Excess or Mispriced Capacity?

In a response to this post, NorthGG asks: How does one differentiate between excess capacity and mispriced capacity? What are the policy responses to them?

Excess capacity is always, in some sense, mispriced capacity. When I say excess capacity, I mean that at current prices the capacity of the global system is too high. In order for markets to clear, prices must fall. Lower prices, however, imply lower investment and lower production: firms shift inward along the supply curve.

In an ordinary downturn, the shift in demand is temporary and the long-term implications for the economy are relatively small. In this case, fiscal transfers, either in the form of investment tax credits or outright cash transfers, can provide a temporary boost and ameliorate any negative effects.

I don’t think this is not an ordinary downturn. In this post, I argued that U.S. households are consuming too much relative to their income. Further, I argued that the most likely resolution to this problem was for consumption to fall. A substantial portion of global capacity is dedicated to satisfying the desires of the American consumers. This capital stock must be transformed to other uses.

In the short run, NorthGG is exactly correct. The relative price of these goods will have to fall, leading to something that looks like a deflation. In the long run, the capital stock will shrink and redirect toward some new use.

If I am correct and this is not an ordinary downturn, then policy responses aimed at supporting the current industrial structure are misguided and will only distort and delay the needed restructuring. I will be forever suspicious of government plans to “improve” the manufacturing base. If the government is concerned over welfare, it may do so in the form of transfers to households (see this post).