Economics - The Internet: A New Economy

Internet and the Economy

Overview: A New Economy - and why US?

“The West had grown increasingly powerful through the invention and development of capitalism and industrialization – two incredibly dynamic forces that overpowered any competing systems… That was Act I.. The twentieth century brought Act II. The twentieth century saw a great global struggle between two competing sets of ideas…. It took the entire century to work out the debate between these two camps, but by the 1990s, the winning combination was clear. Free markets and democracy overwhelmingly won out.” Schwartz, Leyden, & Hyatt, The Long Boom: A Vision of Coming Prosperity

“The new form of education will have much more to do with preparing young people with successful work habits for the New Economy. Young people will have to become veritable learning animals. They will need to become adaptable, innovative people who can continuously move confidently within an economic environment that is constantly in flux." Schwartz, Leyden, & Hyatt, The Long Boom: A Vision of Coming Prosperity

We live in extraordinary times, what Peter Drucker referred to as "The Age of Social Transformation," a time where the world is moving Beyond the Information Revolution. When you are talking about transformations or revolutions, you know we are into something BIG, and we are right in the midst of it. Think about it, we belong to the "first society in which ordinary people - and that means most people - do not earn their daily bread by the sweat of their brow. It is the first society in which ''honest work' does not mean a callused hand. ...Knowledge workers...may not be the ruling class of the knowledge society, but they are already its leading class. ...And in their characteristics, social position, values, and expectations, they differ fundamentally from any group in history that has ever occupied the leading position." It is a society where education takes on increasing importance as a gateway to the "promised land," a world in where flexibility and mobility are seen as the keys to success. The elite in this new society will be, what former Secretary of Labor Robert Reich called, "symbolic analysts," those individuals who, at the nation's best universities, are encouraged to be "skeptical, curious, and creative" and "become problem solvers par excellence, equal to any challenge. Unlike those who engage in mind-numbing routines, they love their work, which engages them in lifelong learning and endless experimentation." ("The revolt of the elites").

As you make your move into the "real world" you will need to know some economics because economics helps you create order out of what often looks like chaos. While most of you are here because you were "forced" into the course and few of you are excited about beginning a semester studying some of the finer points of the "dismal science," many of you may leave the experience excited about it and about what they have learned. The experience will help you on two levels. On a personal level, economics will provide you some insight into an array of critical choices you will be making, and a framework for approaching those choices. What occupation will provide me with a sense of satisfaction and accomplishment? In what industry should I look for a job? Should I go to graduate school? Should I take Spanish as a language, or Chinese? Should I move to Florida or Arizona after graduation? Is this a good time to invest in Google? The list could go on, but you get the point. You have many important personal and professional choices and the things we talk about here will help with those choices.

Economics will also provide you with a way of looking at the world that will allow you to better understand many of the important - and I mean very important - public policy issue you can be expected to voting on in upcoming years. Keynes was right when years ago he wrote: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back." When you hear politicians talking about policy decisions - a tax cut or a new environmental law - you can be assured there are some academics who have studied the issue and provided the theory upon which the decision was made.

It turns out that in your lifetime you will be called upon to help make many important policy changes because we live in a world of too many unsustainable policies. At this time in your life you have probably heard many people make comments similar to "we've always done it this way," as justifications for the status quo, and maybe it has made some sense to you when you have heard it, but be aware that in your lifetime this line of reasoning is wrongheaded and dangerous. The forces that molded the lives of the generation who helped mold today's policies are no longer the forces shaping the world. There are a number of technological and demographic factors that exist today that were never envisioned by those designing today's policies, and in this course we will look at some of those forces and some of these policy choices you will be confronted with in the not so distant future. And there is a sense of urgency since the later we wait the tougher the decisions will be, but politicians who live and die by the election cycle are not likely to make the decisions that protect future workers and their families. To prompt government's to begin to think in terms of sustainability, the International Monetary Fund in 2003 published "Who Will Pay? Coping with Aging Societies, Climate Change, and Other Long-Term Fiscal Challenges, and you might check it out for some ideas on the magnitude of the situation and some possible "solutions."

While there are far too many issues to list them all here, we'll mention just a few that will be in the news because there is no better time than now to get some practice reading and thinking about public policies. A good place to start would be with war. According to economist Brad DeLong, "the twentieth century is unique in that its wars, purges, massacres, and executions have been largely the result of economic ideologies. ... it is hard to see World War II in the absence of Adolf Hitler's insane idee fixe that the Germans needed a better land-labor ratio—more “living space”—if they were to be a strong nation," but it may turn out not to remain unique. The war in Iraq and the efforts to spread capitalism and democracy to those who have yet to embrace those polices. In my generation there were many millions who died in battles between two economic systems - communism and capitalism - and in your generation, in the post 9/11 Afghanistan and Iraq world, there is every reason to believe that the potential for conflict between opposing world views will remain great, although the fault line will be different. For those who tend to learn visually, you might check out the movie 13 Days to see how close this conflict came to blowing up our world, and to see what we never saw at that time. In the early 2000s the US invaded Iraq on the pretense of WMD, but this was not the real reason. The war was an ideological war to spread freedom - read that democracy and capitalism - to the Middle East. For some background on this you might check out "DickCheney's Song of America" that describes the long-standing views of the neocons who pushed for the war since the early 1990s, or you might check out the UN's 2002 Human Development Report, Deepening democracy in a fragmented world where you find the theme for the report to be "For politics and political institutions to promote human development and safeguard the freedom and dignity of all people, democracy must widen and deepen. You can see the US policies as leading the way toward a world where people have freedom, but if you read on there is the cautionary statement that "democracy that empowers people must be built - it cannot be imported."₁

Another key issue would be energy policy since energy is at the heart of the economies of modern wealthy nations and there are billions of desperately poor people around the world who aspire to what these wealthy countries have, and as they jump on the economic growth bandwagon energy demand will skyrocket and conflicts over oil may become a permanent fixture of modern life. Make no mistake, the war in Iraq was about oil, an absolutely crucial input in the modern industrialized world, a fact highlighted in a 1941 National Geographic article "Today's World Turns on Oil" that opens with the statement "Rob US of oil, with its grease and gasoline, and our life rhythm would freeze." Little has changed since then. The same could be said of water, and you can be assured you will hear more about water wars. Maybe Kevin Costner was too early when he produced Waterworld, but the concept is very real. Closely related to energy policies would be environmental policies, and here it is not difficult to see the nature of the problem. At the turn of the millennium, India and China contained 40% of the world's population, but consumed slightly more than 10% of its energy, a clearly unsustainable allocation of energy given the rapid growth rates in the two countries. When we read articles such as "Welcome to the Asian Century" in magazines like Fortune written by well respected economists, then its time to begin to contemplate life in a world where the Chinese do turn in their bicycles for cars and the Indians do manage to industrialize the world's largest democracy. In this world energy consumption in these three countries in twenty five years will be about four times the world's entire energy consumption in 2000 and the images in the movie The Day After will look all too familiar.

Domestically, there are questions of who should pay taxes, what should be taxed, and what the taxes should pay for. Should we move toward replacement of the income tax with a consumption tax and toward a reallocation of taxes from capital to labor? Should the tax system be used to increase or decrease the inequity in the US? These are important questions as tax cuts are being passed that overwhelmingly favor the nation's wealthiest individuals at a time when increasing inequality in the US created a situation in 2000 such that "the share of income received by the top one percent exceeded that of the bottom 40 percent. As a result, the 2.8 million people who made up the top one percent of the population received more after-tax income in 2000 than did the 110 million Americans in the bottom 40 percent of the population." This prompted Paul Krugman to write in "The End of Middle-Class America:" “The first point you learn from these estimates is that the middle class America of my youth is best thought of as not as the normal state of our society, but as the interregnum between Gilded Ages.” Bill Moyers, in a 2003 speech This is your story - The progressive story of America - Pass it on, sees strong parallels in the growing inequality in the US at the turn of the 20th and 21st centuries, which should surprise no one since they have both been described as revolutionary periods - the industrial and information revolutions. We will follow Moyer's lead in this course and examine today's pressing economic and social problems, as well as proposed solutions, in an historical context.

Closely associated with the accumulation of these massive fortunes has been the increased concentration of market power in the hands of a few multinational companies. In this course we will spend time looking at the economic dimension of the concentration of economic power, but you should not lose sight of the political dimension pointed out by Moyers.

And as powerful as the partnership between BIG business and BIG government that comes with the rise of the mega corporations can be, beware increasing concentration in the media. This is a point raised by Robert Hormats in his op-ed article "Technologies of Freedom" that appeared in the Wall Street Journal. According to Hormats, "the lesson of the last five centuries is that information confers political, economic, and social power on those who have access to it," which suggests the control of that information will also confer power.

A little closer to home, the current system for the public financing college education is unsustainable and you will need to join in the debate over the financing of higher education to determine whether in the future the solution will be more funds or less education. For those looking for issues with the potential to set one generation against another, try retirement and health care since today's policies cannot persist too far into the future. Who will pay for the new extended drug benefits? Who will pay for my retirement? Do workers have a right to retire after 20 or 30 years of work or once they reach age 65, and should the elderly be guaranteed life- extending medical treatments and drugs? Many think they do, and it will be your generation that will pay for these "rights," so you can expect a heated debate / battle over these and related issues. What we are talking about here is intergenerational equity, a concept you will be hearing much about in the future because the numbers are HUGE - maybe $45 trillion. This is what Nathan Littlefield, in "The $45 Trillion Problem," explains it this way: "if the US government were a company its owners would pay a rational investor $45.5 trillion to take it off his hands." Putting this number in perspective, "each American's share of the government's long-term unfunded liabilities - meaning tomorrow's debt as well as today's -- comes to about $156,000," and the BIG question is which generation will pay off that debt.

What is it about Economics that will prove so valuable as you grapple with all of these choices? Economics fills a general education requirement in the Social Science division and economists, like the other social scientists (Psychologists, Sociologists, and Political Scientists), are concerned with uncovering the secrets of human society - the "real" world in which we all live and work. If you want to see this first hand you can check out a wonderful publication, Foreign Affairs, where you will find ample evidence of the overlap between political science and economics. In fact, it would be safe to conclude that the division between these disciplines is often blurred, that economics cuts across topics normally considered within the realm of the other social sciences while other social scientists are increasingly using economic frameworks and researching topics once thought to be within the domain of economics. Economists, like psychologists, are very much concerned with the study of human behavior, human judgment, and human well-being. Economists also share with sociologists an interest in the history and structure of human society - in issues of poverty, crime, and discrimination. As one student put it, "Economics is the study of how the world works." Psychologists, meanwhile, have contributed much to the understanding of human behavior that is at the center of modern microeconomics. In fact the 2002 Nobel Prize in Economics was awarded to a psychologist, DANIEL KAHNEMAN, "for having integrated insights from psychological research into economic science."

What separates economics from the other social sciences is therefore not the subject matter. It is also not the method of analysis since in each of the social sciences there has been an effort to employ the scientific method - the development and testing of theories and hypotheses. We are all professional observers of the "real" world whose job it is to make order out of what may appears to many as chaos, to explain why things happen by developing and testing of hypotheses. This is why some think of Economics as a "bunch of theories." There is one minor difference in terms of the method of analysis. Economics tends to be a bit more mathematical than the other social sciences as economists tend to tell their stories with more often with graphs and equations, although researchers in all of the disciplines have increasingly utilized sophisticated quantitative techniques in their work. This explains why many think of economics as "lots of graphs." Because we will rely on some graphs during the semester we will take a little time at the beginning of the course in the second unit to review some of the basics of graphical analysis, but there will certainly be fewer graphs and possibly more tables here than you will find in most of the other introductory economics sections.

If it is not the method or subject that sets economics apart, what then is it that is unique about economics? We will call it perspective. Economists tend to begin with the premise that scarcity exists - it has always existed and it will always exist - and individuals and society must therefore devise systems to deal with it. At the individual level scarcity means people must make choices - precisely the subject matter of much of microeconomics. Success in the "real world" will be dependent upon your decision-making skills, so we begin with a brief introduction to one of the central concepts in economics- opportunity cost. To get yourself up to speed on the topic you might want to look at the Opportunity Cost Reading. The same is true at a larger, societal level. There is not enough "stuff" so everyone can have a 'hot' car, a fancy house, a good education and first-class health care, so each society has had to develop an economic system to allocate scarce resources. Even though economic systems vary across space and time, each system must provide the answers to a set of very basic questions scarcity has imposed on each society - What will be produced? How will it be produced? and Who will get it? Economics is the study of the systems devised to solve these three basic questions - what we will call an economic system - and we will begin this course by taking some time to examine alternative economic systems. As we look back over time there have been many "solutions" to the basic economic questions, but they can be classified into three broad types - Tradition, Command, and Market.

There is one additional factor to consider as you head into your economics course. One of the significant differences between different 'versions' of economics is the ideological bias of the instructor - the way the instructor tends to see the world. It will not take you long to realize that economists have a well earned reputation for disagreement, and one thing they disagree on is the relative merits of these economic systems. These competing views on economic systems will be discussed in the alternative perspectives section where you see why economists disagree so often and why what you read about in the financial section of the New York Times is likely to be so different from what you read about in the Wall Street Journal. We will begin the unit with a discussion of the evolution of economic systems and ideological biases, which provides a backdrop for our discussions of the New Economy.

The evolution of economic systems - or the very brief history of the world

It should not surprise you that over the centuries many solutions to the basic economic problems have been tried, and each solution is unique. The economic system in ancient Greece was different from the systems in ancient Egypt and Rome as well as being different from the current system in the US, which is also substantially different from the systems in Germany, Japan, China ... . Rather than focusing on the differences in the myriad of economic systems that have existed, we will focus our attention on similarities and discuss three major types - Traditional, Command, and Market Systems. The differences between these three systems is readily apparent when you look at your career - how you found yourself in business (or TMD or engineering), how you ended up in an economics course, and how others decided not to enter college. One approach to allocating the limited number of "university slots" would be to allocate them the way they had always been allocated. If your parents went to college, then you would go to college: if your father was an engineer, then you would be an engineer; if your mother liked her economics course or thought it was valuable, then you would enroll in an economics course. Scarce resources would be allocated as they had always been - by Tradition.

An alternative approach would have been to have some "BIG BOSS" make the decisions on who would go to college and who would major in engineering. For this system to run smoothly we would need a modern-day Pharaoh or Czar with the power to decide how many engineers are needed, who they should be, and where they should work. You would also need someone to determine who needed to take economics courses. In this world scarce resources would be allocated by Command. A wonderful example of life in a command society could be found in the article "This is Monika. I'm Over the Wall" that appeared in the Wall Street Journal. In that article a young East German girl who comes in contact with a Westerner describes her career "choice" as follows. "It doesn't what we will become when we grow up. We will still always be treated like children." As Monika saw life in the East, she would always be told what to do so she would never get the chance to "grow up" and make her own choices.

And then there is the system in which you choose to be an engineering student. For some the choice may have been made because a parent enjoys life as an engineer; for others it may be the higher-than-average starting salaries for college graduates with an engineering degree; and for others it may be the love of applied mathematics that was the deciding factor in the choice. As for enrollment in economics courses, students were there because they thought it was in their best interest to be there. If we had a world where the allocation of resources was determined by people pursuing their own interest, we would have a world in which the Market determined resource allocation.

Which of these three systems is best? This is a tough question since each system has advantages as well as disadvantages, but you can see that in your career and course choices. There is a great comfort in following in your parents' footsteps because they can act as mentors and contacts. It can also be nice to have someone tell you what to do so you will not be forced to make too many difficult choices. We may very well find a young woman who is quite satisfied becoming a lawyer because her mother was one, or a young man happy to be taking courses he is required to take. It should not be surprising that societies organized by tradition or command are rather static, that the pace of change is slow and the concept of economic growth is virtually nonexistent. Some indication of the situation in a world dominated by tradition and command can be seen in the graph of GDP per person (a measure of the standard of living) that appeared in The Economist magazine a few years ago. When you look at GDP per person you should think standard of living, or income the "average" person has access to. It is very clear in the graph that for many centuries there was little increase in income - Western Europe was characterized as a zero-sum game where the gains of any individual were offset by the losses of others. For the "common person" there was little difference between life in 1000 BC in Greece and Germany in 1500 AD - the overwhelming number of people lived off the land, were illiterate, never ventured more than a few miles beyond their home, and died young. This was a world where society was organized under either a Command or Traditional economic system.

It is also clear that something BIG happened around 1700-1800 in Western Europe, something that introduced to the continent the concept of economic growth. The zero-sum world of no growth was replaced by a world of continued rapid growth, and while there were many factors responsible for the turning point, one was certainly the emergence of a new economic system providing a foundation for the industrial revolution that was responsible for the sudden change in income trajectory.₂ It was just around this turning point, in 1776, when Adam Smith wrote his book, The Wealth of Nations, in which he demonstrated how "self interest, tamed by sympathy and constrained by economic rivalry, leads to a widespread prosperity known as 'universal opulence." Smith was laying out the framework for the market system he believed would unleash economic growth on the world and improve the standard of living for the common person. Make no mistake though, it was a very painful and difficult transition from the ordered agricultural world of feudalism in the Middle Ages, where everyone knew their position in life, to the chaotic industrial world where markets determined what one would do and how much one would be paid for that work. For a glimpse of the hardships associated with this transition all you need to do is read any of Charles Dickens' work such as The Christmas Carole or David Copperfield where the human misery is readily apparent. And for those with a true taste for travel, you could travel to South America, Asia, or Africa where you would see many nations currently in the midst of much faster transition to a market-driven industrial society. Or you might rent the video, Battle of the Titans, where you will see unsettling scenes of industrialization and urbanization in developing Asia and Africa.

Not surprisingly, the ideas of Smith came to America with the thousands of immigrants from Europe, and one of the benefits of going to school in New England is that you can get an idea of how life and society was transformed by the industrial revolution and the emergence of the market system by taking a brief road trip. For those less adventurous, you might take a virtual trip through time by checking out A Digital Archive of Architecture and Digital Archive of American Architecture. On your road trip start with a visit to Plimouth Plantation where you can see first-hand a recreation of a community in the early 17th century (1627), and then head to Slater Mill in Pawtucket where you can see one of the nation's first factories of the industrial revolution from the late 18th century (1790s). These places give you an insider's view on life in the pre industrial revolution world, the world before the turning point in the graph. And before leaving these places make sure you look for the closets in these early homes. They are there but you'll need to look carefully because there weren't many. It turns out this was pre " universal opulence" and it was unlikely there would be those extra clothes and shoes that take up modern walk-in closets. And forget about looking for indoor plumbing and central heating.

Then head off to Sturbridge Village where you can get a 'feel" of rural, agricultural life and then to Lowell National Park where you get a "feel" of urban, industrial life in the mid 19th century (1830-1860). This was the early stages of the industrial revolution in the US, and you can see it in the massive size of the mills with their boarding houses for young women workers in cities such as Lowell and in the appearance of some of the trappings of universal opulence in the dining room of a home in Sturbridge Village that most certainly had closets, but you wouldn't find running water or a modern toilet.

Now get back on the road and head to Fall River where the massive granite and brick mills give you a glimpse at what a "world-class" textile city looked like in the early 20th century as the US found itself in the midst of the second industrial revolution that forever changed the lives of Americans. It was this era when there was a surge in innovation that brought us electricity, the telephone, radio, and the car. To give you some idea of the situation in the US at the turn of the 19th century, check out the images created by Gordon who wrote "Does the New Economy Measure up to the Great Inventions of the Past?."

And to finish your journey you should head to Boston where you can see a world-class city of the early 21st century with its glistening skyscrapers and McDonalds and Starbucks shops. What should be clear from your trip would be the massive changes that took place during this period, and you can easily imagine the > rapid pace of change was often unsettling as people continually changed jobs and locations.

The "beauty" and potential that Smith saw in the market system was not seen by everyone, which should not be a surprise since not everyone benefited from the system. There were certainly a number of characters in Dickens' work who would have had a hard time seeing the good in capitalism. Karl Marx, writing during the second half of the 19th century, had a very different view of capitalism, one more in line with what you would have expected by Dickens' characters. Where Adam Smith saw capitalism as possessing a potential for unprecedented economic growth, Marx saw it as possessing a fatal flaw that would eventually bring about its collapse. Capitalism was a system built on the exploitation of labor. Over time the number of laborers would increase while their earnings would decrease, while the number of capitalists would decrease while their earnings would increase. This ever widening gap between the wealthy few and the numerous poor would eventually cause a collapse in the capitalist system so Marx viewed capitalism as an intermediate stage in the evolution of economic systems. The first outbreak of such a revolution occurred in Russia in the early 1900s as the Russian peasants overthrew the Czar in 1917 during WW I and established the Union of Soviet Socialist Republics (USSR). As of 1917 there was now an alternative to capitalism, and people around the world would eventually have to "choose" sides - between capitalism and communism. [You might want to check out the Karl Marx web site for more information and some of his original writings].

If there were any doubts about the ability of communism to appeal to other people, the doubts were ended in the 1920s with the beginning of a second "communist" revolution - this one in China. Following the lead of the Russians, a communist revolution began in the South of China, but by the 1930s, after possibly a million deaths, the communists were "forced" from their land and began the "long march" into the mountains of northern China where they 'regrouped" under the leadership of Mao Ze Dong. With the defeat of Japan in WW II the communists renewed their attacks on the government and by 1949 the communists were victorious. The rest, as they say, was history. It did not take long before the world was divided into three groups - the capitalist countries lead by the United States (US), the communist countries led by the Soviet Union (USSR), and the "undecided" countries that the US and the USSR spent a good deal of time and money trying to bring into their sphere of influence. In fact, much of the post WW II Cold War era can be viewed as a battle between two economic / political systems - capitalism (market control) in the West vs. communism (command control) in the East. The US and the USSR spent many billions of $s on building up military capabilities to "protect" their territory and the wars in Vietnam and Korea are just two examples of where the Cold War heated up.

The nature of the conflict, however, changed dramatically in the late 1980s as the people in a number of communist countries revolted against the ruling communist party and the Iron Curtain that had shut them off from the capitalist West began to crumble. The most notable part of the collapse of Eastern Germany was the dismantling of the Berlin Wall. When the wall between Eastern and Western Germany came down, the consensus was that capitalism had proved itself superior to communism and the ideological debate had been settled. In fact in 1989 Francis Fukuyama wrote an essay entitled "The End of History" in which he noted that "a remarkable consensus concerning the legitimacy of liberal democracy as a system of government had emerged throughout the world over the past few years, as it conquered rival ideologies like hereditary monarchy, fascism, and most recently communism. More than that, however, I argued that liberal democracy may constitute the "end point of mankind's ideological evolution" and the "final form of human government," and as such constituted the 'end of history.' That is, while earlier forms of government were characterized by grave defects and irrationalities that led to their eventual collapse, liberal democracy was arguably free from such fundamental internal contradictions." Although his focus was on political systems, the same could have been said about economic systems and the superiority of capitalism. Capitalism had shown itself to be a superior system and it would only be a matter of time before it spread across the remainder of the world sweeping aside the last remnants of tradition and communism.₂ Not everyone agreed that history had ended, and in fact Samuel Huntington gained some notoriety for a very different view of the future, one in which the Cold War that pitted two economic systems against each other would be replaced by a new conflict, The Clash of Civilization?. In the 'new world" you will see Western civilization competing with other civilizations - Confucian, Japanese, Islamic, Hindu, Slavic-Orthodox, Latin American, and African - and there was no reason to believe in 1993 when Huntington was writing that the other civilizations would openly adopt the Western view. Robert Kaplan, in "Was democracy just a moment?," goes a step further and suggests that maybe democracy is not always the ideal system, and that as the process of globalization continues and corporations gain increasing power you may see democracy as we know it today disappear. You would not be too far off the mark if you looked at the US invasion of Iraq as one such clash, one that would hardly be described as peaceful. The belief expressed by the Bush administration that American soldiers would be treated as liberators suggests their acceptance of the end of history over the clash or civilizations view, but as I write and you read we would have to say it is "too early to call."

What is it about the market system that helped unleash the powers creating unimaginable growth? How is it that an entire system in which scarce resources would be allocated by the choices of individuals doing exactly what they want to do would actually work? For this system to be effective, decision makers need both the information necessary to make informed choices as well as the incentive to make those choices. You need to have some incentive to get out of bed in the morning as well as some idea of what to do with your time once you are out of bed. In the market system, prices provide the necessary information while property rights, which enable the owners of property to use their property and to sell it, provide the incentives. Getting back to the career choice problem, you have decided to be an engineer because the price (income) was right and with your new wealth, which you have the rights to control, you would be able to obtain those things that matter to you. Furthermore, you are much more likely to work diligently if you are studying to be a lawyer because you want to be a lawyer, if you are taking a course in history because you want to know more about history, or if you are working on development of a web site because you own stock options that could make you rich if the product ever hits BIG.

But how do we avoid chaos when all decision makers are pursuing their self interest? The "secret" is in the interaction between the individual decision makers. The nature of the interaction can be seen below in a very simple version of the Circular Flow Diagram identifying the three major aggregate markets (output, capital, and labor) that tend to bind the major decision makers (households, firms, and government) together. Households / individuals buy goods and services in the output market, sell labor in the labor market, and borrow money (mortgages, car loan) and lend money (savings account, mutual fund) in the capital market. [We have ignored the rest of the world here, but we will expand this model later to include it.]

In the case of your career choice, the logic of the system would go something like this. In the output market we could find evidence that people want computers. The output market would send a signal (high profits) to firms prompting them to raise the production of computers. This generates a need (demand) for more electrical engineers prompting the labor market to send out a signal (higher wages for engineers). People respond in a predictable fashion to this signal. Because they can keep the money earned from selling their skills, more people will decide to become engineers as the wages of engineers increase. As more people decide to become engineers there will be more people needing to borrow money to finance their schooling and the capital market will send out the appropriate signal (higher price). The higher interest rates (price of money) should increase savings, which should result in an inflow of money into the capital market providing adequate financing for the new students ... . We can stop now because you can see the pattern of interaction that defines the market system. To get yourself up to speed on the topic you might want to look at the Supply and Demand Readings

Before we move on, however, it is important to know that there are many versions of capitalism. A very abbreviated overview of the versions can be found in "The good (and bad) model guide," an article that appeared in The Economist magazine where reference is made to a number of models including the American, Japanese, German, and East Asian models. In the Japanese model, loyalty and longevity were highly prized so workers - at least some - had guaranteed lifetime employment and pay was largely determined by length of employment. Corporations, meanwhile, because of their strong relationships with banks, were able to avoid the focus on short-term stock prices and focus their efforts on loner term investments. And the system worked BIG TIME. Japan's economy had been obliterated during WW II, but by the end of the 1980s Japan economy had risen to the point where people were beginning to talk about the 21st century as the Japanese century. The US was slowly losing its economic leadership role as we began to buy Japanese products - think cars and electronics - and the Japanese began buying the US with the $s - think Pebble Beach in CA and Rockefeller Center in NY. The belief in the superiority of the Japanese model can be seen in James Fallows' 1993 article in The Atlantic Monthly, "How the World Works." Fallows identifies significant differences in the "Anglo-American" economic theories and policies and those in other capitalist countries such as Germany and Japan. If you look carefully at Fallows work you will find he believed the Anglo- Americans were being beaten in the world economy by a country that was better managed by agencies such as Japan's MITI (Ministry of International Trade and Industry), by countries that "managed" markets rather than let them run freely. As Fallows saw it, "violating the rules of Anglo-American economics - may be indispensable for nations that are trying to get ahead' and that the US would eventually lose out to those countries that "rigged" the system of markets. The problem for Fallows was that the US had lost its way, had given up on its "managing" of its economy, and that the slide of the 1970-1980 period could be expected to continue unabated as the managed economies continued their rise.

As it turns out Japan did not take over the world and in fact they had to sell back Pebble Beach and Rockefeller Center at a substantial loss. Confidence in the Japanese model was shattered as Japan's economy suffered through a decade long recession, and for those looking for an interesting perspective on why the Japanese model ground to a halt you might want to check out The Social Contradictions of Japanese Capitalism where you see the uglier side of a well-developed case of crony capitalism. The US economy, meanwhile, boomed as it became the center of the Internet revolution that amazingly began in the early 1990s. This should be no surprise given that the American model of capitalism is one where resources can move quite freely between sectors of the economy, where markets are quite flexible, taxes are low, and corporations tend to focus on stock market value - a perfect setting for the Internet revolution. To better understand the American model, consider the situation in Megacorp, a hypothetical world leader in the production of high tech widgets. This is an organization with a well developed management hierarchy, a structure that has made it the world leader, a structure filled with individuals who have learned the secrets of success in the industry. Now imagine yourself as a young hot shot who has to tell the boss, who has been there for years, that there is a need to change strategies, that all the boss has been responsible for creating in his or her professional life will need to be destroyed to enable the creation of a newer, better, faster, cheaper way of doing things. It will not be an easy meeting for you, and as the company gets bigger, it will be even more unpleasant and difficult to elicit change. Unfortunately Japan's economy, dominated by large companies that rewarded loyalty and longevity, was not the right environment to foster a revolution. A wonderful example of this could be found in John Markoff's article "A Rebel in Japan, an Inventor is Hailed as an Innovator in US," that appeared in the New York Times in 2002. Markoff relates the story about a scientist in Japan who had to hide his patents from his bosses. Another example can be found in the 2001 Foreign Affairs article by Clayton Christensen, Thomas Craig, and Stuart Hart, "The Great Disruption" where we see how the structure of Japan's corporate management was responsible for Japan's missing the Internet revolution. Success in the New Economy requires individuals willing to take risks, individuals willing to look relentlessly for a better way to build that mousetrap - and the US had more than its share of these change agents while Japan had less than their share. The downside is that inequality is a problem with the gulf between the well-to-do and the poor being wider in the US than any other rich country.₄ The prevalence of inequality is also a growing problem in China as they move from a command to a market economy - the theme in the article "To each according to his abilities." Another place to look for some insight into the important differences between versions of market economies and the significance of these differences would be the OECD's publication, The New Economy: Beyond the Hype in which explanations for the growth differentials - the ability of the US to pull away from most of the wealthy countries in the 1990s - are sought. The contrast between the European and American models can also be found in Gordon Brown's article "Old Europe's Choices" that appeared in the Wall Street Journal in 2003 and "Europe's Scrap-heap" that appeared in The Economist in 2001.₅ The short answer is the dynamism of the US version of capitalism where markets are more powerful and freer to adjust to shocks and government interferences are smaller.

Before we begin our detailed discussion of what you can expect in this particular course, we will take a moment to discuss some of the alternative perspectives on economic systems. Economists are notorious for their ability to disagree and we will briefly examine one source of disagreement - what some would call an ideological perspective.

Anyone who listened to even a little of the committee hearings on Bill Clinton's impeachment in December of 1998 or the debate on George Bush's tax cut in 2003 knows the power of political parties. Regardless of one's views on the validity of the charges against Clinton or the value of Bush's tax cuts, there was no question they were partisan affairs where you could identify a person's party from his / her comments. There is a difference between the way Republicans and Democrats see the world, and this is reflected in nearly all that they say and do, although sometimes it is not so obvious in their campaign statements. The same is true to some extent in economics because economists have very different views of the world - what we will call ideology. Whereas in politics we have Democrats and Republicans, in economics we have Conservatives and Liberals.₆ It is conservatives and liberals whose opinions and theories you might expect to see in print on the pages of The Wall Street Journal and The New York Times.

Conservatives tend to possess a general distrust of the state (government) and an unending faith in the supremacy of "free choice" as a mechanism for allocating resources and promoting growth. The Father of Conservative economists would be Adam Smith who wrote The Wealth of Nations in 1775 and first outlined the capitalist economic system that allocates resources in a decentralized fashion by individuals pursuing their own self interest. According to Smith, "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest," and it is the pursuit of this self interest that society will produce what individuals want in the most efficient manner. For conservatives, a good government is a small government simply setting the "rules" to govern the competition among businesses and individuals. In his book Smith describes the situation as follows:

Liberals, meanwhile, share with the Conservatives a strong faith in the market, but believe there are advantages to be gained by moving to a "compromise" position where the government is able to devise policies to offset some of the "structural flaws" of the system. Liberal theorists believe there are instances where the capitalist system behaves less than optimally, including a tendency to produce unacceptable and avoidable levels of economic instability. One of the more influential liberals, and the father of modern macroeconomics, is John Maynard Keynes who wrote The General Theory of Employment Interest and Money. In his critique of the prevailing conservative theory, Keynes wrote:

As Keynes saw it, the conservative view emphasizing the power of markets to allocate resources may be an adequate explanation of what would happen in the long-run, but we may not have the will to wait that long.

The truth, as so often happens, probably falls somewhere in the middle. For those with an open mind I trust you will find truth in the statement: “the liberal mistake is to think that there is a program or policy to alleviate every problem in the world, the conservative flaw is to be vigilant against concentrations of power in government only – not in the private sector.” Keep this in mind as you read the op-ed pieces in The Wall Street Journal pushing the conservative agenda and The New York Times where you will find the liberal perspective. A great example of the differences could be found in the 2003 discussions of Bush's tax cut proposal. The Wall Street Journal continually supported the tax cuts designed to "starve" the government of funds and force it to get smaller while The New York Times relentlessly focused on the cuts in government services that were associated with the tax cuts. A good example of a liberal bias can be found in Paul Krugman's article, "Bums and Rushes" that appeared in the New York Times.

A reoccurring theme in the two introductory courses will be the parallels between economic theory, economic policy, and economic performance. Economic policies will be grounded in the prevailing economic theories and there will be little pressure to unseat those theories or policies as long as the economy is performing adequately. It is only in times of economic crises where there is any real movement in public policies and any shift in the balance of power among theorists - a reversal of the ideological pendulum.₅

When we look at the history of the US there have been only two turning points, two time where the ideological pendulum reversed itself. The first such crisis was the economic collapse of the Great Depression in the 1930s that was so complete that it is difficult to comprehend its magnitude today - but we'll try. First, take a moment to read a passage from John Steinbeck's book, The Grapes of Wrath, and then look at the unemployment rate graph.

With nearly 25 percent of the nation's workers unemployed and countless thousands migrating out of the cities and farms and heading westward, it was time for the nation's leaders to reconsider the status quo, which is precisely what Roosevelt did. Following the advice of economic theorists such as John Maynard Keynes, Roosevelt moved the country to the ideological left with adoption of the liberal policies known as the New Deal. The philosophy of the liberals is captured in a 1960s Supreme Court decision: "We have come to recognize that forces not within the control of the poor contribute to their poverty. .... Public assistance, then, is not mere charity, but a means to "promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity." ("Evident truths," Harpers July 2004) It was the responsibility of the government to protect its people, and Roosevelt, having seen the ravages of the Great Depression and WWII, recognized that all of the enemies of the American people were not foreign countries. Roosevelt committed the nation to a second Bill of Rights in his 1944 state of the union address in which he set out the guidelines for the nation once the war was over. These rights were to complement the first set of rights, free speech, free press, free worship, trial by jury, freedom from unreasonable searches and seizures that appeared in the US Constitition. According to Roosevelt, Americans had the:

In fact you can see this philosophy in the interim Iraqi constitution "ghost written" by the US: "The individual has the right to security, education, health care, and social security." ("Evident Truths," Harpers July 2004).

This is not, however, the prevailing mood in the early 21st century in the US. There was a second economic crisis significant enough to shift the ideological balance, this one in the 1970s when the US suffered through the Great Stagflation - the simultaneous appearance of both high levels of inflation and unemployment - what a policy official might consider the worst of all possible worlds. The liberal economists found themselves unable to adequately explain the rising unemployment and inflation rates, the loss of 100,000s of American jobs to foreign competition, and home mortgage rates nearing 20 percent, which opened the door for conservative economists who provided the theoretical basis for Ronald Reagan's movement of the country back to the ideological right with his supply-side policies. It is this conservative ideology that continued to dominate economic theory and policy at the turn of the millennium, where you might characterize the situation as: "the United States seems to have embraced a form...of individualism, which endorses rights of private property and freedom of contract but claims to distrust 'government intervention' and insists that people must fend for themselves." ("Evident truths," Harpers July 2004) You can also see the significance of ideology in the following excerpt that appeared in Harpers magazine. A journalist documented changes in the US Fish and Wildlife Service website in the week following Bush's inauguration. The words with the strikethrough were dropped from the wording under the Clinton administration. ("Dept. of Corrections" Harpers 6/2001).

If you take out the deleted words the "picture" looks very different, and this is the power of ideology. In this course the discussions will be focused on the ideological spectrum spanned by conservatives and liberals, although there are important ideas about economics that do not fall in that range and we will also touch on some of them during the semester. You should also realize that the introduction to economics is generally divided into two separate courses. The first would be Microeconomics. The analysis of a career choice, as well as the choice of someone to teach you economics, would be the subject matter of microeconomics where the emphasis is on the choices made by individuals and firms - how many hours to work, how many children to have, how much output to produce, and how many workers to employ? As you will hear me say many times, we look at decision makers as calculators continuously weighing the costs against the benefits associated with any decision/choice, and we'll look closely at how those calculators work.

In Macroeconomics the emphasis is on how well these aggregate markets function. Can we expect the labor market to function effectively so all people looking for work can find it? Will there be a job waiting for you when you graduate? Can we expect the output market to function properly? Will there be inflation eroding the buying power of your earnings, and will there be economic growth so we can enjoy a future in which the standard of living continues to rise? And will the capital market provide enough funds so people can borrow money to finance their education and buy their cars and homes on credit, or will there be a return to 18 percent mortgage rates and credit crunches. These are important issues, but they are beyond the scope of the micro course.

Now for the question so many of you have been waiting for: How much math will you need? As you saw earlier, economics involves story telling and the teller of the story has a considerable say in how much math will be used in the story. While my college degree was in mathematics and I believe very strongly that adequate quantitative skills would be on the short-list of skills all students should posses upon graduation from college, there is no need to rely on sophisticated mathematical / statistical techniques to tell the stories that told in this course.

There are actually four ways in which to tell our stories, and during this semester you will run into examples of all of these. The four forms for story telling are:

To give you an idea of the differences in the "presentation" of the story, consider the following rather simple story about population growth. In the past few years we have heard much about the rapid growth of the world's population and the havoc it is wreaking on the environment, but how important are the proposals which would reduce the growth rate of the world's population.

As a first step toward answering this question, let's look at the situation in twenty years. At the present time the world's population is approximately 5.8 billion and it is growing at a rate of 1.4 percent per year. If it continues to grow at that rate, then the world's population in ten years would be 6.67 billion, and at the end of twenty years it would be nearly 7.7 billion people. So much for the verbal approach.

In addition to the verbal representation, the story of population growth could also have been told using a table such as the one below. The advantage of this is that more information can be seen quickly - we can see what the population would have been at six different points in time in the future.

Or you could present the relationship between time and population with a graph comparable to the one below. The advantage of the graph is we see the continuous growth of the population for the twenty years. The disadvantage is we cannot read off what the population would be in any one year.

Finally, for those who have a good command of mathematics, we could use the algebraic version. The solution for the world's population in twenty years [Pop (20)] using the equation would be:

Now let's look at the New Economy that this course focuses on during the semester.

What a difference a decade can make. At the outset of the 1990s Japan was being touted as the "role model" for economic growth and prosperity and the US economy mired in a recession. This was a time of "downsizing" with workers being laid off from the nation's largest corporations and doubts beginning to surface about the ability of the nation to generate enough jobs for those being replaced by computers. The US economy had slipped into a recession that hit the two coasts hardest, with the Massachusetts' Miracle turning into the Massachusetts' Massacre as the New England real estate bubble of the 1980s burst. US firms were not competing effectively with the highly efficient Japanese firms, the US economy had lost its vitality as it struggled under the weight of enormous federal budget deficits, and the nation seemed incapable of moving out of a recession that swept Bill Clinton into office in 1992 on the strength of his "It's the economy stupid" campaign. For those with RI ties, you may remember this as the time when Governor Bruce Sundlun closed the state's credit unions. The gravity of the situation is evident in the titles of a few articles from that period.

At the outset of the 21st century, however, things looked very different. Japan found itself mired in a decade long decline - what some called a "Quiet Depression" and prompted many to revisit the Great Depression in the US in the 1930s for some insight into the problems and policy choices facing Japan. One example of this literature would be Paul Krugman's Foreign Affairs article, The Return of Depression Economics. Another would be "What ails Japan?" a 2001 Survey of Japan in The Economist (April 20, 2002). On the other side of the Pacific the US had reestablished its position as the developed world's most vibrant economy, actually distancing itself from the other developed countries after decades of slower than average growth. At the end of the 1990s the United States was THE dominant economy in the world - it was THE economic super power with no challengers in sight. While it may be possible to debate the validity of the claim that the world is in the midst of another truly great revolution, there is little disagreement with the assertion that the US has been ground zero in the Internet "explosion," that the flurry of innovations behind the meteoric rise of the Internet has been centered in the US, that at the start of the 21st century the US was the "role model" for developed countries. At the outset of the new millennium it was virtually impossible to listen to the news and not hear mention of the "New Economy," or maybe it was the Knowledge Economy, the Internet Economy, the Information Economy, the E-conomy, or the Post-Industrial Economy. Regardless of what it was called, it was the marvel of the developed world, as can be seen in the headlines at the decade's end. The gloom-and-doom headlines had been replaced by stories of hope and promise, and if there were any concerns, it was that things were too good to last.

The 1990s was also a decade in which dot.com seemed to mesmerize investors and drove the NASDAQ stock market index into the stratosphere - a surge that dwarfed the stock market run-up in the 1920s. Using annual data to compare the six years leading up to the crashes of 1929 and 2001, the Dow Jones Industrial Average (DJIA) increased by 100 percent during the nineties, slightly less than the 150 percent run up during the 1920s, and substantially less than the technology stocks on NASDAQ that increased 350 percent in the 1990s.

But as so often happens, dramatic rises in asset markets are followed by equally dramatic collapses and by early 2001 the boom had become a bust and the mania had become a massacre. One response to the crash was "I told you so," as the nay Sayers focused on the stock market crash as an indicator of the New Economy's demise. In fact they often took it as a sign that the New Economy was more hype than substance, that AOLs of the world had no business taking over the Time-Warners, and the market has corrected itself. A second response to the crash was that the stock market crash had little to do with the New Economy. Robert Litan, in The Death of the Dot-coms Spells the Beginning of the End of the New Economy debunks some popular myths about the New Economy including one entitled, "The Death of the Dot-coms Proves the Internet Was Overhyped." To Litan, who has spent a considerable amount of time exploring the link between the economy and the Internet, it is very clear that the stock market bust of 2000-2001 will have little bearing on how the future plays out in the long run and on whether the revolution ever gets off the ground.

So if the stock market boom and bust does not tell us much about the New Economy, then what is it - what's so new about it, what were the critical factors behind its emergence, and why did it emerge in the US? This is what we will focus on in this unit. To find answers to these questions it is essential to understand the basics of economic systems and alternative perspectives (ideologies).₇ Much of the 20th century was dominated by a conflict between two economic systems - capitalism and communism, but once the "Wall" separating East and West began to crumble in 1989, the conflict was accepted by many as being over, and for Francis Fukuyama, it meant "The End of History."₈ At the heart of the capitalist system that had "won" the Cold War are prices that provide the necessary information for decision makers to make those "rational" decisions, while the incentives - to get out of bed for example - are provided by property rights that enable the owners of property to use the property and sell it as they please. All market systems, however, are not created equal and the consensus seems to be that American "version" was better suited to "host" the Internet revolution and become the "poster child" for the New Economy.₉

To understand the nature of the turnaround in both Japan and the US it is essential to appreciate the peculiarities of the two countries and their economic systems. A good sense of the situation in the two countries, as well as how thinking on the sources of economic power and success changed during the 1990s can be found in the 2001 Foreign Affairs article by Clayton Christensen, Thomas Craig, and Stuart Hart, "The Great Disruption" and James Fallows' 1993 article in The Atlantic Monthly, "How the World Works," It turns out that Japan and the US have very different versions of capitalism, and that Japan's version proved itself to be less receptive to hosting a revolution, although the decade began with widespread belief that Japan's economic system was superior. Another place to look for some insight into the important differences between economies and the significance of these differences would be the OECD's publication, The New Economy: Beyond the Hype in which explanations for the growth differentials - the ability of the US to pull away from most of the wealthy countries in the 1990s - are sought.

So what is it about the US that made it so receptive to the Internet Revolution? To introduce you to the basics of the New Economy you should read Chapter 1 of the Council of Economic Advisors' 2001 Economic Report of the President. In this work you will learn what the New Economy is and what factors contributed to it's appearance, with a heavy emphasis on policies in the Clinton administration since this is an assessment of the Clinton years by Clinton's Council of Economic Advisors (CEA). A somewhat abridged version of the "New Economy story" can be found in the article, "Do We Have A New E-conomy?" by Martin N. Baily, the Chair of the CEA for Bill Clinton and author of the 2001 Economic Report of the President, and Robert Lawrence. It turns out the story of the New Economy has both microeconomic and macroeconomic dimensions, a division emphasized by J. Bradford De Long and Lawrence H. Summers in their article "The New Economy: Background, Questions, Speculations. And William Sahlman, in "The New Economy is Stronger Than You Think," arrives at much the same conclusion - that all is well with the US economy - a conclusion he reaches by focusing attention on the business system. In his view "[t]he economic, social, and cultural factors under girding the new economy are rock solid."

What was it that was "new" about the US economy, why was the US the center of the New Economy, what impact has it had on the US economy to date, and what impact can we expect it to have in upcoming years? These are the questions to be addressed in this course. A good place to start the search for answers to these questions would be the Council of Economic Advisors' (CEA) 2001 Economic Report of the President in which the theme was, "The Making of the New Economy," and the OECD's Growth Report, "The New Economy: Beyond the Hype." An abridged version of the New Economy story can be found in the short article, "Do We Have A New E-conomy?" by Robert Lawrence and Martin N. Baily, the Chair of the CEA for Bill Clinton and an author of the 2001 Economic Report of the President. Furthermore, not surprisingly it turns out that the story of the New Economy has both microeconomic and macroeconomic dimensions, a division emphasized by DeLong & Summers.

According to the CEA, the Report "presents evidence of fundamental and unanticipated changes in economic trends that justify this claim [of a new economy]." The New Economy can be 'captured' in the exceptionally favorable macroeconomic performance in the 1990s - strong economic growth, low and stable levels of core inflation, declining rates of unemployment, the disappearance of the federal deficit, and a strong performance of the US relative to that of the world's other developed countries. The US was the economic superstar in the 1990s after decades of relative decline - a testament to the power of the New Economy. At the center of the transformation was the revival of productivity growth, which is why the CEA devotes so much attention to this issue in Chapter 1 of the 2001 Economic Report of the President - and why we will devote time to this issue in the macroeconomics unit - so you need not worry at this time about the details.

The first, and the one that gets the most press, is the rapid rate of technological change in computer hardware and software and telecommunications, an issue we explored in the course's first unit. The figures are simply mind-boggling. When we talk about technological advances in computers the discussion usually comes around to what is known as Moore's Law, in honor of Gordon Moore, a founder of Intel, who in 1965 made his famous prediction that the number of transistors per integrated circuit would double every 18 months. This is what DeLong believes is the driver in the New Economy. As you can see in the table below that appears on the Intel web site, the law is still very much in effect, although it appears to be doubling in approximately 24 months. Over this 29 year period the number of transistors per chip increased at an average annual rate of 76%.

*Processor*	*Year of introduction*	*Transistors*
4004	1971	2,250
8008	1972	2,500
8080	1974	5,000
8086	1978	29,000
286	1982	120,000
386™ processor	1985	275,000
486™ DX processor	1989	1,180,000
Pentium® processor	1993	3,100,000
Pentium II processor	1997	7,500,000
Pentium III processor	1999	24,000,000
Pentium 4 processor	2000	42,000,000

By being able to put more transistors on a silicon wafer, the cost and size of the chips drops sharply, which is why Moore's Law is at the heart of the productivity growth in computers and the fall in their prices. A few stats from Chapter 3 of the 2001 Report will convey the magnitude of the advances. Between 1980 and 2000 the speed of processors increased 100-fold, while the cost of performing 1 million instructions fell from $100 to less than $.20. Over the same period the price of 1mb of hard drive storage fell from $100 to less than $.01, while micro drives shrunk from the size of a refrigerator to the size of a matchbook - and the price dropped from about $40,000 to under $500. In An E-conomy?, DeLong et al note that in the 1950s there were about 2000 installed computers that averaged 10,000 instructions per second (ips), and by 1999 the number had grown to 200 million computers averaging 100,000,000 ips - a million fold increase driven by an annual growth rate of 35%. And there were also significant improvements in the area of telecommunications. Between 1980 and 1999 the cost of sending 1 trillion bits of information electronically fell from $129,000 to $.22. And if anything, the pace of change has accelerated since 1995. Between 1995 and 2000 the quality adjusted prices for computers and peripherals declined 71% while fiber optic capacity increased by factor of 20 between 1996 to 2000. In An E-conomy? DeLong et al note that in the 1960s and 1970s data could go over phone lines at 300 bits per second, but by 2000 the speed was 53,000 bits per second - an 18% per year improvement in speed of data transmission. And finally the software industry, private investment increased from $11 billion in 1980 to $225 billion in 2000 - a 16 percent per year annual rate of increase.

There is no question computers could do more, faster and cheaper, than anyone could have reasonably envisioned fifty years ago - and the data could be transmitted at unforeseen rates, but would someone buy all this technology? The answer was a resounding Yes. The result of these technological advances was a burst in spending on IT. A decade of IT spending that average 19 percent growth a year - and 28 percent after 1995 raised the IT sector's share of the entire economy 43 percent - from just under 6 percent of the economy to 8.3 percent. IT investments accounted for approximately 33% of output (GDP) growth during the latter half of the 1990s. A good "picture" of the technological improvements and the expansionary effects of the Internet can be seen in the graphs of the Intel data and the CEA data on worldwide Internet hosts. In the 1990s the number of transistors per chip increased at an average annual rate of 38%, about half the rate of increase in Internet hosts.

The second set of factors identified by the CEA are the organizational changes that the CEA places in one of four categories - "changes in the competitive environment, changes in organizational structure, changes in compensation and finance, and innovation in complementary technologies." Cohen, DeLong, and Zysman (CDZ), in "Tools for Thought: What is New and Important about the E-conomy?" see much the same thing. "The E-conomy is as much a story about changes in business organization, market structures, government regulations, and human experience as it is about new technology. Taken together, the business innovations represent a new business ecology that includes a prominent role for venture capital, the start-up, the spin-off, the new option based ways of compensating skilled workers and entrepreneurs - innovations that have unleashed a tsunami wave of new business and new technology." In fact CDZ give this a name - "The Silicon Valley System" - a set of "[s]ocial institutions-such as research universities, venture capitalists, and specialized law firms - and market institutions - such as an extremely flexible labor market, incentive compensation, financial capital, and ultra-high-skilled people from the entire world - have come together to form a Silicon Valley system. ... This new industrial system has become a critical growth engine for the world, and a strong source of comparative advantage for America -and will be until it is successfully imitated elsewhere." The rapid pace of technological change in the IT industry that was reflected in the unprecedented price declines was not an exogenous "event," but rather the product of a socio-economic system that existed in the US, or, more specifically, were centered in Silicon Valley, California. Furthermore, the changes in the IT industry, a relatively small industry, were the result of demand originating in the non IT sectors, a demand that was rooted in the same socio-economic system.

The "story" of the contributions of organizational change to the New Economy outlined by the CEA and by CDZ goes something like the following. In 1990 there was no reason to expect the existing economic order to produce the massive shift of resources into the IT industry and generate the new ideas and products that defined the Internet revolution. Large established successful corporations too often do not possess the ability to cannibalize themselves, a key element of Schumpeter's creative destruction process that is at the heart of the New Economy. It is also identified as one of the keys to building wealth in the New Economy by Thurow, and Kevin Kelly, in "New Rules for the New Economy," identifies one of the three overarching rules of the New Economy as "the domestication of the unknown inevitably means abandoning the highly successful known." The corporate world is littered with examples of leading companies "missing" something BIG. Western Electric, a leader in telegraphs, missed the telephone; IBM, a leader in mainframe computers, missed the personal computer; Motorola, a leader in analog, missed digital; AT&T missed Internet communications; and Microsoft, a leader in PC operating systems, missed the web browser, although it eventually saw the 'light' and worked hard to make up for its mistake. As Clayton Christensen, Thomas Craig, and Stuart Hart (CCH) point out, the fact that many well managed companies "missed" important breakthroughs and disruptive technologies can be attributed to the fact that they were well managed. According to CCH, there are four reasons managers are paralyzed by disruptive technology - they tend to listen to customers, to like measurement of performance, to like high returns, and to like large markets. This explains why mainframe computer makers missed minicomputers, why most minicomputer makers missed PCs, why Xerox missed the cheap copiers, why the telephone was missed by telegraph, and why in disk drives, "the leaders of the 14-, 8-, 5.25-, and 3.5-inch product generations were different companies." Because of the fact that "[t]he path to greater revenue is in up market migration, and the ride up that trajectory, is exhilarating and rewarding" the authors find "every leader found itself paralyzed when faced with smaller, disruptive drives."

The same could be said about entire economies and nations. In the 1980s Japan was recognized as THE force to be reckoned with in the future - a real threat to American dominance in the world economy. This was the theme in James Fallow's articles Containing Japan and How the World Works. Fallows identifies significant differences in the "Anglo-American" economic theories and policies and those in other capitalist countries such as Germany and Japan. If you look carefully at Fallows work you will find that he believed the Anglo- Americans were being beaten in the world economy by a country that was better managed by agencies such as Japan's MITI (Ministry of International Trade and Industry), by countries that "managed" markets rather than let them run freely. As Fallows saw it, "violating the rules of Anglo-American economics - may be indispensable for nations that are trying to get ahead' and that the US would eventually lose out to those countries that "rigged" the system of markets. Fallows cites the work of economist Alice Amsden who describes Korea's rapid ascent as: "...successful nations have gotten extra money by rigging their markets. The goal is to get people to save more of their paychecks, and banks to lend more money for long-term expansion, than normal market forces would allow." What surprises Fallows is that these countries have simply taken a page from US history, that the US has a long history of rigging markets as apparent in the quote of president McKinley: "we lead all nations in agriculture; we lead all nations in mining; we lead all nations in manufacturing. These are the trophies which we bring after twenty-nine years of protective tariffs." The problem for Fallows was that the US had lost its way, had given up on its "managing" of its economy, and that the slide of the 1970-1980 period could be expected to continue unabated as the managed economies continued their rise.

This is what makes the events of the 1990s in the US so remarkable - and so central to our understanding of the New Economy. To better understand the problem consider the situation in Megacorp, a hypothetical world leader in the production of high tech widgets. This is an organization with a well developed management hierarchy, a structure that has made it the world leader, a structure filled with individuals who have learned the secrets of success in the industry. Now imagine yourself as a young hot shot who has to tell the boss, who has been there for years, that there is a need to change strategies, that all the boss has been responsible for creating in his or her professional life will need to be destroyed to enable the creation of a newer, better, faster, cheaper way of doing things. It will not be an easy meeting for you, and as the company gets bigger, it will be even more unpleasant and difficult to elicit change. Unfortunately for large companies, and economies such as Japan's that are dominated by large companies, Thurow is correct when he states "there are no institutional substitutes for individual entrepreneurial change agents."

Success in the New Economy will thus require individuals willing to take risks, individuals willing to look relentlessly for a better way to build that mousetrap - and the US had more than its share of these change agents while Japan had less than their share. But why? Why is it that paralysis did not set in in the US? Competition is one place to look for an answer - and you could look for the competition in two places. First, the IT industry was quite competitive, with the CEA reporting the number of IT firms more than doubling in the first seven years of the 1990s while total national nonagricultural employment rose less than ten percent. Someone would be likely to listen to you in a competitive environment because if they didn't, there would be another firm willing to listen. This is why one-company towns have never been innovation centers. But while competition in the IT sector meant there would be someone willing to listen to a good idea, there needed to be adequate demand for the ideas before the industry could take off as it did. Competition in the IT intensive industries provided the necessary demand. The timing in the US was perfect as the deregulation movement that began in the 1970s introduced competition into the transportation, finance, and telecommunications industries and these industries looked to IT for that competitive edge. The result was the demand necessary to keep the newest products flying off the shelves of the IT producers.

So now we have a demand for IT in the US and a number of big firms in the IT industry that possess the tendency to be conservative, but if change is not going to come from theses BIG firms, then where is the entrepreneurial effort going to come from? Given the increasing complexity of the product creation process, how would small entrepreneurial firms be able to bring an idea to market? What would motivate the best-and-brightest to devote their energies to highly risky ventures? What would prompt those engineers from Stanford and MBAs from Harvard to take jobs in the high risk information technology industry? Sahlman described his Harvard MBAs heading away from finance and consulting into start ups as a healthy feature of the economy in the late 1990s. According to the CEA, the explanation was to be found in changes in "the organizational structures within which innovation takes place."

At this point we have seen how the dot.coms thrived in the new institutional setting, but for the emergence of a New Economy to become a reality, there was a need for substantial changes in the "Old Economy." The bricks-and-mortar companies that dominated the US economy, the driving force behind the insatiable appetite for the "latest and greatest" output of the IT industry, had to change. And the changes did occur. They were major changes with some of the most important noted by the CEA being "changes in production, inventory, and supply management, customer relations, and corporate structure." Production could become much "leaner" when real-time information became available to those who could use it, while the compensation changes provided the incentive to look for greater efficiencies. Inventories that are held primarily to cover "mistakes" in matching supply to demand could be further reduced - transforming the Japanese "just-in-time" inventory model into the American "just-in-the-nick-of-time" model. Also by thinking of the supply of a good or service to the market as a chain of individual functions, you can see how IT could alter the management of that chain and how IT could alter the boundary of firms. On one hand you have some firms that believe the technologies push them to get bigger as they decide to control more of the supply chain functions - a good example being the merger between AOL and Time Warner. Others, meanwhile, believed the improvements in IT allowed better coordination between companies so that each could focus on their core competencies and farm-out other functions. This is why you started hearing about core competencies in the management literature at this time. In essence the boundaries of firms were shifting as a result of the IT improvements. Cross-national production systems, efficient customer response systems (ECR), and B-2-B exchanges reduced transactions costs of markets, changed the procurement process, and led to outsourcing and numerous alliances. And finally, the advances in IT allowed for firms to develop new relationships with customers that could be seen in the move toward mass customization.

And where would the new firms to come up with the funds to support themselves? Americans retain their love affair with the image of the tinkerer who discovers something really BIG working after hours in a garage and then makes millions, but the reality is that it takes BIG money to support the research that underpins the technological revolution driving the New Economy. Here is where those finance and compensation changes came into play. First there is a need to finance the research, and banks have never been keen on funding risky ventures. Bankers tend to be conservative, which is a good thing since they are 'playing' with your money, and they would rather lend money to you to buy a house or car than to start a new business. This is why the heavy reliance of Japanese companies on debt financing from banks worked against them in the 1990s. Another problem is that in the "old economy" loans would often be made to purchase physical capital that would act as collateral, but what would be collateral on a loan to finance human capital?

A big part of the 'solution' was the meteoric growth of the venture capital market that the CEA estimates expanded by 17 percent per year in the 1980s and 34 percent per year in the 1990s. In the simplest terms, the venture capital market has historically been the place where very wealthy individuals lend money to individuals to support their research. For a more detailed description of the venture capital market, you might want to visit some venture capital web sites. At one, Vcapital, you will find the following description of what the company does for entrepreneurs and business owners.

In general the deal is that the venture capitalists provide the funds to finance early research and product development when the company is burning through money with little, if any, revenue since they have yet to develop a product. For the successful ventures, and make no mistake there are more failures than successes, the next step is a call to the investment bankers - the suits from companies like JP Morgan, Morgan Stanley, Goldman Sachs, and Solomon, Smith Barney. These investment bankers will help these start-up companies take their companies public with an initial public offering (IPO) - the second key piece in the financing system. This is an important step because it allows the company to tap into a world-wide pool of money rather than relying on the deep pockets of the venture capitalists who supplied the seed money. In many respects this is similar to what DeLong et al described in An E-conomy? when they identified the growth of the stock market and the limited liability company as essential changes needed to bring about the Second Industrial Revolution. For the Information Revolution it was VC and IPO that allowed entrepreneurs to tap into the necessary finances while in the Industrial Revolution it was the limited liability company and the stock market.

The new system also allowed the venture capitalists and the company's founders to make BIG bucks. To do this there is a need to bring the sellers of the stock in the new corporation together with potential buyers; a need to get the stock listed on a stock exchange, most likely NASDAQ; and there is a need to determine the price to charge when sale of the stock opens. The venture capitalist (VC) makes money on this since they are given a large block of the initial stock offering as part of the original 'deal' with the entrepreneur. This helps the VCs to easily exit and offers the company's principals access to funds on favorable terms. During the stock market boom this was very close to a sure ticket to untold wealth for many since very often the price of the stock would rise sharply after its initial opening price and money poured into these stocks. The CEA estimates that between 1993 and November 2000, IPOs raised $319 billion. It was also an opportunity for some of the big investment banks to 'reward' some of their best clients with IPO stocks - something that had caught the attention of regulators and investigators looking into the situation after the bubble burst. For an overview of the IPO situation you should check out the Edgar web site.

And herein lies the secret for attracting the best-and-brightest from around the world to US high tech companies and for motivating the "nerds" to work long hours for low pay. Rather than paying a high salary, what a company would have to pay workers in established firms like Xerox, GE, GM, and American Airlines, a high tech start up could pay them in stock options. These entrepreneurs would work loooong hours with little compensation to bring a product to the market, if they were given ownership rights to some of the company's stock when it went public. They would then have a strong incentive to succeed in their work because if they did take the company public and the stock price went up, as it tended to do in the boom market, then they would make BIG bucks. For example, if you received 10,000 shares of Cisco stock on October 17, 1991 at the price of $.31 a share rather than a salary of $3,100, if you held onto the shares until July 20, 2000, the price would have been $69.50 so the $10,000, which is actually not real money to the company, would have grown to $2,241,935.

This brings us to the third set of factors identified by the CEA as responsible for the success of the New Economy - enlightened public policies. As Christensen, Craig, and Hart point out in "The Great Disruption, "economic growth is tied to the infrastructure that supports disruptive technologies" and governments play a key role in providing the infrastructure. The "three major pillars" of policy identified by the CEA were "fiscal discipline, investing in people and technology, and opening markets at home and abroad." To this list CDZ in The New Economy: Background, Questions, Speculations would add rule making, which deals with issues such as privacy, security, and the definition of property rights and maintenance of flexible and fair markets. Without enlightened public policies, it is unlikely that we would have witnessed the introduction of new production methods, changes in inventory and supply chain management, new relationships with customers, and shifting corporate boundaries that created demand for IT products.

Fiscal discipline refers to the elimination of the federal budget deficit during the 1990s, one of the more notable economic events of this decade. In the space of ten years the federal deficit of nearly $300 billion was transformed into a federal surplus of $300 billion. This is important because the government needs to finance a budget deficit by borrowing funds, the same funds you would be trying to borrow to buy a car or house or a college education and the same funds a firm would be tapping into to buy new machinery and build new factories and offices. The federal budget turnaround meant the government would sharply decrease its demand for funds, which would drive down interest rates - the price of those funds. These lower rates meant a lower cost of funds to businesses who would respond by increasing their spending on new technology - which they did. In the latter half of the 1990s US businesses went on a technology buying spree. The lower rates would also tend to push the stock market higher as investors shifted their portfolios from bonds into stocks - and this helped fuel the stock market boom. It is precisely this effect that is behind the Bush proposal to eliminate taxes on dividends.

The second contribution enlightened public policies made to the New Economy, according to the CEA, has been substantial investments in people and technologies. The government, and more specifically, the Defense Department has long been a significant source of demand for high technology. After WW II the US became involved in the Cold War, a conflict between two nations, the US and the USSR, and between two economic systems, capitalism and communism - a conflict that increased substantially the demand for information technologies.₁ In fact it was fear that a nuclear attack on the US would destroy vital communications circuits that prompted DARPA to finance research into a new type of communications, one based on packets rather than the circuits carrying voice communications, a system that would eventually mature into the Internet - but that is a story of another time. To continue to act as a catalyst to innovation in a time of declining defense spending, the government could not rely on defense spending. Instead the government focused its attention on programs targeted at increasing the investment in human capital by supporting education and job retraining, and increasing funding to basic research. The focus on education can be traced back to the early work of Peter Drucker who identified the knowledge worker as the key resource in the new economic order. In The Age of Social Transformation Drucker writes that "[e]ducation will become the center of the knowledge society, and the school its key institution" and that "the acquisition and distribution of formal knowledge may come to occupy the place in politics of the knowledge society which the acquisition and distribution of property and income occupied in our politics over the two or three centuries that we have come to call the Age of Capitalism."

A third contribution of public policies has been the opening of new markets including the development of an institutional framework to support globalization. The opening of new markets refers in large part to the deregulation of important industries in the US, specifically airlines, finance, and telecommunications. In the US these industries had been regulated, which meant the government controlled many of the decisions made by the firms - they would tell the airlines what routes to fly and what prices to charge and they would tell banks what interest rates they could charge borrowers and pay to lenders. Beginning in the 1980s, however, the government embarked on a program of deregulation, including the airline and finance industries. The result was increased competition in these industries and, given the nature of the industries, the search for a competitive edge created an enormous demand for information technology to complement demand from the military in the 1980s and replace it in the 1990s as US industries began to spend the Peace Dividend. Deregulation in the telecommunications industry, a process begun with the breakup of AT&T in 1984 and continued with the Telecommunications Act of 1996, brought competition to telecommunications which provided the incentives for experimentation and lower prices.

Globalization, meanwhile, refers to the opening of foreign markets. The most notable government policies here were passage of NAFTA (North American Free Trade Agreement) in 1994, which moved toward the creation of a single North American market encompassing Canada, Mexico, and the US, and support for extensions of free trade through GATT and the WTO. These developments were important for a number of reasons. The reduction of trade barriers allowed US firms in the high tech industry to buy imported components at lower prices and this allowed them to lower prices and gain a competitive edge. It also allowed firms to tap into a pool of skilled foreign workers, either attracting them to the US or employing them in their home countries. Lower trade barriers also allowed the US firms to reach a larger, worldwide market, and this allowed them to reap the benefits of economies of scale and the network effect. The ability of US companies to reach foreign markets was matched by an ability of foreign companies to sell in the US, and the resulting competition drove US companies to innovate and invest in information technology.

And finally, there is the maintenance of flexible and fair markets. Assume you have decided to take a risk and run with one of your ideas. Would you be able to hire a large group of workers to get a start-up company off the ground? The answer to this question would most likely depend upon the structure of the labor market. In a society where the labor market is flexible, where it is relatively easy to hire and fire workers, then you would expect little reluctance to hiring workers when business was growing. This is the situation in the U.S. where it is much easier to hire and fire workers than it is in Japan or Europe. For this reason, you would expect the boom in Internet companies to be centered in the more flexible American labor markets, which is exactly what happened in the 1990s.

The story of the New Economy is very similar globally as can be seen in the OECD's final report of a project designed to explain the "causes underlying differences in growth performance in OECD countries and identify factors, institutions and policies that could enhance long-term growth prospects." Included in the countries that experienced a speed-up in growth in the 1990s were Ireland, the true success story of the decade, Australia, Netherlands, Greece, and the United States, while those experiencing slowdowns were Korea, Japan, Germany, Switzerland, Italy, and France. The factors identified as contributing to the divergences in growth were investment in new capital, especially ICT (information and communications technology), investments in labor and labor quality, and greater efficiency in how capital and labor are combined (multi-factor productivity). Growth rates tend to be highest in those countries that are experiencing the fastest growth rates of multi-factor productivity growth, and in countries with the largest penetration of electronic commerce, as measured by secure servers. Success has also been dependent upon government policies, and at the top of the list are policies that "ensure the fundamentals - macroeconomic stability, openness and competition, as well as economic and social institutions - are working."

Looking forward, the drivers behind long-term economic growth are innovation and competition, and the writers of the OECD report believe that governments must take an active role in the promotion of both. Included in the governments' responsibilities would be five policy priorities:

For those who would like to read more about the future and how to make order out of the developments that will shape this new world, you could look to authors such as Lester Thurow.₂ Lester Thurow, in "Building Wealth" offers eight "secrets" to success in the New Economy, many of which are directly related to what we have already discussed. The eight secrets are:

The outlines of the New Economy have now been laid out for you. It is now time to explore the macro and micro aspects of the New Economy in more detail. We will begin with the macro that will allow us to look more closely at the productivity issue that we have to this time ducked.

1. As you now know, this was not the end of history in the sense that the collapse of communism ushered in a peaceful world. In fact after the events of 9/11 president George Bush announced the US was engaged in a "War on Terrorism" that sounded very much like the Cold War when he said it could cost many 100s of billions of $s to fight it and that it could go on for 40 years. The War in Iraq is viewed by some as an opportunity to bring capitalism and democracy to the Middle East, and once it establishes itself in Iraq it will spread to the surrounding countries. While it may be costly in the short run, the view of the neoconservatives pushing this plan is that the replacement of the stagnant traditional society in the Middle East with a prosperous capitalist society will reduce the likelihood of disgruntled Middle Easterners to strike out at the West.

2. Another interesting question is: why was the change centered in Europe and not China, which during the Middle Ages was at least as advanced as Europe? Jared Diamond in The Ideal Form of Organization provides a clue to the widening gap between Europe and China. The short answer was competition and lack of central control. In China the decision was made to eliminate international travel and trade, to close down China to external influences. In Europe where there were a number of competing monarchies, there was no single ruler who could eliminate international trade since each made their own decision. A good example of this was Christopher Columbus who shopped around his idea of a journey to India to many rulers before he found Ferdinand and Isabella wiling to provide the funds. And when the other rulers saw the wealth coming from the New World, they bought into the idea and began their own colonization and exploitation.

3. Debates on how the economy operates and on appropriate government policies generally that you follow in the mainstream press are generally between the two ideological groups falling within the midrange of the ideological spectrum. There are also Marxists and Institutionalists who also posses differing views on these issues, but they tend to not be represented in the mainstream press.

4. Another article that describes the limitations of the Japanese model is Edmund Phelps' "The Global Crisis of Corporatism," that appeared in the Wall Street Journal in 1999.

5. The German model is centered on a generous welfare state and worker-management cooperation, while the dominant characteristics of the East Asian models are an openness to international trade - they tend to export vast numbers of goods to the US, and their people tend to have high savings rates. You should look at the article to see the characteristics of the other models not discussed here.

6. Bruno and Easterly (1996) suggest that economic crises, in this case crises triggered by bouts of hyperinflation, can speed the process of economic reform in lower income countries and the return of growth will be faster in those countries that experienced the hyperinflation. If we follow the logic a bit further we end up where Albert Hirschman (1987) did and conclude that "inflation has acted as the equivalent of war in eliciting change" or Alesina and Drazen (1991) who "model delayed stabilization as a war of attrition."

8. Baby boomers who came of age in the 1960s spent much of their life in the midst of a Cold War that pitted capitalism (markets) against communism (command), a war that was actually quite 'hot" in much of South America, Asia, and Africa where countries were "choosing" between the two economic systems with the two superpowers were trying to influence the choice. You can also see in Fred Kaplan's Atlantic Monthly article (October 2001), "JFK's First-Strike Plan" that the Cold War was closer to a "Hot" War than most thought as the Kennedy White House drew up detailed plans for a nuclear first strike against the Soviets. When the wall separating Eastern from Western Europe came down at the start of the 1990s, there was a belief that the Cold War was over, that capitalism had been victorious over communism, and at least one individual thought we had reached the "End of History." As we saw in the tragedies of September 11, 2001, however, the end of the Cold War has not necessarily transformed the world into a safer place. What we may have witnessed is the opening salvo of a war between Capitalism and Tradition that threatens to dominate the lives of the boomers' children. This is a theme in Thomas Friedman's article, "World War III" that appeared in the New York Times in the aftermath of the September 11, 2001 terrorist attacks.

All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet