The high-tech stock market mania has come to a screeching halt. The US Nasdaq index is now down 20% from its highs. Does this herald the beginning of a huge secular meltdown in stocks around the world? I think not. On the contrary, it marks a healthy reallocation of capital away from companies of the "new" economy towards the "old". The major argument against this optimistic view is that the new cyber economy will destroy us all by creating competition so great that prices will collapse faster than costs. Then whole swathes of the traditional economy will be wiped out, as capital structures collapse.
This is what Marx said would happen to capitalism. Over-investment would first substitute capital for labour and then produce massive excess capacity. That, in turn, would drive down the return on investment until the edifice of capitalism crumbled.
Believing the opposite, which I do, may be an act of faith, not scientific measurement. But Marxist-style collapse hasn't happened and it won't now. I reckon the cyber economy is a coherent economic model that can find its own fast-growth equilibrium without the need for Keynesian-style government intervention.
Sure, there will be deflation. But it will be constructive. The inefficient will die, but the efficient are likely to benefit from higher demand. Prices may fall faster than marginal costs for those corporations that do not embrace the new economy, but not for the ones that do. They will be able to keep costs falling faster than prices. Many investors will lose a packet in the inevitable shakeout of Darwinian e-volution. But that's how capitalism gets the job done.
Why will the cyber world avoid collapse? Instead of creating excess capacity, e-commerce companies expand markets by creating new products and improving supply of traditional products at lower prices. The cyber law is that better supply creates bigger demand.
Take the web. Bandwidth, processing power and memory improvements spark increased demand that, in turn, generates technological improvements in everything from software and computers to routers, chips and storage. That creates new demand for the products and the cycle starts again - but as condensed super-history compared with other technology cycles.
The difference between high and lousy returns on capital is all about filling capacity by maximizing positive marginal contribution. The cyber economy will allow that to happen as fast as the spare capacity appears on the control room radar screen. It doesn't matter whether you're loading a Boeing or filling a naphtha cracker, the positive effect is enormous on the company's bottom line.
Although inflation will remain asleep in the cyber world, central bankers around the world will raise interest rates anyway. US Federal Reserve chairman Alan Greenspan wants to slow the US economy. fiim Duisenberg at the European Central Bank will follow faster economic growth in the eurozone and Masaru Hayami of the Bank of Japan is looking to end his zero-rate policy as soon as the Japanese consumer starts spending again.
But there are good reasons why higher short-term rates won't kill the trend towards higher asset values in the global cyber economy. Global liquidity drives asset markets. And central bankers don't control that any more. The capital that used to lie dormant in domestic bank accounts is now flowing freely across national borders in search of productive investment. Look at the increasing allocation of capital by European individual investors to global equities through mutual funds. And, of course, the huge flows of European capital into mergers&acquisitions in the US.
Indeed, the birth of the cyber economy sounds the death-knell of the sovereign state and national economy. Consider the US. Many economists have been worried about the size of the US current account deficit as it heads over 4% of US GDP. They fear that if it cannot be financed, the dollar will collapse and bring down global asset prices with it.
But in the cyber economy, US corporations will shift more activities relating to manufacturing and lower value-added services (such as back offices) offshore, while the US domestic skill-set migrates into higher value-added services (such as information technology). As US corporations expand direct investment abroad, this increases the demand for dollars. And that's the fuel the global cyber economy runs on. So the pool of international dollars, which is growing exponentially, will remain a major source of dollar strength.
All of this means that rising interest rates won't produce a global bear market in long-term financial assets. Sure, the cyber dream will eventually run out of steam like all others, but to shatter it in a really violent fashion would take an exogenous shock that no-one can predict.
There's one shock for Europe that I can see on the horizon. Europe's economic cycle is on the rise. Corporate Europe should close the gap with the US, particularly in the cyber economy. But success also depends on whether European governments will stand in the way of corporate Europe or promote it.
The cyber economy dictates that the state must shrink and pursue pro-business tax policies. European governments understand the latter but not the former issue. That's a long-term liability for the performance of the European economy and financial assets.
Government spending in Europe as a proportion of GDP has fallen in the past five years. And government balances (excluding interest payments on past debt) have moved into surplus. But this is all an illusion. Real government spending in absolute terms is rising throughout Europe. In core Europe, it's up nearly 200% in the past 30 years. Only the UK has broken with that trend. But even there, the Labour government's latest budget, with its increased expenditure plans, will take real spending to new heights.
With rising government expenditure has come an army of government employees, up 50% in 30 years. In France 25% of the workforce is still employed by the state. And the overall tax burden on households and companies in Europe has not budged from 45% to 50% of GDP, compared with 35% in the US. That's despite significant cuts in direct taxes. Indirect taxes and social security charges have more than kept pace with economic growth.
The danger is that when growth eventually slows or there is a recession, Europe's politicians will be put on the spot. To keep to the Emu stability and growth pact, which demands that fiscal deficits virtually disappear, eurozone governments would either have to cut back on spending, risking social instability, or raise the tax burden and so stifle economic growth and corporate profitability.
The mismatch between EU governments' readiness to cut direct taxes and their failure to reduce the size of the state is only sustainable for as long as Europe's economic cycle remains strong. Once the economic cycle weakens, the euro dream will fall down a chasm into nightmare. But that's a while away yet.