Dangerous Global Overcapacity?

COOPER, RICHARD N.

Are we entering a dangerous period of global overcapacity in which policymakers underestimate deflationary conditions but later become increasingly desperate to boost demand? Estimates are that during periods of steady improvement in technology, productive capacity increases by four times for each two years of improvement. If the world is indeed entering such a

"Schumpeterian" period, will the end result be a round of protectionist initiatives by the industrialized nations? In this regard, to what extent does China, with its virtually limitless cheap labor supply, represent an obstacle to reaching equilibrium in the area of global capacity?

BARTON BIGGS Managing Director, Morgan Stanley & Co., Inc.

I believe we are already in a period of global over-capacity characterized by a widespread loss of pricing power and low inflation. The bubble created a capital investment boom fueled by cheap money. The world is in for an episode of Ice (deflation) rather than Fire (inflation), but because the Authorities will respond with both fiscal and monetary policy, this will be a winter rather than a new and prolonged Ice Age.

I suspect that in a couple of the next four quarters we will see small declines in nominal GDP in major industrial countries besides Japan as the GDP deflator dips below zero. This will result in sales declines for many of the so-called "Old Economy" companies and will wreak havoc on corporate profits generally. However, the massive and continuing rate cuts by the Central Banks eventually including the ECB will keep the world from tipping into the kind of persistent deflation that has plagued Japan and I anticipate "stagdeflation" rather than a true "Schumpeterian" period. Of course there will be some protectionist initiatives by the industrialized nations, but it seems unlikely that protectionism will run amuck because first, the global recession will not be that severe, and second, because too many corporate interests would be wounded by protectionism. Of course there is always the danger of a policy miscalculation or bad luck causing a direr outcome. As for China, my guess is that despite its massive low cost labor supply, it is not a mature enough or a sufficiently organized economy to destabilize the rest of the world.

RICHARD N. COOPER Maurits C. Boas Professor of International Economics, Harvard University.

The world undoubtedly has overcapacity in some sectors. But it is not due mainly to technological change. Rather, it is due to vigorous investment during the past half decade in expectation of growth in demand that did not in fact materialize. Japan has remained sluggish for several years. Europe had a good year in 2000 but has generally not demonstrated robust growth. The United States grew at exceptional rates in the late 1990's, but slowed sharply in 2001.

Rapid technical change can result in over-investment by innovators, either because of exuberance or to gain early market share. But it also makes obsolete existing capital stock in competing lines of business. Old capital ceases to be competitive when product quality is crucial.

Overcapacity exists in steel and automobiles for a quite different reason: These are the major symbols of economic modernity, leading one developing country after another to foster domestic production whether or not it makes economic sense. Thus, many countries have--with the complicity of the major automobile firms--installed capacity to assemble and produce parts for automobiles even when it would be cheaper to import cars.

China of course is investing extensively in new productive capacity. That has less to do with technical change--indeed, much of the new capacity is not especially advanced--than with China's rapid growth. Demand and output grow broadly in sympathy, so it is inappropriate to designate this new capacity as "excess," although mistakes in business judgment--for example, overestimating prospective sectoral growth--can lead to transitory periods of excess capacity. When Chinese production has a competitive edge in the world market, investment for export will lead to "excess"--no longer competitive--capacity in the importing countries. That process always occurs in a dynamic economy. It raises standards of living, but in doing so creates problems of adjustment. And while China has a huge population, it is still poor, and has just passed the Netherlands in total exports.

JAGDISH BHAGWATI Professor, Columbia University; Andre Meyer Senior Fellow, Council on Foreign Relations; and Special Adviser to the UN on Globalization.

It is hard and also hazardous to forecast macroeconomic outcomes, for reasons that Walter Heller discovered when he found that fine-tuning was virtually impossible. I have indulged in it only three times, with surprising success: twice on the TV program Debates/debates when, against several prominent forecasters, I predicted during the Asian crisis that the next quarter would be better when they predicted a downturn, and at Davos where I told The Wall Street Journal (and ,they printed my opinion on the front page) that, contrary to the soothsaying of most there, the U.S. economy would be slowing down significantly.

In all cases, I proceeded from first principles. What do they say about the thesis that productivity increases will lead to a global glut and hence worldwide deflation? Surely, we have an elementary mistake here. At the level of an industry, you can certainly have excess production because of productivity increases. But at a macro level, surely one must not forget that more output also means more demand (unless investment ex ante fails substantially to match the extra savings).

But even if a world glut was conceded, the notion that protectionism would break out is not a sensible one. The Asian financial and economic crisis, the worst manmade disaster courtesy of Washington (i.e., Clinton administration) policies since the Great Crash and Smoot-Hawley, did not unleash protectionism. The architects of GATT triumphed: They had put GATT into place precisely to throw sand in the gears, through tariff bindings and procedures, to avoid the outbreak of competitive beggar-my-neighbor protectionist policies.

As for China, it is again an elementary fallacy to think that its added supplies in the world markets would create a macro glut. Unless it accumulates surpluses, which is improbable, its exports are matched by its imports. True, specific industries get into adjustment problems; but no overall subtraction of markets for the world follows. So, I remain sanguine. If there is going to be a worldwide deflation, it will come, not from the rise of productivity, but from the weaknesses in the decade-old U.S. expansion that are already becoming manifest, and from Japan's continuing failure to revive her economy. That, now, is something I do worry about.

BARRY EICHENGREEN George C. Pardee and Helen N. Pardee Professor of Economics and Political Science, University of California at Berkeley.

Global economic slowdowns, and especially recessions, always intensify protectionist pressures. The current slowdown is no exception: Witness the pressure brought to bear on the Bush administration to protect the steel industry, and the administration's surprising and, in my view, regrettably sympathetic response.

But to say that such periods increase the competitive strains on particular industries (that is, that they create problems of sectoral excess capacity) is different from saying that they create a problem of global overcapacity. Marxian theories of under-consumption and secular stagnation are out of fashion, and rightly so. Increases in the global capacity to produce and expect may be impressive for their extent and speed, but there is no reason why they shouldn't be matched, unit for unit, with increases in global consumption and in the demand for imports, assuming that demand conditions are sensibly managed by monetary and fiscal policymakers worldwide. Central bankers and budgetary authorities have made plenty of blunders in the past, and no doubt they will make blunders in the future. But it has been a long time since they made a series of blunders as serious as those of 1929, which produced a demand shortfall, a protectionist backlash, and the most pronounced period of "global overcapacity" the world has ever seen. Demand management is in better shape now than it has been in a long time.

Does China's emergence as an export powerhouse threaten this fragile equilibrium? I see no reason to think so. Policymakers can see Chinese supply coming. They can adjust demand to accommodate it. They have the requisite instruments at their command. If there is a threat to global balance, it comes not from China but from Japan, where there is a continued reluctance to use monetary policy to get growth restarted and to help keep global demand on a sound and stable expansion path.

ROBERT D. HORMATS Vice Chairman, Goldman Sachs International.

The United States and much of the world today suffer from overcapacity in several sectors, especially those related to information technology and telecommunications. In the United States, the rate of capacity utilization is the lowest since 1983--below that experienced during the 1990 recession. Much of this is the legacy of the investment boom in the latter part of the last decade. Demand in the United States and around the world has dropped off sharply, leaving excess capacity and excess inventories.

This boom-bust cycle should be no surprise to economic historians. The introduction of new technologies frequently leads to investment excess. In the 1880's, the United States built seventy thousand miles of new rail track thanks to abundant financing. Lots of this was redundant. In the 1890's, forty thousand miles of that track went into bankruptcy.

Now we have a similar global phenomenon in information technology, although the vast portion of the capacity overhand is in the United States. For instance, in the 1990's U.S. capital investment in the IT sector as a percentage of GDP was double that of Japan.

Other countries that invested heavily in equipment to produce integrated circuits, cell phones, servers, routers, and laptops will suffer for a time from the same excess capacity that currently affects the United States. This will be due to continued weak sales to the American market and in their own markets as well, because of slow domestic demand. There is also chronic excess capacity in other more traditional areas, such as steel, where trade issues have recently arisen over questions of dumping.

Some global excess capacity will be reduced as growth in the United States picks up, although overcapacity here and abroad is likely to last for several quarters after aggregate U.S. demand recovery. Many companies will run out of cash. Many will find their business models or technologies obsolete. Others will be subsidized or protected by governments, thus slowing the downsizing of capacity.

A second issue relates to shifts in market shares of world production and sales. A growing portion of the U.S. market, for instance, is being served by increased exports from Mexico and China. The goods of both countries are displacing those of Japan and emerging economies of East Asia in some markets. Since 1993, Japan's market share in the United States has dropped by more than 6 percent and in the emerging economies of Asia by 2 percent, while Mexico's share is up by over 4 percent and China's by 3 percent. Yet countries whose capacity in key sectors should be reduced for economic reasons might refuse to do so for social and political reasons, raising issues of dumping and subsidies.

Sharp market shifts and resistance to them worldwide could be highly disruptive to the global economy, especially if aggregate international demand remains low and unemployment increases. China will take a growing share of world markets, not just because of cheap labor but also because it is becoming increasingly competitive in high technology products. With further economic reform, so will India. Other competitors will emerge in key areas. Whether smooth adjustment will take place and whether service sector jobs can absorb workers displaced by shifts in manufacturing jobs will be an enormous economic and social issue in many nations.

So we are in for a period of medium term overcapacity worldwide. We will also see longer-term shifts in production capacity and export strength--and probably resistance to them--that will have a substantial impact on world trade.