A Supply Side Nightmare Scenario

Paul Solman: This past winter, economic historian James Livingston, author of “Against Thrift,” denounced, on The Business Desk, “the nonsense of austerity,” arguing that the last thing the U.S. economy needs is more saving — more capital.

Thursday, we feature Daniel Alpert, author of the new book, “The Age of Oversupply: Overcoming the Greatest Challenge to the Global Economy,” which goes on sale Thursday. In this adaptation of the first chapter, Alpert argues that not only has the world been experiencing a capital glut, but a labor glut as well.

Daniel Alpert: Late December 1978 is not typically remembered as a watershed moment for the U. S. economy. Another year of sluggish growth was drawing to a close, with unemployment hitting 6 percent.

OPEC had announced a big hike in oil prices on Dec. 18, a move that would further hurt growth, but that was nothing unusual. Many Americans weren’t thinking about the economy at all as Christmas approached; they were fixated on what was happening in Chicago, where police had just arrested the serial killer John Wayne Gacy and were hauling one body after another out of a crawl space in his home in a Chicago suburb.

Yet 6,600 miles away, in the inner sanctum of government power in Beijing, China, America’s economic future was being set by a group of Communist Party leaders. A historic five- day meeting took place from Dec. 18 to Dec. 22, 1978 — the Third Plenum of the Eleventh Central Party Committee — and, on the last day of that meeting, the party issued a communiqué that committed the party to far-reaching economic reforms.

This was the moment when China started down the path to becoming the fastest-growing capitalist economy in the world. China’s transformation would not only radically increase the global supply of cheap labor but also — and nearly as important — decades later create a flood of cheap money as China built up record piles of cash, thanks to its export juggernaut and the growing savings of its newly affluent population and enterprises.

Another important event occurred in 1978, far across the Eurasian continent from China: a young and little-known Communist Party bureaucrat named Mikhail Gorbachev was appointed to the Central Committee’s Secretariat for Agriculture. From there, Gorbachev would move up to the Politburo within just three years. Four years after that, he would be named general secretary and initiate a series of far-reaching economic reforms that would ultimately bring 400 million people living under communist rule in the Soviet Union and Eastern Europe into the global market economy.

Economic liberalization came more slowly to India, the second most populous country in the world. But in just 20 years, India’s gross domestic product (GDP) would grow sevenfold, with annual economic growth hitting 9 percent by 2007. India, long considered the world’s basket case, would come to have foreign reserves larger than Germany’s and more than 60 billionaires — every one of them looking for places to put their spare cash. Welcome to the age of oversupply.

What we have seen in the past few decades is an unprecedented global explosion of cheap labor and cheap money. This trend is a huge driver of the developed world’s economic problems. Yet most policy makers, not to mention ordinary citizens, barely understand what has happened and, worse, many political leaders, economists, and think tanks still embrace a set of solutions to today’s economic malaise that aims to create even more supply — call them supply-side zombies if you will.

Meanwhile, even those who do realize the need for greater demand have yet to face up to the monumental scope of the challenges we face in this age of oversupply. But before we say more about the policy implications of oversupply, let’s further explore this breathtaking shift — what I call the Great Rejoining.

The Great Rejoining

The year is 1995. After severe credit and financial crises in the late 1980s and early 1990s, the United States has stabilized its economy, restarted growth, and reduced its budget deficits. Great strides in laborsaving productivity and enormous opportunities for investment are emerging from the acceleration of Internet technology.

The economist Lester Thurow, who in 1993 had published a book titled “Head to Head,” about America’s coming fierce battle with Japan and Europe for economic dominance, now seems to have been laughably wrong. The United States, it is clear, will be the supreme power of the millennium’s last decade.

And, indeed, in 1995 the future was looking bright for America’s economy. The young president who occupied the Oval Office understood the importance of investing in education and technology. Growth was picking up. The federal budget deficit wasn’t just going down, the nation was on a trajectory toward a surplus.

But lurking over the horizon were entire nations, collectively outnumbering the population of the developed world by fivefold, that had, only a few years before, thrown off the last vestiges of socialism — in substance, if not in name, in the case of China. For decades prior, these nations had been largely inconsequential, at least in economic terms. The largest nations in the world had been cut off from free-market capitalism. Now, in a trend largely ignored during the first half of the 1990s by economists like Thurow — experts still focused on the world’s traditional industrial centers — these nations were rejoining the global economy with a vengeance.

The Cold War’s end was widely seen as a triumph for liberal free-market democracies. In fact, in a grand irony, the demise of the socialist experiment set the stage for the greatest threat yet to the supremacy of the United States and other advanced democracies.

The expansion of the global labor force — and the sheer number of new workers now ready to truly go “head to head” with Americans and Europeans — has been especially stunning. Thirty years ago, most of the poorest people in the world lived in statist societies walled off from the global economy, and many were essentially peasants, inhabiting impoverished rural landscapes much as their ancestors had.

All that has changed. Today, the world has a market labor force of roughly 3 billion people, many of whom are in a position to compete directly for a wide range of jobs held by workers in the developed world, thanks to the wonders of multinational corporations, the Internet and other features of a flat world.

Of these 3 billion workers, nearly half live in China, India and the former Soviet Union. Which is to say that the fall of the Bamboo and Iron curtains, along with economic liberalization, has quite literally brought the other half of the world on line, doubling the global labor supply in the free market in the past two decades.

Only after the collapse of the Internet bubble, and after China had joined the World Trade Organization in 2001 and become fully integrated into the global economy, was the developed world fully exposed to the onslaught of several billion new people who, by that point, were fully prepared to be directly competitive.

Tallying up trends of recent decades, a 2012 study by the McKinsey Global Institute estimated that 1. 7 billion new workers joined the global labor force between 1980 and 2010, with most of this increase taking place in developing economies undergoing a “farm to factory” shift. The better pay of these jobs enabled some 620 million people to escape poverty.

Keep this sea of cheap labor in mind the next time you pass an empty factory and wonder why America’s 150 million workers are having a hard time. Another thing to keep in mind is that this vast expansion of workers hasn’t just created an oversupply of labor but has also contributed to the oversupply of capital as hundreds of millions of people have emerged from peasant societies to work for wages and stash at least some of their earnings in savings accounts.

In fact, because many of these workers live in countries with insufficient social safety nets or pensions (or in nations such as China, which is only slowly expanding its social protections), they tend to put away far more earnings than workers in developed countries. Business enterprises in those countries sock away even more (especially in China). And in places like China, where the number of people graduating college has increased eightfold over 15 years, people are earning, and therefore, saving more.

A Sea of Cheap Money

In 1988, China had a GDP of just $390 billion — and $144 million in gross savings. By 2011, China had a GDP of $7. 3 trillion and an estimated $3. 8 trillion in gross savings. In a flash — at least in terms of its own long history — China went from being a poor country to one sitting on trillions in excess cash. This money piled up not just because the Chinese are such religious savers, but also because China initially didn’t move aggressively enough to expand public investments in the things that countries typically spend money on when they become rich: schools, libraries, parks, a social safety net, and so on.

As James Fallows observed in 2008: Some Chinese people are rich, but China as a whole is unbelievably short on many of the things that qualify countries as fully developed. Shanghai has about the same climate as Washington, D. C. — and its public schools have no heating. (Go to a classroom when it’s cold, and you’ll see 40 children, all in their winter jackets, their breath forming clouds in the air.)

Between 1998 and 2011, tax revenue as a percentage of China’s GDP nearly doubled, and China then dramatically stepped up its investments in infrastructure, energy and education. But this spending barely made a dent in the rising mountain of money. So, instead, all those dollars needed to be invested somewhere outside of China.

All told, the total foreign-currency reserves of emerging nations rose from around $700 billion in 2000 to nearly $7 trillion in 2012. Meanwhile, several export powerhouses in the developed world also piled up more cash. Japan’s reserves tripled during the first decade of the 21 century, to over $1 trillion. Germany’s reserves also almost tripled, as did South Korea’s. What’s more, many of those nations getting richer fast were just as bad as China at consuming their new wealth.

As a practical necessity, most of this money went looking for decent returns at relatively low risk of loss in — guess where? The United States and certain nations of Western Europe, with a seemingly limitless appetite for incurring debt of every kind — public, private and corporate. (Japan has tons of debt, too, but it is mostly self-funding.)

The enormous pool of private capital in the developed world was left to search for returns on investment anywhere they could be found, and the financial institutions of Wall Street and the City of London were happy to oblige. Borrowers were sought everywhere, in governments, corporations, real estate and households.

Capital on Steroids

It’s no big secret where all the new easy money ended up, at least on the U. S. side of the Atlantic. Just about every sector in the United States gorged on cheap debt, with everyone from unemployed home flippers to the U. S. Treasury to local mayors to CEOs getting in on the feast. For starters, consider the truly gargantuan amount of money that Americans borrowed to buy and build homes and commercial real estate.

All this money had to come from somewhere, and much of it came from China. In fact, as the housing bubble inflated, China became the single largest holder of government guaranteed mortgage bonds issued by Freddie Mae and Fannie Mac — with an estimated $376 billion tied up in these securities as of June 2007.

Still more money poured into U. S. capital markets from domestic investors who had been effectively displaced by foreign investors willing to take low returns on government (and government-guaranteed) debt, and so set off to find borrowers who would pay more to use their money — like, say, via subprime lending. The story of binge indebting by governments is even better known. Thanks to George W. Bush’s fiscal plan of cutting taxes while waging two wars and expanding Medicare, the federal government developed massive borrowing needs during the same period in which China and other emerging countries were piling up record amounts of cash.

But while America’s borrowing from China has gotten all the attention, many other foreign countries rolling in reserves also loaded up on Treasuries. Brazil’s holdings soared from $12 billion in 2002 to over $226 billion a decade later. And when Russia started finding itself with piles of excess wealth, it too started bankrolling America’s deficit spending to the tune of billions of dollars a year, buying over $150 billion in U. S. securities by 2010. Japan kept buying Treasuries, too, as it had for years, tripling its holdings to over $1 trillion over the past decade.

American state and local governments took advantage of cheap money as well, borrowing more than $1 trillion between 2000 and 2008. Twenty-two state and local government leaders thus avoided unpopular tax increases while providing public services at an often expanding rate. Recent municipal bankruptcies in cities such as Stockton and San Bernardino, California, are the aftermath of such practices.

Cheap money also had another effect: it put the financial sector on steroids, and helped to greatly grow and supercharge the so called shadow banking system, as both David Stockman and Terry Burnham have argued on this page.

In this remade financial sector, a little-known American International Group (AIG) executive named Joseph Cassano could make hundreds of millions of dollars for himself, and billions for his firm, by selling derivative products such as credit default swaps — insurance to protect bondholders against default. With the crash, unfortunately, came actual defaults. The insurance had to be paid. AIG went under.

It is truly remarkable just how quickly a growing pile of money — whether owned by sovereign funds, Indian billionaires, union pensions, Saudi sheiks, or Chinese banks holding middle-class people’s savings — hooked up with legions of creative MBAs in places like New York and London. According to estimates by the Financial Stability Board, total worldwide assets in the shadow banking system grew from $26 trillion in 2002 to $62 trillion in 2007.

The age of oversupply created a lot of easy money for people to play with, too often with very little oversight. Bad things inevitably happened. The reckless overleveraging of a top Wall Street firm like Lehman Brothers, which collapsed with startling speed in the financial crisis, would not have been possible in a world where money was less plentiful and more costly.

It would be nice to think that such bad behavior will never happen again. In fact, though, all signs point to a future in which capital will remain cheap and regulators will struggle to impose oversight in the face of constant attack by the financial industry and its powerful political allies.

Oversupply Is Here to Stay

The great credit bubble may have burst, but the age of oversupply hasn’t ended — and won’t anytime soon. Abundant labor, excess capital, and cheap money are here to stay.

The expanding savings accounts of an exploding middle class represent only one reason, among others, that cheap money is going to keep flowing. Exports are another, as in the past. In fact, in the five years since the financial crisis, the foreign-currency reserve holdings of emerging countries have more than doubled, according to the IMF.

Via extraordinary monetary-easing measures, the developed world’s central banks have turned trillions of dollars of financial investments into so much cash that it is metaphorically bulging out of the pockets of banks and other investors. Yet it is not getting lent and it is not getting invested in new capacity. Why?

In a nutshell, the reason that the enormous ocean of liquidity is not being deployed is that there is so much global supply and excess capacity of labor, plants, equipment, and goods and services relative to present demand that there is little reason for private-sector investment in the development of additional capacity to produce additional supply.

What we have on our hands is a supply-side nightmare scenario.

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