—Liaquat Ahamed, author of Lords of Finance
“A fascinating new book.”
—Martin Wolf, The Financial Times
Governments and central banks across the developed world have tried every policy tool imaginable, yet our economies remain sluggish or worse. How did we get here, and how can we compete and prosper once more?
Daniel Alpert argues that a global labor glut, excess productive capacity, and a rising ocean of cheap capital have kept the
Governments and central banks across the developed world have tried every policy tool imaginable, yet our economies remain sluggish or worse. How did we get here, and how can we compete and prosper once more?
Daniel Alpert argues that a global labor glut, excess productive capacity, and a rising ocean of cheap capital have kept the Western economies mired in underemployment and anemic growth. We failed to anticipate the impact of the torrent of labor and capital unleashed by formerly socialist economies.
Many policymakers miss the connection between global oversupply and the lack of domestic investment and growth. But Alpert shows how they are intertwined and offers a bold, fresh approach to fixing our economic woes.
—Liaquat Ahamed, author of Lords of Finance
“A fascinating new book.”
—Martin Wolf, The Financial Times
In September 2012, the U.S. Federal Reserve Bank announced and—shortly thereafter—implemented its third, and by far largest, installment of “quantitative” monetary easing. “QE3,” as the initiative is known, has resulted in the Fed acquiring over $1.35 trillion in U.S. government securities through January 2014,1 and it is expected to generate aggregate purchases of over $1.5 trillion through the anticipated end of the program in mid-2014.
QE3 went well beyond the Fed’s two earlier rounds of quantitative easing—QE1, from November 2008 to June 2010, and QE2, from November 2010 to June 2011—and will, when ended, have gone on for longer than even the Fed’s initial round of easing during the heart of the global financial crisis and the Great Recession. The rationale behind QE3 can best be described as “shock and awe,” an effort to shock the U.S. economy into reflation and growth by flooding it with awe-inspiring amounts of cash while attempting to bring long-term interest rates back near historic lows seen in mid-2012 and perhaps forcing down the value of the dollar to make U.S. exports more competitive and imports less attractive.
However, by those measures, QE3 was less than successful. Inflation in the United States continued to fall during the implementation of the policy, reaching lows unseen since the Great Recession itself. Per capita real disposable income barely budged, falling well off its trajectory from 2010 through the commencement of QE3. Long-term interest rates, while falling back a bit initially, ultimately rose well past their 2012 lows, sending bond markets tumbling even before the announcement of the Fed’s tapering back its purchases—which sent long-term interest rates well above levels before QE3 began. Needless to say, for a variety of reasons I address in the book, the dollar did not tank.
What was “successful” about QE3, in the eyes of some, was what happened in the financial economy (as opposed to the real “main street” economy). As I wrote in chapter 6 of this book, in a section entitled “The Limits of the Fed,” hyper-easy money policy set off a rush of speculation in risk assets. As is the intent with any extraordinary monetary-easing measures, the Fed’s interventions over three rounds of QE flooded the economy with liquidity to avoid lock-up of the financial economy, made it very inexpensive to borrow, and, ultimately, made so-called “risk-free” assets—such as high-quality government debt—very unattractive to own by virtue of the parsimonious returns thereon. Commodities—especially gold, having seriously burned speculators in a spectacular collapse after its run up resulting from QE1 and QE2, and non-monetary metals and oil, having been overvalued by speculators during those prior rounds, relative to end demand—were no longer seen as safe.
So liquidity finally flocked to public equities, especially those easily leveraged with cheap money, which ran up to valuations by the end of 2013 that by some measures (such as the CAPE ratio popularized by 2013 Nobel laureate Robert Shiller) made them more expensive than anytime other than during the market bubbles of 2008, 2000, and 1929. From the announcement of QE3 through the end of 2013, the S&P 500 Index appreciated by over 31 percent.2
U.S. housing, which did not reach its post-bubble statistical low valuation until early 2012 (a fact that seems forgotten two years later),3took off as well—rising gradually at the start of the historically low bond yields that were reached between QE2 and QE3 and then accelerating greatly during QE3. By the end of 2013, U.S. housing prices had, on average, retraced nearly half the value lost since their bubble-era peak. Prices rose, fueled by the same low interest rates that fueled the stock markets, but were driven higher still by the post-crises anomaly of tight inventories of for-sale housing amid rates of household formation (and thus incremental demand) that continued at levels lower than at any time since the Great Depression (no, that isn’t a typo—and that’s in nominal, nonpopulation-adjusted terms).
Looking back at the recovery in home prices that occurred simultaneously with QE3, we saw a continuation of the phenomena described in chapter 11 hereof—inventories constrained by homeowners remaining underwater relative to their bubble-era mortgage and thus unable, or unwilling, to sell their homes—combined with those with very low levels of home equity, insufficient to afford a down payment on a new home and therefore de facto non-sellers. We also experienced a large number of investor purchasers of homes able to access low-cost capital to acquire the limited inventory that was available and to pay up for it when necessary. Writing about the third quarter of 2013, Zillow, the real estate database firm, noted:
. . . One in five American homeowners with a mortgage remains underwater, a stubbornly high rate that is contributing to inventory shortages and holding back a full market recovery. The “effective” negative equity rate, which includes those homeowners with a mortgage with 20 percent or less equity in their homes, was 39.2 percent in the third quarter. Listing a home for sale and buying a new one generally requires equity of 20 percent or more to comfortably meet related expenses.4
One cannot find a more classic example of a market unable to find a true “clearing” price level because of nonmarket influences (i.e., government policy initiatives).
But in elevating price levels for U.S. housing and sending public equity markets to new historic highs, the Fed’s impact on the real economy—demand for goods, services, labor, and new capacity (plants and equipment)—was far less than anyone could have possibly expected from such a massive intervention. Ultimately, the rapid appreciation of financial assets (and both here and throughout the book I, as is generally the practice in economics, include real estate as a financial asset) in 2013 created a “wealth effect” recovery in which the small percentage of Americans owning stocks—and a far more substantial number owning homes—were, and felt, richer and supported a modest recovery in consumption. This, for a while at least, spilled over into the economies of other developed and developing exporting economies, which benefitted from the increased consumption—which some economists refer to as “leakage” of the U.S. monetary stimulus. But as events seem to be demonstrating at this writing, such wealth effect–created demand is proving unsustainable in the age of oversupply.
One of the most obvious reasons why wealth effect–reliant demand is unsustainable is that the price of equities influences the consumption patterns of only a small, but very wealthy, number of consumers. A more disturbing reason is that in an age in which wages are not growing (and are unlikely to, as discussed throughout the book, but particularly in chapter 8), the wealth effect has been transmitting to consumers who were made exuberant by rising home prices, chiefly by means of rising consumer debt, which hit new post-bubble highs in 2013,5 resulting in the exacerbation of the declining U.S. household savings rate. The ability of households to continue to consume by taking on more debt has rather unpleasant limits, as we saw in 2007. Lastly, in a world of inadequate global demand for labor, production, and capital relative to the supply thereof, there is a tendency for businesses, consumers, and investors to materially misread improvements in one nation’s economic results when other competitive nations are showing downwardly trending performance.
In a nearly fully globalized economy for goods, and even some services, strength in the United States that comes with concomitant weakness in China and other emerging producers (or in Germany that comes at the expense of the European periphery and emerging producers), as we saw in the second half of 2013, can only be sustained for a very limited time, until the price levels offered by those deprived of demand for their output are lowered to recapture such demand. This would not be the case in an environment in which supply and demand were more evenly matched, but in the age of oversupply what we get instead is the tossing around of the “hot potato” of inadequate demand among nations and regions, yielding disinflationary tendencies around the world.
Thus, financial asset price appreciation, the resulting wealth effect, and short-term rises in business activity fail to result in the advanced economies reaching “escape velocity” where increased consumption produces a virtuous demand for additional domestic capacity and labor, which in turn sets wages and prices on a reflationary path. As 2014 dawned and the reality of the Fed’s exiting the policy that sustained financial asset appreciation set in (which it is doing precisely because the Fed came to see little sustainable benefit to the real economy from quantitative easing—and potentially problematic distortions therefrom), global stock markets—first in the emerging nations and then in advanced nations—initially reacted with dread.
The failure of QE3 to ignite price and wage reflation was writ large in 2013, during which U.S. goods prices actually deflated from twelve months earlier.6 While services rose in price, the principal contributor to price inflation in services was, unsurprisingly given the above discussion, inflation in the cost of housing. Housing costs comprise some 41 percent of the U.S. Consumer Price Index, and shelter alone is over 52.5 percent of the services component of the CPI.7 The peculiar confluence of easy money and structural anomalies in the U.S. housing market resulted not only in price appreciation of owner-occupied homes but also restricted inventories. These factors, together with an enormous rise in the number of households that—since the Great Recession—no longer qualified for mortgages, saw many more families thrust into the conventional rental housing market, causing U.S. rents to rise by 2.9 percent over the course of 2013.8
Add inflation in medical services during 2013 (which has since been staunched, for a variety of underlying reasons) and you have the vast majority of 2013’s anemic 1.6 percent core U.S. inflation. As further housing price inflation is unlikely to prove sustainable in the absence of wage growth, with healthcare service pricing already declining and with prices of imports (and exports) falling with global oversupply, where is price inflation to come from in 2014? In fact, there are few sectors to look to, and the bias going forward is far more likely to be deflationary.
During the course of 2013, especially after the Fed announced its intention to taper its asset purchases, the conventional bond market wisdom was that interest rates on U.S. treasury securities would rise as a result of the planned change in policy. The benchmark ten-year yield increased by over 1.25 percent from their 2013 low to their high at the end of the year.9 At year end, expectations were that they would rise further still. But as I wrote in Q2 2013, in chapter 13 of this book, and have reiterated publically numerous times since, with the confluence of ultra-low inflation (tending toward deflation in the absence of the factors previously discussed), a global “oversupply” of demand for high-quality, hard-currency sovereign debt, and with both domestic and global growth data continuing to be unimpressive, there simply is nothing underpinning a more precipitous rise in U.S. sovereign debt yields.
What there was, at year-end 2013, was a collective fear of what financial market participants call a “falling knife.”10 The perception that the Fed’s buying of U.S. obligations had been materially influencing the prices at which those bonds were trading (and, perhaps just as importantly, the perception that all market participants shared that notion) overwhelmed the aforementioned underlying economic fundamentals. Sure enough, as the Fed reasserted that it would proceed with QE despite soft economic data at the beginning of 2014, instead of rising, interest rates fell to a point at which the trading range of the U.S. ten-year treasury note fell by over 50 basis points from its level at the end of 2013. Quantitative easing had proven so disruptive of market pricing mechanisms that even the normally staid and sensible bond market didn’t know which end was up.
• • •
I have spoken and written recently about 2014 being the year of economic “cyclicalists”—those believing that the Great Recession and its aftermath have just been the result of a very severe decline in the business cycle—versus the “secularists”—who believe that what we continue to experience is the outcome of profound shifts in the way the domestic and global economy is working, relative to its behavior in the past, as is argued in The Age of Oversupply. Secularists, myself included, believe that cyclical upswings—while still of course present—are now both muted in amplitude and of very short duration. I expect this will continue to be the case for some time, until the global secular issues of oversupply of labor, productive capacity, and capital are either addressed directly as recommended in this book, or until the imbalances discussed herein—gradually and likely painfully—resolve themselves over a protracted period of time.
The failure of monetary policy alone to revive robust growth in the United States and the European Union (which admittedly has limited monetary tools available to it because of the Euro regime) has become evident to their central bankers. The euphoria that greeted the Bank of Japan’s massive QE program—part of its government’s forceful effort to reverse deflationary pressures, known colloquially as “Abenomics”—has subsided as endogenous inflation has come almost entirely from the currency market’s devaluation of the yen and the resulting rise in import prices (almost entirely energy related), as opposed to wages or prices for domestically produced goods. Such a condition is unsustainable, and, as I predicted in chapter 7, Abenomics will ultimately join previous Japanese reflationary efforts in failing to reverse the disinflationary trend that, since the Great Recession, has seen the rest of the developed world join Japan’s fate.
In early 2014, the U.S. economy saw a continuation of weak wage growth and ultra-low core inflation. Furthering limits on wage growth at the high end of wage sectors and the failure of the U.S. congress to extend long-term unemployment insurance benefits will pose ongoing challenges. I am particularly concerned that more folks coming off long-term benefits and being forced into taking jobs at whatever they can find will exert further downward pressure on U.S. wages. Of some alarm at the time of this writing has been recent data demonstrating falling unit labor costs with a contemporaneous rise in productivity. As I discussed in chapter 2, rising productivity that comes from weakness in wages and exploitation of excess capacity is a far cry from the version of productivity that comes from technological advancement at optimal levels of employment. The declining labor force participation rate in the United States—notwithstanding the decline in the headline unemployment rate—is particularly ominous in this regard (only a portion of this decline is attributable to the demographic shifts that are often named as the culprit). Indeed, in April 2014, the then newly minted chair of the Federal Reserve Board observed that despite the decline in the headline unemployment rate to 6.7 percent since the Great Recession, many other indicia indicated considerable ongoing labor slack.
I wrote The Age of Oversupply in order to offer those perplexed and frustrated by present circumstances in advanced nations a comprehensive explanation of why the credit bubble, the Great Recession, and the ensuing lack of full recovery evidence a situation that is truly apart from past economic tribulations. Shortly after the September 2013 hardcover release of this book, the often-controversial economist Larry Summers—the former Secretary of the Treasury,11 Director of the National Economic Council,12 and President of Harvard University—gave a speech at an International Monetary Fund13 conference on a subject he referred to as “Secular Stagnation.”14Summers, with whom I have had many disagreements during his terms in government, but who I credit in chapter 13 with having seen the light after his departure from the Obama administration at the end of 2010, pretty much hit the nail on the head in that speech. Summers noted that even before the global financial crisis, something was clearly amiss:
If you go back and study the economy prior to the crisis, there is something a little bit odd. Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody agrees that wealth, as it was experienced by households, was in excess of its reality. Too easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilization wasn’t under any great pressure; unemployment wasn’t under any remarkably low level; inflation was entirely quiescent, so somehow even a great bubble wasn’t enough to produce any excess in aggregate demand.15
This book will tell you why I think Summers’s insights into the present state of affairs are correct, even though I do not believe his IMF remarks presented a complete case for causality. This time in global macroeconomics truly is different and requires thinking outside the boxes imposed on us by the ideological limitations of the past several decades. Those differences and limitations are also responsible for the failure of policy since the Great Recession to produce a resurgence of growth, as Summers concluded in his IMF address:
. . . It does seem to me that four years after the successful combating of the crisis, there is really no evidence of growth that is restoring equilibrium. One has to be concerned about a policy agenda that is doing less with monetary policy than has been done before, doing less with fiscal policy than has been done before, and taking steps whose basic purpose is to cause there to be less lending, borrowing, and inflated asset prices than there was before.
Speaking of ideological limitations, I must offer a small apology with this republication of The Age of Oversupply. The book I hope you are about to read does not deal generously with the predominant economic ideology of the Republican Party or the version of macroeconomics espoused by of the so-called “freshwater school.” In fact, I am—admittedly—sometimes contemptuous of what I have seen to be self-serving ignorance from the party’s increasingly more doctrinaire elements and the academic supporters thereof. The fact is that several of my more candid observations in this book have been taken by a minority as being excessively partisan and therefore dismissed by said individuals as pushing a political agenda. To the extent that that interpretation has caused people who might benefit most from an apolitical consideration of the content of this book, I wish I had not been quite as candid in assessing blame. As I noted in chapter 15, in failing to understand the underpinnings and manifestations of our unprecedented age of oversupply “no one, and nearly everyone, was wrong.” With that mea culpa I urge those among you who count yourself among the most persuaded of those on the far right and your supply-side mentors to keep an open mind when forging ahead into this book. In truth, it was written for you.
THE ENDLESS SLUMP
The past twenty years have seen a transformation of the global economy unlike any ever witnessed.
In the time it takes to raise a child and pack her off to college, the world order that existed in the early 1990s has disappeared. Some three billion people who once lived in sleepy or sclerotic statist economies are now part of the global economy. Many compete directly with workers in the United States, Europe, and Japan in a world bound together by lightning-fast communications. Countries that were once poor now find themselves with huge surpluses of wealth. And the rich countries of the world, while still rich, struggle with monumental levels of debt—both private and public—and unsettling questions about whether they can compete globally.
This shift is hardly news. Starting a dozen or so years ago, we began to hear all about globalization and the economic threat that the new, “flat” world poses to developed countries. Yet since 2008, that talk has been overshadowed by the financial crisis and its aftermath—a crisis that eviscerated trillions of dollars in household wealth, created near-record levels of unemployment, and left the United States and Europe in adverse economic straits that persist to the present day (joining Japan, which has been hobbled for two decades). The causes of the crisis, it was said, lay in too much risk taking by the lords of finance, along with too big an appetite for debt among ordinary people. And so for the past five years, we’ve heard less about China and India and more about how to fix the financial systems and economies of the developed countries.
When people think about today’s economic challenges, many of them put the problems facing the United States and Europe in separate baskets: one basket for such thorny issues as how to jump-start growth, reduce unemployment, and control the national debt; and a second basket for how to deal with trade deficits, currency issues, and competitiveness writ large.
This book argues that all these challenges belong in one basket. You can’t understand the housing bubble and the financial crisis without appreciating how the rise of the emerging nations distorted the economies of rich countries. And you can’t chart a course to more growth and stability in the developed world without recognizing that many of these distorting forces are still at work.
In the pages ahead, I argue that the central challenge facing the global economy is an oversupply of labor, productive capacity, and capital relative to the demand for all three.
Beginning in the late 1990s, a tidal wave of cheap money began flooding the global economy, much of it coming from Asia as China and other countries began to run huge trade surpluses and their burgeoning middle classes and thriving corporations socked away savings. Easy credit set the stage for the real estate bubble and the financial crisis. And cheap money also allowed Americans to sustain a high standard of living with low-cost borrowing and to ignore their declining competitiveness amid a growing surplus of global labor. Of course, the party couldn’t last forever.
Yet five years after the financial crisis, many leaders and commentators in the United States and Europe still don’t get what happened. Nor do they seem to realize that the age of oversupply is here to stay and that oversupply is a central obstacle to restarting growth. Many of the standard tools for fueling growth simply don’t work. As I show in the pages ahead, cheaper credit through monetary easing doesn’t yield much in an era when cheap capital already exists in abundance. And policies that seek to stimulate growth run up against the fact that there is a huge oversupply of global labor and productive capacity. Meanwhile, major risks linger in the banking sectors of the United States and Europe, where reforms have not gone nearly far enough. Today, despite the painful lessons of recent years, the global financial system is anything but stable.
Finally, the United States and Europe face a huge overhang of unresolved private debt, a legacy of the credit bubble—debt on a scale no nation has ever before confronted. These debts hold back growth, but asset holders—mostly the banks—have been loath to write these debts off and take the hit they have to take. Few political leaders are ready to force a painful resolution of these debts. And across both the political and financial worlds, hopes abound that growth will resume, inflating the value of “underwater” assets and devaluing outstanding debt.
That is simply unlikely to happen anytime soon. Economic growth won’t rebound in a sustained way until the developed countries confront deep systemic problems in their own economies and the new and profound distortions in the global economy. Even though three billion people and trillions of dollars in wealth have emerged on the world scene, most policy makers are still stuck in denial about the earth-shattering nature of this shift.
Can the United States and Europe get out of this mess? (And what about Japan, which has seemingly been unable to do so for decades?) I believe they can, and this book offers a road map for avoiding a future of economic stagnation and new crises.
We must begin by acknowledging how much everything has changed. Economic troubleshooters—from presidents to central bankers to lawmakers to economists—need a fresh playbook in the age of oversupply. In particular, monetary policy—historically a critical tool for fighting economic downturns—simply doesn’t have, in a world of easy money, the bite it once had. And while fiscal stimulus can help restart growth, I argue that developed nations need to try this approach on a much larger scale than ever before if we are to put the advanced nations’ huge surplus of workers back to work. I suggest major new investments that deal strategically with infrastructure and I detail how such investment would not only help restart growth but also lay the foundation for future prosperity.
At the same time, I propose an aggressive effort to clear away the crushing burden of unresolved debt that is a legacy of the credit bubble. This is a daunting political challenge, because it means taking on creditors who hold trillions in bad debt. But until our advanced economies can emerge from under debt overhang, strong growth will be impossible. The United States, the world’s largest economy, must also confront two major obstacles to its global competitiveness: runaway costs for higher education and health care—and I suggest ways to confront these costs.
My other recommendations include further reforms to the banking sector to reduce risky behaviors and foster more stability. These efforts need to involve leaders and institutions from across the developed world if they are to succeed, given the interconnected nature of today’s global financial system. Likewise, new multilateral cooperation is needed to create a global currency system that will ensure stability and a level economic playing field.
I come to these seminal challenges not as an economist or a policy expert, but as an old-school investment banker. For three decades, I have worked with a range of companies to help them find the capital they need to grow and succeed, and to provide solutions to their problems. At times, I have restructured failed enterprises and those beset by unforeseen challenges.
During my career, I’ve had many dealings in Japan, experiences that strongly color my views and the arguments in this book.
By now it’s become a cliché to say that the United States risks turning into Japan, a country that has experienced two decades in the economic doldrums since the collapse in 1989 of a huge asset bubble of its own. Yet long before the global financial credit bubble imploded, I could see that the United States was on a path similar to Japan’s and that we might someday face comparable stagnation. As it turned out, far more countries than just the United States were to be drawn into crisis.
I vividly recall sitting in a conference room with other bankers and attorneys one sunny, warm day in Tokyo in the summer of 2005. I was involved in the acquisition of a long-defaulted mortgage loan collateralized only by land, a leftover from the late 1980s Japanese bubble era, with an outstanding balance of about $800 million in today’s U.S. dollars. We were in the process of closing the purchase of the loan for the shockingly low price of $50 million. But I was not particularly astounded. My firm had opened our office in Japan in 2000, and by 2005 I guess I was already an old Japan hand. Nothing surprised me. Although I mostly commuted to Asia monthly and did not reside there for long periods of time, I had spent nearly half of my recent years in Japan. This was the country in which the grounds of the Imperial Palace in Tokyo—1.3 square miles of land—were once estimated to have the same value as all of the real estate in California.
I was in that conference room that day as an undertaker of sorts: a small pile of the remaining ashes of the greatest real estate bubble in history were being laid to rest.
It was all very ominous because in 2005, of course, the United States was in the midst of its own property bubble—one already quite apparent to the small number of us who followed the relationship among markets, lending, and global macroeconomic trends—an unusual combination of disciplines. Prices of homes and commercial properties in the United States had already become unmoored from reasonable investment returns, the ability of incomes or rents to support prices paid, and—most ominously in the U.S. residential sector—the ability of most buyers to secure ownership of a home with a conventional mortgage product. The connection between what was occurring in the United States and what I was doing that day in Tokyo did not escape me. Even as Japan’s leaders struggled with the debt overhang of a decades-old real estate bubble, America’s and Western Europe’s leaders were turning a blind eye as an even bigger bubble (in nominal terms) inflated in the United States and Europe.
After a break, I returned to the conference table and listened to the conversation for a while. During a lull, one of the Japanese lawyers turned to me and said:
“Alpert-san, you must think we Japanese were very foolish to lend so much money against just land. You would never do such a thing in the U.S.”
The Japanese, particularly the men, have a customary and somewhat endearing way of sucking wind through their teeth and screwing up their faces during moments of consternation, intense consideration, or confrontation.
I thought for a moment, smiled, and said, “Unfortunately, I think the U.S. is next up in terms of this type of foolishness.”
“What do you mean?” came the reply, accompanied by much sucking of wind and quizzical facial expressions. “In the U.S., businesspeople could never do something like this!”
“I think you might be very surprised,” I said—to even more sucking of wind through teeth.
Today, seven years after home prices in the United States hit peak bubble values in the summer of 2006 and five years after the financial system of the entire developed world nearly ground to a halt, the economies of the United States, Western Europe—and yes, still Japan—remain mired in severe economic dislocation.
The demand for goods and services in the developed world remains muted, relative to potential. Amid this flat demand, even the most profitable companies see little reason to invest in new equipment or hire new workers. And never has there been such bitter disagreement and deep confusion, among politicians and economists alike, about what ails the economies of the developed world and how to fix them.
To combat the ongoing slump, for half a decade despairing policy makers have employed almost every conventional, and many far more heterodox, economic countermeasures—measures that arose from a century of modern economic scholarship and experience. As a result, they have succeeded in avoiding an outright collapse of key institutions and enterprises, while kicking down the road a growing list of unresolved problems.
At this writing, an alarming percentage of the political leadership in the developed countries have flirted with or have outright implemented fiscal austerity policies. Nothing could be more damaging to the interests of the 800 million or so people of the advanced nations. Commenting in March 2013 on the dominance of austerity policies in Europe, Gideon Rachman of the Financial Times of London wrote, “There are many who argue that this prescription is dangerous. But the anti-austerians have failed to come up with a set of alternative policies that is coherent enough to turn the intellectual tide.”1
The Age of Oversupply is intended to answer precisely that type of criticism: to provide a coherent intellectual rationale for why we are where we are, to deliver policy initiatives that focus on the ongoing challenges to the global economy, and, particularly, to chart a way forward toward the renewal of developed-world growth and prosperity.
THE RISE OF OVERSUPPLY
How the Emerging Nations Remade the Global Economy
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 December 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 December 18 to December 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. In time, these reforms would change everything. 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. By the early 2000s, Russia would be the biggest energy exporter in the world, a country with a half trillion dollars in foreign reserves and nearly a hundred billionaires—yet another vast pool of money looking for returns.
Economic liberalization came more slowly to India, the second most populous country in the world. But when that process started in 1991 (and was rewarded four years later when India joined the World Trade Organization) it brought another huge army of workers into the global economy—a labor force of nearly half a billion able-bodied adults, or three times the number of workers in the United States.
Liberalization also turbocharged India’s economy. In just twenty 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 sixty 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 United States’ top economic competitor, Japan, is no longer a “rising sun” and Japanese investors are no longer snapping up iconic U.S. landmarks such as Rockefeller Center. Instead, Japan is trapped in an endless twilight of malaise and deflation. Tokyo, a once heady city now filled with depressed underwater property owners and developers, is deeply rattled after a cult releases sarin gas in its subway system, killing thirteen people. Europe is doing better, but has its own deep economic problems broadly described under the term “Euroscelerosis.” Unemployment across the Continent is above 10 percent, a record postwar high.
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.1 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. In a remarkably short span of time, a full 50 percent of the global population had been freed, or freed itself, to challenge decades—if not centuries—of the international commercial status quo. Ironically, while the Cold War, with its ever-present specter of nuclear disaster, had deeply unnerved the West, that long standoff had also sheltered the developed world from meaningful competition with the world’s most populous countries.
The Cold War’s end was widely seen as a triumph for liberal free-market democracies, and even as “the end of history.”2 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 three 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 three 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.
The final stage of the fall of international communism, such as it was, can be tracked to the events of 1989, with the fall of the Berlin Wall and the rise in Chinese urbanization that followed from the Tiananmen Square incident in that year. As a practical matter, the impact of these events was negligible throughout the early 1990s. The developed world’s economies were weak anyway and the post-socialist world had not yet gotten its act together. Even after the largest emerging nations’ export juggernaut had commenced, the direct impact on advanced nations was muted by the enormous productivity boost arising from the Internet technology revolution.
Only after the collapse of the Internet bubble, and after China had joined the WTO 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.
Rapid population growth in several developing countries, coupled with the ongoing spread of liberalization, has swelled the global labor force even more since those bright, hopeful years of the mid-1990s. Just six countries that were all heavily statist when Bill Clinton was president—Indonesia, Brazil, Bangladesh, Pakistan, Mexico, and Vietnam—account for another 450 million workers.
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.3 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),4 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). What that means is that the arrival of nearly two billion new workers on the scene hasn’t generated anything near the demand you might think, in terms of these people buying goods. Instead of a balanced rise of both supply and demand, we’ve seen a totally skewed situation of ever-growing supply, particularly with regard to capital.
I’ll say more about the flood of cheap money in a moment. But let me add one more piece to the labor picture—the explosion of more educated workers. In China alone, the number of students graduating annually from college has risen eightfold in the past fifteen years, from 830,000 in 1998 to 6.8 million in 2012.5 A similar trend holds for India. In 2000, there were seats for just 390,000 young Indians in universities. Now there are spots for 1.5 million.6 Granted, a college degree from a Chinese or Indian university is not the same as one from a U.S. or European university . . . yet. But with at least some portion of this new educated class able to undertake tasks such as accounting and computer programming, we have seen a quickly expanding global pool of white-collar workers who are earning higher salaries, saving more, and competing more for jobs previously held by workers in the advanced nations.
A SEA OF CHEAP MONEY
After so many decades of subordinating their prosperity to a failed ideology, the world’s formerly socialist (or socialist-leaning) countries played a remarkable game of catch-up.
During the fifteen years from 1993 through 2007, the GDP of the emerging nations grew at an average rate of between 4 and 8 percent, with some countries, like China, famously firing much hotter than that.7 And between 1990 and 2010, the emerging nations doubled their share of global GDP—from under 20 percent to 38 percent.8 (In 2013, for the first time, emerging nations will account for more than half the world’s GDP.)
As trade in manufactured goods and its associated jobs migrated inexorably to lower-cost labor markets, despite the productivity increases in the advanced economies the emerging nations began to develop substantial current account and trade balance surpluses.
In other words, wealth—lots of it—began to pile up in those countries.
The obvious place to start this part of the story is China, which has the biggest pile of cash of all.
Part of that pile, of course, is due to its exports. In an effort to “sterilize” its currency from trade flows that typically cause a nation’s currency to appreciate and thus curtail its competitiveness, China blocked free conversion and began to accumulate vast foreign-currency reserves—to the point where, at year-end 2012, it held over $3.31 trillion in the form of dollars, mostly, but also euros, yen, and other currencies.9 Following the Asian currency crisis of 1997, which set off fears of global recession, emerging nations became wary of borrowing in foreign currencies and floating the value of their currencies against others without maintaining sizable hard-currency reserves. China was a different story—it not only sought to protect the yuan against speculation, but also strove to control its appreciation so as to optimize competitiveness and build its employment base as swiftly as possible.
China’s reserves of hard currency and related assets—chiefly U.S. dollars—totaled less than $250 billion in 2000. They grew to $2 trillion by 2008 and to over $3 trillion as of this writing, as set forth above. This vast pot of money is managed by the State Administration of Foreign Exchange (aptly abbreviated SAFE in English) and the People’s Bank of China.
Talk about an outfit that has seen good times and bad: the original Bank of China was founded in 1912, when China’s power was near a historic low. It is now the fifth-largest central bank in the world and among the largest lenders to the U.S. government, with quite a lot of China’s reserves invested in U.S. Treasury and government agency bonds.
At the same time that China’s currency reserves soared, Chinese workers and businesses were saving monumental amounts of cash. Anyone who thinks that the Japanese are good savers clearly hasn’t been to China. Data from the World Bank shows that the Chinese national savings rate grew from 37 percent in 1988 to 48 percent in 2005 to 53 percent of GDP in 2011. By comparison, thrifty Japan’s savings rate is now under 25 percent. The U.S. rate is at about 12 percent.10 (Keep in mind that a nation’s gross savings rate isn’t just a reflection of what individual earners are socking away. It’s an overall reflection of the difference between the wealth a country produces and what it consumes.)
Either way, even as China’s GDP was growing by leaps and bounds, the slice of that wealth being saved also grew. In 1988, China had a GDP of just $390 billion—and $144 million in gross savings. Ten years later, it had a GDP of $1 trillion—and $390 billion in savings. By 2011, China had a GDP of $7.3 trillion and an estimated $3.8 trillion in gross savings.11
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.) Beijing is more like Boston. On winter nights, thousands of people mass along the curbsides of major thoroughfares, enduring long waits and fighting their way onto hopelessly overcrowded public buses that then spend hours stuck on jammed roads. . . . Better schools, more-abundant parks, better health care, cleaner air and water, better sewers in the cities—you name it, and if it isn’t in some way connected to the factory-export economy, China hasn’t got it, or not enough.12
Maybe most notably, China’s spending on health care has barely risen in fifteen years. China spent 4 percent of its GDP on health care in 1998; it spends a bit over 5 percent today.13
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.
And it wasn’t just China that started piling up huge amounts of excess wealth starting in the 1990s. Other emerging countries did, too. Brazil’s total reserves soared from $33 billion in 2000 to $352 billion in 2011. Tiny Singapore had $71 billion in reserves in 2000—and $244 billion in 2011. Indonesia’s reserves grew fivefold. Russia’s grew by eighteen times thanks to its natural-gas exports. Rising energy prices boosted Saudi Arabia’s reserves from $21 billion to $595 billion, a twenty-eight-fold increase. (As if there weren’t already enough rich Saudis looking for good places to put their money.)14
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 twenty-first 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. Indonesia’s savings rate, for example, increased to 37 percent, up from 29 percent, during the early 2000s even as GDP grew sixfold.15
Never before in history had so much money piled up so fast. The assets of banks and other financial entities in the world’s top jurisdictions grew from roughly $110 trillion in 2002 to $240 trillion in 2008—a staggering rise in wealth, just sitting around.16
Of course, such money can’t just sit around. 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).
With a torrent of global savings flowing back to deficit countries (mostly the United States, but also the weaker countries of Europe), their governments did not need to borrow as much domestic private capital, and interest rates plummeted. Even Japan, which had seen minor challenges to its post-bubble ultra-low interest rate environment, saw its borrowing costs plummet to new lows despite its huge debt load and poor fiscal metrics.
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.
But there was a problem: Over the past two decades, and especially in the early 2000s, the rising pool of capital far outstripped the rise in demand and real economic growth. Which is to say that even as rivers of cash looked for returns, there was not nearly enough productive activity to sop up all the money. As a November 2012 study by Bain & Company observed: “The rate of growth of world output of goods and services has seen an extended slowdown over recent decades, while the volume of global financial assets has expanded at a rapid pace.”17
That was—and still is—a recipe for trouble.
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. In 1990, total household and commercial mortgage debt outstanding in the United States was $3.7 trillion. By 2000, it had all but doubled, rising to $6.7 trillion. Then, in just six years, it doubled once more, to over $13 trillion, and kept rising to a historic peak of $14.6 trillion in 2008.18
All this money had to come from somewhere, and much of it came from China, either directly or, more often, by “crowding out” domestic capital from government bond markets. 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. Japan, with its own big reserves to invest, had also gone big into the U.S. mortgage market and found itself holding $228 billion in Freddie and Fannie securities when the crisis came.19 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 ill-advised 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. Total federal debt doubled to $10 trillion during the Bush presidency, with foreign governments coming to own almost half of this debt.
In January 2001, the month Bush took office, China owned a mere $61 billion in U.S. government securities. Four years later, when Bush was sworn in for his second term, that figure was up to $223 billion. And by the time the Obamas walked the Bushes to Marine One during the 2009 inaugural, China owned $739 billion in U.S. securities. As of this writing, the total stands at over $1 trillion.20
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.21
American state and local governments took advantage of cheap money as well, borrowing more than $1 trillion between 2000 and 2008.22 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. Most people know this part of the story, so I’ll skip all the details about how hedge funds, money market funds, private equity groups, and insurance companies turned into 900-pound gorillas, thanks to the magic of cheap borrowing and heavy leverage. 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.23
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 (when one considers all non-bank financial intermediation). The United States, as the world’s largest economy, developed by far the largest shadow banking system in the world, accounting for a third or more of all assets in this system.24
“A fascinating new book.”
—Martin Wolf, The Financial Times
Daniel Alpert is founding managing partner of investment bank Westwood Capital, LLC. He is widely quoted in the business media and is a fellow in economics of the Century Foundation, the country’s oldest policy think tank. He lives in New York.
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A very well written book but as much a book of political commentary as economics. If you are a proponent of bigger government and a larger welfare state you will love this book. If not, you may not get past the first chapter.
I hesitate to write a review for a book that will certainly upset everyone today. Conservatives will object because Bush is criticized. Liberals will revolt because Democrats are criticized. No one will enjoy reading what the author says BUT--- this said, it is one of the clearest explanations of the problems facing not just the US but the entire planet. It is written in easy to understand terms and the author walks you through each step of the problem as it has unfolded to date. His forecast is also, in my opinion, spot on. A great book for anyone not afraid of reading "outside the box" to better understand today's issues.
Terrific assessment of the macro-level problems facing the developed world. Alpert presents a clear examination of why certain economic and monetary policies have and will continue to fail, while presenting some well-researched evidence in support of alternate solutions. A smart, enlightening read sure to provoke much thought.
Age of Oversupply truly makes you stop and think. Excellent read!
In his clear and concise style, Daniel Alpert nails it. Wonderful reading.