Excess Supply: A More Robust Explanation

Steven Ricchiuto
Steven Ricchiuto Mizuho Chief US Economist
December 14, 2016

The term “new normal,” coined by Mohamed El-Erian during his PIMCO days, has sparked a debate among economists and market participants which continues to rage without consensus.  The debate centers on the lack of plausible explanation for the economy’s abnormal behavior in its tepid response to the monetary policy stimulus following the 2008 financial crisis. Secular stagnation, a liquidity trap and even excess leverage have all been advanced as possible causes for the shallow recovery/expansion over the eight years. Although these theories all have merit, we believe a simpler, but more problematic dynamic is at the heart of the problem – the transition from the excess demand of the post-war period to excess supply spurred by China’s admission to the WTO. 

Secular stagnation suggests that the economy suffers from an increased marginal propensity for individuals and households to save and a decreased propensity for companies to invest in new plants and equipment.  The resulting imbalance between savings and investment drags down demand, reducing growth and inflation and pulls down real rates to the point where monetary policy becomes ineffective.  

In a liquidity trap, a shock to the economy drives up the desire to save and pushes down interest rates to the point where monetary policy becomes ineffective.  The liquidity trap is a special case of secular stagnation and both result in calls for increased fiscal stimulus funded by government borrowing. These two popular explanations contrast sharply with the excess leverage thesis which argues for a reduction in debt rather than an increase in deficit spending. Essentially, this explanation rests on the notion that at some point the future tax liability needed to pay down the debt starts to alter current spending and savings decisions.

A key problem with this reasoning is that households have not significantly increased their willingness to spend. While the household savings rate has crept up from an unsustainable pre-crisis low of about 4% to approximately 5.5% today, this is hardly the structural change in saving behavior that secular stagnation or the liquidity trap are based on. Moreover, households have repeatedly shown a willingness to buy big ticket items like new vehicles, and more recently, new homes.  This implies there has been no fundamental change in household behavior necessary to validate these hypotheses.

Our more robust excess supply explanation suggests that China’s desire to avoid the worst of the financial crisis by boosting investment exacerbated the imbalance between supply and demand that had been slowly building since the Great Inflation of the 1980s. China, in fact, doubled down on investment in markets where the world already produced more than it could consume. This tipped the scales toward excess supply. Raw materials providers also expanded to meet China’s expected future demand assuming its double-digit growth would continue unabated. The result was excess capacity in commodities as well as manufactured goods. 

The shift to excess supply started in the 1980s when Volcker and Reagan implemented policies designed to control inflation and boost supply, resulting in the institutionalization and globalization of wealth and increased emphasis on quarterly earnings targets. Corporate management teams focused on cost-cutting to achieve higher returns over the short-term exacerbated this process.

To shift the economy back towards a better supply / demand balance, investment horizons need to be lengthened and after-tax returns boosted. A simple change in capital gains taxes could accomplish both. Tax any gain less than five years as ordinary income, but make any gains five years or longer tax-free. All corporate tax expenditures should be eliminated to minimize and trim the deficit.

Excess supply explains why monetary policy has become less effective, why deflationary forces have surfaced, and why investment spending has disappointed. It also explains why income inequality continues to increase. 

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