Untangling e-conomics
Sep 21st 2000
From The Economist print edition

Will the economic benefits of information technology match
those of earlier technological revolutions? Quite probably,
says Pam Woodall, our economics editor; but the laws of
economics will still apply

“EVERYTHING that can be
invented has been
invented.” With these
sweeping words, the
Commissioner of the
United States Office of
Patents recommended in
1899 that his office be
abolished, so spectacular
had been the wave of
innovation in the late 19th century. History is littered with such
foolish predictions about technology. The lesson is that any
analysis of the economic consequences of the current burst of
innovation in information technology (IT—computers, software,
telecoms and the Internet) should proceed with care. At one end,
the Internet’s boosters have boldly proclaimed it as the greatest
invention since the wheel, transforming the world so radically that
the old economics textbooks need ripping up. At the other
extreme, sceptics say that computers and the Internet are not
remotely as important as steam power, the telegraph or
electricity. In their view, IT stands for “insignificant toys”, and
when the technology bubble bursts, its economic benefit will turn
out to be no greater than that of the 17th-century tulip bubble.

The first programmable electronic computer, with a memory of 20
words, was built in 1946, but the IT revolution did not really start
until the spread of mainframe computers in the late 1960s and the
invention of the microprocessor in 1971. The pace of technological
advance since then has been popularly summed up by Moore’s
Law. Gordon Moore, the co-founder of Intel, forecast in 1965 that
the processing power of a silicon chip would double every 18
months. And so it has, resulting in an enormous increase in
computer processing capacity and a sharp decline in costs (see
chart 1). Scientists reckon that Moore’s Law still has at least
another decade to run. By 2010 a typical computer is likely to
have 10m times the processing power of a computer in 1975, at a
lower real cost.

Over the past 40 years global computing power has increased a
billionfold. Number-crunching tasks that once took a week can now
be done in seconds. Today a Ford Taurus car contains more
computing power than the multimillion-dollar mainframe computers
used in the Apollo space programme. Cheaper processing power
allows computers to be used for more and more purposes. In 1985,
it cost Ford $60,000 each time it crashed a car into a wall to find
out what would happen in an accident. Now a collision can be
simulated by computer for around $100. BP Amoco uses 3D
seismic-exploration technology to prospect for oil, cutting the cost
of finding oil from nearly $10 a barrel in 1991 to only $1 today.

The capacity and speed of communications networks has also
increased massively. In 1970 it would have cost $187 to transmit
“Encyclopaedia Britannica” as an electronic data file coast to
coast in America, because transmission speeds were slow and
long-distance calls expensive. Today the entire content of the
Library of Congress could be sent across America for just $40. As
bandwidth expands, costs will fall further. Within ten years,
international phone calls could, in effect, be free, with telecoms
firms charging a monthly fee for unlimited calls.

As communications costs plunge, more and more computers are
being linked together. The benefit of being online increases
exponentially with the number of connections. According to
Metcalfe’s Law, attributed to Robert Metcalfe, a pioneer of
computer networking, the value of a network grows roughly in line
with the square of the number of users. The Internet got going
properly only with the invention of the World Wide Web in 1990
and the browser in 1993, but the number of users worldwide has
already climbed to more than 350m, and may reach 1 billion within
four years.

Between the extremes

IT is revolutionising the way we communicate, work, shop and
play. But is it really changing the economy? The ultra-optimists
argue that IT helps economies to grow much faster, and that it
has also eliminated both inflation and the business cycle. As a
result, the old rules of economics and traditional ways of valuing
shares no longer apply. Cybersceptics retort that sending e-mail,
downloading photos of friends or booking holidays online may be
fun, yet the Internet does not begin to compare with innovations
such as the printing press, the steam engine or electricity. Some
even say that America’s current prosperity is little more than a
bubble.

Whom to believe? The trouble is that IT commentators go over the
top at both extremes. Either they deny that anything has
changed, or they insist that everything has changed. This survey
will argue that both are wrong, and that the truth—as so
often—lies somewhere in the middle. The economic benefits of the
IT revolution could well be big, perhaps as big as those from
electricity. But the gains will be nowhere near enough to justify
current share prices on Wall Street. America is experiencing a
speculative bubble—as it has done during most technological
revolutions in the past two centuries.

The Internet is far from unique in human history. It has much in
common with the telegraph, invented in the 1830s, as Tom
Standage, a journalist on this newspaper, explains in his book “The
Victorian Internet”. The telegraph, too, brought a big fall in
communications costs and increased the flow of information
through the economy. But it hardly turned conventional economic
wisdom on its head.

Extra brain-power

The value of IT and the Internet lies in their capacity to store,
analyse and communicate information instantly, anywhere, at
negligible cost. As Brad DeLong, an economist at the University of
California at Berkeley, puts it: “IT and the Internet amplify brain
power in the same way that the technologies of the industrial
revolution amplified muscle power.” But is IT really in the same
league as previous technological revolutions? There are several
tests.

First, how radically does it change day-to-day life? Arguably, the
railways, the telegraph and electricity brought about much more
dramatic changes than the Internet. For instance, electric light
extended the working day, and railways allowed goods and people
to be moved much more quickly and easily across the country. Yet
the inventions that have the biggest scientific or social impact do
not necessarily yield the biggest economic gains. The printing
press, seen by some as the most important invention of the past
millennium, had little measurable effect on growth in output per
head. In scientific terms, the Internet may not be as significant as
the printing press, the telegraph or electricity, but it may yet turn
out to have a bigger economic impact. One reason is that the cost
of communications has plummeted far more steeply than that of
any previous technology, allowing it to be used more widely and
deeply throughout the economy. An invention that remains
expensive, as the electric telegraph did, is bound to have a lesser
effect.

A second test of a new technology is how far it allows businesses
to reorganise their production processes, and so become more
efficient. The steam age moved production from the household to
the factory; the railways allowed the development of mass
markets; and with electricity, the assembly line became possible.
Now computers and the Internet are offering the means for a
sweeping reorganisation of business, from online procurement of
inputs to more decentralisation and outsourcing.

The ultimate test, however, is the impact of a new technology on
productivity across the economy as a whole, either by allowing
existing products to be made more efficiently or by creating
entirely new products. Faster productivity growth is the key to
higher living standards. After years when people puzzled over the
apparent failure of computers to boost productivity, there are
signs at last that productivity growth in America is accelerating.
The question is whether that faster growth is sustainable.
Undeniably, though, America’s economy has had a fabulous decade
in which it achieved both faster growth and lower inflation, and
some part of that is due to IT.

And whatever the impact of IT so far, there is more to come. Paul
Saffo, who heads the Institute for the Future, in California,
believes that the IT revolution has only just begun, both in terms
of innovation and the adoption of new technologies. Corporate
America’s R&D has increased by an annual average of 11% over
the past five years, which suggests that innovation will go on. As
yet, only 6% of the world’s population is online; even in the rich
world, the figure is only 35%. Only a third of American
manufacturing firms are using the Internet for procurement or
sales. All technologies follow an S-shaped path (see chart 2).
They are slow to get going, but once they reach critical mass the
technology spreads fast. The world may already be half-way up
the curve for computers, but for the Internet it is only at the
bottom of the steep part, from where it is likely to take off rapidly.
Moreover, IT is only one of three technological revolutions
currently under way. Together with fuel-cell technology, and
genetics and biotechnology, it could create a much more powerful
“long wave” than some of its predecessors.

Even so, predictions about
future growth must be kept in
perspective. Those who claim
that technology has created a
new growth paradigm that will
allow America’s GDP to keep
expanding at well over 4% a
year do not realise just how bold
their forecasts are. That sort of
annual rate implies growth in
GDP per head of more than 3%.
For that to materialise,
computers and the Internet
would need to be a far more
important engine of growth than
steam, railways or electricity.
Through most of the 19th century America’s GDP per head grew by
less than 1.5% a year, and in the 20th century by an average of
just under 2%. In truth, many current expectations for American
growth are probably unrealistic.

On the other hand, global growth may well turn out to be faster
than in the past. America has been the first to embrace the IT
revolution and the new economy, which is why so much of the
evidence in this survey is concentrated in that country. But it is
no longer alone. A later section of the survey will argue that if the
rewards from IT are significant in America, the gains in Europe,
Japan and many emerging economies could be even bigger. If so,
this could yet prove to be the biggest technological revolution
ever for the world as a whole.

So is it true that the “new economy” is making a nonsense of the
laws of economics? It is argued that rules for, say, monetary and
antitrust policy that worked in the age of steel and cars no longer
apply now that computers and networks hold sway. But as Carl
Shapiro and Hal Varian neatly put it in their book “Information
Rules”: “Technology changes, economic laws do not.” The
business cycle has not really been eliminated; if economies grow
too fast, inflation will still rise; share prices still depend on profits;
and governments still need to remain on their guard against the
abuse of monopoly power.

Don’t burn the textbooks

But perhaps the most important economic rule of all is that new
technology is not a panacea that cures every economic ill. To reap
the full benefits from IT, governments still need to pursue sound
policies. America’s recent economic success is not due to new
technology alone, but also to more stable fiscal and monetary
policies, deregulation and free trade. A period of pervasive
structural change lies ahead. Economies will enjoy big gains
overall, but these will not be evenly spread. Many existing jobs
and firms will disappear. In this environment, the risks of policy
errors are high.

To see how governments can choke the economic benefits of
innovation, look back 600 years to China, which at that time was
the most technologically advanced country in the world. Centuries
before the West, it had invented moveable-type printing, the blast
furnace and the water-powered spinning machine. By 1400 it had
in place many of the innovations that triggered the industrial
revolution in Britain in the 18th century. But then its technological
progress went into reverse, because its rulers kept such tight
control on the new technology that it could not spread. It is a
warning that the fruits of the IT revolution should not be taken for
granted.