O.T. - Deflation. Best article I have ever read on deflation. Read this and you will understand why I am stunned that Warren Buffett (who is supposedly "real smart" about investments) exited his massive position in long-dated U.S. Treasury zero coupon bonds.
(This is from yesterday's Wall Street Journal. I initially missed it, when glancing at the WSJ's Internet version. I wonder if it was "buried" in the middle of the paper, since it is more important to have articles about things like movie studios on page 1).
November 30, 1998
Manufacturers Face Race to Survive
As Excess Hits the Industrial World
By MARCUS W. BRAUCHLI
Staff Reporter of THE WALL STREET JOURNAL
What imperils the world economy most?
Everything -- or, rather, too much of everything.
From cashmere to blue jeans, silver jewelry to aluminum cans, the world is in
oversupply. True, some big industries, such as steel, autos and
semiconductors, have been grappling with excess for years. But a remarkable
range of others have been losing their leanness only lately, as crisis-battered
nations ramp manufacturing to try to earn more money, and as consumers in
many lands, spooked by financial-markets gyrations, slow their spending and
conserve savings.
In business-minded Europe, there are too many tank and
armored-personnel-carrier plants, relics of the Cold War. In reformist China,
textile factories spin out so many excess garments, the country could
practically clothe its entire population out of inventory. Thailand has an
embarrassment of idle golf courses, Hawaiian beaches are lined by underused
hotel rooms and South African mines grind out more gold and diamonds than
the bejeweled classes want (at current prices, anyway). There's even a surfeit
of coffee shops -- not just in high-caff towns such as Seattle, but in tea towns
like Seoul.
Rocky Realignment
Facing a glut of nearly everything but gluttony, the world economy is in for a
continuing, possibly rocky realignment, despite the recent, heartening recovery
in some financial markets. That is because there are essentially two solutions to
extreme excess that afflicts the world economy: either industrial downsizing,
consolidation and layoffs; or faster growth, more consumer spending and
improved industrial efficiency.
For years, companies have been muddling through, counting on humanity's
sheer size to absorb output. Indeed, a moral dimension shadows the very
notion of overcapacity when billions of people live in poverty, deprived of
many of the goods and services that saturate the developed world. The
problem of excess is limited to the markets that can afford and obtain those
goods and services.
But in the places that dictate economic trends a reckoning looms. "You have a
finite number of customers" at the moment, says Richard Siber, who advises
telecommunications companies for Andersen Consulting. Noting that more
than 100 U.S. cities soon will have six or more competing wireless-telephone
providers, he warns of a shakeout that could wipe out companies that have
invested billions of dollars installing new networks in already-wired places.
"Just because you build it, it doesn't mean they're going to come."
Battling Chinese Rivals
Buyan Holding Co., the biggest cashmere producer in distant, landlocked
Mongolia, hopes that adage doesn't hold. Facing a slump in the price of its
main product, cashmere, Buyan's president, Jargalsaikhan, is building a $30
million factory that will increase output tenfold. His logic: raise his quality and
lower prices, so he can outlast rivals in neighboring China. "They produce
sweaters, but only a few types," says Mr. Jargalsaikhan, who uses only one
name.
Decisions such as his escalate what might seem healthy competition into
excess, in two virulent forms. Manufacturers and service companies not only
build too much capacity, in which an industry has invested in the capability to
produce goods or deliver services at a higher level than the market needs, but
also create oversupply, in which industry is making or delivering more than the
market needs.
The two problems are self-reinforcing. Surplus goods tend to fall in price,
which makes it less profitable to produce them. Producers try producing more
to lower the cost-of-production-per-item price. Unbought goods clog the
system. Prices shrink and, at some point, some producers are forced out of
the business and supply diminishes. The economy slows. Demand shrinks.
Equilibrium returns.
Taxco Jewelry Makers
The first phase of that cycle is under way, but with what ING Barings
strategist Paul Schulte says is "something systematically different" from the
past: global impact. Consider the traditional silver jewelry makers of Taxco,
Mexico. In business since the 17th century, Taxco's silversmiths are being
squeezed out of export markets such as the U.S. by cheaper goods not just
from across the street, but by technologies and money in far-off Asia.
Maria de los Angeles Lagunes Vera, president of the local jewelers' chamber of
commerce, says Asian producers have copied Mexican designs and can stamp
them out at a price and volume Taxco's 5,000 family-owned workshops can't
match. "We have saturated markets with the exact same pieces," Ms. De los
Angeles says, "but we aren't competitive."
Taxco jewelry makers use an average of 10 grams of silver to produce a pair
of earrings with dangling silver globes known around Taxco as "Africanos."
Chinese producers, newcomers with machine-tools, flood world markets with
identical-looking pairs made with only five grams of silver, undercutting the
Mexican originals.
Problem's Epicenter
"The pattern is almost universal and across an astonishing range of industries,"
says Christopher Clarke, managing director for Southeast Asia at consultancy
A.T. Kearney. As with last year's economic crisis, and for many of the same
reasons, Asia is the epicenter of the problem. Massive investment made on the
assumption that high rates of growth would go on forever resulted in broad
overcapacity; even China, a relative latecomer, so overbuilt its industry that
state newspapers recently carried articles showing only a half-dozen industries
where new investment is truly needed.
The problem only grew worse when many of the region's economies collapsed
into recession during the past year. "Companies should go bankrupt,
companies should get taken over and inefficiencies should be taken out,"
Kearney's Mr. Clarke says.
That is easier said than done. The reasons for overcapacity or oversupply vary
widely, but many are deeply rooted and hard to undo.
One of the most intractable: national pride. Country after country, especially in
Asia, has a domestic auto industry. The result? What former Chrysler Corp.
Chairman Robert Eaton, justifying the virtues of Chrysler's recent merger with
Daimler-Benz AG, estimated was excess capacity equal to 18 million cars
world-wide -- more than annual U.S. demand of 15 million cars and light
trucks. Some of that excess is in small markets such as Indonesia and
Malaysia, where governments wanted to show they too had what it takes to be
major players in the global auto industry, regardless of the economic illogic of
running auto factories in tiny markets.
Abundant Electricity
Even reform-centered systems haven't avoided the problem. China's opening
means foreign companies have been permitted into many new industries. Too
many, it now appears. There is too much of many things that not so long ago
were scarce. The most striking: electricity, from privately built power plants.
(For different reasons -- severe economic slumps, mainly -- Russia and
Indonesia have similar surfeits of electrical power; more, anyway, than people
can afford now to buy.)
Getting caught midstride in reforms also causes capacity problems. In France,
pig farmers are in an uproar because Europe produces too much pork, too
cheaply. One reason: liberalizations in the European Union mean they must
compete with much cheaper pork from other countries. At today's prices of
five French francs a kilo (about 40 U.S. cents a pound), French farmers say
they can't stay in business. They want fresh subsidies or fixed government
purchases to stay in business -- even though that will simply perpetuate pork
oversupply.
So how did the world get into this mess?
Ground Zero: Japan
The answer is apparent at ground zero of the world's overcapacity time bomb:
Japan. Always an export-centered dynamo, Japan built massive industrial
capacity, both at home and abroad, throughout the 1980s. The secret to its
overproduction was cheap money: low interest rates that make it easy for
companies to raise capital and make the decisions to build factories or other
investments. In the late 1980s, Japanese monetary authorities lowered real
interest rates to nearly nothing to help Japanese exporters survive a drastic
strengthening of the yen in 1986. That policy fueled a huge stock-market
bubble and made bank loans look cheap.
The implosion of Japan's financial markets in 1990 didn't end the problem. The
rest of Asia and later the U.S. soon enjoyed financial bubbles of their own,
with soaring stock prices. That was a boon for new industries, which in more
conservative times might have had trouble raising money.
"The boom in Asia coincided with a progressive investment uptrend in the
U.S.," says Giles Keating, Credit Suisse First Boston's chief strategist in
London. "If you take a progressive investment boom and then you hit it with a
demand downturn, you're heading for trouble."
The trouble took the form of bad investments in many traditionally cyclical
industries -- which often build oversupply into their profitability equations -- as
well as some new ones. Shipping lines fell into their habit of ordering too many
vessels, and airlines bought too many planes. They were joined in the binge by
newfangled industries such as semiconductors and, for the first time, service
industries, the source of U.S. economic strength.
Widespread Carnage
The breadth of the problem is visible in the carnage. The Anglo-Dutch giant
Philips Electronics NV said it would close one-third of its 244 sites world-wide
because demand didn't meet expectations. Motorola Inc. led a global retreat in
semiconductor-manufacturing investment.
All of this may sound bad for industry, but it seems positive for consumers,
who will get the benefit of lower prices. The phenomenon, known as deflation,
has been around in Japan for nearly a decade. But it goes by a different and
more ominous name there: "price destruction." The reason for negative
connotation, as corporate Japan has discovered, is that falling prices eventually
drop below producers' ability to stay profitable. Then the producers shut
down, and layoffs ensue.
The survivors of overcapacity downturns often emerge as big winners. A
group of economists centered in Vienna between the world wars concluded
that "malinvestment" resulting from easy money -- a boom -- inevitably breeds
a down cycle -- a bust. It is a kind of creative destruction, a Darwinian
winnowing that leaves low-cost, efficient factories in business.
-- Jonathan Friedland and Leslie Chang contributed to this article.
Copyright © 1998 Dow Jones & Company, Inc. All Rights Reserved. |
