Ambrose Evans-Pritchard has a good piece up at the Telegraph on an issue that appears not to have gotten the attention it merits, namely, the level of underutlization of capacity and the risk it poses to anything dimly resembling recovery. Evans-Pritchard brings up a related topic, that deflation is a bigger issue that most commentators are acknowledging. He sees it as a perceptual bias, as a result of inflation being something everyone knows all too well, but not deflation. It may be hard to conceive of deflation being possible after massive central bank liquidity creation. Yet that can happen with banking systems choked with dud credit, as the Japan experience attests.
Another point Evans-Pritchard makes late in his piece is that the widely-held assumption, thanks to the weightiness of Milton Friedman’s and Anna Schwartz’s Monetary History of the United States, is that the Great Depression resulted from bad monetary policy. But other academics, such as Peter Temin, argue that the near-hallowed tome failed to deliver the goods, that extensive detail masked a failure to prove the argument. But the Friedmanite view is driving policy.
Separately, on another failure to prove an argument, I have to take issue with a post at International Economy Zone, “Ambrose Evans-Pritchard, Worst Financial Reporter,” at International Economy Zone, which is a long-form ad hominem. The only substantive charge is that Evans-Pritchard is “sensationalist,” without once saying whether he has his facts wrong, which would seem to be a basic requirement for deserving the charge.
Gretchen Morgenson of the New York Times happens to hyperventilate too, and veers from being spot on and well researched (usually in equity markets, executive comp, and litigation, where she reads court filings diligently) to having a mix of solid fact and mistaken inferences in her pieces on credit markets. So if you are going to bash Evans-Pritchard, you need to bash Morgenson too (and frankly, on accuracy, I’d say AEP has the edge here). And while Bloomberg has some strong columnists (Caroline Baum, Michael Lewis, Jonathan Weil) they also have some who will go unnamed who are pretty dubious.
In fact, one the things that Evans-Prichard got exercised about in 2008 when everyone was going nuts about inflation risk and the oil bubble was that deflation was the real danger. He seems to have gotten that one right. One could argue he is a deflationista, but he does back up his grim views with data.
Evans-Pritchard does have a bearish bias, and has a very strong anti EU fixation. But the flip side is he covers topics that get short shrift elsewhere, and provides useful detail. Most readers are smart enough to tune down his occasional rhetorical excesses, which I frankly find entertaining. Most finance writing is deadly dull.
The real beef seems to be his book against the Clintons. Sorry, even if he was sloppy or wrong on that, you can’t use that to attack his financial reporting, or at least not if you intend to be fair and accurate. I take note of the fact that writers who I disagree with on many issues nevertheless upon occasion put out something that is very solid and sensible. If you are going to accuse him of doing a bad job as a financial reporter, you need to deliver the goods, as in say where and how he was wrong, not take pot shots.
From the Telegraph:
Too many steel mills have been built, too many plants making cars, computer chips or solar panels, too many ships, too many houses. They have outstripped the spending power of those supposed to buy the products. This is more or less what happened in the 1920s when electrification and Ford’s assembly line methods lifted output faster than wages. It is a key reason why the Slump proved so intractable, though debt then was far lower than today.
Thankfully, leaders in the US and Europe have this time prevented an implosion of the money supply and domino bank failures. But they have not resolved the elemental causes of our (misnamed) Credit Crisis; nor can they.
Excess plant will hang over us like an oppressive fog until cleared by liquidation, or incomes slowly catch up, or both….
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.
My discovery as a journalist is that deflation is a taboo subject. Those who came of age in the 1970s mostly refuse to accept that such an outcome is remotely possible, and that includes a few regional Fed governors and the German-led core of the European Central Bank.
As a matter of strict fact, two- thirds of the global economy is already in “deflation-lite”. US prices fell 2.1pc in July year-on-year, the steepest drop since 1950. Import prices are down 7.3pc, even after stripping out energy. …
Elsewhere, the CPI figures are: Ireland (-5.9), Thailand (-4.4), Taiwan (-2.3), Japan (-1.8), China (-1.8), Belgium (-1.7), Spain (-1.4), Malaysia (-1.4), Switzerland (-1.2), France (-0.7), Germany (-0.6), Canada (-0.3).
Even countries such as France and Germany eking out slight recoveries are seeing a contraction in “nominal” GDP…
Global prices will rebound later this year as commodity costs feed through – though that may not last once China pricks its credit bubble after the 60th anniversary of the revolution in October…
The sugar rush of fiscal stimulus in the West will subside within a few months. Those “cash-for-clunkers” schemes that have lifted France and Germany out of recession – just – change nothing. They draw forward spending, leading to a cliff-edge fall later. (This is not a criticism. Governments did the right thing given the emergency). The thaw in trade finance has led to a V-shaped rebound in East Asia as pent up exports are shipped. But again, nothing fundamental has change….People talk too much about “liquidity” – a slippery term – and not enough about concrete demand.
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?
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That World Bank warning was rather significant…and generally, this type of over capacity has led to war between nation states. But we are in a 'peace bubble' due to MAD.
Surely one of the hard-won lessons of the Depression was that there had to be broader distribution of income if there were going to be enough consumers of Mr Ford's automobiles. However with unions decimated (and public service unions likely to be the ultimate scapegoats of imploding state budgets), I don't see any indication of that lesson being relearned today.
More likely we will devolve into a police state of gated communities and private police forces, with bread and circuses to keep the riff-raff from revolting.
we all live in a fiat currency regime. deflation is such a setting is very difficult to attain. another month to work out the effect last year's record oil prices and the deflationistas will have to look for another subject to clamour about.
a link no one seems to be making as well is that all this now excess capacity was funded during the credit bubble of the last 20 years, and the bulk of china's growth occurred almost exclusively during the past 10 years. this means one thing: all this capacity has not been paid off, it is not owned by the producer, but by the bank. when sales decrease, businesses still have to break even at the very least, so they can service their huge amounts of debt. most of that debt has to be rolled over as well. this will have as well accounting implications regarding amortization allowances. lowering prices beyond what allows companies to make timely debt payments will be suicidal. add unions in most of europe and some sectors in the u.s. and you have an environment where deflation simply cannot occur, because companies do not actually own their means of production, cannot upgrade due to depressed sales, pay higher taxes due to expired amortization allowances.
Expansions and contractions. God we make such a big deal out of it. The insanity is in trying to prevent the cycle.
Yes tomorrow we are only going to breathe in!
The deflationary effect of excess capacity is not likely to last. Liquidation and salvage, neglect and concomitant deterioration, galloping obsolescence in some sectors, all that will take care of the surplus quite nicely. When idle capacity does change hands, the new owners will take care to increase market dominance and pricing power.
The King Report
M. Ramsey King Securities, Inc.
February 11, 2008
Issue 3808
PART1
We want to take a moment and disabuse our readers of the propaganda that has been spewed for years, ‘if only the Fed had pumped more credit after the 1929 Crash, there would not have been depression.’
This is patently wrong. The Fed and NY Fed went Bernanke after the 1929 Crash and pumped as much credit as it legally could until late 1931 when a global gold run handcuffed the Fed. Interest rates then increased, but for only two quarters.
We pulled out an old reference book over the weekend, Economics and Public Welfare – A Financial and Economic History of the United States, 1914-1946, by Benjamin M. Anderson, a professor who taught at Harvard, Columbia and Cal, and was Chase Bank’s economist from 1920-1939. Professor Anderson notes the Fed and NY Fed aggressively expanded credit after the ’29 crash until they exhausted their ability to create credit in Q3, 1931.
By Q3 1931 the Fed had bought as much collateral they could – the US government only had about $3B of debt issued. This was before FDR created the welfare state and budget deficits generated large issuance of US government debt. And at that time, US law forbade Fed repoing of most instruments.
The stuff hit the fan in 1931, when a series of global crises created global depression. First, Kredit Anstalt went bankrupt on May 12, 1931. Austria collapsed on May 29, 1931. A foreign run on Germany commenced just three days later. The runs of Austria and Germany’s gold supply precipitated an international effort to bail them out in July 1931.
After the international bailout effort failed, a run on England commenced on July 13, 1931. On September 20, 1931, England abandoned the gold standard. Sweden abandoned the gold standard on September 27, 1931. The first run on the US’s gold supply commenced after England’s abandonment.
The run on the US gold supply devastated banking reserves and by law sharply reduced Fed reserves and its ability to create credit. Glass-Steagall mandated that Federal Reserve Notes would be backed 40% by ‘free’ gold. All the Fed’s gold was ‘free’ gold.
“Moreover, Federal Reserve notes were not created by the Federal Reserve banks…they were obligations of the government of the United States issued not by but through Federal Reserve banks. They were issued to the Federal Reserve banks by the government.”
Poignantly, Professor Anderson pens a sub-chapter as, Reckless Buying of Government Securities in 1930 Made for Money Market Tension in Winter of 1931-1932.
“The Federal Reserve System was gambling, using dangerous devices to stave off and unpleasant liquidation, and hoping for a return of the prosperity which was “just around the corner. They succeeded in making cheap money. They succeeded in bringing about a further expansion of bank credit against securities. [Sound familiar?]
But the Federal Reserve System also succeeded in bringing the banking system of the United States into and extremely vulnerable position, tragically revealed when the foreign run on our gold came in late 1931, and when depositors, fearful of individual banks, were taking cash out of these banks and hoarding it.” (p. 263)
Foreigners repatriated gold and other securities from US banks. US citizens and businesses hoarded cash,which produced a cataclysmic collapse in system reserves – sound familiar? We are back to the future.
PART 2
Interest rates increased in Q4 1931 to Q2 1932 due to the above-mentioned factors. Treasury notes,which had declined from 4.58% in September 1929 to 0.41% by July 1931, increased to 2.41% by December 1931 and 2.42% by May 1932. Commercial paper went from 6.25% in September 1929 to 2% by July 1931. The rates then increased to 4% by December 1931 and declined to 2.75% – 3.5% by May
1932. The Fed shot all its bullets and that fact precipitated a global run on gold and securities in 1931.
One chapter in the book is, The Consequences of Cheap Money Policy in the United States Down to the Summer of 1927. (Five years of cheap money policies) A long period of egregiously easy money precipitated stock bubbles in the ‘20s and the past 10 years.When the bubbles burst, the Fed created even more cheap credit until the global financial system revolted.
Too many steel mills have been built, too many plants making cars, computer chips or solar panels, too many ships, too many houses. They have outstripped the spending power of those supposed to buy the products. This is more or less what happened in the 1920s when electrification and Ford’s assembly line methods lifted output faster than wages. It is a key reason why the Slump proved so intractable, though debt then was far lower than today."
Taking from Sandwichman and Chapman:
"Technology doesn't destroy jobs. What technology does is make possible and make necessary either increased consumption, increased leisure or both. Unemployment results not from a quantity of jobs deficit but from an adjustment deficit. Unemployment results, that is to say, from a failure to establish a new income, consumption and work time regime commensurate with the new production potential offered by the technological advance."
Depicted by Evans-Pritchard is a typical Capacity versus Consumption versus Technology scenario. Instead of passing along the gains to labor in the form of leisure time or higher wages, business pushed for higher output chasing hopeful and greater consumption. You reach a point where neither of the later is possible as labor, the bulk of the population driving consumption, being downsized and deprived of wage growth (matching the technological advancement) or other compensatory gains, can no longer afford the products being manufactured. The gains from the technological advancement and capacity growth are being passed along to capital creationists, business, and stockholders. Didn't Henry Ford teach business the value of adequately compensating labor so as to be able to afford the product being manufactured?
Evans-Pritchard misses this point by laying the bulk of the argument upon capacity outstripping the spending power of labor. As it does not have to be a technological advancement, increased capacity does not necessitate increased wages. Increased capacity can be established to sustain old and new markets dependent upon the ability to consume in the old market and growth of consumption in the new market. Although both are growing, neither the Chinese or India markets are to a similar size as the US. And neither has business raised the wages and living standards of these two countries to a level where the population could afford a sizeable portion of the product produced and exported to the US, the largest global economy and consumer nation.
With regard to US automotive; consistently, they have pursued a push-demand manufacturing and capacity strategy (if we build it, we will sell it) and have failed to recognize the reoccurring energy crisis since the seventies. While the US provided a large percentage of its own oil requirement, automotive could safely pursue a push-demand business strategy. It based its business model and capacity growth upon an uninterruptible cheap supply of oil and a continued demand for big, fast, coupled with old technology.
What triggered today's events wasn't automotive producing old cars as it was in progressing towards a long over due change. Nor was it triggered by too much capacity. The trigger was on on W$ at the Sachs, Lehmans, AIGs, Merrills, Citigroups, etc. (thank you Phil Gramm) and their speculation on the creation of paper wealth with CDO, CDS, etc. Automotive could have limped along and their first request was for help to modernize, not help to prevent bankruptcy. Wasn't over speculation the same issue in the twenties?
With wages being relatively stagnant in the US for 95% of the population, wages in Asia being low and not sufficient enough to buy the product manufactured, and profits and wealth being concentrated to a relative; the environment was set. If W$ and business wishes to continue a consumption based society, it needs to recognize "who" is doing all the consuming and pass along the wealth and profits from technological advances and product manufacture. For sure W$ paper creation can not do such.
Massive infusions of cash created out of thin air can't be good.
Massive unemployment can't be good.
The first produces inflationary pressures.
The second produces deflationary pressures.
And the idea that the two are somehow going to balance each other out to keep the economy on an even keel is insane!
What the inflation-deflation aporia is telling us is that the free market capitalist system isn't working and is due for imminent collapse — very soon imo. The handwriting is on the wall and the result will be the same no matter what we do.
And by the way, I see no sign of deflation anywhere, least of all at the supermarket, where prices continue to rise. In fact the solution almost all organizations have come up with is to raise prices, raise premiums, raise interest, raise tuitions, etc., etc. They know they'll be losing customers, clients, students, etc., but they don't see any other way to do things, because they are trapped in their old habits.
What's needed is not inflation or deflation but a fundamental paradigm shift. http://amoleintheground.blogspot.com/2009/04/shifting-paradigm.html
Thank You Anonymous Monetarist.
There is however one point that should be clarified. Did the Fed slow money growth during the period 1926 thru 1928? I believe so. The effect what to set in motion the triggers that set the stage for the October crash and the subsequent depression.
What you also omitted was the fact that international trade was being affected by the difficulty that Germany was having with reperations and what that effect had on trade. Gold was accumulating in the US and in France. The First War brought even more gold to the US.
To read Friedman/Schwartz and not read the balance of the story is to lose the value of the Freidman/Schwartz effort. The real point is that it is presumptious for the Fed or any Central Bank to presume that it can eliminate the business cycle.
The excess capacity is less a problem than the idle labor force. The real question is how do you scrap a labor force?
An extension of that problem is how do you prevent excess credit?
DocG:
"least of all at the supermarket, where prices continue to rise."
Food/agriculture imports are becoming a larger percentage (40+%) of the total so the US would have less control of increased pricing at the super market with a cheapening dollar, etc. Not quite as bad as oil.
Re:The Economic Risk of Excess Capacity.
debt fueled GDP growth combined with modern accounting and government productivity/tax policies creates the problem. Those of us on the manufacturing end have been experiencing price deflation for years but productivity gains+new technology glosses over the day to day reality of paying the overhead and actually making a profit which has been papered over by the financial sector through consolidation and corporate BK.
Faster high tech manufacturing equipment not only needs less floor labor but VOLUME production and faster depreciation schedules to make it work but somebody forget to tell the economist that demand for the product is still necessary and at these high levels of production the store shelves fill up quickly.
It isn't just excess capacity in industry but in housing and labor that are pushing us into deflation. Banks are holding on to much of the liquidity they got from the government in part to hide their underlying insolvency but also because in a deflationary environment money increases in value relative to everything else.
I agree with Mr. Forbin that stable demand can only come from a broad based unendebted middle class. Yet for 30 years wages have remained flat. Consumption was made up for first by increasing the number of wage earners per household and then by acquiring great levels of debt. We need to steer money out of the paper economy and back into the hands of the middle class.
Excess capital accumulation a.k.a overcapacity leads to declining profits from further investment, and such a declining rate of profit leads to an oversupply of investable funds, which leads to inflation of financial asset prices a.k.a the generation of fictitious capital. That the housing bubble was based on the creation of fictitious capital could scarcely be more obvious.
BTW the Professor James Livingston mentioned can be found commenting last Oct. here:
http://hnn.us/articles/55368.html
http://hnn.us/articles/55614.html
Scott Sumner's view is money has been very tight and Ben has not done enough yet. I fear he is correct.
Bernanke's credit fix, I think, is an attempt to substitute credit for wages and push the envelope out further.
It might work for a few years, but if this thesis is correct, the only real fix is to align wages with production capacity. One way or the other.
And it certainly seems we've got plently of production capacity.