... from "The Washington Post" today ...
Too Much Supply, Too Little Demand - Businesses Have Few Incentives to Expand or Hire, Economists Say
By Steven Pearlstein
Washington Post Staff Writer, Sunday, August 25, 2002
To understand why the U.S. economy can't seem to muster a stronger recovery, it helps to look for clues in Victorville, Calif., where 500 unused and unwanted passenger jets -- some of them brand new -- sit wingtip to wingtip in the desert.
Or in Detroit, where the Big Three continue to churn out large numbers of passenger cars that they sell at little or no profit, just to keep their factories busy.
Or in nearly every major metropolitan area, where office vacancy rates are still rising after 18 months, and have reached 25 percent in Dallas, 24 percent in Raleigh-Durham, N.C., and 18 percent in San Francisco.
But perhaps the best explanation can be found in those falling prices shoppers find for clothing, televisions, hotel rooms and cellular phone service. While the bargains are great for American consumers, they are being paid in the form of continued corporate layoffs, lackluster stock prices and a sky-high trade deficit -- in short, an economy that's having trouble building up a head of steam.
Economists refer to this phenomenon as overcapacity, which is really nothing more than too much supply chasing too little demand. And it can be found these days across a wide swath: agriculture, autos, advertising, chemicals, computer hardware and software, consulting, financial services, forest products, furniture, mining, retail, steel, textiles, telecommunications, trucking, and electric generation, just to mention a few. In most every case, it is accompanied by prices that are flat or falling.
To be sure, overcapacity is a feature of every recession. A slowdown in consumer spending and a decline in business investment suddenly leave too many companies with too many workers, underutilized plants and underperforming stores. In most cases, it is only after most of that excess is cut back, and supply and demand get back into some rough balance, that businesses begin hiring and investing again, laying the foundation for another period of economic expansion.
This time, however, that process is turning out to be longer and more drawn out than in the past, making for a slower and weaker recovery than forecasters, executives and policymakers had expected.
There are some economists, such as Alan Blinder of Princeton University, who believe the problem now is insufficient consumer and business spending -- "demand," as economists call it. But increasingly, economists are coming to realize that heavily indebted consumers aren't likely to significantly increase their spending. And with stock prices well off their highs, businesses are still slow to resume capital expenditures, even as profits have begun to rebound.
The Boom's Reverberations
The big culprit in the supply-demand mismatch was the investment boom of the late 1990s, arguably the longest and most exuberant since the 1920s. Flush with cheap money made available by Wall Street, businesses of all sorts rushed out and expanded their capacity -- not simply to satisfy the increased demand of the moment, but in anticipation of continued high economic growth rates well into the future. When the growth failed to materialize, they suddenly found themselves with more capacity than they could profitably employ.
"In hindsight, it's now clear that we invested too much in plant and equipment during the last boom -- maybe 20 to 25 percent too much," said Jerry Jasinowski, president of the National Association of Manufacturers. "We were looking at things in an analytically flawed way."
Ironically, another reason why this recovery may be so weak is that Washington policymakers moved so quickly to prop up the economy when it became clear a recession was in the offing. In January 2001, the Federal Reserve began cutting short-term interest rates so aggressively that by year's end they were at their lowest levels in four decades. And for a variety of reasons, the federal government has cut taxes and increased spending over the past year, which also stimulates the economy.
By all accounts, those policies helped to make the recent recession one of the shortest and mildest in recent memory. But according to economist Stephen Roach of Morgan Stanley & Co., it also meant that the necessary task of working off all that excess capacity has been only partially completed. Until it is, he argues, it will continue to be a significant drag on the economy.
"Like it or not, the post-bubble excesses of the U.S. economy remain largely intact," Roach said. "That's the unfortunate outcome of a mild recession -- it doesn't result in a major purging of long-standing imbalances of the economy."
The degree of excess capacity in the economy is difficult to measure.
In the manufacturing sector, where reliable data is available, the Federal Reserve calculates plants were operating at 74.4 percent of capacity last month. That's closer to the low point of 73 percent last December than the 81 percent average of recent decades.
To David Wyss, chief economist at Standard & Poor's Corp., this stubbornly low utilization rate suggests that it could be six months or more before manufacturers begin to think about investing in new plant and equipment or hiring new workers. And that's one big reason that he and other economists have lowered their economic growth forecasts for the rest of this year.
Recently, one bright spot for the economy has been the auto industry, which has posted near-record sales for cars and light trucks. But according to industry executives and analysts, such encouraging numbers obscure the fact that domestic auto manufacturers still suffer from a serious overcapacity that will require painful restructuring, beginning around this time next year.
One reason it hasn't happened already can be found in the labor agreement between the United Auto Workers and General Motors Corp., Ford Motor Co. and Chrysler Corp. that requires companies to pay the workers their full salaries through the end of the contract, whether they are working or not. Because of that provision, it makes more sense for the Big Three to produce and sell cars even at a small loss rather than shut down plants completely. And for much of the past two years, that is just what they have been doing -- keeping sales up by offering no-interest financing, at an average cost of $2,000 per vehicle, according to the Center for Automotive Research. As a result, while lower-cost General Motors is still able to eke out a small profit on its U.S. production, Chrysler only breaks even and Ford is running in the red.
All that is likely to change when the UAW contract expires in September 2003. Industry executives determined to return to sustained profitability are already preparing the list of plants they intend to shut down, even if it means giving up market share to imports and "foreign" cars, such as Toyotas and BMWs, that are produced at non-union U.S. plants.
"We have this no-plant-closure agreement this time, but as soon as the contract is up, I know that everybody -- everybody -- is going to talk about closing plants," GM Vice Chairman Robert Lutz recently told Automotive News.
Sean McAlinden of the automotive research center estimates that the Big Three are likely to eliminate at least 1.5 million units of automaking over the next few years -- the equivalent of seven assembly plants employing roughly 15,000 workers. And with each job lost at a final assembly plant, McAlinden said, nearly four others are likely to be lost at nearby parts suppliers -- hardly the stuff of a robust economic recovery.
A similar dynamic is already at work in the troubled airline industry, which has only recently come to the conclusion that a modest economic recovery won't be enough to return it to profitability.
In the past week, US Airways, American and Continental all announced plans for another round of layoffs and route reductions, with United threatening to join US Airways in bankruptcy court if it cannot quickly win major wage concessions from its unionized workers.
Obviously, part of the airlines' problem stems from the Sept. 11 terrorist attacks, which continue to affect the willingness of people to fly. But an even greater impact has come from the growth of low-fare airlines such as Southwest and JetBlue, which have been driving down fares.
The result is an industry where supply and demand, cost, and fares are out of whack. The industry as a whole lost a staggering $11 billion last year and is on a glide path this year to lose $7 billion more.
So far, all this turmoil has been good news for price-conscious airline passengers, but the implications for the economy are not so positive.
Already, airline payrolls have been trimmed by 10 percent, or 120,000 employees, over the past 12 months, with another 7 percent to 10 percent likely to be cut in this next round of restructuring, according to Steven Morrison, an economist at Northeastern University who follows the industry. The airlines have also begun to delay or cancel hundreds of millions of dollars in new terminal construction, along with billions of dollars in orders for new planes and engines from Boeing Co., Airbus SAS, General Electric Co., United Technologies Corp. and their vast network of suppliers. And with those new and barely used jets sitting out in Victorville going for bargain-basement prices, pricing for new jets is also under pressure.
Along with the airlines, the hotel industry is lowering its expectations for the next year. Although the industry began to slow construction of new hotel rooms beginning back in 1998, excess capacity in most major cities has now forced down room rates to levels that discourage the building of any new hotels.
"In terms of travel, this recession was much broader and deeper than people anticipated," said Patric Ford, president of Lodging Economics in Portsmouth, N.H. "Even with modest growth next year, it will take all of 2003 to finally absorb all the capacity we now have." In terms of occupancy and room rates, Ford doesn't see a genuine rebound to pre-recession occupancy and room rates until 2004.
With that in mind, Cendant, the largest franchiser of hotel rooms, announced late last week that it would sell 300 underperforming hotels with 40,000 rooms.
Wholesale Restructuring
The retail sector is also in for another few years of restructuring as more efficient and effective competitors such as Wal-Mart, Target, Kohl's, Lowe's and Home Depot continue to expand rapidly, taking share from specialty chains and department stores that in many cases are now fighting for survival.
"Although there has been overcapacity in retail for the past 15 years, I'd say it's now as bad as it's ever been," said Ira Kalish, chief economist at Retail Forward, a consulting firm in Los Angeles. "The end result has been a high level of bankruptcies, a lot of consolidation and a lot of retail space performing badly."
According to Kalish and other experts, the recent bankruptcies of Kmart, Ames, Bradlees and Caldor is but the first wave of closures that will be necessary to right-size the retail sector. The closing of these "anchor" stores, in turn, now threatens the viability of many malls and strip centers where smaller merchants relied on the traffic the big outlets generated.
"What you're seeing now is American retailing hitting the wall," said Burt Flickinger, president of Strategic Resources Group, an industry research firm in New York. "And it's only going to get worse before it gets better."
Although calculating capacity rates in service sectors is difficult, one proxy is the market for office space, which nearly all service businesses use. And so far the data show that there are still more companies moving out of space than there are companies moving in. And that's been going on now for the past 18 months.
"Right now we're swimming in excess space," said David Shulman, a real estate analyst with Salomon Smith Barney Inc.
Shulman reports that a lot of service companies have held off getting rid of their unused space in anticipation that the economy would bounce back by this summer. Now that it hasn't, he said, he is expecting a lot of additional office space to be dumped on the market in the coming months.
"In places like New York and Boston, I don't think we're even halfway through this process," said Shulman, who expects another round of layoffs in the financial services sector in particular.
Law firms, advertising agencies, consulting and architectural firms -- all big beneficiaries of the '90s boom -- are also still in the process of quietly cutting back on people and office space, according to partners contacted last week. And all of this is also depressing business for the construction industry, which is getting few calls these days to break ground on new offices or hotels.
In the high-tech sector, meanwhile, recent data and company reports indicate that the bottom may have been reached as businesses begin to invest again in personal computers, software and networking equipment -- not so much to increase capacity but to improve efficiency, lower costs and improve product quality.
But while the volumes coming out of high-tech plants have begun to pick up, prices have not -- a reflection, analysts say, that the globalized industry still suffers from serious overcapacity estimated at anywhere from 15 percent to 25 percent.
"In terms of weeding out the weak players and downsizing capacity, I don't think this is over at all," said Rob Enderle, a researcher at the GIGA Information Group in San Francisco. The recent decision by International Business Machines Corp. to stop manufacturing its own computers and the merger of computer makers Hewlett-Packard Co. and Compaq Computer Corp. were early steps in that process, he said.
Nowhere is the plague of overcapacity more evident than in the once high-flying telecommunications sector. The unprecedented overbuilding there has now created a vicious downward cycle in which price wars beget bankruptcies and bankruptcies beget more price wars, dragging down weak and strong companies alike. Although WorldCom Inc. is the biggest and most celebrated failure, the industry landscape is crowded with wounded giants such as Lucent Technologies Inc., Nortel Networks Ltd., AT&T Corp. and Qwest Communications International Inc., along with hundreds of once-promising and well-funded start-ups such as Winstar Communications Inc., Teligent Inc. and PSINet Inc. Already, the industry has shed nearly half a million jobs since its peak in 2000, with profits still in a free-fall and fresh layoff notices still being posted nearly every week.
"We'd like nothing more than to say the worst is over, but it's not clear we're not there just yet," Gary Smith, chief executive of Linthicum, Md.-based Ciena Corp., said last week. Smith made his comments as the once-prosperous maker of fiber-optic equipment announced that its sales for the three months ended in July were down 89 percent compared with the same quarter of last year, to levels not seen since 1997.
The big problem for Ciena and the industry in general is that even after weak telecom companies close their doors or trim their operations, the capacity they built remains -- bought up at bargain-basement prices by surviving competitors or aggressive new upstarts.
The ruthlessness of the process was evident earlier this month when two Asian companies agreed to buy a controlling interest in Global Crossing Ltd.'s worldwide network, which had cost the now-bankrupt firm $13 billion to construct and assemble. The selling price: $250 million, or roughly 2 cents on every dollar of original investment.
© 2002 The Washington Post Company
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