The revolution in technology and the boom in global investing may be very real, but they can create false hopes and even shocks. Managers must be fully aware of the forces driving the boom. Failing to understand the full implications of the undercurrents in the global economy, says this author, can lead us all to the poorhouse.
Real technological revolutions are extremely rare, but when they do occur, their economic implications can reverberate around the world for a generation or more. Events such as the Industrial Revolution and the invention of electricity effectively transformed the very core of economic behaviour, allowing society to produce far more with the same resources.
Today, the increasing scope and power of the computer chip are having a similarly profound and positive effect. At the same time, they are setting in motion forces of adjustment that could unsettle consumers and business alike over the next few decades. Moreover, the speed at which information is shared and reflected by financial markets only magnifies the damage that can result from a misunderstanding or of those forces adjustment, especially by decision makers in public institutions and private corporations.
THE ANATOMY OF A TECHNOLOGY SHOCK
At the company level, a new technology reduces the cost of capital equipment that the firm uses. Today, the falling price of computer technology and its expanding capabilities are transforming the way companies organize themselves worldwide.
To illustrate the magnitude of this force, and to appreciate the depth of the adjustments it has set in motion, just consider the Canadian price index. Today, the index for new machinery and equipment is nearly 20 percent below its 1990 level. Meanwhile, over the same 10 years, the average price of goods and services has risen by more than 13 percent.
This means that the relative price of capital goods has declined by more than one-third in the last 10 years, opening up an enormous and still-growing wedge between the price of capital equipment and labour. To appreciate the consequences, consider that a typical robot used in auto assembly today costs only about $30,000, far less than the annual cost of the services of a single assembly worker. This new reality has set in motion profound adjustments that few people recognize. These adjustments are akin to the gradual drift in the tectonic plates of the Earth’s crust, a process that is completely invisible, except when those forces cause an earthquake.
What are the real world manifestations of this phenomenon? Everyone is looking for ways to use more capital equipment and less labour in their production processes. As a result, investment spending is booming. In Canada, for example, the share of GDP dedicated to spending on new machinery and equipment was less than six percent in 1990; now it is nearly 10 percent. In the U.S., the rise has been even greater, from below eight percent to more than 12 percent. This capital intensification process is generally recognize it as “downsizing.”
This global investment boom is likely to continue for a long time. Consider that it took over 30 years for electricity to become widely used and to have its ultimate effect on productivity. Capital intensification is occurring at different rates in different countries. The U.S. led the way, beginning in the mid-1980s, and Canada and the U.K. followed a few years later. The process is really just gathering momentum in Europe and Japan.
THE ASIAN CRISIS: A SIDE EFFECT
The Asian crisis was a major side effect of this wave of investment. During the first half of the 1990s, developing Asia was a magnet for new investment. The fundamentals for increased investment in new technology were clear, and many companies, faced with the decision of whether to upgrade existing facilities or to develop new ones, chose the latter. Asia’s infrastructure, labour force and entrepreneurial spirit made it the ideal destination for such “Greenfield” investments. Global capital flows, which for years had been tilted in favour of Latin America, shifted course. Convinced that the Japanese miracle, which foundered in 1990, was being replicated in its satellite economies, global investors laid their bets on Asia. In the mid-1990s, the developing Asian economies were investing more than one-third of their GDP, on average. This was an extraordinary situation.
Investors clearly believed that the developing Asian economies did not face the risk of a collapse like Japan’s in 1990. Yet, the symptoms were similar, and suggested a similar explanation. During the second half of the 1980s, Japan went on an investment binge of historic proportions, investing nearly 30 percent of its GDP between 1985 and 1990. At that time, Japan looked like it would take over the world, and the U.S. manufacturing sector would be its biggest victim. Yet, Japan’s pursuit of global market share proved to be its undoing. The weight of too much investment, too much capacity, too little attention to the bottom line, and a government intent on engineering the entire scenario, produced a great crash early in 1990. Japan is still working off those excesses today. That is why the Japanese government’s efforts to spur investment spending have failed repeatedly in the past 10 years.
TOO MUCH OF A GOOD THING
It is easy to imagine overinvestment at the individual company level. Consider a company that has an opportunity to invest in a new technology that will boost productivity significantly. By making the investment the company increases its production capacity, an inevitable result. This is a rational decision for the company, since the new, lower-cost structure is bound to permit it to expand its market.
The problem is that the competition must also buy the new technology too, otherwise it will fade into oblivion. The end result is a group of very productive companies and, coincidentally, an increase in the sector’s capacity to produce goods or services.
However, positive, this is also the way that a large number of rational, individual decisions can add up to too much of a good thing. An investment boom of the sort we are observing, where new technology is driving significant productivity improvements, can generate an overhang of excess capacity for that market, and for the economy as a whole. The next phase in the process, then, sees natural competitive forces pushing market prices down. This is where the final chapter in the creative destruction process is written, one characterized by consolidation, or the exit of the weakest firms in the sector.
A NATION’S HEALTH IS…
Just as a company can invest its way into the poorhouse, so too can an entire economy. In the past, the actions of central banks have cut most business cycles short of the collapse that appeared inevitable. As the economy reaches its full potential, the central bank raises interest rates and dulls the incentive to invest further. This did not happen in the Japan of the second half of the 1980s. Indeed, the opposite situation prevailed: The Japanese government, under intense pressure from the rest of the G7 countries to keep credit cheap, expanded the economy and shrank the country’s trade surplus.
Financial markets are willing participants in the over-investment phenomenon. The combination of strong growth and rising productivity provides a bullish backdrop for stock markets. A symptom of the coming troubles in Japan was clearly the stock market bubble of 1988-90. When the shakeout comes it affects not only companies, but also all those who have invested in the bubble.
Unfortunately, the rest of Asia did not learn from Japan’s crash in 1990. Investment in the rest of Asia skyrocketed in the wake of Japan’s collapse. Developing economies always invest more than mature economies—that is how growth and the gradual convergence of living standards occur. But in several key Asian economies, investment reached the point of diminishing returns in the mid-1990s. An overhang of excess capacity emerged, putting downward pressure on world prices for Asian goods.
The first country to feel the pinch was China, during 1992-93. The demand for its exports was falling short of supply, and the quickest way to ease these pressures across the board was to devalue the renminbi. The more than 30-percent devaluation sent shock waves through the rest of developing Asia. Many of those countries had fixed exchange rates against the U.S. dollar and were committed to maintaining them. Meanwhile, the dollar was rising against many other world currencies, throwing countries like Thailand and Korea even further offside.
These pressures reached a crescendo in mid-1997, and Thailand was forced to devalue in order to restore its competitiveness. Malaysia, Indonesia and the Philippines were quick to follow, and Korea was just a few months behind. Incidentally, most of the devaluation that China had put in place was offset by these reactions.
The crisis did not end there. Interpreting Asia’s woes as a case of financial contagion, global authorities prescribed a strong dose of tight fiscal and monetary policies. The prescription exacerbated Asia’s excess supply problem by causing an even greater contraction in Asian demand and slower growth for the world.
With this more fundamental interpretation of events in hand, the subsequent crises in Russia, and then in Latin America, appear more natural. Given the global economic slowdown centred in Asia, world commodity prices plunged and Russia’s sole source of livelihood was cut off. Other commodity producers also saw their currencies decline to absorb the shock, including Canada and Australia. Meanwhile, the competitive pressures created by Asia’s devaluations proved too much for Brazil, Chile and others, and they eventually followed suit. The holdout, Argentina, is still adjusting to this shock. This is why Argentina’s recovery is lagging that of the rest of South America.
Placing these major economic and financial events in this fundamental context has two immediate implications. First, it underscores the power and pervasiveness of the underlying technology shock. Second, it implies that the preconditions for a financial and economic crisis are not behind us, but are still percolating below the surface of a deceptively calm sea.
The global investment boom has a second important dimension: An increasing share of investments is crossing international borders. During 1991-99, foreign direct investment (FDI) grew at an average annual rate in excess of 20 percent, vastly outpacing world GDP growth of five percent, and international trade growth of seven percent. Increasingly, companies are looking at the entire world when deciding where best to locate their production facilities, and with which partners to build alliances. Globally, FDI’s share of total capital investment has nearly tripled in the last decade, from 4.5 percent in 1990, to more than 14 percent in 1999. Cross-border mergers and acquisitions, as a share of global GDP, have risen from 0.7 percent to 2.5 percent during the same period. This is the essence of globalization.
Inbound FDI is widely regarded as a key driver of economic growth. The fact that volatile FDI flows played a central role in the Asian crisis has not dented this view.
Some countries, including Canada, are perceived to be investing too little and falling behind the global productivity trend. In such a setting, attracting more FDI can take on even greater urgency, prompting the authorities to offer incentives. The risk of such an interventionist policy is that investment decisions will be distorted, breaking the basic law of comparative advantage in the process. A distorted decision today will generally require more government support in the future. A much better approach is to remove barriers to domestic investment or inbound FDI, whether in the tax system or in other investment review policies. Strong, undistorted FDI inflows would then be a very clear indicator of success.
In any case, the benefits of inbound—as opposed to outbound—FDI have often been overrated. The most basic lesson in economics has taught us that there are mutual gains from exchange, because trade allows two parties to specialize their production. In so doing, they can trade the surpluses hey generate so that everyone ends up with more than they would by attempting to fulfill all of their own needs.
This means that international trade—not investment per se—is the most basic building block of national prosperity. While investment permits companies to capture the benefits of a technological advance, it is mainly a means of increasing the scale of prosperity-enhancing trade between multiple parties. Indeed, comparing two economies is fundamentally like comparing apples and oranges. It is entirely possible that it will be ideal for one economy to invest at a much lower rate than another, thereby focusing on its own comparative advantage and enabling it to benefit the most from trade. Making all economies exactly the same leaves us to gain the least from international trade.
Closet mercantilists and anti-globalization groups will continue to resist these propositions, to the detriment of domestic and global prosperity. This is despite the fact that Japan and other countries in Asia tried to invest their way to a larger share of global markets, only to demonstrate that it was a sure route to the poorhouse.
The benefits of outbound FDI derive from the fact that it generates international trade, as companies choose the very best place in which to produce their wares. This is a relatively new phenomenon. In the immediate postwar period, FDI was essentially a means of avoiding tariffs, serving a large market from within. Hence, FDI was a substitute for trade, caused by the restrictive nature of the global trading system. Today, with trade much more liberal, FDI lays the groundwork for international trade. In short, FDI and trade are now complementary.
Indeed, research conducted by the OECD has demonstrated that outbound FDI generates a subsequent flow of exports from the home country, usually in the form of capital goods and supporting engineering or other consulting services. Moreover, it has been found that the subsequent flow of exports exceeds the original FDI outflow, on average by a factor of two. (Fontagne, L. “Foreign Direct Investment and International Trade: Complements or Substitutes?”, OECD Directorate for Science, Technology and Industry, Working Paper 1999/3, October 1999.)
The benefits of outbound FDI have been dismissed in the past, because the benefits of inbound FDI—the investment spending and the jobs that are created—are more immediate and obvious. However, notice that, according to the OECD’s research, inbound FDI will also cause imports to flow from the domestic economy into the investing country. From a GDP perspective, this creates a partial—and rarely recognized—offset to the benefit of inbound FDI.
FINANCIAL MARKETS: THE GREAT FACILITATOR
The tendency of financial markets to overshoot their fundamentals, in both directions, is well documented. This generalization applies to credit, stock and foreign exchange markets. Yet, the distortions that these overshoots provoke in the underlying economy are given far less attention.
The dynamics of overinvestment described above could not occur without the participation of financial markets. The enthusiasm of investors for the profit-enhancing restructuring of companies shows up in the form of abundant capital, low interest rates, narrow credit spreads and rising equity prices. Today, with a much stronger cross-border dimension to these investment flows, exchange rates reflect the same forces as they move into overvalued territory. All of these realities existed at the peak of Japan’s boom in 1988-89, and again during Asia’s peak in 1995-96.
To some degree, these reactions in financial markets are essential, providing the signal that draws even more capital to the heart of a self-sustaining economic expansion. But the advent of a new technology takes financial markets into uncharted territory. It is impossible to know the ultimate benefits of the new technology, or which companies or countries will benefit. Yet, not investor wants to stay on the sidelines and miss what may be the greatest bull market in history. As a consequence, he is willing to pay a premium for almost any technology shock simply to participate in the potential windfall. The results?
- An overvalued, hypersensitive stock market, with an enormous gap valuation between stocks representing the New Economy and the rest
- Technology stocks whose value can decline by 50 percent in a single day, simply because the company has announced that its sales growth and profits next quarter will be less than markets are hoping for
- Credit spreads that appear to completely ignore the volatility of the past five years
- Enormous capital flows destined for the U.S. economy, considered the epicentre of the world’s new technological revolution. Accordingly, there is an extreme overvaluation of the U.S. dollar.
None of these market conditions appears sustainable, according to standard economic and business models. The key underlying adjustment mechanism is overinvestment. The new technology will ultimately deliver more output, at a given level of resources, and the principal means by which society will be able to purchase that output will be through lower prices for goods and services. The falling-price phase will succeed in shaking out the less efficient companies, whose stock prices will collapse. Investors know this, yet the risk of owning stocks in companies that will eventually disappear is judged acceptable, so that the investor has a chance to realize the returns associated with owning a company that may be the next Microsoft.
THE ROLE OF THE POLICYMAKER
After the fact, the policymaker always receives some of the blame for allowing a financial crisis to occur. The lessons people have taken from Japan are that the central bank should have tightened credit earlier during the bubble period (against the contrary advice and urgings of their G7 partners, apparently) and eased much more aggressively after the bubble’s collapse. The main lesson of the Asian crisis appears to be that floating exchange rates are preferable.
These lessons appear superficial when placed in the context of the underlying technology shock we are dealing with. The macroeconomic effect of the shock is an expansion of the economy’s productive capacity, putting downward pressure on prices and increasing real economic growth. This is a central banker’s dream. It is precisely the opposite of the nightmare of the energy price shocks of the 1970s. Then, skyrocketing energy prices invalidated a large part of the economy’s capital stock, reduced productivity, caused output to contract and inflation to rise. Coincidentally, global bond and equity markets entered one of the greatest bear markets in history, and the U.S. dollar depreciated.
Today, while watching their dream scenario unfold, most central banks are simply monitoring inflation risks and tightening policy only as a form of insurance. Policymakers are balancing two risks. One is that overly easy monetary conditions could allow the investment boom to overshoot, causing a Japan-style collapse later. A second risk is that overly tight monetary conditions could cause the deflationary effects of the technological revolution to dominate, pushing inflation below target, possibly below zero.
Finding the right solution will prove to be a delicate balancing act, indeed. Meanwhile, policymakers are focusing on developing a more transparent architecture for the world financial system. This is timely, for the preconditions for a global financial crisis remain largely intact. Asia is not out of the woods yet, as the banking system is still largely under water. At the same time, global capital flows appear to be too focused on the U.S., as indicated by the growing tensions on foreign exchange markets. Latin America has again emerged as the destination of choice for international capital flows. Will overinvestment occur there next? It is impossible to know where the next earthquake will appear, but the trigger is almost certain to be the sudden collapse of an overvalued financial market price, one driven by the undercurrent of overinvestment.
Ultimately, the ongoing technological revolution and the associated global investment boom will be very positive for all of us. There will, inevitably, be some losers, but the winners will dominate by far. This is clear from past leaps in technology, each one of which has taken the world to new heights of prosperity.
The risks we face along this road are not particularly new. However, by failing to understand the full implications of the undercurrents in the global economy, we risk ending up in the proverbial poorhouse. Efforts to distort, interrupt or prevent these forces from unfolding naturally will compound this risk. In the end, the road to prosperity will be built on increased intimacy between countries, more cross-border investment flows, more two-way trade and unfettered financial markets.