CHAPTER 1

THE RISE OF OVERSUPPLY

How the Emerging Nations Remade the Global Economy

Late December 1978 is not typically remembered as a watershed moment for the U.S. economy. Another year of sluggish growth was drawing to a close, with unemployment hitting 6 percent. OPEC had announced a big hike in oil prices on December 18, a move that would further hurt growth, but that was nothing unusual.

Many Americans weren’t thinking about the economy at all as Christmas approached; they were fixated on what was happening in Chicago, where police had just arrested the serial killer John Wayne Gacy and were hauling one body after another out of a crawl space in his home in a Chicago suburb.

Yet 6,600 miles away, in the inner sanctum of government power in Beijing, China, America’s economic future was being set by a group of Communist Party leaders. A historic five-day meeting took place from December 18 to December 22, 1978—the Third Plenum of the Eleventh Central Party Committee—and, on the last day of that meeting, the party issued a communiqué that committed the party to far-reaching economic reforms. In time, these reforms would change everything. This was the moment when China started down the path to becoming the fastest-growing capitalist economy in the world.

China’s transformation would not only radically increase the global supply of cheap labor but also—and nearly as important—decades later create a flood of cheap money as China built up record piles of cash, thanks to its export juggernaut and the growing savings of its newly affluent population and enterprises.

Another important event occurred in 1978, far across the Eurasian continent from China: a young and little-known Communist Party bureaucrat named Mikhail Gorbachev was appointed to the Central Committee’s Secretariat for Agriculture. From there, Gorbachev would move up to the Politburo within just three years. Four years after that, he would be named general secretary and initiate a series of far-reaching economic reforms that would ultimately bring 400 million people living under communist rule in the Soviet Union and Eastern Europe into the global market economy. By the early 2000s, Russia would be the biggest energy exporter in the world, a country with a half trillion dollars in foreign reserves and nearly a hundred billionaires—yet another vast pool of money looking for returns.

Economic liberalization came more slowly to India, the second most populous country in the world. But when that process started in 1991 (and was rewarded four years later when India joined the World Trade Organization) it brought another huge army of workers into the global economy—a labor force of nearly half a billion able-bodied adults, or three times the number of workers in the United States.

Liberalization also turbocharged India’s economy. In just twenty years, India’s gross domestic product (GDP) would grow sevenfold, with annual economic growth hitting 9 percent by 2007. India, long considered the world’s basket case, would come to have foreign reserves larger than Germany’s and more than sixty billionaires—every one of them looking for places to put their spare cash.

Welcome to the age of oversupply.

What we have seen in the past few decades is an unprecedented global explosion of cheap labor and cheap money. This trend is a huge driver of the developed world’s economic problems. Yet most policy makers, not to mention ordinary citizens, barely understand what has happened and, worse, many political leaders, economists, and think tanks still embrace a set of solutions to today’s economic malaise that aims to create even more supply—call them supply-side zombies if you will. Meanwhile, even those who do realize the need for greater demand have yet to face up to the monumental scope of the challenges we face in this age of oversupply.

But before we say more about the policy implications of oversupply, let’s further explore this breathtaking shift—what I call the Great Rejoining.

THE GREAT REJOINING

The year is 1995. After severe credit and financial crises in the late 1980s and early 1990s, the United States has stabilized its economy, restarted growth, and reduced its budget deficits. Great strides in laborsaving productivity, and enormous opportunities for investment, are emerging from the acceleration of Internet technology. The United States’ top economic competitor, Japan, is no longer a “rising sun” and Japanese investors are no longer snapping up iconic U.S. landmarks such as Rockefeller Center. Instead, Japan is trapped in an endless twilight of malaise and deflation. Tokyo, a once heady city now filled with depressed underwater property owners and developers, is deeply rattled after a cult releases sarin gas in its subway system, killing thirteen people. Europe is doing better, but has its own deep economic problems broadly described under the term “Euroscelerosis.” Unemployment across the Continent is above 10 percent, a record postwar high.

The economist Lester Thurow, who in 1993 had published a book titled Head to Head, about America’s coming fierce battle with Japan and Europe for economic dominance, now seems to have been laughably wrong.1 The United States, it is clear, will be the supreme power of the millennium’s last decade.

And, indeed, in 1995 the future was looking bright for America’s economy. The young president who occupied the Oval Office understood the importance of investing in education and technology. Growth was picking up. The federal budget deficit wasn’t just going down, the nation was on a trajectory toward a surplus.

But lurking over the horizon were entire nations, collectively outnumbering the population of the developed world by fivefold, that had, only a few years before, thrown off the last vestiges of socialism—in substance, if not in name, in the case of China. For decades prior, these nations had been largely inconsequential, at least in economic terms. The largest nations in the world had been cut off from free-market capitalism.

Now, in a trend largely ignored during the first half of the 1990s by economists like Thurow—experts still focused on the world’s traditional industrial centers—these nations were rejoining the global economy with a vengeance. In a remarkably short span of time, a full 50 percent of the global population had been freed, or freed itself, to challenge decades—if not centuries—of the international commercial status quo. Ironically, while the Cold War, with its ever-present specter of nuclear disaster, had deeply unnerved the West, that long standoff had also sheltered the developed world from meaningful competition with the world’s most populous countries.

The Cold War’s end was widely seen as a triumph for liberal free-market democracies, and even as “the end of history.”2 In fact, in a grand irony, the demise of the socialist experiment set the stage for the greatest threat yet to the supremacy of the United States and other advanced democracies.

The expansion of the global labor force—and the sheer number of new workers now ready to truly go “head to head” with Americans and Europeans—has been especially stunning. Thirty years ago, most of the poorest people in the world lived in statist societies walled off from the global economy, and many were essentially peasants, inhabiting impoverished rural landscapes much as their ancestors had.

All that has changed. Today, the world has a market labor force of roughly three billion people, many of whom are in a position to compete directly for a wide range of jobs held by workers in the developed world, thanks to the wonders of multinational corporations, the Internet, and other features of a flat world.

Of these three billion workers, nearly half live in China, India, and the former Soviet Union. Which is to say that the fall of the Bamboo and Iron curtains, along with economic liberalization, has quite literally brought the other half of the world on line, doubling the global labor supply in the free market in the past two decades.

The final stage of the fall of international communism, such as it was, can be tracked to the events of 1989, with the fall of the Berlin Wall and the rise in Chinese urbanization that followed from the Tiananmen Square incident in that year. As a practical matter, the impact of these events was negligible throughout the early 1990s. The developed world’s economies were weak anyway and the post-socialist world had not yet gotten its act together. Even after the largest emerging nations’ export juggernaut had commenced, the direct impact on advanced nations was muted by the enormous productivity boost arising from the Internet technology revolution.

Only after the collapse of the Internet bubble, and after China had joined the WTO in 2001 and become fully integrated into the global economy, was the developed world fully exposed to the onslaught of several billion new people who, by that point, were fully prepared to be directly competitive.

Rapid population growth in several developing countries, coupled with the ongoing spread of liberalization, has swelled the global labor force even more since those bright, hopeful years of the mid-1990s. Just six countries that were all heavily statist when Bill Clinton was president—Indonesia, Brazil, Bangladesh, Pakistan, Mexico, and Vietnam—account for another 450 million workers.

Tallying up trends of recent decades, a 2012 study by the McKinsey Global Institute estimated that 1.7 billion new workers joined the global labor force between 1980 and 2010, with most of this increase taking place in developing economies undergoing a “farm-to-factory” shift.3 The better pay of these jobs enabled some 620 million people to escape poverty.

Keep this sea of cheap labor in mind the next time you pass an empty factory and wonder why America’s 150 million workers are having a hard time. Another thing to keep in mind is that this vast expansion of workers hasn’t just created an oversupply of labor but has also contributed to the oversupply of capital as hundreds of millions of people have emerged from peasant societies to work for wages and stash at least some of their earnings in savings accounts.

In fact, because many of these workers live in countries with insufficient social safety nets or pensions (or in nations such as China, which is only slowly expanding its social protections),4 they tend to put away far more earnings than workers in developed countries. Business enterprises in those countries sock away even more (especially in China). What that means is that the arrival of nearly two billion new workers on the scene hasn’t generated anything near the demand you might think, in terms of these people buying goods. Instead of a balanced rise of both supply and demand, we’ve seen a totally skewed situation of ever-growing supply, particularly with regard to capital.

I’ll say more about the flood of cheap money in a moment. But let me add one more piece to the labor picture—the explosion of more educated workers. In China alone, the number of students graduating annually from college has risen eightfold in the past fifteen years, from 830,000 in 1998 to 6.8 million in 2012.5 A similar trend holds for India. In 2000, there were seats for just 390,000 young Indians in universities. Now there are spots for 1.5 million.6 Granted, a college degree from a Chinese or Indian university is not the same as one from a U.S. or European university . . . yet. But with at least some portion of this new educated class able to undertake tasks such as accounting and computer programming, we have seen a quickly expanding global pool of white-collar workers who are earning higher salaries, saving more, and competing more for jobs previously held by workers in the advanced nations.

A SEA OF CHEAP MONEY

After so many decades of subordinating their prosperity to a failed ideology, the world’s formerly socialist (or socialist-leaning) countries played a remarkable game of catch-up.

During the fifteen years from 1993 through 2007, the GDP of the emerging nations grew at an average rate of between 4 and 8 percent, with some countries, like China, famously firing much hotter than that.7 And between 1990 and 2010, the emerging nations doubled their share of global GDP—from under 20 percent to 38 percent.8 (In 2013, for the first time, emerging nations will account for more than half the world’s GDP.)

As trade in manufactured goods and its associated jobs migrated inexorably to lower-cost labor markets, despite the productivity increases in the advanced economies the emerging nations began to develop substantial current account and trade balance surpluses.

In other words, wealth—lots of it—began to pile up in those countries.

The obvious place to start this part of the story is China, which has the biggest pile of cash of all.

Part of that pile, of course, is due to its exports. In an effort to “sterilize” its currency from trade flows that typically cause a nation’s currency to appreciate and thus curtail its competitiveness, China blocked free conversion and began to accumulate vast foreign-currency reserves—to the point where, at year-end 2012, it held over $3.31 trillion in the form of dollars, mostly, but also euros, yen, and other currencies.9 Following the Asian currency crisis of 1997, which set off fears of global recession, emerging nations became wary of borrowing in foreign currencies and floating the value of their currencies against others without maintaining sizable hard-currency reserves. China was a different story—it not only sought to protect the yuan against speculation, but also strove to control its appreciation so as to optimize competitiveness and build its employment base as swiftly as possible.

China’s reserves of hard currency and related assets—chiefly U.S. dollars—totaled less than $250 billion in 2000. They grew to $2 trillion by 2008 and to over $3 trillion as of this writing, as set forth above. This vast pot of money is managed by the State Administration of Foreign Exchange (aptly abbreviated SAFE in English) and the People’s Bank of China.

Talk about an outfit that has seen good times and bad: the original Bank of China was founded in 1912, when China’s power was near a historic low. It is now the fifth-largest central bank in the world and among the largest lenders to the U.S. government, with quite a lot of China’s reserves invested in U.S. Treasury and government agency bonds.

At the same time that China’s currency reserves soared, Chinese workers and businesses were saving monumental amounts of cash. Anyone who thinks that the Japanese are good savers clearly hasn’t been to China. Data from the World Bank shows that the Chinese national savings rate grew from 37 percent in 1988 to 48 percent in 2005 to 53 percent of GDP in 2011. By comparison, thrifty Japan’s savings rate is now under 25 percent. The U.S. rate is at about 12 percent.10 (Keep in mind that a nation’s gross savings rate isn’t just a reflection of what individual earners are socking away. It’s an overall reflection of the difference between the wealth a country produces and what it consumes.)

Either way, even as China’s GDP was growing by leaps and bounds, the slice of that wealth being saved also grew. In 1988, China had a GDP of just $390 billion—and $144 million in gross savings. Ten years later, it had a GDP of $1 trillion—and $390 billion in savings. By 2011, China had a GDP of $7.3 trillion and an estimated $3.8 trillion in gross savings.11

In a flash—at least in terms of its own long history—China went from being a poor country to one sitting on trillions in excess cash.

This money piled up not just because the Chinese are such religious savers, but also because China initially didn’t move aggressively enough to expand public investments in the things that countries typically spend money on when they become rich: schools, libraries, parks, a social safety net, and so on.

As James Fallows observed in 2008:

Some Chinese people are rich, but China as a whole is unbelievably short on many of the things that qualify countries as fully developed. Shanghai has about the same climate as Washington, D.C.—and its public schools have no heating. (Go to a classroom when it’s cold, and you’ll see 40 children, all in their winter jackets, their breath forming clouds in the air.) Beijing is more like Boston. On winter nights, thousands of people mass along the curbsides of major thoroughfares, enduring long waits and fighting their way onto hopelessly overcrowded public buses that then spend hours stuck on jammed roads. . . . Better schools, more-abundant parks, better health care, cleaner air and water, better sewers in the cities—you name it, and if it isn’t in some way connected to the factory-export economy, China hasn’t got it, or not enough.12

Maybe most notably, China’s spending on health care has barely risen in fifteen years. China spent 4 percent of its GDP on health care in 1998; it spends a bit over 5 percent today.13

Between 1998 and 2011, tax revenue as a percentage of China’s GDP nearly doubled, and China then dramatically stepped up its investments in infrastructure, energy, and education. But this spending barely made a dent in the rising mountain of money. So, instead, all those dollars needed to be invested somewhere outside of China.

And it wasn’t just China that started piling up huge amounts of excess wealth starting in the 1990s. Other emerging countries did, too. Brazil’s total reserves soared from $33 billion in 2000 to $352 billion in 2011. Tiny Singapore had $71 billion in reserves in 2000—and $244 billion in 2011. Indonesia’s reserves grew fivefold. Russia’s grew by eighteen times thanks to its natural-gas exports. Rising energy prices boosted Saudi Arabia’s reserves from $21 billion to $595 billion, a twenty-eight-fold increase. (As if there weren’t already enough rich Saudis looking for good places to put their money.)14

All told, the total foreign-currency reserves of emerging nations rose from around $700 billion in 2000 to nearly $7 trillion in 2012.

Meanwhile, several export powerhouses in the developed world also piled up more cash. Japan’s reserves tripled during the first decade of the twenty-first century, to over $1 trillion. Germany’s reserves also almost tripled, as did South Korea’s.

What’s more, many of those nations getting richer fast were just as bad as China at consuming their new wealth. Indonesia’s savings rate, for example, increased to 37 percent, up from 29 percent, during the early 2000s even as GDP grew sixfold.15

Never before in history had so much money piled up so fast. The assets of banks and other financial entities in the world’s top jurisdictions grew from roughly $110 trillion in 2002 to $240 trillion in 2008—a staggering rise in wealth, just sitting around.16

Of course, such money can’t just sit around. As a practical necessity, most of this money went looking for decent returns at relatively low risk of loss in—guess where?—the United States and certain nations of Western Europe, with a seemingly limitless appetite for incurring debt of every kind—public, private, and corporate (Japan has tons of debt, too, but it is mostly self-funding).

With a torrent of global savings flowing back to deficit countries (mostly the United States, but also the weaker countries of Europe), their governments did not need to borrow as much domestic private capital, and interest rates plummeted. Even Japan, which had seen minor challenges to its post-bubble ultra-low interest rate environment, saw its borrowing costs plummet to new lows despite its huge debt load and poor fiscal metrics.

The enormous pool of private capital in the developed world was left to search for returns on investment anywhere they could be found—and the financial institutions of Wall Street and the City of London were happy to oblige. Borrowers were sought everywhere—in governments, corporations, real estate, and households.

But there was a problem: Over the past two decades, and especially in the early 2000s, the rising pool of capital far outstripped the rise in demand and real economic growth. Which is to say that even as rivers of cash looked for returns, there was not nearly enough productive activity to sop up all the money. As a November 2012 study by Bain & Company observed: “The rate of growth of world output of goods and services has seen an extended slowdown over recent decades, while the volume of global financial assets has expanded at a rapid pace.”17

That was—and still is—a recipe for trouble.

CAPITAL ON STEROIDS

It’s no big secret where all the new easy money ended up, at least on the U.S. side of the Atlantic. Just about every sector in the United States gorged on cheap debt, with everyone from unemployed home flippers to the U.S. Treasury to local mayors to CEOs getting in on the feast.

For starters, consider the truly gargantuan amount of money that Americans borrowed to buy and build homes and commercial real estate. In 1990, total household and commercial mortgage debt outstanding in the United States was $3.7 trillion. By 2000, it had all but doubled, rising to $6.7 trillion. Then, in just six years, it doubled once more, to over $13 trillion, and kept rising to a historic peak of $14.6 trillion in 2008.18

All this money had to come from somewhere, and much of it came from China, either directly or, more often, by “crowding out” domestic capital from government bond markets. In fact, as the housing bubble inflated, China became the single largest holder of government guaranteed mortgage bonds issued by Freddie Mae and Fannie Mac—with an estimated $376 billion tied up in these securities as of June 2007. Japan, with its own big reserves to invest, had also gone big into the U.S. mortgage market and found itself holding $228 billion in Freddie and Fannie securities when the crisis came.19 Still more money poured into U.S. capital markets from domestic investors who had been effectively displaced by foreign investors willing to take low returns on government (and government-guaranteed) debt, and so set off to find borrowers who would pay more to use their money—like, say, via subprime lending.

The story of binge indebting by governments is even better known. Thanks to George W. Bush’s ill-advised fiscal plan of cutting taxes while waging two wars and expanding Medicare, the federal government developed massive borrowing needs during the same period in which China and other emerging countries were piling up record amounts of cash. Total federal debt doubled to $10 trillion during the Bush presidency, with foreign governments coming to own almost half of this debt.

In January 2001, the month Bush took office, China owned a mere $61 billion in U.S. government securities. Four years later, when Bush was sworn in for his second term, that figure was up to $223 billion. And by the time the Obamas walked the Bushes to Marine One during the 2009 inaugural, China owned $739 billion in U.S. securities. As of this writing, the total stands at over $1 trillion.20

But while America’s borrowing from China has gotten all the attention, many other foreign countries rolling in reserves also loaded up on Treasuries. Brazil’s holdings soared from $12 billion in 2002 to over $226 billion a decade later. And when Russia started finding itself with piles of excess wealth, it too started bankrolling America’s deficit spending to the tune of billions of dollars a year, buying over $150 billion in U.S. securities by 2010. Japan kept buying Treasuries, too, as it had for years—tripling its holdings to over $1 trillion over the past decade.21

American state and local governments took advantage of cheap money as well, borrowing more than $1 trillion between 2000 and 2008.22 State and local government leaders thus avoided unpopular tax increases while providing public services at an often expanding rate. Recent municipal bankruptcies in cities such as Stockton and San Bernardino, California, are the aftermath of such practices.

Cheap money also had another effect: it put the financial sector on steroids, and helped to greatly grow and supercharge the so-called shadow banking system. Most people know this part of the story, so I’ll skip all the details about how hedge funds, money market funds, private equity groups, and insurance companies turned into 900-pound gorillas, thanks to the magic of cheap borrowing and heavy leverage. In this remade financial sector, a little-known American International Group (AIG) executive named Joseph Cassano could make hundreds of millions of dollars for himself, and billions for his firm, by selling derivative products such as credit default swaps.23

It is truly remarkable just how quickly a growing pile of money—whether owned by sovereign funds, Indian billionaires, union pensions, Saudi sheiks, or Chinese banks holding middle-class people’s savings—hooked up with legions of creative MBAs in places like New York and London. According to estimates by the Financial Stability Board, total worldwide assets in the shadow banking system grew from $26 trillion in 2002 to $62 trillion in 2007 (when one considers all non-bank financial intermediation). The United States, as the world’s largest economy, developed by far the largest shadow banking system in the world, accounting for a third or more of all assets in this system.24

The age of oversupply created a lot of easy money for people to play with, too often with very little oversight. Bad things inevitably happened. The reckless overleveraging of a top Wall Street firm like Lehman Brothers, which collapsed with startling speed in the financial crisis, would not have been possible in a world where money was less plentiful and more costly.

It would be nice to think that such bad behavior will never happen again. In fact, though, all signs point to a future in which capital will remain cheap and regulators will struggle to impose oversight in the face of constant attack by the financial industry and its powerful political allies.

OVERSUPPLY IS HERE TO STAY

The Great Credit Bubble may have burst, but the age of oversupply hasn’t ended—and won’t anytime soon. Abundant labor, excess capital, and cheap money are here to stay.

For all the modernization and urbanization in India and China, vast swaths of the population of both these societies are still rural peasants, and these people will continue to make their way to cities to join the global economy. Fifteen years ago, just a third of all Chinese lived in urban areas. Today 51 percent do, which means that while urbanization is growing at a rapid pace, with literally millions of Chinese moving to cities every year in one of the greatest mass migrations in history, nearly half of China’s vast population still live in the countryside. So even though China’s population is aging, thanks to its one-child policy, that country hasn’t yet touched the bottom of its labor barrel. A study by the Asian Development Bank estimated that the growth of China’s labor force wouldn’t flatten out until after 2020.25

India has an even bigger pool of untapped labor, given that 69 percent of its fast-growing population—over 800,000 people—still live in rural areas and that half of all Indians are under the age of 25. It’s been estimated that 275 million new workers will enter India’s labor force between 2000 and 2030. That army of new, able bodies is nearly as big as the entire U.S. population.

Overall, while the growth rate of the global labor market will slow substantially over the next two decades, it will still get vastly bigger in absolute terms. The McKinsey Global Institute estimates that a total of 600 million workers will enter the labor force between now and 2030.27

Millions of residents of poorer countries will also get better educated—to the extent that by 2020 41 percent of all young adults with a college degree in leading countries worldwide will be either Indian or Chinese (up from 29 percent in 2010). The number of Chinese and Indians with more-advanced degrees—and thus capable of earning higher salaries and saving more money—will also soar.28

The expanding savings accounts of an exploding middle class is only one reason, among others, that cheap money is going to keep flowing. Exports are another, as in the past. In fact, in the five years since the financial crisis, the foreign-currency reserve holdings of emerging countries have more than doubled, according to the IMF.29 China alone has piled up over $1 trillion in new reserves since 2008. Brazil’s reserves have nearly doubled during the same period. A study by Bain & Company, aptly titled “A World Awash in Money,” notes: “Capital superabundance will continue to exert a dominant influence on investment patterns for years to come. Bain projects that the volume of total financial assets will rise by some 50%, from $600 trillion in 2010 to $900 trillion by 2020, even as the world economy increases by $27 trillion over the same period.”

That’s a lot of new money. However, the Bain study also notes that many of these assets don’t have real, tangible value underlying them and that the gap between actual assets and financial assets will only grow: “As it has for more than the past two decades, the large volume of global financial assets will continue to sit on a small base of global GDP. . . . Total capital will remain 10 times larger than the total global output of goods and services—just as it is today—and three times bigger than the base of nonfinancial assets that help to generate that expanded world GDP.”30

Even with all of the easy “play money” floating around in recent years, it may be that we haven’t seen anything yet.

Capital superabundance helps explain why monetary easing by the Fed and other central banks, together with today’s record low interest rates, hasn’t done much for the economy. In “normal” times, easy money would incentivize lending and investment that would jump-start economic expansion. Monetary easing does this in two ways: not only does it make money cheap to borrow, but it makes the low returns on the safest investments so unattractive that those with capital should be willing to take greater risk. In extreme cases, it induces a condition known as “financial repression” in which the nominal rate of return (interest rate) earned on government bonds and other high-credit-quality investments falls below the rate of inflation so that merely holding those instruments becomes an exercise in losing money on a real (inflation adjusted) basis.

Ultimately, the mechanisms of capital formation—banks, non-bank financial institutions, and the capital markets at large—should normally transmit the surplus of cash resulting from extraordinary easing into longer-term, less-liquid investment in physical assets—plants, infrastructure, major equipment—and other new capacity that spurs additional production, job creation, and thereby new demand, in a virtuous circle. Also normally, the additional demand for labor and goods and services would spur wage, price, and asset inflation.

Too bad these aren’t normal times.

The transmitters of easy money to the rest of the developed economies are blocked. Via extraordinary monetary-easing measures, the developed world’s central banks have turned trillions of dollars of financial investments into so much cash that it is metaphorically bulging out of the pockets of banks and other investors. Yet it is not getting lent and it is not getting invested in new capacity. Why?

In a nutshell, the reason that the enormous ocean of liquidity is not being deployed is that there is so much global supply and excess capacity of labor, plants, equipment, and goods and services relative to present demand that there is little reason for private-sector investment in the development of additional capacity to produce additional supply.

What we have on our hands is a supply-side nightmare scenario.