Date: Wed, 01 Oct 1997 13:09:47 -0400
From: Louis Proyect <lnp3-AT-columbia.edu>
Subject: M-TH: Overcapacity?


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."

Copyright 1997 The New York Times Company




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