THE SPECTER OF EXCESS CAPACITY / SEEKING ALPHA ( RECOMMENDED READING )

The Specter of Excess Capacity

by: Tom Lindmark

August 17, 2009

One of the least reported aspects of this recession and in my opinion perhaps one of the most important is the incredible excess capacity that has developed throughout the world. There is just too much of everything. Too many factories to produce things, too many houses for people to buy and too much commercial real estate for lease.

As we move forward into whatever halting recovery the future may have in store, this excess is going to hang over us like a guillotine. Not only is it going to retard business profitability but the demand for workers to staff factories running at reduced rates of production is going to be dampened.

Ambrose Evans-Pritchard touches on this in an article in the Telegraph:

Excess plant will hang over us like an oppressive fog until cleared by liquidation, or incomes slowly catch up, or both. Until this occurs, we risk lurching from one false dawn to another, endlessly disappointed.

Justin Lin, the World Bank’s chief economist, warned last month that half-empty factories risk setting off a “deflationary spiral”. We are moving into a phase where the “real economy crisis” bites deeper – meaning mass lay-offs and drastic falls in investment as firms retrench. “Unless we deal with excess capacity, it will wreak havoc on all countries,” he said.

Mr Lin said capacity use had fallen to 72pc in Germany, 69pc in the US, 65pc in Japan, and near 50pc in some poorer countries. These are post-War lows. Fresh data from the Federal Reserve is actually worse. Capacity use in US manufacturing fell to 65.4pc in July.

The introduction of the deflation word into the conversation is interesting. It seems almost an article of faith that central banks around the world have beat back that monster with all of their monetary prestidigitation. Inflation is what you hear we have to worry about and inflation is presumed by many to be the inevitable outcome for many countries.

Yet, if indeed we are suffering from a serious problem of excess capacity, and I see no reason to suppose that isn’t the case, then deflation certainly can and does remain a danger. The assumption that we slide seamlessly from recession to recovery and need to worry most about when to start mopping up liquidity may be totally false. As producers around the world become increasingly desperate to generate cash, it isn’t at all unreasonable to think that we might well see debilitating price competition. In fact, as Evans-Pritchard notes, CPI figures for many countries are already negative.

Evans-Pritchard introduces another idea that I must say I find intriguing:

Professor James Livingston at Rutgers University says we have been blinded by Milton Friedman, who convinced our economic elites and above all Fed chair Ben Bernanke that the Depression was a “credit event” that could have been avoided by a monetary blast (helicopters/QE). Under that schema, we should be safely clear of trouble before long this time.

Mr Livingston’s “Left-Keynesian” view is that a widening gap between rich and poor in the 1920s incubated the Slump. The profit share of GDP grew: the wage share fell – just as now, in today’s case because globalisation lets business exploit “labour arbitrage” by playing off Western workers against the Asian wages. The rich do not spend (much), they accumulate capital. Hence the investment bubble of the 1920s, even as consumption stagnated.

I reserve judgment on this thesis, which amounts to an indictment of our economic model. But whether we like it or not, Left or Right, we may have to pay more attention to such thinking if Bernanke’s credit fix fails to do the job. Back to socialism anybody?

That’s pretty radical stuff and like Mr. Evans-Pritchard I’m not convinced that the professor is right. At the same time, should the economies enter into prolonged periods of deflation in which unemployment remains painfully high and government efforts prove ineffective at correcting the imbalances then social unrest is a likely outcome. Whether the economic model is broken remains to be seen but if enough people begin to view it as unjust then it becomes academic as to its validity.

Past periods of severe economic distress have reshaped political systems and there is little reason to assume that would not happen this time. The likely outcome is that we recover slowly from this recession and the lid stays on. But that nasty overhang of overcapacity could upset the apple cart mightily.