The longest economic expansion in US history is over. Personal and corporate bankruptcies are rising, as is unemployment, while the Nasdaq has tumbled. Making matters worse, terrorist attacks have introduced an extra degree of uncertainty. Instead of offsetting these developments, European and Asian markets, for the first time, are moving in lockstep with those in the United States.

Many observers see the collapse of the Japanese stock market at the end of the 1980s, following a decade of economic exuberance, as a forerunner of March 2000 in the United States. Japan is still suffering from the deflation of its stock market bubble. Is the United States too facing more than a decade of economic stagnation?

We at the McKinsey Global Institute (MGI) believe that such worries are unfounded. Certainly, some of the stock market euphoria of recent years wasn’t justified. Still, the underpinnings of the US economy—unlike Japan’s—are fundamentally sound. Twenty-five years of deregulation, healthy competition in most sectors, and a renewed tradition of entrepreneurship have made the US economy stronger than ever.

A new MGI study of US labor productivity confirms this belief. Between 1995 and 1999, labor productivity, the basis of the US standard of living, grew by 2.5 percent annually, far better than the 1.4 percent yearly rate from 1972 to 1995. Contrary to popular belief, neither the Internet nor another new-economy technology was chiefly responsible for these gains. Instead, credit is due to product, service, and process innovations—sometimes aided by technology, sometimes not.

What role did information and communications technology play? Apart from on-line securities trading, the Internet didn’t figure in this story at all. Many industries invested heavily in IT, without any change in productivity growth. IT, the study found, boosts productivity only when deployed as part of a broader reorganization of core business processes or a plan to create new products.

Competition—essential for diffusing the innovations of Charles Schwab, Intel, Wal-Mart, and a few other companies, thus spurring the nationwide acceleration in productivity—intensified during the period studied, thanks in part to regulatory changes. Despite the current uncertainties, the contributions of those companies will continue to push US productivity growth rates above what they would otherwise have been.

Not surprisingly, countries, like Japan, that are less open to competition than the United States have fared less well. Although manufacturing giants such as Sony and Toyota lead the world in productivity, they account for just 10 percent of economic activity in Japan. The rest of the country’s economy is hampered by Byzantine land, labor, and product market regulations and government subsidies that stifle competition, deter new entrants, and prop up inefficient firms. As a result, years of fiscal-stimulus spending haven’t sparked growth.¹

The prospects for Europe are mixed. Many countries have had the wisdom to liberalize their financial markets and to reform the governance of their corporations. Still, many European product markets—especially the retail and wholesale sectors—remain bound by regulations that limit competition. Half of the acceleration in US productivity growth during the late 1990s occurred in these two sectors.

Fortunately, many countries, from the United Kingdom to South Korea to Poland, have moved over the past decade or so toward freer markets and less government interference. Certainly, there have been bumps along the way, including costly financial crises. But freer markets and less regulation have also provided the flexibility and strength to surmount them. Likewise, the US economy, though not immune from unforeseen shocks, is fairly well prepared to cope with them.