Feature Stories | Apr 24 2006
By Greg Peel
GaveKal Research is an independent economic research house and consultancy created in 1999 in the US by Charles Gave and partners. GaveKal has a reputation for "original thinking". The following feature series is drawn from a GaveKal publication of 2005 entitled: Our Brave New World. This is Part II.
Three of the pillars upon which the platform company business model rests are technology, which allows the rapid exchange of information and ideas; free trade, which allows for economic integration across borders; and infrastructure spending, which provides for the benefits of the first two to be efficiently exploited.
The final pillar, or requirement, of the model is prevalent overcapacity. Overcapacity is an inherent part of capitalism which ensures competition and the lowering of prices through efficiency. One problem with overcapacity is it means there must be successes and failures, winners and losers along the way. But that is capitalism.
Overcapacity leads to falling prices. The concept that prices must fall is something Marx took as a reason why capitalism must ultimately destroy itself. However, falling prices also affect greater sales and greater disposable income which then flows back through the system. It might become cutthroat but the system will not destroy itself simply on falling prices.
While acting with the best intentions, it is unlikely Marx would have ever envisaged what his doctrine would lead to – particularly the cold war. But communism was never really communism anyway (a fact which George Orwell was quick to point out), and even well-meaning hippies eventually bowed to the inevitable.
Overcapacity is inherent in the capitalist world, and it has become particularly prevalent in the twenty-first century. Enter China. China’s excess savings have been used in a rush to exploit the country’s inclusion in the capitalist world by building ridiculously excessive manufacturing capacity.
In China today, for example, there are reputedly 3000 ball-bearing manufacturers. The market can probably support ten. The Chinese government has been moving to place some controls over capacity madness, and prevent the collapse of markets and subsequent ramifications. It seems a bit like shutting the gate after the horse but again, no one was quite ready for what was about to happen.
What China has slowly succeeded in doing is evolving a manufacturing industry which is not only competitive on price, but also on quality. It is shaking off the "Made in China" joke. Recent years of capacity overspending can be utilised by aggressive exporting of competitive products which will then challenge producers elsewhere.
To do this China needs to be able to move goods around, to source production anywhere, and to create producer competition. The Chinese have begun to buy outside China – facilities, mines, oil wells – and boy doesn’t this scare a few people.
However, this is the goal and not yet the reality. China is still in the midst of a capacity bubble. This bubble has provided impetus for the platform company business model to develop and thrive as established industries in the Western world remove the low return business of production from their balance sheets and shift the risks elsewhere. But were this bubble to burst, would the whole model implode?
To discuss this point consider that there are two types of bubbles – those that take place on non-productive assets such as land, gold or tulips (the "rarity" factor), and those that take place on productive assets such as canals, railroads or telecom lines.
In the first case, if the bubble bursts well, prices fall, but we still have the same assets as we started with. In the second case, prices will fall, but only until such time as the assets come to be more efficiently utilised by someone else. In the case of an overcapacity bubble, assets ultimately move "from weak hands to strong hands".
Then there is the finance issue. Bubbles financed by banks have widespread ramifications that upset the banking system and can cause collapses. Bubbles financed by the financial markets (stocks and bonds) are not as destructive as only the investors lose out. An example of a "bad" bubble is the Japanese real estate boom of the 1980s which was financed largely by banks. An example of a "good" bubble is the tech boom of the 1990s which was financed by stocks and bonds.
For a productive asset market to be revived after the bursting of the bubble, the assets must move from weak to strong hands. For this to occur, companies must be allowed to go bankrupt, assets redistributed, and efficiencies sought. If this is not allowed then the deflationary effects will linger as the vain support of excess capacity will continue to keep prices low.
Japan attempted to prop up its system for decades. That is why it is only now looking at some light at the end of the tunnel. The UK and Europe have a history of not allowing iconic companies, such as car manufacturers, to die. This has contributed to economic sluggishness. The US, on the other hand, let everyone do their dough on the tech boom, shrugged, and moved on.
China’s system equates to that of Japan, and not to the US. The country’s bubble in infrastructure, factories and construction has been financed either by retained earnings, by foreign investment, or by banks. In China’s case, the banks are merely an extension of the government. Thus the government is the ultimate owner of failed enterprises, and it is unlikely it will sell off the ranch for a loss. Instead, it will keep unproductive companies on life support. Overcapacity will linger.
As commodity prices have soared, the world has been waiting for the subsequent inflation wave to hit (particularly with regards to the oil price). It hasn’t. What we have is a "things are different this time" scenario. The combination of globalisation, industry deregulation, technological progress, the internet, and the platform company have moved the economic world close to the concepts of perfect information and perfect competition. Prices are made at the margin, and no longer on average.
Overcapacity leads to lower prices, but shortages and supply disruptions still lead to price spikes. A global platform company is a deflationary force. Take a company like Wal-Mart in the US. It has a computer system reputedly second only to the Pentagon. Wal-Mart can rapidly identify excess capacity somewhere in the world and exploit it at the optimal price. Thus prices will tend to be kept low.
As much as the platform company is a deflationary force, it still can’t prevent supply shortages or infrastructure disruptions. However, China and other emerging markets ensure a massive amount of labour and manufacturing capacity, and with equally massive amounts of savings it can be guaranteed that the cost of capital in China, for example, will remain low for some time and that excessive investment will continue.
This explains why global inflation has not reared its ugly head. The expression "China has exported deflation to the world" is often used. Whereas in the past increases in inputs – oil, copper, labour etc – have been passed through to the consumer, resulting in a fall in disposable income, in today’s world price increases lead to a fall in the profits of the companies that cannot increase productivity fast enough and who, because of the internet-connected world, have no pricing power.
Commodity price increases have not hit the Western consumer, they have hit the Chinese corporation.
If ever one needed evidence of this just look at the Chinese stock market. The country is undergoing unprecedented economic growth, a percentage of its population is a lot wealthier than it used to be, and yet its stock market is at five-year lows. Chinese companies have not been able to make money in the boom because they are unable to raise prices.
The platform company model has opened the way to a world in which inflation is totally discontinuous. Instead of hurting the consumer, inflation wipes out the most marginal producer. China has been growing at a colossal pace in economic terms as it rushes to become part of the mature capitalist world. Unfortunately for the Chinese, the mature world has been able to benefit from a world containing globalised, integrated networks and rapid information exchange. China has been unwittingly exploited. Capitalism is returning to its deflationary roots.
Coming up: The rich get richer, the poor get the picture, and is this a problem?
Part III to follow. The ideas and examples put forward in this series are the work of Gave, Kaletsky & Gave: Our Brave New World, self-published, 2005. The writer has added observations as well.