has lost its appetite for IPOs. So it gave investors some of their money back. Indeed, the shell-shocked look on the faces of dotcomers who only yesterday had dreamed of Maseratis is no accident. In the past month alone, as many as 4,000 people have quit or been laid off from online ventures.

It's no small irony that even as Silicon Valley suffers, much of the heartland still basks in the good times the New Economy has made possible. Throughout the Midwest, consumers have been shrugging off the downturn in stocks and taking out home-equity loans to finance remodeling, or a new car or a European vacation. "There's not a chance this boom is over," says Diane Swonk, chief economist for Bank One in Chicago. "Consumer attitudes are high in the face of high oil prices, stock-market volatility and even election rhetoric. Most Americans live on Main Street, not in Silicon Valley."

Consumers are still spending with a vengeance. Use of revolving credit, largely credit cards, is way up--a startling 13.5% over last year's rate. That could mean a stronger Christmas season than the weak one expected--and more inflation worries for the Fed.

At the same time, there are too many places to spend, and the rapid expansion of e-tailers hasn't helped. Just last week Home Depot warned that it would miss its profit targets for this year's third and fourth quarters--a disclosure that contributed to the Dow's slump. Other retailers, such as Gap and Nordstrom, are also struggling. "We have gone from being an over-stored country to being an even more over-stored country," says Todd Slater, who watches the industry for Lazard Freres. The situation, Slater says, leaves many companies "dangerously overextended."

Heartland America is where the new and old economies are melding, and the ultimate winners will be those companies that can do it best. K Mart and fellow Midwest giants Sears and Target have been leading the online parade of bricks-and-mortar retailers. K Mart, which is expanding its BlueLight.com line from 150,000 to 500,000 items, jump-started the site by offering free Internet access to customers.

In Detroit the Big Three automakers are building a global parts exchange on the Internet. They also envision a Web-based system that lets buyers send custom orders to factories, which would then deliver vehicles direct to customers without going through dealers. Meanwhile, DaimlerChrysler offers Internet access as an option on the 2001 Mercedes-Benz, the first automaker to put the Web on wheels.

To see how far a company can go in transferring its brand to the Internet, take a look at General Electric. Every GE business has an e-commerce strategy, and most include self-help sites that show users how to repair and maintain GE products. Builders and architects can use Web-based programs to design kitchens and lighting systems with GE wares. Want prompt delivery of that new refrigerator? Punch in your order at a Home Depot, and GE will deliver the appliance straight from its warehouse. GE even offers insurance, loans and mutual funds online through a financial website.

The New Economy has created faster growth with less inflation than anyone would have thought possible only five years ago. Even the 3.5% growth that many economists forecast for next year as the result of a slowdown is substantial by 1980s standards. In the same way, the 2001 inflation forecast of 3.5%--in contrast to 3.1% for this year--looks deliciously low in a 1980s context.

Yet none of that makes U.S. prosperity bulletproof. "The fact that the New Economy is here doesn't mean that you can't have a new recession," warns Standard & Poor's economist Wyss. "All it means is that we can grow faster than in the '70s and '80s." Quite so. And since the new and the old economies have become virtually synonymous, we are all better able to withstand whatever risks may lie ahead.

--With reporting by Eric Roston/New York, Chris Taylor/San Francisco, David Thigpen/Chicago and Adam Zagorin/Washington

With reporting by Eric Roston/New York, Chris Taylor/San Francisco, David Thigpen/Chicago and Adam Zagorin/Washington