Consumer prices in the U.S. fell at a breathtaking annual rate of nearly 13% in the last three months of 2008. Prices plummeted for all sorts of goods, ranging from clothing to TVs to furniture, as retailers advertised sale after sale.
But deflation missed big chunks of the economy. For all of 2008, college tuition and fees increased by 5.8%, followed closely by price increases for hospitals and legal services. Even fees for preparing tax returns are going up.
This inconsistency in prices casts doubt on the usual explanation for the recession, which is that it's mainly due to the credit crunch and the resulting squeeze on demand. It also hints at why government efforts to fight the downturn have been ineffective so far.
Here's the big idea: If the lack of demand that the Obama Administration is fighting were the only problem, you'd expect prices to fall across the board. Instead, it appears that supply—that is, oversupply—is at least as important a factor. The sectors in which prices are falling are those plagued by an excess of factories and ways to get goods to consumers, often because of huge investment in plants in China and other developing nations. Most services, in contrast, are not in severe oversupply and have domestic labor as their main ingredient. Consider this: Prices of goods fell 4.1% last year; prices of services rose 3%.
The government's deflation-fighting weapons—low interest rates, financial bailouts, and spending packages—can boost demand but do little to deal with oversupply. As Microsoft (MSFT) CEO Steven A. Ballmer and General Electric (GE) CEO Jeffrey R. Immelt have observed, long-term demand growth has been "reset" downward. The world's productive capacity is simply too big. That means prices need to fall further, or more factories need to close in the U.S. and abroad, or some combination of the two.
That's not to say the Obama Administration is on the wrong track with its nearly $900 billion-plus stimulus plan. But it's important to have realistic expectations. The stimulus can ameliorate the downturn, but not prevent continued contractions in the sectors of the economy where global overcapacity is the most extreme. Examples? The world is able to make 90 million vehicles a year, but at the current rate of production, it's making only about 66 million, according to estimates from market researcher CSM Worldwide. Global production of semiconductor wafers is running at only about 62% of capacity, estimates market researcher iSuppli.
Such overhangs hurt not only manufacturers, but retailers who sell goods and the truckers who distribute them, not to mention the financial wizards around the globe who abetted the buildup of overcapacity through foolish lending and financial inventions. (Finance is one service sector where prices are falling, in part because banks lent so heavily in housing.)
For the U.S., global overcapacity will mean bargain prices for consumers in 2009 but tougher-than-ever competition for domestic producers that compete with imports, such as carmakers and steel producers. "Pricing power is now deteriorating," Morgan Stanley (MS) economist Richard Berner wrote on Feb. 3, describing a "vicious circle" of declining output, prices, and profits. In the North American steel industry, 16 of 29 blast furnaces are temporarily shut down, says Michael Wessel, a member of the U.S.-China Economic & Security Review Commission. At the end of 2008, North American auto plants were running at just 70% of capacity even after massive shutdowns. "It's going to get worse," says IHS Global Insight economist Michael Montgomery, because inventories of manufactured goods piled up before producers realized how badly demand had fallen. Says Montgomery: "My first boss in the steel industry told me, nobody thinks there's any inventory until they look out the window and say, 'Oh my God, what's all that stuff?'"
The picture is dramatically better in education and health care, to name two robust service sectors. Enrollment is rising at many community colleges. Hospitals are still adding workers.
For economists, overcapacity is a tricky concept. Human wants are unlimited, so how could the world ever produce too much of a good thing? The key is what people can pay: In many goods sectors, prices still aren't low enough to bring forth enough buyers. There will have to be some combination of falling prices and destruction of productive capacity before supply and demand come back into balance.
The question is how that balance will be achieved. Global overcapacity in major industries will provide a critical test of the statesmanship of G-20 world leaders, who next meet on Apr. 2 in London. The economic crisis is transnational, says Paul A. Laudicina, a vice-president for consultant A.T. Kearney. "The conundrum is that we [tend to] make decisions nationally."
China is under pressure to help soak up its overcapacity by switching from investment to domestic consumption. Trouble is, its economy isn't geared that way. Toy manufacturing in China is a "disaster area" because export orders are drying up and factories can't crack their own home market, says David Wong, vice-president of the Chinese Manufacturers Assn. in Hong Kong. "There are so many obstacles to selling domestically," he says. "Even we from Hong Kong are outsiders."
In any case, China is far less influential as a consumer than as a producer. At the World Economic Forum in Davos, Switzerland, in January, Bank of China Group Executive Vice-President Zhu Min told BusinessWeek Editor-in-Chief Stephen J. Adler in a panel discussion that even rapid growth in Chinese consumption can't make up for weaker spending in the U.S., the world's No. 1 shopper.
What can companies in overcapacity-plagued sectors do? For one thing, the strongest producers among them will be able to buy the weakest. "Deflation will be an opportunity for companies to be able to buy assets 10% to 20% below their replacement value," says Nicholas Heymann of brokerage Sterne Agee & Leach. Companies can also benefit from the increased buying power of people who still have jobs. Wages and salaries outpaced inflation by 2.6% in 2008, the biggest gain for workers since at least the early 1980s.
Some American companies that buy low-priced merchandise from China are not squeezing suppliers on price but instead are trading up to a better class of supplier by offering to pay in as little as 10 days instead of 60, says Peter Brown, a retail strategist and vice-chairman at Kurt Salmon Associates, a global consulting firm. Says Brown: "The savvy buyers are saying, 'I know I can get some reductions, but I also know it doesn't help me if the supplier is not there to ship in six months.'"
Deflation is a signal that all is not right. For businesses and policymakers, the key is to diagnose the malady correctly.