Investors and managers who learned their trade since 1981 have a prominent weakness in their toolkit. They think they have had 19 years of experience since 1981. In fact, they have had the same one-year of experience nineteen times in a row. There has only been one story since 1981, the incredible shift of wealth from real to financial assets caused by lower inflation and tax rates. Until recently, if you got that right, nothing else mattered.

The economy has moved on to a new story. Macro portfolio shifts are behind us. Today the driving force in the economy is technological change. This is no accident; the two are directly linked. The aftermath of the Reagan era was a low inflation, low interest rate environment that set up the incentives that made the economy ripe for innovation. This means that investors and managers and policy makers must make decisions differently. The technology boom is the result of those decisions.

In late 1980, inflation was 15% and the top marginal tax rate was 70% on earned income. Investors knew you made money by owning real estate and that you kept your financial assets in the money market, where rates were more than 20%. Managers indexed their prices and wages, avoided long-term contracts with their customers, and refused to do capital spending on all but the quickest payout projects.

In the early days of the Reagan administration, the economics profession was divided into two camps. Mainstream economists worried the tax cuts would balloon the budget deficit, and drive interest rates still h igher. Supply-siders argued tax cuts would raise savings, which would push interest rates down.

In December 1981 I wrote an article on this page saying they were both wrong. The big story was that lower inflation and tax rates would upset the balance between the returns on financial assets as a class and the public's $7 t holdings of tangible assets, forcing them to attempt a massive rebalancing of their personal portfolios. This would systematically drive the prices of real assets down, leading to a host of restructuring activities. And it would drive the prices of financial assets up, reducing interest rates. This would be true regardless of budget deficit and savings behavior.

Over the past 19 years this story has dominated the US economic landscape. Inflation has declined from double-digit levels to the 1-2% range we see in most western economies today. Hard asset producers and heavy industry has lived through a wrenching restructuring. Managers learned how to use less capital to run their businesses by switching to JIT and flow manufacturing methods. Long-term interest rates fell by more than half from 15% to 6.5%. As a result, stock market valuations have soared to record levels.

These transitory macro effects are now pretty well understood. The micro effects of low inflation are not so easy to see but they are much more important because they have permanently altered our expectations, in the sense of Dickens, of an unearned legacy. In 1980 a 40-year-old person with a job and a home could reasonably expect his income to increase by 10% per year for the rest of his working life, simply due to indexed wages. And he could expect the value of his $100,000 house to increase by 10%, or $10,000, the following year, and so on. At the point of his retirement at age 65, he would be earning ten times as much in wages and salary per year and his (now older) house would be worth more than a million dollars.

In 1980, people like this were awash in a sea of expected future income. One by one, since 1980, disinflation has erased these sources of income. Like a neutron bomb, it has killed the income streams but left the people standing, wondering how they were going to get by in future years. This systematic drying-up of income sources has made future dollars -- i.e., the price of a long-dated zero coupon bond -- very expensive, and interest rates very low.

This has had, and will continue to have, profound effects on people's lives. The most visible micro effect of the past 19 years is that the steady decline of interest rates and increase in stock market valuations has made total returns in the stock market huge, both relative to history and in relation to the underlying returns on the companies themselves. Everyone wants to be an investment banker or a stock market investor, and a restructuring expert rather than an efficient operator. But underlying those huge total returns is a growing paucity of companies with sustainable growing cash profits. After all, in an economy with 2% inflation and 4% growth, like the US in recent years, we would expect operating profits to rise at only 6% a year.

In this world of scarce future income streams, anyone who can create a new one from scratch by building a company with demonstrated growth prospects will be anointed an instant paper millionaire by a hungry IPO market. In this world of hungry young people, the best and brightest will migrate into operating, engineering, and entrepreneurial jobs, minting future income from their own sweat and creative efforts. That is what is happening today in Silicon Valley.

This phenomenon has happened before. It is no accident that the introduction of railroads, the telegraph, electricity, and telephones all took place after a fifty year period of declining prices and wages and interest rates. Entrepreneurs are more likely to make the long duration investments required in start-ups when inflation and interest rates are low and visibility into the future is high.

And like previous episodes of major technological change, we have our bubble -- this time in the prices of the dot.com stocks. The technology sector as a whole today is vastly overvalued. But within that sector there are undervalued companies that will dominate the economy for the next hundred years. This is the natural order of things. We once had hundreds of automobile companies and dozens or railroads. Now we can count each on one hand. How many ISP’s will we need when the dust settles?

The technology companies are just the visible tip of the iceberg. The real, lasting benefits of today's technology boom will be enjoyed by relatively simple companies. The Internet revolution is essentially a way of taking the time out of doing business. This tempo-suction device, by allowing companies to complete the same work in less time, allows them do more work in a day, week or year, i.e., it increases economic activity. At the macro level this raises growth rates and lowers inflation.

For investors this analysis implies times will be tougher. The big, easy gains in both the stock and bond market in the past several years have been driven by falling interest rates and rising multiples. These ended with the tangible asset story. Big returns in future will be earned by identifying the companies that produce growing profits for their owners. That requires serious work and knowledge of companies, products, technologies and managers.

For managers this means the restructuring, re-engineering mindset of the ‘90s won’t work. They must focus instead on top-line growth, research and development, marketing and e-commerce. The technology revolution creates tremendous incentives to find ways to sell more products, and gives them the tools to do so. Every company I know, large or small, has an e-commerce initiative underway now.

For Government the key question is what the Fed should do to handle the bubble without interfering with the main event. Federal tax policy should give small companies the incentives to experiment with new technologies and should keep capital gains tax rates as low as possible to encourage value-creating investments. And it should not allow state and local governments to derail the Internet growth train by taxing e-commerce sales

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