A paper posted on the San Francisco Fed’s web site provides some surprising takes on the post-bubble economy. The paper, by economist Kevin Lansing, is almost Austrian in the way that it tells the story.
The seeds for the subsequent drop in investment were actually sown during the boom years of the late 1990s.
Much of the surge in business investment during the late 1990s was linked to computers and information technology. During these years, measured productivity growth picked up, inflation remained low, and the unemployment rate declined. Such observations were often cited as evidence of a permanent structural change-one that portended faster trend growth in the years ahead. Widespread belief in the so-called “new economy” caused investors to bid up stock prices to unprecedented levels relative to earnings (see Lansing 2002).
It is now clear that the investment boom of the late 1990s was overdone. Firms vastly overspent in acquiring new technology and in building new productive capacity—with an attendant increase in employee headcount—in an effort to satisfy a level of demand for their products that proved to be unsustainable.
In a recent paper, Caballero and Hammour (2002) present the view that the stock market bubble and the investment boom were mutually reinforcing phenomena. In particular, rapidly rising stock prices provided firms with a low-cost source of funds from which to finance their investment projects. The resulting surge in capital accumulation served to increase measured productivity growth which, in turn, appeared to justify the enormous run-up in stock prices. Figure 4 shows that the trajectory of the S&P 500 stock index, both before and after the 2001 recession, is strikingly similar to the trajectory of investment.
About two quarters after the bubble burst in March 2000, firms started to cut back sharply on new investment as it became clear how much excess capital had been accumulated. Rather than investing in new technology or capacity, firms started to make better use of the technology and capacity they already had. Firms also began to undertake the painful but necessary steps to bring their cost structures into line with the post-bubble demand environment.
