Idle Speculation

from Peter Radford

One of the most heated discussions during the current crisis has been the argument over the imminence, or not, of inflation. Most often those arguing we are in danger base their dire predictions on the growth in money supply – the monetary base, which is the narrowest definition of money, has grown by about 58% since 2008. Worse still, they argue, is the constant printing of money going on over at the Fed as it tries to revive the economy. That there has been no burst in inflation since the  money supply erupted, and that all measures of inflation indicate continuing disinflation seems , to these people, of no importance.

The other side of the argument, where I sit, is based on the observation of the enormous and ongoing slack in the economy. To give just one measure of that slack: capacity utilization is hovering around 75%, having sunk to a low of 68.2% in June 2008. That’s an awful lot of spare capacity yet to be re-absorbed into production before we hit any of the bottlenecks usually associated with rapid price gains. In other words it is still a buyers market, and thus there is little or no room for prices to rise either rapidly or consistently.

While I was thinking about this I began to speculate about the longer term ramifications of all that idle capacity. Looking at the data series reminded me that decades ago, in the mid to late 1960′s, capacity utilization rates would routinely reach nearly 90%. Indeed in January 1967 the index hit 89.4%. But since then we have witnessed a steady secular decline in the utilization rate, such that our recent cyclical peaks have been lower, at around 82%.

At the same time inventory to sales ratios have moved down also. The time series I had quick access to only goes back to 1992, but there is a definite trend towards a leaner inventory holding by business. In January 1992 the ratio stood at 1.56, it fell to 1.25 by mid 2005, and then spiked in January 2009  – up to 1.48 – due to the drop in demand caused by the recession, and is now back to 1.27 as companies keep their balance sheets lean once more.

This all led to my idle speculation:

We have all heard about the trend towards lean management over the past few decades. “Just in time” inventory management was designed to reduce the drag on corporate earnings by cutting the financing needed to carry and accommodate inventory. One side effect of this relates back to my comment here on Coase, uncertainty and the reason forms exist.

Firms exist as a hedge against uncertainty. If that is true, as I believe it is, then they must act as buffers against changes in the environment. One consequence of this is that they hold excess stocks of their products so that unexpected upturns in sales do not  go unfulfilled. Conversely, sudden declines in sales will leave business with undesired stocks that have to be unwound before production picks up again. The movement in the inventory to sales ratio is a rough indication of the extent to which uncertainty is affecting business.

This is not in any way new, other than to note the link with uncertainty.

Now add in the capacity utilization rate.

Obviously a firm running at a high capacity rate has little room to raise production when faced with a sudden rise in demand. It thus makes sense to carry a larger buffer of product in inventory. Raising capacity can be time consuming, being first met by running production at even higher capacity rates, and then by adding new physical capacity – hiring extra workers, adding more machines, and building new plant and so on.

So, we see that firms clearly mitigate the effects of uncertainty by carrying stocks of unsold goods. Not only does this represent a problem for neoclassical economic theory it is expensive. It is inefficient and in a world of perfect information – the free market wonderland – no one needs to keep inventory since they always know what sales will be. And stocks need to be financed. But there is an alternative: keep sufficient spare capacity. Obviously both capacity utilization and inventories are ways to offset the impact of uncertainty. The two can be balanced against each other depending on the level of risk deemed acceptable, cost, and ease of adjustment. Apparently somewhere in the last few decades it became accepted practice to keep capacity rather than stocks.

Again this is nothing particularly new, and I am speculating. But one possible interesting offshoot of this switch in tactics has been the change in employment cycle. If firms are managing inventories more tightly and loosening capacity, they will tend to fire workers less rapidly and then re-hire them less rapidly also. So we would expect the trajectories of the employment cycle to change from being sharp “v” shapes to more shallow and prolonged “u” shapes. Which is what we see.

So by implementing “just in time” inventory systems businesses have been forced to change their hiring policies. Why? Because they still need to maintain a bulwark against uncertainty. They have shifted the burden from their balance sheets to their income statements. They have protected profit by making their workforce into a more active component of their protection against the vagaries of uncertainty. Another consequence of this is the three decade long trend of gradual shift from wage growth to profit growth: as workers were forced more and more to act as a buffer against uncertainty they lost traction in wage growth while businesses were able to stabilize and protect profits.

So to summarize: if we look at firms as a response to uncertainty, we can view the trends in capacity utilization, inventory to sales ratios, and even the employment cycle as interconnected. A shift in one shows up as a shift in another.

And, unfortunately, in a recession as deep as the current one, the perception of uncertainty by business is driving a very long and slow employment cycle. Traditional microeconomics can’t deal with this. Ours can.

Or at least it looks that way. Just an idle pe-holiday speculation on my part.