Safehaven | Is Excess Capacity Dragging the World Economy Down?

August 30, 2009

Is Excess Capacity Dragging the World Economy Down?
by Gerard Jackson

The world economy is winessing excess capacity reaching levels not seen since the 1930s. In the US it is now about 68 per cent. Last March Justin Lin, the World Bank's chief economist, gave a speech in which he warned about the dangers of excess capacity. In July he followed this up with another speech in which he stated that "unless we deal with excess capacity, it will wreak havoc on all countries". Excess capacity is evidently becoming an idee fixe. And he is not the only one to sufferomg from this affliction.

Like the great majority of economists Lin was spoon-fed Keynesianism as a student. Now in fairness to Lin he did say that economists must move beyond Keynes to solve the present problem. What this really means is that Lin has yet to discover what the real problem is. Now economics is qualitative and not quantitative. This means that because economics deals with human action there can be no mathematical relationships. What economists should be applying to economic problems are not formulas or correlations but long chains of complex reasoning, sometimes referred to as "verbal logic".

Unfortunately this approach is sneered at by the vast majority of today's economists who treat that method as hopelessly old fashioned. This is why those like Lin who are steeped in the mathematical approach find -- unlike the Austrians -- the current situation incomprehensible. Left floundering for a solution Lin is reduced to calling out for an explanation that goes beyond Keynes. However, sound economics long preceded Keynes and easily provides a ready explanation for what confounds the perplexed Mr Lin.

Lin is buying into the fallacy that excess capacity risks triggering a "deflationary spiral" that will result in "mass lay-offs and drastic falls in investment as firms retrench". Deflation properly understood is a contraction in the quantity of money, not a fall in prices. From about the 1874 to the mid-1890s prices fell steadily in Great Britain. Because of this phenomenon the period is sometimes called the "Great Deflation" even though the money supply continued to grow along with wages and employment.

In other words, the received wisdom that this was a deflationary period is a myth whose origins spring from the lamentable fact that the vast majority of economists can no longer distinguish between a monetary induced fall in prices and a productivity induced fall. The first phenomenon is a real deflation. The second phenomenon is the result of falling costs brought about by greater investment in capital goods embodying improved technology. What makes the present situation truly deplorable is that this fact was well known to contemporary economists. Alfred Marshall pointed out that

...in the same way a manufacturer, though he has to pay for raw material and wages would not check his production on account of a fall in prices, if the fall affected all things equally, and were not likely to go further. If the price which he got for his goods had fallen by a quarter, and the prices which he had to pay for labour and raw material had also fallen by a quarter, the trade would be as profitable to him as before the fall. Three sovereigns would now do the work of four, he would use fewer counters in measuring off his receipts against his outgoings; but his receipts would stand in the same relation to his outgoings as before. His net profits would be the same per centage of his total business. The counters by which they are reckoned would be less by one quarter, but they would purchase as much of the necessaries,, comforts and luxuries of life as they did before. (Economics of Industry C. J. Clay, M. A. & Son, 2nd edition, 1881, p. 156).

In other words, falling prices are not only not a symptom of deflation when they are productivity-induced but they are to be welcomed. Therefore what matters to the producer is not the absolute level of prices but price margins. Robertson endorsed this view when he wrote:

Thus ... a policy aiming at ultimate stability of the general price-level seems to be neither the "most natural" nor the "most effective" policy for the monetary authority to adopt. (D. H. Robertson, Banking Policy and the Price Level, Augustus M. Kelley, 1989, p. 32, first published 1926).

On the other hand, nineteenth century economists were very much aware of the existence of excess capacity. Unlike today's economists they did not confuse cause with effect. They knew that the emergence of idle capacity and widespread unemployment was a symptom of depression not a cause just as they knew that deflation is the product of a monetary contraction. Although their view of capital was far from being fully developed (John Rae's New Principles of Political Economy, published in 1834, was a remarkable exception) they understood that it involved the misallocation of resources and this is why they called this state of affairs one of "disproportionality", meaning that the saving-consumption ratio had been disturbed which in turn created a situation where a great number of unsustainable investments (malinvestments) had been made that would have to be liquidated at a later date. There was not the slightest doubt in their minds that booms were an economic curse that must always have a most unhappy ending. Thus Mill observed more than 170 years ago:

If alI are endeavouring to extend them [their operations], it is a certain proof that some general delusion is afloat. The commonest cause of such delusion is some general, or very extensive, rise of prices (whether caused by speculation or by the currency) which persuades all dealers that they are growing rich. And hence, an increase of production really takes place during the progress of depreciation, as long as the existence of depreciation is not suspected.... But when the delusion vanishes and the truth is disclosed, those whose commodities are relatively in excess must diminish their production or be ruined: and if during the high prices they have built mills and erected machinery, they will be likely to repent at leisure. (John Stuart Mill, Essays on Economics and Society, University of Toronto Press 1967, London: Routledge & Kegan Paul, p. 275).

The Austrians built on these insight and explained that "excess investments" were created by forcing the rate of interest down below its market rate, the rate that equates the supply of capital with demand for capital. This sent a false signal to businessmen that there was more capital available than actually existed, encouraging them to take on more time-consuming investments. Eventually the party would have to come to an end as the shortage of capital made itself felt and bottlenecks emerged.

Of course, if the current account was blowing out that might cause the central bank to apply the monetary brakes before the shortage of capital became too severe. Nevertheless, "excess capacity" would still emerge and for the same reason. We can see that the idea that "excess capacity" is the result of demand deficiency is a dangerous fallacy that results in accelerating inflation and even more malinvestments as the central bank ramps up the money supply in an attempt to cut "idle capacity".

There is only one way avoid mass layoffs and to prevent masses of capital from being rendered idle and that is for central banks to adopt sound economics. Unfortunately this will never happen while economists like Bernanke and Lin insist on practising "macromancy".

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.