The Challenge of Surplus Capital
March 3rd, 2015
in aa syndication
by Marc Chandler
Copernicus never really proved the earth went around the sun. Rather he argued, that if one were to assume it did, other phenomenon would be understandable. This essay proposes to employ the Copernican strategy to understand the political economy. This thought experiment requires holding in abeyance the usual narrative one hears from commentators, analysts and policy makers from across the political spectrum. They typically give capital a privileged position, but what if it is not true, or no longer true?
Economists recognize three factors of production: land, labor and capital. Under capitalism, these factors are treated as commodities that can be bought and sold. How revolutionary this was to traditional society is colorfully documented by Karl Polanyi in the Great Transformation.
There is an income stream associated with each. Land receives rents; labor, wages and capital, profits. The income stream is a function of the relative supply and demand. When there are more workers, for example, than available jobs, labor's income in aggregate, the wage bill, tends to decline.The integration of the former Soviet Union, China and many low and middle income countries into the world economy, partly meant an influx hundreds of millions of low skilled workers.
This, in turn, both caused and obscured an even more critical imbalance, and that is one of excess capital. This is inconceivable to most economists and policy makers so they cannot perceive it. There cannot be too much capital. Yet this theme, this possibility, is discussed in the works of famous economists starting in the last third of the 19th century and running through the 1920s and 1930s.
The American economic journalist and policy advisor, Charles Conant, and the English economist, John Hobson, saw the export of capital from the industrialized countries as a solution for the congestion of capital that was occurring It coincided with the expansion of both the market and the state (e.g. the foundation of the modern Italian and German states and the post-Civil War America).
As Hobson explained in 1902:
"When productive capacity grew faster than consumer demand, there was very soon an excess of this capacity (relative to consumer demand), and, hence, there were few profitable domestic investment outlets. Foreign investment was the only answer. But, insofar as the same problem existed in every industrialized capitalist country, such foreign investment was possible only if non-capitalist countries could be “civilized”, “Christianized”, and “uplifted” — that is, if their traditional institutions could be forcefully destroyed, and the people coercively brought under the domain of the “invisible hand” of market capitalism.'
The Great War killed 80-90 million people and destroyed much capital, in terms of both the means of production and the means of destruction. Capital was not in surplus in the post-war years, and its central place in economic discourse and analysis was forgotten. To the extent that it is picked up in the 1970s and early 1980s, it was relegated to the periphery, and not integrated in the mainstream discourse.
By the late 1960s and early 1970s, the surplus capital problem had reemerged. After the Bretton Woods regime collapsed, it took a good decade before a new vision and institutional arrangement emerged that addressed the problem. Ever since the late 19th century, US policy makers had consistently recognized the need to export capital --foreign direct and portfolio investment. The Reagan-Thatcher solution was essentially for the Anglo-American economies, with deep (and being made deeper) capital markets, to absorb the world's surplus capital through running trade and current account deficits. The US, of course, was the biggest, but for the size of their economies, the UK and Australia recorded substantial deficits.
It turned out that the surplus eventually overwhelmed the US ability to recycle it. Rules and regulations that ensured the financial pipes were robust had either been diluted, abolished entirely, or went unenforced. With leverage, the proverbial house of cards was built. The so-called Minsky-moment arrived: the long credit expansion cycle promoted behaviors and incentive structures that encouraged extensive risk taking, and complex financial innovation, that were its ultimate downfall.
At the same time, there was a limit on the extent and duration of the US current account deficit, without hitting that Triffin moment, when that deficit undermines investors' embrace of the dollar as the numeraire and central bankers use of it as a reserve asset. There was, and continues to be, a protectionist current in the US. It began weakening the fragile support for free-trade and open markets. There was international backlash as well, with countries arguing that the US current account deficit posed the greatest risk to the global economy.
Reagan-Thatcher was, in part, a response to the problems that emerged and submerged Bretton Woods. The solution it offered worked for two decades, also now lies in ruin. A new solution to the surplus capital problem has yet to emerge.
As a governor of the Federal Reserve, Bernanke argued that the surplus savings in Asia helped explain the Greenspan conundrum, which referred to low long-term interest rates even as the Federal Reserve tightened monetary policy. Bernanke suggested that the under-developed domestic capital markets led some countries to therefore export their savings. The surplus was relative to a country's ability to absorb it itself.
This is not the same thing as the surplus capital problem which we want to discuss here. Staying with our physics metaphor, the difference between the surplus savings Bernanke identified and the surplus capital problem that we suggest lies at the heart of the financial crisis is like the difference between Einstein's theory of special relativity and general relativity.
Bernanke argued that the surplus savings problem was specific to several countries, mostly in Asia and the Middle East. While there was a demographic component, the problem could be remedied by boosting domestic consumption, which tended account for a low proportion of GDP, and developing the capital markets.
We propose that modernity itself is predicated on a surplus of capital. It is a generalized condition and speaks to the incredible success of the market economy. It has produced enormous quantities of wealth, beyond the imagination of all past civilizations; unleashing productive power unfathomable previously.
Alas, we can produce more goods than we can consume. The problem is exacerbated by the distributional issues--the disparity of wealth and income, However, transfer payments by governments, especially since the end of WWII have been of great significance. They fund consumption even when there is not sufficient work (e.g., unemployment compensation and social security/state pensions). In the US, transfer payments have been the fastest growing component of income since the late 1970s. Yet, even with consumption elevated by these payments, it is not sufficient to keep pace with the capacity to produce.
This over-capacity itself is one dimension of the surplus capital problem we think is so central. Over-capacity is often understood in the context of China. China's development has been predicated in part on its ability to rapidly enter new fields with economies of scale.
There is strong competition between local officials to fund the next boom. Their special investment vehicles borrow the money to finance projects ranging from steel, cement and chemicals to earth moving equipment, flat screen televisions, cell phones and solar panels.
Previously when fixed costs were low and a situation of over production arose, a producer might cut back on output rather than produce at a loss. However, when fixed costs are relatively high, as they are under modern production, a producer has little choice than to continue to produce, even at a loss. Consider a couple of specific examples. China produces about half of the world's aluminum supply. The price of aluminum has fallen sharply in recent years and, a recent report noted, that half its producers are now operating at a loss. Nevertheless, more smelters are being built. Meanwhile, capacity is being shuttered elsewhere, unable to cope with China's cheap output.
On the eve of the financial crisis, Chinese steel companies were highly profitable. This attracted huge investment flows and expansion of capacity. Moreover, the form of China's massive stimulus program underpinned even more investment. Last year, it had a surplus of 160 mln tonnes. Output is near record levels, but utilization is near 80%. Around half the output is going into inventory.
The cement industry followed a similar pattern. Despite the vast infrastructure projects under way, China's cement industry, which accounts for almost 2/3 of the global industry, is operating at less than 70% capacity. There have been press reports documenting excess production in numerous other sectors, including glass, paper, solar panels and other clean technology, and shipbuilding. There are a wide range of consumer durable goods plagued by excess capacity as well, such as cell phones and autos.
The Chinese government has officially identified 9 key sectors that are suffering from over investment (excess capacity). Steel, aluminum, rare earths, cement, electronics, pharmaceuticals, autos, shipbuilding, and industrial agriculture. Over time the government will help foster the rationalization of these industries, which means an increased consolidation and the shuttering of inefficient capacity. There were an estimated 2700 steel mills in China in 2012 and the top ten account for less than 50%. This is an important point. These industries that suffer from excess capacity (and therefore falling prices) tend to be fragmented. Industry concentration is one way to reduce and regulate excess capacity.
Command economies, such as China, are not the only ones suffering from over-investment and excess capacity. Consider the European auto market. It has the capacity to produce a little more than 19 mln vehicles a year. Sales in 2012 were 13.1 mln and this year they are projected to fall to 12 mln. In 2008, 16 mln cars were bought in the EU.
Given the protracted contraction in the euro area and UK, one might want to dismiss the excess capacity as cyclical in nature. However, this is to miss three of important points. First, even in the best of times, Europe grows slowly and the institutionalization of ordo-liberalism warns of a extended period of slow growth ahead. Second, Europe is on the cusp of significant demographic changes with a number of countries poised to experience declining as well as aging populations.
Third, there is a shift in the global division of labor and auto production is moving east. While Italy, Spain and France have seen sharp declines in their auto output for more than a decade, output in the Czech Republic and Slovakia has grown 3-fold in the past 10 years and now produce more than France. Slovakia, incidentally, has the highest auto output per capita in the world.
Reports suggest Russia has a growing domestic market and is set to surpass Germany. Romania is poised to surpass Italy in auto production. Italy's auto factories are operating near 45% of capacity. The older and less efficient capacity is in the euro area. Some has been closed, but insufficient for industry analysts to anticipate profitable production any time soon. Moreover, with high levels of unemployment and weak economies, Italy, Spain and France have indicated that they will not tolerate any more rationalization of the European auto industry--plant closings--at their expense.
The US also suffered from excess capacity in the auto sector. The bankruptcy of General Motors and Chyrsler and the near-death experience of Ford, helped spur on an industry restructuring. It included the closure of capacity. All three are now operating profitably and operating near 90% capacity. They are being cautious about adding capacity, according to industry reports. The normal summer shutdown is being foregone this year.
It remains, however, a very fluid situation. Other producers, such as German and Japanese companies are expanding production in the US. In, addition, the US capacity is not just in the US-proper. Some foreign producers are expanding output in Mexico that can be exported to the US duty free under the terms of NAFTA. Third, replacing older capital stock with new often boosts capacity. Fourth, productivity has risen by nearly 40% since 2000, according to industry reports. Capacity may increase faster than sales again.
Japan's Abenomics proposes to boost investment back to the JPY70 trillion level seen prior to the financial crisis in 2008, through mostly lower taxes and supply side reforms. Yet Japanese businesses have not responded forcefully. Capital expenditures have been stagnant in recent quarters, despite low interest rates and the availability of funds. Japan has over-invested previously.
Over the past decade, gross fixed income in the US averaged 10.5% of GDP, while in Japan it averaged 13%. Abe's growth strategy is likely to aggravate the excess investment problem. That, in turn, seems to be at the heart of the persistent low returns on capital (profits), low interest rates and deflationary pressures. The famed Japanese excess savings is not, or no longer, in the household sector.
Household savings have fallen below 2% of GDP; being drawn down in by the adverse demographic conditions and weak wage growth. In contrast Japan's corporate sector has accumulated savings of 7.5% of GDP. Work by Lombard Street Research shows that the combination of depreciation and retaining earnings amounted to almost 30% of Japan's 2011 GDP.
In the US, where corporations also enjoy a financial surplus, the comparable ratio is about half as large as Japan's. The link between productivity and inflation on one hand, and wages on the other, have been severed. This allows the decoupling of wages from profits in the US and globally, as illustrated by this chart posted by Bruce Bartlett, former advisor to Presidents Reagan and Bush, on the New York Times Economix blog. Labor's share of the social product is near record lows, while profit margins are near record highs.
Profits margins are high, but not only from squeezing more out of labor. Some equity analysts suggest that 2/3 of the improvement in US profit margins, are being driven by changes below the operating line: taxes and interest rate expenses. This is helping disguise the deterioration of profits that one would expect under the general conditions of excess supply. As the chart, from Pragmatic Capitalism here shows, US corporate revenue growth itself is weak and falling. The incredible development is not so much the decoupling of wages and profits. That happened a few decades ago. What has taken place now is that profits have become decoupled from investment.
This third chart, posted on FT Alphaville, illustrates how unprecedented this is. Investment, the red line, was historically correlated to the profits, the blue line. That correlation weakened during the Reagan-Thatcher era, and since 2000, the two have become inversely correlated.
This illustrates another key characteristic of surplus capital and reveals one of the channels that relate it to the financial crisis. Corporations do not only recycle their profits into expanded output and redundant investment, but have also kept a growing part of their capital outside the production process.
As of the end of 2012, US corporations had an estimated $1.8 billion of cash (liquid financial assets) on their balance sheets. European companies had an estimated $1.3 trillion, while Japan's corporates had cash holdings of $2.4 trillion. And now, imagine that those funds need to be placed somewhere, and that $5.5 trillion is also likely to be levered up several times during the circuit of capital.
In addition, another even larger pool of capital emerged that also largely stayed out of the circuit of production via direct investment, but stayed within the circuit of capital; namely the reserve managers: the central banks and an increasing number of sovereign wealth funds. Those funds essentially arose in the circuit of capital itself. Financial products have to be created, sold and distributed; creating new speculative opportunities.
Bernanke attributed the the surplus savings to Asia and the Middle East, but there was a large domestic component as well. There was redundant investment in many key industries and a growing financial surplus, generated by non-financial corporations, that had to be managed by the financial sector, Just as the capital surplus was growing, the political forces through both Republican and Democrat Administrations saw the dismantling of large parts of the safeguards established after another large credit cycle ended in tears. It seems that many policy makers hope that the fiscal and monetary measures taken, in recent years,will buy time to make stronger financial pipes so the old system can re-start.
In fact, it seems that the policies being pursued in many countries to cut corporate taxes, while increasing the taxes on consumption, will aggravate the surplus capital condition. It is a similar exercise to the Smithsonian Agreements, which were attempts to re-introduce new fixed exchange rates after the collapse of Bretton Woods. There is no going back now either. The financial sector, which also had vast excess capacity, is in the process of being rationalized, to some extent as well. It has lost capacity, while the surplus continues to grow.
The Reagan-Thatcher strategy for absorbing the surplus capital has run its course. There are two main obstacles to developing a new solution: mis-diagnosis of the problem and ideological constraints. Most observers operate under a different paradigm. To the extent that a surplus capacity, or over-production problem is recognized, it is seen as a special case, largely limited to command economies such as China, or a few countries in which the state distorted the allocation of capital. We propose here that it is a much more generalized problem and grows out of profit-seeking behavior itself. This analysis, which places surplus capital at the center of the narrative can be rooted in a long intellectual tradition and policy history.
The ideological constraints to a solution should not be under-estimated. These constraints resist calls for greater redistribution of the surpluses in the form of wages and public investment (e.g., infrastructure, schools, conservation). The is a reluctance for a jubilee of sorts that would destroy capital through debt forgiveness. Ideologically, we attribute to capital and profits a privileged place in our political and economic discourse. Even if not recognizing the problem as sketched in this essay, there are implications for surplus capital in some the views of others. Of course, the libertarians (modern day anarchists and largely WEIRD males, in the sense of Western, Educated, Industrial Rich Democracies men, would argue against any state-oriented solution to address the surplus of capital.
There are some conservatives who argue that the market, left to its own devices, can be self-correcting and falling rates of return will discourage over-investment over time. The state itself, they argue, has distorted the investment incentives through subsidies and taxes and creates the conditions for surplus capital. However, there is another group of conservatives, like Edmund Phelps, the Nobel Prize winning economist, who are not as antithetical to a more activist state. Financial capitalism has threatened to undermine what they see as our way of life, which the market and its mechanisms are means to the end.
The end is important. Phelps explains in the speech he delivered upon receiving the Nobel Prize in economics (2006):
“I have argued that…suitably designed employment subsidies would restore the bourgeois culture, revive the ethic of self-support and increase prosperity in low wage communities.”
Even many of the so-called liberals, who generally favor re-distributional goals, don't talk about subsidized wages. Francis Fukuyama's recent observations in Foreign Affairs is particularly relevant in this context. He noted that:
"one of the most puzzling features of the world in the aftermath of the financial crisis is that so far, populism has taken primarily a right-wing form, not a left-wing one."
He argues that the left is largely intellectually bankrupt. It has been several decades, Fukuyama suggests, since the left has articulated a coherent and compelling analysis of what is happening to high income societies and a realistic solution for preserving middle class society. Capitalism is terribly unstable. The Bretton Woods order broke down.
The Reagan-Thatcher provided roughly two decades of the Great Moderation, which, as we know, produced its own imbalances and unsustainable practices. When social relations interfere with the expansion of our productive and creative powers, society's institutions change.
The surplus capital challenge may not be able to be addressed within the current social relations and structures. This means that we may be on the cusp of a significant social transformation, even if initially, it does not seem to be the goal or intent. As Kierkegaard taught, life is lived forward, but only understood backwards.