TLFeBOOK DIGITAL DEFLATION The Productivity Revolution and How It Will Ignite the Economy GRAHAM Y. TANAKA McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul 3183_U00.qxd 8/7/03 3:07 PM Page i TLFeBOOK Copyright © 2004 by Graham Y. Tanaka. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-138967-9 The material in this eBook also appears in the print version of this title: 0-07-137617-8. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales pro- motions, or for use in corporate training programs. For more information, please contact George Hoare, Special Sales, at george_hoare@mcgraw-hill.com or (212) 904-4069. TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS”. McGRAW-HILL AND ITS LICENSORS MAKE NO GUAR- ANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMA- TION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the func- tions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inac- curacy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of lia- bility shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. DOI: 10.1036/0071389679 ebook_copyright 6x9.qxd 10/20/03 11:23 AM Page 1 TLFeBOOK Want to learn more? We hope you enjoy this McGraw-Hill eBook! If you d like more information about this book, its author, or related books and websites, please click her e. DOI Page 6x9 10/2/02 1:33 PM Page 1 , TLFeBOOK DEDICATION This book is dedicated to my mom, Yuri, and in memory of my dad, Yasuo Clifford, who always encouraged me to do my best and who gave me the guidance and education to achieve my goals. I would also like to dedicate this book to my wife, Molly, and my kids, Spencer and Russell, who were patient and accommodating on those count- less weekends and evenings I spent researching and writing Digital Deflation. 3183_U00.qxd 8/7/03 3:07 PM Page iii TLFeBOOK CONTENTS Preface xii Introduction xiv CHAPTER 1 MYSTERIES, PUZZLES, AND PARADOXES OF THE NEW ECONOMY 1 The New Economy of the 1990s 1 Was the New Economy of the 1990s Real? 3 Why Were the 1990s So Great? 5 Is There Too Much Optimism or Too Much Pessimism? 7 Are We Heading for Deflation Like Japan in the ’90s or the U.S. in the ’30s? 9 Can the Future Be What It Used to Be? 10 CHAPTER 2 SOLVING THE MYSTERY: MISSING PRODUCTIVITY AND THE GREAT INFLATION MISMEASURE 11 Demographics: Baby Boomers, Working Women, and the Super Bull Market 11 Three Hits and a Miss 15 Where’s the Missing Productivity? 15 The Boskin Reports on the CPI 19 “Faster, Better, Cheaper”—The Parable of the Pink Caddy 21 The Intel–Microsoft Double Helix and John the Barber’s PC 23 The Consumer Knows Best 24 How the Government Counts Quality Improvement 26 Solving the Mystery of the New Economy 28 CHAPTER 3 THE THEORY OF DIGITAL DEFLATION: FASTER, BETTER, CHEAPER 31 Digital Deflation Is a Good Thing 31 Digital Deflation Defined 32 The Digital Drivers 35 iv 3183_U00.qxd 8/7/03 5:29 PM Page iv For more information about this title, click here. Copyright 2004 by Graham Y. Tanaka. Click Here for Terms of U se. TLFeBOOK The “Next Big Thing” 39 Is the Digital Revolution Better Than the Industrial Revolution? 40 The Laws of Digital Deflation 41 How Big Is Digital Deflation? 43 What’s Missing from the GDP Deflator? 47 The Lost Components 49 CHAPTER 4 WHY THE OLD MODELS DIDN’T WORK IN THE 1970s AND 1980s 53 Economic Models Work Best in Times of Stability and Few Surprises 53 The 1950s and 1960s: Existing Economic Models Worked Well 54 The Late 1960s/Early 1970s: Models Break Down with the Rise in Inflation 55 Internal Disruption from Wage-Price Controls 56 External Disruption from OPEC Oil Price Increases 59 The Late 1970s: Hyperinflation 59 The Demise of the Keynesian Dynasty 60 Monetarism Takes the Lead 60 The 1980s: Volcker to the Rescue 62 The Early 1980s: Enter the Supply-Siders 64 The Late 1980s: Market Price Rule Predictors 67 Demographics—Why the Traditional Models Didn’t Work 69 Demographic Forces Turn Positive in the 1980s and 1990s 71 CHAPTER 5 WHY ECONOMISTS HAVE DIFFICULTY EXPLAINING THE NEW ECONOMY 74 The Amazing 1990s—Strong Growth and Low Inflation 74 Information Technology, Productivity, and the New Economy 77 Overstated Inflation and Undermeasured Productivity 78 Was the Internet Driving the New Economy? 80 Digital Deflation—Why the Old Models Didn’t Work in the 1990s 80 Productivity from Digital Deflation Is About Quality, Not Quantity 83 What the Government Didn’t See… 86 …Consumers and Investors Could See 87 The Year 2000 Lockdown 88 The Wealth Effect—A Rising New Force in the New Economy 92 v CONTENTS 3183_U00.qxd 8/7/03 3:07 PM Page v TLFeBOOK Is There a Corporate Wealth Effect? 95 Investor-Consumers 95 New Models Needed 96 CHAPTER 6 REDEFINING THE NEW ECONOMY 98 New Forces in the New Economy 98 What Is the New Economy? 99 Digital Deflation Redefines the New Economy 100 Old Economy Companies in the New Economy 103 The Importance of R&D 106 The Old Economy Will Lose Share and Profits to the New Economy 107 How the New Economy Lifts Productivity 108 Structural Productivity Gains 109 When Did the Government Start to Measure Digital Deflation? 110 How Did Computer Quality Improvement Boost Productivity in the Late 1990s? 112 Massive Implications for Productivity Across the Economy 114 Software Quality Improvements Are Elusive but Real 115 Communication Services Are Getting Faster, Better, Cheaper 117 The Huge Healthcare Quality Mismeasure 119 The Service Sector Is Grossly Undermeasured 120 The Service Sector Supply Chain 122 Solving the Mystery of Rising Capital Spending and Declining Productivity 124 The “Productivity Revolution” Is Under Way 126 Disaggregation into the New Economy and the Old Economy 128 CHAPTER 7 NEW MODELS FOR THE NEW ECONOMY 129 Better Models, Better Forecasting 129 I. DEMOGRAPHIC MODELS 130 A Demographic Foundation for the New Economy 130 The Demographic–Inflation Model 131 The Demographic–Stock Market Model 135 The Demographic–Productivity Model 135 Demographic–Productivity Model Adjusted for Unmeasured Digital Deflation 136 vi CONTENTS 3183_U00.qxd 8/7/03 3:07 PM Page vi TLFeBOOK Demographic–GDP Models 137 The Stock Market and Real GDP 137 The Stock Market and Corporate Profits 139 “Potential Productivity” 139 II. PRODUCTIVITY MODELS 140 The Capital Spending–Productivity Model Revisited 140 How Long Has the Government Undermeasured Productivity? 142 Productivity and Profit Margin Model 143 The 120% Profit–Productivity Rule of Thumb 145 The Over 3.0% Productivity Growth Rule 146 The New Economy Productivity–Profit Enigma 146 Are Quality Gains Empty Calories? 148 The Fed’s Productivity and Capital Decomposition Model 151 New Models for Predicting Information Technology’s Contribution to GDP and Productivity 153 III. DIGITAL DEFLATION MODELS 156 Estimating the Undermeasurement of Digital Deflation 157 The “GDP Deflator-Digital Deflation” Model 159 Computer and Semiconductor Digital Deflation “Lost” As Intermediate Goods 161 IT Industries Not Yet Measured for Quality Improvement, Including Computer Services, Software, and Communications 163 Non-IT Industries Not Yet Measured for Quality Improvement, Including Healthcare, Financial Services, and the Military 167 The Quality Improvement Quotient 172 The “CPI-Digital Deflation” Model 173 IV. WEALTH MODELS 177 Household Tangible and Net Financial Assets 177 The Wealth Effect 181 The Consumer Wealth Effect 181 The Realized Capital Gains Wealth Effect 185 The Corporate Wealth Effect 186 CHAPTER 8 THE WEALTH IN OUR FUTURE 191 The 2020 Vision 191 A Wide Range of Possible Outcomes 193 vii CONTENTS 3183_U00.qxd 8/7/03 3:07 PM Page vii TLFeBOOK Value Created from Digitally Driven Quality Improvement 194 Two More Decades of Value Creation 196 Value to Wealth: The New Economy’s Virtuous Circle 198 Measuring Wealth 200 Adjusting Wealth for Digital Deflation 202 A Strong Demographic Foundation for Generating Wealth 203 The Digital Deflation Wealth Multipliers 206 The Key to Wealth Is Low Inflation 207 A “Near Zero Experience” 208 Picturing Zero Inflation Will Be Difficult for Many 209 The GDP Deflator Adjusted for Digital Deflation 210 The CPI Adjusted for Digital Deflation 212 Why the CPI and GDP Deflator Will Diverge 213 Which Is the Right Inflation Rate? 214 Four Scenarios for the Wealth In Our Future 215 Fair Value P/E’s and Wealth 217 CHAPTER 9 THE NEW ECONOMY STOCK MARKET 218 The Importance of Equities 218 A “New Economy Stock Market Model” 219 Inflation, Interest Rates, and Fair Value P/E’s 224 P/E Ratio Forecasts for the Next Two Decades 228 Higher Productivity and Profit Margins in the Next Two Decades 229 New Economy Stock Market Projections 236 Two More Decades of Wealth Creation 236 A New Economy Wealth Model 239 Growth in Equity-Like Assets 240 How Digital Deflation Helps Homeowners Build Wealth 242 Digital Deflation Helps Tangible Assets by Driving Interest Rates Lower 243 The Enormous Upside Potential for Wealth Creation in the United States 244 On the Upside 245 On the Downside 247 Most Likely Scenario 248 The Surprising Importance of the Real Bond Rate 248 Stocks, Wealth, and the New Economy 252 viii CONTENTS 3183_U00.qxd 8/7/03 3:07 PM Page viii TLFeBOOK [...]... growth and creating prosperity, only to suddenly disappear The process for developing the Theory of Digital Deflation started with unrelated theories on Demographics and productivity well before anyone was talking about the New Economy As luck would have it, however, these theories established an absolutely critical foundation for researching and understanding Digital Deflation and how it uniquely drives the. .. can understand what drove it and whether it can return WAS THE NEW ECONOMY OF THE 1990s REAL? After the Y2K spending spike and “nonevent,” the bursting of the Dot-com Bubble, the 1929-like decline in the Nasdaq, and the abrupt TLFeBOOK 4 CHAPTER 1 and persistent downturn in IT capital spending, it is understandable that much of the general public has begun to doubt the existence of a New Economy Many... good times of the 1990s will reassert themselves sometime in the new decade of the 2000s But they aren’t sure why Most consumers and investors sense that technology will in some way help the economy and improve their lives They see the benefits of the ongoing Digital Revolution and newly developed digital technologies all around them in faster, better, cheaper, and lighter laptop computers and wireless... fueling the New Economy It was the realization that the Demographic Theory had been so well validated through a full labor cycle—except for the productivity numbers—that provided the first clue to understanding the New Economy Maybe productivity growth really was being undermeasured Another clue was provided by the Boskin Reports on the CPI THE BOSKIN REPORTS ON THE CPI The next clue came from the government... sectors of the economy to productivity gains.”1 While there is some validity to each of the above explanations, it turns out that there are more fundamental forces at play, particularly in regard to inflation and productivity Those larger forces are what this book is about * It will be seen that the New Economy is largely a nonpolitical phenomenon, and its return will be best achieved with the cooperation... almost 8% of the economy by the end of the 1990s? Or was the New Economy merely the result of a temporary, late-decade surge in spending to combat the dreaded Y2K millennium bug? Some have suggested that it was the Internet and the dot-com phenomenon that powered the New Economy of the late 1990s If that was the case, does the bursting of the Dot-com Bubble mean that we’ve seen the end of the New Economy? ... record-high inflation in the 1970s and early 1980s, then disinflation in the 1980s, and eventually the need for greater productivity gains if the economy was going to grow at all Remarkably, in the 1990s, reported inflation continued to decline, and late in the decade, productivity growth finally began to climb Could these trends be related, and could they help solve the mystery of the New Economy? * DEMOGRAPHICS:... Must Recognize Digital Deflation to Optimize It 322 Cowboy Capitalism and Wealth Creation 326 The Soviet Experiment 327 Digital Deflation and the Dollar 328 Global Prosperity Will Lift All Boats 330 CHAPTER 14 THREATS AND OPPORTUNITIES: MAKING THE WORLD A BETTER PLACE 331 Making the Digital Revolution Better Than the Industrial Revolution 331 The Politics of Better Data 333 Fixing the Third Rail 335... after the New Economy expansion of the 1990s Getting the numbers right is not simply an academic exercise With new perspectives and better data, we will reach some very different conclusions about how to manage the economy of the future We will have to understand why the United States has been able to enjoy such low inflation in recent years We will have to understand the strange patterns of productivity. .. conditions ever be seen again? How did the U.S economy set a record for the longest expansion ever, while at the same time, surprisingly, the rate of inflation declined in half? Why did productivity gains suddenly accelerate in the late 1990s after decades of disappointment? Despite the economic downturn and the stock market’s sharp declines in the early 2000s, the achievements of the New Economy of the . TLFeBOOK DIGITAL DEFLATION The Productivity Revolution and How It Will Ignite the Economy GRAHAM Y. TANAKA McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New. Rising Capital Spending and Declining Productivity 124 The Productivity Revolution Is Under Way 126 Disaggregation into the New Economy and the Old Economy 128 CHAPTER 7 NEW MODELS FOR THE. researching and understanding Digital Deflation and how it uniquely drives the New Economy. With the benefit of growing Digital Deflation over the next two decades, the U.S. econ- omy can attain higher growth