The New York Times October 1, 1997
WHEN OPTIMISM MEETS OVERCAPACITY
By William Greider
An edge of anxiety has crept into the celebration of America's supposed
triumphant economy. Maybe because it's autumn. Manias and panics in the
financial markets typically occur in October or November, for very human
reasons. When the days are growing shorter, investor optimism may shrivel
with the leaves.
Or perhaps the new uneasiness stems from a creeping recognition that
deeper disorders are stalking the global economy -- deeper than the
business cycle. A friend notices increasing references to the "O word" and
the "D word" -- overcapacity and deflation. Neither term is in the usual
lexicon of economic observers. They hark back to earlier eras, when booms
mysteriously turned into busts.
Early this year, an article in The Wall Street Journal announced that the
globalized economy had entered a "new era" of stronger, trouble-free
prosperity. In August, the newspaper revised the outlook. Actually, The
Journal reported, many industrial sectors are burdened by dangerous levels
of overcapacity, too much potential output and not enough buyers. This
glut, it said, promises ugly shakeouts ahead -- failing companies, more
closed factories -- if not something worse.
For the same reason, a cover story in The Economist summed up the
global auto industry this way: "Car firms head for a crash." The industry
will be able to produce nearly 80 million vehicles by 2000 for a market of
fewer than 60 million buyers. The imbalances create downward pressure on
prices and reduce return on sales. More factories must close, more large
companies will merge or fail.
The Financial Times reported that, thanks to the deluge of investment,
even a hot market like China is now stuck with overcapacity, from cars to
chemicals to electronics. A couple of years back, every multinational
rushed to build plants there and catch the wave of China's rising
consumption. Now factories, not consumers, are overabundant.
Some respected Wall Street observers are now expressing concern, as
the glut of productive capacity drives down prices and, eventually, profits.
James Grant, editor of Grant's Interest Rate Observer, noted a general glut
in areas as diverse as semiconductor plants and aircraft factories. "There
are too many hotels in Phoenix and there is too much manufacturing
capacity in China," he wrote.
If a general deflation does occur, whether sudden or gradual, it will
generate a negative cycle of falling prices and wages, depressing output
and financial values, from real estate loans to stocks and bonds.
William H. Gross, the respected managing director of Pacific Mutual
Investment Company, which manages more than $90 billion in bonds
worldwide, now pegs the risk of a general deflation at 1 in 5 over the next
several years. "My deflationary fears are supported by two arguments --
exceptional productivity growth and global glut," Mr. Gross said. He cites
twin causes: real wages, both in the United States and abroad, cannot keep
up with the rapid growth of new production -- that is, there won't be
enough demand to buy all the excess goods. And emerging economies
create aggressive new players eager to outproduce and underprice
everyone else.
Why did the euphoria suddenly dim? The abrupt stall-out of Southeast
Asia's booming young economies was a consciousness-raising event. It
began as a financial crisis in Thailand, then swiftly spread to Malaysia,
Indonesia, the Philippines. (The Asian debacle resembles Mexico's, except
this time Japan is financing the bailout.)
The visible disorder that gets official attention involves finance --
dramatic currency devaluations, overexposed banks, the sudden flight of
foreign investors. But the underlying cause, as some acknowledge, is
overcapacity.
Thailand is a classic illustration of how financial markets can get ahead
of reality and destabilize the real economy of producers and consumers.
Bankers and investors are so busy lending and investing and bidding up
prices that they don't see that the new factories they're financing may not be
able to sell their output.
The typical explanation for gross overcapacity is that misguided
managers and their bankers got carried away. That truism does not explain
much. Here's another explanation: The overcapacity problem is driven by
globalization itself, as it interacts with technological innovations. The fierce
cost-price competition leads companies to take measures -- cutting labor
costs, modernizing production, trading jobs to gain access to hot markets -
- that both erode the worldwide consumption base and create excess
output. As established companies struggle with the imbalances, new
competitors enter the market. South Korea intends to be a major player in
autos and semiconductors. So eventually does China, then India.
All this does not prove, of course, that things will fall apart. In the
1890's, when similar deflationary conditions endured for years amid
industrial revolution, the economy continued to expand, albeit with
periodic banking crises and horrendous recessions. It was not until the late
1920's that supply-demand imbalances crashed the world economic system.
Today's deflationary pressures in the industrial system will inevitably
interact with the financial system. When investors discover that the boom in
corporate profits cannot continue indefinitely, they will sell stocks and bid
down prices, a disaster if they do so all at once. Last winter, Alan
Greenspan, chairman of the Federal Reserve, courageously tried to tamp
down the market euphoria. His jawboning failed, but he has since backed
away from his own stern operating principles for monetary policy.
The economy, Mr. Greenspan used to preach, cannot be allowed to
grow faster than 2 percent to 2.5 percent without risking inflation. If
unemployment falls below 5 percent or 6 percent, he warned, workers will
win real wage increases in tight labor markets and thus generate
inflationary pressures. Now he is permitting both to occur. For good
reason: prices are still declining.
Why are these flush conditions not producing inflation? Because with
the global overcapacity, too many goods are chasing too little demand.
If so, then the reflation of wages becomes a necessary part of any Fed
strategy to back out of the danger zone. Wages have finally begun rising
again in real terms, but only modestly. The so-called Clinton boom is
distinctive from earlier cycles because, despite five years of economic
growth, family median income has still not recovered from the last
recession.
It's no secret how consumers cope: they borrow to keep buying.
Household debt has reached an astonishing 91 percent of disposable
personal income, compared with 65 percent in 1980, according to the
Financial Markets Center. No one knows at what point the buyers will be
tapped out.
Consumer debt is being assumed on punishing terms. Nominal interest
rates have declined somewhat, but real interest rates -- the true cost of
credit calculated by nominal rates discounted for inflation -- are still
extraordinarily high, because as nominal rates subside, the price level keeps
falling, too.
Will central banks have the wisdom to declare victory and back off now
that inflation is approaching zero? In other words, the Federal Reserve
should be cutting interest rates now, not keeping them steady, as the board
did yesterday, or raising them again, if it wishes to avoid the dark
possibilities of overcapacity and deflation.
The politics of accomplishing this is treacherous. The central bank has
to develop a new monetary strategy that is more generous to wage earners,
buyers, borrowers and business enterprises -- and that will require reduced
returns for financial assets.
Mr. Gross, the California fund manager, believes financial markets will
accept the end of the "super bull market," once they understand the
fundamentals. As he explains, investors have enjoyed a hidden annual
bonus from disinflation for 15 years. As the Fed pushed down price levels,
the real value of their wealth steadily increased. That's over. Instead of 15
or 20 percent real returns, Mr. Gross expects 6 percent returns ahead. I
suspect many investors will resist and pressure the Fed to keep interest
rates high.
Nonetheless, the central bank has to begin explaining things to its
political constituents in the bond market and banking. We are, indeed, in a
"new era," but not the one that Wall Street is celebrating.
-------
William Greider is the author of "One World, Ready or Not: The Manic
Logic of Global Capitalism."
