Economics: Plague of overinvestment is restricted to Asia

Gavyn Davies On why Japan needs a huge fiscal package
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The high-investment economies - Japan, the Asian tigers, even Germany - were only a few years ago deeply revered in the think-tanks of the west. Libraries were written about the lessons that could be learned from them, and about the shortcomings of the Anglo-Saxon system.

But their startling recent collapse has prompted several serious economists to argue that they are gripped by a new malaise known as overinvestment.

This notion, the latest fad to sweep the business magazines of North America, holds that economies can drive themselves into recession, not by a slump in demand, but through an excessive build-up of capital equipment which eventually ends in the misery of empty factories, uninhabited skyscrapers and weed-strewn fairways on deserted golf courses.

The overinvestment school asserts that an excess of potential supply can be just as likely to cause a recession as the more familiar shortage of demand, and that it can take much longer to eradicate. Some of the more pessimistic members of this school fear that what is now happening in Asia may soon spread to the United States, where business fixed investment has increased at double-digit rates for much of this decade. If the US should catch the overinvestment bug, then global deflation could indeed become a reality.

Conventional macro-economists have generally not troubled themselves with such possibilities, which is not too surprising in view of the fact that they have spent the past two decades trying to think of ways of increasing aggregate supply rather than worrying about an excess of productive capacity. In fact, The Economist last week dismissed concerns about overinvestment as nothing more than trendy clap-trap.

According to conventional thinking, it is impossible for an economy to experience too much supply. This is simply another way of saying too little demand and - since there is nothing easier than boosting demand through reducing interest rates or raising public sector deficits - a demand shortage can never turn into a real problem.

Tell that to the Japanese. Any explanation of the present travails of the Japanese economy would have a hard time ignoring the role of overinvestment in the bubble economy of the late 1980s.

Owing to ludicrously easy monetary policy at that time, the stock market reached unheard-of extremes of overvaluation and the cost of raising equity capital for companies fell almost to zero. Since Japanese companies had always been more interested in maximising market share than in increasing profits, the availability of virtually free equity capital was a temptation too great to ignore. As the graph shows, the share of investment in GDP rose substantially relative to its long-term trend for several successive years. The rate of return on equity capital fell dramatically as increasingly marginal projects were blindly pursued. Yet for quite a while the equity market, even more blindly, rocketed skywards.

This alone may not have been too much of a problem. But the banking sector was increasingly accepting equities as collateral when making loans, or directly acquiring shares as part of its capital base. Companies raised capital by issuing low-interest debt, spiced up with equity warrants. Life insurance companies offered their customers guarantees of future income which relied on implausible assumptions about high total returns extrapolated into the indefinite future. By these and other means, the health of the financial sector became dependent on the assumption that the overvalued equity market would continue to defy gravity, and that in turn ultimately depended on the profitability of projects undertaken during the era of overinvestment.

Perhaps all that would have been enough to have spelled disaster. But the real coup de grace was delivered by the chronic overvaluation of the yen, which in the 1990s emphatically ended the Japanese export miracle and priced out of world markets exactly those new factories which had been erected during the investment bubble.

Japan therefore managed to do the following in short order - first, overinvest in capital equipment; second, make the health of the financial sector dependent on the profitability of this overinvestment; and third, price the new capital equipment out of the market by overvaluing the currency.

The result of this underutilised and overpriced capacity was recession and deflation at home, followed by a collapse of the banking sector which made all the above problems worse. And the fourth key mistake was to refuse to embark on a massive and continuous programme of fiscal expansion to ensure that domestic demand recovered rapidly, and to inject sufficient public money to shore up failing banks.

The excuse for this final calamity was, and still is, that the future ageing of the Japanese population would one day lead to an unsustainable rise in public sector debt unless the budget deficit was rapidly brought under control. True enough but, as the American government has tirelessly pointed out, the problem of excess public debt can be solved over the long term, while the problem of recession and a failing banking sector is very much in the here and now. Last year, the IMF calculated that Japan needed to tighten fiscal policy by 4 per cent of GDP in order to stabilise its public debt ratio.

But it also calculated that, if this tightening were delayed by two years, the required action would rise to only 4.2 per cent of GDP. In other words, a delay of a few years would make no significant difference to the long- term build-up of debt.

The Hashimoto government rejected this analysis and pressed ahead with a fiscal tightening of 2.5 per cent of GDP last April. The economy duly collapsed, and hence we arrive at the problems of last weekend. Maybe the penny has finally dropped with the collapse of Yamaichi Securities, but even now this must be rather doubtful. The political impediments to decisive fiscal expansion in Japan are still very severe, and a further dose of piecemeal reform seems much more likely than the introduction of the huge fiscal package which is now so urgently needed. Without this package, Japan will limp forward for many more years.

But, on the brighter side, there is no need to fear that overinvestment is becoming a problem for the world as a whole. True, the Asian economies (ex Japan) have recently been investing about 33 per cent of their GDP, part of which has almost certainly been wasted in sectors which will not produce high returns. This could cause Japan-like problems for the Asian tigers, despite the fact that the recent massive devaluations of emerging Asian currencies suggest that at least some of Japan's mistakes will not be repeated.

More important for the rest of us, the overinvestment malaise has not spread to the US, the EU, or the OECD countries taken as a whole. For the entire developed world, investment has been falling as a share of GDP for more than 25 years, and there has been absolutely no sign of an investment bubble in recent years, even in the US. In fact, underinvestment seems to be more of a problem than the reverse, especially in Europe.

Overinvestment is exclusively an Asian problem, and to suggest that it will lead to global deflation is to get Asia out of scale in the world order.