FINANCE AND ECONOMICS
Deflation and all that
Some economists argue that worldwide overcapacity threatens to unleash deflation in the world economy. These fears are exaggerated
|ECONOMICS is not
called the dismal science for nothing. Even though America’s economy has
been growing strongly in recent years, American economists are becoming
intrigued by an increasingly fashionable theory. This is the idea that
a global excess of productive capacity together with a slowdown in East
Asia will result in worldwide deflation. Some people are already urging
America’s Federal Reserve to cut interest rates in order to stave off trouble.
The Fed ignored this advice when its Open Market Committee met on November
12th, and left rates unchanged.
The deflationists’ case is quite straightforward. Around the world, too many factories are making too many cars, too many computer chips and too many chemicals. As a result, they say, supply is outpacing demand. And things could get worse if Asia’s financial problems turn an economic slowdown into a slump. The result will be global deflation—a period of falling prices, shrinking profits and lots of bankruptcies.
There are, indeed, many examples of excess supply around the globe. A mountain of computer chips, largely the result of overinvestment in Asia, caused the price of memory chips to tumble by 80% in 1996. The world car industry now has enough capacity to churn out 35% more vehicles than are bought each year. Car sales have levelled off in the rich world, and although demand in the developing countries has been rising rapidly, production is growing even faster.
An article in the November 10th issue of Business Week argues that “production everywhere is running ahead of consumption” and warns that overcapacity will get worse as Asia tries to export its way out of its economic mess. Undeterred by the fact that the very next article in the magazine sounds the alarm about a growing shortage of workers—and hence rising wage costs—in America, the authors conclude that “the global economy may well be heading into a new era—an era of deflation”. Several prominent American economists, such as Ed Yardeni of Deutsche Morgan Grenfell, agree that Asia’s overcapacity poses a deflationary risk to the world economy.
What is the wider evidence that global supply is outpacing demand? Supporters of the global-glut thesis point to the fact that in all regions of the world, industrial production is currently growing faster than consumer spending. But this is misleading. The bulk of American consumer spending is on services, not goods. And manufacturing (which accounts for a mere 20% of GDP in most rich economies) tends to be more cyclical than services, so it is not surprising that, during an economic expansion, industrial production is outpacing total consumer spending.
Bold claims about prices falling across the board as a result of excess supply are also misleading. It is true that the prices of many products, such as cars, computers and telephone calls, are falling. But the prices of many other things, including aerospace components, hotel rooms and business-class air tickets are still rising strongly.
Letting off steam
In essence, the global-glut thesis is based on two questionable assumptions about why overcapacity can only get worse.
The first is the claim that global productive capacity is growing at an unprecedented rate. In fact, total investment in rich economies has actually fallen as a share of GDP over the past decade (see chart). It is true that capital spending by American firms, especially on information technology, has surged over the past few years; but that follows a decade of sluggish investment. Moreover, a large chunk of spending on computers and suchlike is intended either to boost productivity or to replace obsolete equipment, not to increase capacity. So the net increase in productive capacity has been much smaller than the gross investment figures suggest.
Where there has indeed
been an investment boom over the past decade is in developing Asia. The
region’s investment increased from 23% of GDP
in 1980 to 36% last year. Overall, however, world investment has remained
broadly unchanged in relation to world output over the past ten years.
Moreover, a large chunk of the increased capital spending in Asia went
into property, not manufacturing capacity.