JANUARY 8, 2001 VOL. 157 NO. 1

This Time It's Different
Forget the dotcom collapse. The first real slowdown of the New Economy has arrived. And it comes with its own set of rules
By ADAM COHEN

ALSO
Fallout: If the U.S. sneezes, does Asia have to catch a cold?
Viewpoint: America's woes spell opportunity for Asia

The latest poster child for dotcom misery, for those still keeping score at home, is eToys. Since the Grinch stole its Christmas season, it has been hunting for a buyer or a merger partner—anything to avoid bankruptcy. Employees are bracing for layoffs as the site unloads toys like Sing 'N Strum Barneys and Talking Wimzies for as much as 75% off. And the stock? Down from a 52-week high of $31.50 to about 20. Some folks have been taking perverse pleasure in seeing the dotcoms crash and burn. "Is anyone else morbidly watching this stock like you stare at a car wreck when driving by?" a posting on Yahoo's finance message board asked last week. But watching economic distress has suddenly become a lot less fun.

That's because the distress is no longer confined to young dotcommers who got rich fast and lorded it over the rest of us. And it's no longer confined to the stock market. The economic uprising that rocked eToys, Priceline.com, Pets.com and all the other www.s has now spread to U.S. blue-chip tech companies and Old Economy stalwarts. Now it's Microsoft warning, for the first time in more than a decade, that quarterly earnings will lag behind estimates. It's Union Pacific railroad announcing that 2,000 employees will be involuntarily disembarking. It's steelmaker LTV filing for bankruptcy for the second time in 14 years. It's Montgomery Ward announcing that it is ending 128 years of American retailing history by closing its 250 stores and pink-slipping its 37,000 employees.

If all the news were this grim, at least people would know where they stand: just haul out the dreaded R word. But America's current economic plight isn't (at least yet) as simple as the two quarters of negative economic growth that define a recession. Instead, the indicators are like a glitchy traffic light, flashing red and green and yellow at the same time. The NASDAQ has plunged a portfolio-punishing 50% from its highs in March. But the U.S. Labor Department announced last week that new claims for state unemployment insurance were down sharply last month. The Conference Board's Consumer Confidence Index fell for the third consecutive month, to its lowest level in two years. But the National Association of Realtors reported on the same day that sales of existing homes rose 4.4%, to the highest level since August. The vaunted New Economy may not have suspended the business cycle, as some of its cheerleaders predicted, but it is definitely a new kind of slowdown.

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In the latest quarter for which results are in—the one that ended in September—the U.S. economy expanded at a 2.2% annual rate, a steep drop from the 5.2% annualized rate of the first half of 2000. Economists at J.P. Morgan Chase predicted last week that growth in the first half of next year would drop to less than 1%. And a few experts even predicted recession.

There are clearly some old-style brakes at work, including rising energy prices, interest rates and debt burdens, all of which take money out of consumers' pockets. But we're also seeing several new wrinkles, like the way the beaten-up NASDAQ appears to be pulling the economy down rather than the other way around. However shallow or deep this downturn proves to be, it is unfolding according to a fresh set of New Economy rules. Among them:

No. 1: What Goes Up Fast Can Come Down Even Faster
Financial pundits liked to refer to the recent expansion as the Goldilocks economy: everything from jobs to inflation was just right. Companies that were in favor were wildly in favor. Just how giddy was it? Remember the name of 1999's buzzy, fast-selling financial Bible? Dow 36,000.

The risk in New Economy investors' enthusiasm is that at the height of the market, every possible piece of good news is factored in. Then when companies whose stock sells at sky-high multiples of their earnings announce even minor setbacks, their stock gets pummeled. Last month networking powerhouse Cisco Systems announced it was setting aside $275 million in a rainy-day fund to cover missed payments from failed customers. Wall Street's reaction was a punishing 12% drop.

In Old Economy days, the stock market was a source of stability. Wealthy old men would read the listings in the morning paper and learn that their shares had swung up 1/4 or down 1/8. Today we have the Internet and the "CNBC effect." People see a trend as it's happening and call or click their broker to chase the momentum. High volatility on the upside is fun; it's nice to see that a stock you bought on Tuesday is worth 30% more on Thursday. But on the downside, it can turn a minor downtick into a major bloodbath. And that's one reason why for the NASDAQ the year 2000 was the worst in its 29-year history.

ALSO IN TIME COVER: Lowdown on the Slowdown America braces for a downturn as policymakers try to smooth the road ahead • Fallout: If the U.S. sneezes, does Asia have to catch a cold? • Viewpoint: America's woes spell opportunity for Asia THAILAND: Rules of Engagement The latest election pageant has exposed a familiar underbelly of guns, gangsters and political deception • Nowhere to Hide: The watchdogs try to clean things up CAMBODIA: The Taxman Cometh An American citizen leads a violent effort to topple Phnom Penh's government, sparking a moral dilemma for the U.S. CHINA: Rockabye Baby In far-western Yunnan province, women are making ends meet by producing infants for sale to wealthier Chinese JAPAN: Youth Gone Wild A disturbing film is prompting citizens—and opportunistic politicians—to reopen the debate on violent kids TRAVEL WATCH Killing Time: A Guide to Asia's Airports

No. 2: Wall Street and Main Street Now Intersect
The stock market has long acted to discount predictions about the future of the economy—and it still performs that role. But today the market's fortunes also influence the performance of the economy to a greater extent than ever. It now helps determine how many toys and cars America is willing to buy.

That's because an unprecedented 49% of American households today own stocks, either directly or through mutual funds and 401(k) retirement plans, compared with just 4% in 1952. When the market rises, Americans feel wealthy. In 1999, when the Dow gained 25% and the NASDAQ soared 85%, household assets swelled by $5.5 trillion. This "wealth effect" translates into increased spending. The rule of thumb is that for every additional dollar in their portfolios, Americans spend another 3 to 5. That discretionary income is critical: consumer spending constitutes almost two-thirds of the nation's economic activity.

The wealth effect has been a strength of the New Economy, but now we're seeing the flip side. When the stock market falls, a negative wealth effect kicks in. The latest bad numbers on consumer confidence come at a time when unemployment is at a hard-to-notice 4%. What's making people skittish, it seems, is watching their portfolios nosedive. Since the Dow peaked in January and the NASDAQ in March, more than $2.5 trillion in wealth has disappeared. And just as investors buy more goods and services when the market is up, they are buying fewer now. The ratio of business inventories to sales—a measure of how long goods remain unsold—is now at 1.35 months, the highest since May 1999. And that's despite great advances in recent years in inventory-management software. "The key at the moment is the confidence factor," says Alice Rivlin, who served as Federal Reserve vice chairman from 1996 to 1999. "If people lose confidence, we could have a down period." (That's Fed-speak for a recession.)

No. 3: Slower Times Don't Always Mean Unemployment Lines
As the new economy has cooled, there has been a steady drumbeat of layoff announcements. More than 36,000 dotcom employees were cut in the second half of last year, including some 10,000 last month. But the firings went well beyond dotcomland. There were more than 480,000 layoffs through November. General Motors is laying off 15,000 workers with the closing of Oldsmobile. Whirlpool is trimming 6,300 workers; Aetna is letting go 5,000.

The remarkable thing is that U.S. unemployment has so far stayed strikingly low. While the NASDAQ plunged and growth trailed off last year, the unemployment rate fluctuated between 3.9% and 4.1%. That pales compared with the unemployment rates during Old Economy dark years like 1992 (7.5%) and 1982 (9.7%). And it gives the lie to an Old Economy article of faith—that there was a "natural rate of unemployment" below which the economy could not operate without spurring inflation. The supposed natural rate: just under 6%.

How to account for the strong jobs picture? In part it's because of the tight labor market of the New Economy. Employers fought hard during the expansion to recruit and retain skilled workers. They are not looking to slash their payrolls unless they think a major recession is coming—because they know how much time and effort went in to building their work forces.

There is also more worker "churning" going on. Employees are losing their jobs for economic reasons, but they're generally finding new work quickly. The latest rite of the Internet world is the "pink-slip party" for those just let go. Dotcommers go to commiserate and often come away with new job offers. Job churning makes the economy more efficient: it directs workers to the positions where they are most useful. But it comes at some psychic cost to employees and weakens the social fabric. Workers who shift from job to job do not have the security, or form the same workplace bonds, that corporate long-timers did in the Old Economy.

No. 4: It's a Small World After All—Maybe Too Small
Free-trade advocates say that globalization is an important reason for the recent economic expansion. As trade barriers have fallen, goods have moved around the world more efficiently and, they say, both producers and consumers have benefited. But globalization also brings risks. When the world was bigger and countries were less interdependent, there were more checks against worldwide recession.

In the Old Economy, different parts of the world experienced different business cycles. That's why financial planners advised putting 10% to 20% of assets in foreign stocks: the diversification would reduce overall risk. But in the New Economy, the world's stock markets are increasingly moving in sync. A recent Michigan State University study found that the average international stock fund now has a 66% correlation to the U.S. Standard & Poor's 500 index. Large companies are becoming increasingly similar wherever they are located. Investing in Finnish cell-phone maker Nokia these days is more like investing in American cell-phone maker Motorola than it is like betting on the economic power of Finland. With improved communication and with computers managing inventory levels worldwide, companies increasingly follow the same business cycles.

Until recently, the U.S. could act as the economic engine for the world, intervening to minimize the damage in the Asian financial crises of 1997 and the Russian debt shock of 1998. But as faster communication brings the world closer together, "it raises the risk of a globalized synchronized recession," says Morgan Stanley Dean Whitter chief global economist Stephen Roach. "We're already seeing that unfold as we speak."

No. 5: Sometimes There's Just Nothing Left to Buy
There may be another explanation for this year's slump in retailing: consumer fatigue. The big guessing game recently was about what this holiday season's gotta-have item would be. The answer: there wasn't one. It wasn't that inventors and manufacturers and marketers and retailers didn't give it their best shot. It's just that in the end, most Americans felt they could live without the latest personal data assistant or robotic dog.

The fact is, the New Economy has done a brilliant job over the past decade of putting high-tech gewgaws on the market and into homes. But maybe it's been a little too brilliant. What's left to buy when you already have your SUV, your dvd and your MP3? The tech industry is learning that one of its biggest challenges is building in enough obsolescence. A key reason for the current slump in computer sales is that box makers haven't convinced consumers that the new models do much that their current PCs can't. And as Microsoft labors on its new operating system, Whistler, it's struggling to build in enough must-have features to make people feel they need to ditch Windows.

Karl Marx theorized that capitalism was condemned to repeated depressions because of "cycles of overproduction." Marx may have got some of the details wrong: he thought the workers would be unable to buy goods because their wages would be continually pushed toward subsistence levels. Now it's more likely that consumers are using their well-above-subsistence wages to pay for noncommodities instead, such as travel, restaurant meals and personal trainers. But if Marx had hit U.S. shopping malls last week and seen the heavy discounting—or looked on the Internet and seen the emergence of cut-rate sites like Amazon.com's new outlet store—he would no doubt have felt vindicated.

No. 6: The Boom's Gone On So Long, We've Forgotten What A Recession Looks Like
The U.S. hasn't had a recession since 1990-91 when oil prices spiked after Saddam Hussein's invasion of Kuwait. And that one was among the shortest and shallowest slumps of the postwar period. We haven't had a major recession since the early 1980s. The upshot is that a whole generation of bankers and stockbrokers has come of age never having seen a bad loan or a bear market.

The stock market has had some setbacks, notably in 1987, 1994 and 1998. But in every case it managed to recover so rapidly and so convincingly that investors were left with the belief—still prevalent until a few months ago—that any market drop was an invitation to "buy on the dip." With the market apparently headed straight up, traditional advice about diversification among stock market sectors and other investment classes, such as bonds and cash, came to be seen as quaint and obsolete. Meanwhile, lenders loosened the spigots and let the money flow freely.

And now investors are paying the price. People who piled into hot sectors like technology without diversifying have been hit hardest in the recent market slide. And profligate lenders are getting hit in their bottom lines. Four times as many companies saw their credit ratings downgraded last year as saw them upgraded—the worst ratio since the recession year of 1990.

There's one new economy rule that is turning out not to be true: the much hyped contention that the tech revolution has permanently repealed the business cycle. You've heard the argument. New technology would raise productivity. Higher productivity would raise workers' income without fueling inflation. Well-paid workers would buy more, leading to more production. It was going to be a virtuous cycle that spun only upward. Well, it just hasn't worked that way. "The biggest surprise," says economist Roach, "is that the business cycle is back—New Economy or not."

But that doesn't mean today's slowdown will turn into tomorrow's recession. In fact, many economists insist it won't. And they credit many of the virtues of the New Economy. It was, after all, enhanced productivity brought on by technological innovation that brought us the economic boom that is now slowing. And increased productivity may help the economy fend off some looming threats. Spikes in energy prices, for example, helped kick the economy into its last three recessions. Oil prices are soaring once again, but the U.S. economy is now able to produce twice as much output per unit of energy as it did 30 years ago, and the convergence of several digital technologies is allowing oil and gas companies to tap resources they couldn't even locate a few years ago.

The chipmakers and fiber networkers may have overproduced themselves into a slump in recent months, but the technologies they're bringing to market will help all sorts of Old Economy businesses, from oil to steel to automaking, operate more efficiently and profitably. That's not to say this New Economy is immune to downturns. We're seeing right now that it isn't. But it just may be better able than economies past to pull off a graceful landing, with growth that is less spectacular than in recent years but more sustainable.

With reporting by Bernard Baumohl, Carole Buia and Eric Roston/New York, Jeffrey Ressner/Los Angeles and Mark Thompson/Washington

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