It’s inventory, stupid!

Alasdair Macleod – 16 July 2009
From the gloomy depths of early spring, there has been a recovery of sorts. People are in the shops, not as many as the retailers would like, but there is some trade going on. In the UK, the vehicle scrappage scheme has encouraged people to buy new cars which are increasingly evident on the roads. While on the subject of roads, the increasing traffic is a sign that people are privately and commercially going about their business to a greater degree than a few months ago.

This evidence is encouraging for stock market pundits, who are increasingly confident of the long-term prospects for shares. Indeed, bank shares have rallied strongly, and those fortunate enough to have picked the bottom have multiplied their money. However, Keynesian economists are becoming confused: one detects defensive desperation in their media interviews. So much deficit spending has being thrown at the economies in the US, UK and elsewhere, and so much money and credit as been created, they are surprised the response has not been stronger.

The market pundits and economists actually have no idea what is happening, and their forecasts are little more than guesswork and extrapolation of hoped-for trends. In all the economic commentary there is little mention of the inventory effect, which has actually dominated global economics since the credit crunch.

Over the years, inventory swings has become a neglected topic. However, in the real world volatility in stock levels plays havoc with business forecasts, impacts bank lending and therefore broad money supply. It can lead to lay-offs or bottle-necks. It also distorts manufacturing output. Before dismissing it as a short-term effect, one must understand it is particularly important today.

After the credit-crunch, banks restricted lending, and consumers stopped buying, so stock piled up on the shelves. Working capital requirements for businesses increased across the board for which there was very little finance available, so virtually all new stock orders everywhere were immediately cancelled. This is why exports by the manufacturing nations collapsed so dramatically. With no finance available from the banks, businesses had to quickly sell their goods at any price, a process that only ended when the shelves were almost bare. Businesses slimmed down where they could, by deferring capital expenditure and slashing costs. By the end of March this year, the survivors were in a position to continue to trade, but at a reduced level.

At this point, overall confidence was rebounding from extremely depressed levels. Some large companies were able to raise equity to reduce their debt burden, but generally finance was and still is strictly limited for everyone else. However, trade has picked up somewhat, hence all those new cars bought at deep discounts, and the increase in commercial and private traffic on the roads. So how much more will the indebted and insecure citizen buy?

Very little. His recent purchases can be described as merely opportunist. He bought the car because it was offered at half price, and courtesy of the government, the tax-payer bought his old one. Purchases are now generally restricted to necessities, so the inventory bounce is tailing off; and as the inventory bounce fades, we are back to too much debt, save-not-spend, and no credit.

This is a bad environment for commercial banking. Banks expect insolvencies to rise and will seek to reduce lending exposure further. Businesses have tightened up by delaying payments as long as possible and by deferring equipment purchases. The continuing contraction of credit is critical, and it is hard to see how a downward spiral of failing businesses and credit withdrawal can now be prevented. The malaise is general, but its timing is controlled by inventory flows. There is very little flexibility left in the system.

How do we resolve the inevitable slump?

So the economic crisis looks like it will shortly enter a second phase, this time driven by a developing business contraction in the private sector. This raises many questions, but probably the most important is the response of governments. They took the decision to bail out the financial sector at great cost in order to stop a financial crisis triggering a recession. In this they failed. They rescued the weaker banks and promised to get them to lend to industry. In this they failed. They pumped money into the private sector by quantitative easing. This has failed. They have allowed their own finances to spiral out of control. This is worse than failure. With few options left, how will they now bail out unwanted manufacturing and services, as they slide further into a slump?

The slump is already here, as pointed out by the World Bank this week, in the form of record levels of excess capacity, though this is not what they called it. Excess capacity drives down prices, implying consumer price indices will start falling. Governments have already pulled all the levers available to no effect to stop this happening. Will they nationalise the next wave of collapsing banks? How will depositor guarantees be paid for? Will they bail out bust businesses? How can they cut public sector costs with all this going on? How much money will they print?

Underlying the confusion in economic circles is a growing suspicion that the situation is drifting beyond intervention. So it will be over to the monetarists, who intervene in a different way. To obtain price stability they will print money, and make sure it gets into the economy, rather than remain on deposit at the central banks. Yet another “Bretton Woods” may be called to co-ordinate this action between central banks. The idea will be to offset falling prices by monetary inflation. Unfortunately, this does not deal with excess capacity, which can only be eliminated by shutting factories.

So it is likely that for a brief time, there will be an illusion of price deflation, while currency inflation spirals out of control. The price deflation will be in those goods and services we do not want any more, while price inflation will persist and grow dangerously in those items we actually need. It is a pity that the monetarists seem not to understand that this difference exists. My note of 14 June showed that in the UK a core price index covering the bare essentials – food, non-alcoholic beverages, clothing & foot-wear and home maintenance products – is rising by over 5% annually. The story in the US is similar. When prices in the last two components stop falling and start rising, this core measure of inflation will rapidly approach 10%.

There is a worrying lack of understanding about the dangers of quantitative easing. It fails to address the real issues of excess capacity and will quickly create higher prices for necessities. It is a mistake to believe we have price deflation, when actually we have falling demand for the non-essentials that make up the bulk of the consumer price indices. It is not as commonly thought a tussle between deflation and inflation; it is inflation alone.

This fallacy invalidates central bank monetarism. The assumption that inflation will only return with economic recovery is incorrect, as is the assumption that interest rates can be raised to head it off in the early stages of that recovery because it is already too late. This complacent hope is based on the erroneous belief that inflation only occurs with economic growth. Central banks forget that stagflation ever happened.

We cannot forget how the authorities behave when controlling inflation becomes too difficult. At some stage, they will resort to price controls on basic necessities. History tells us, from Emperor Diocletian to Zimbabwe, this invariably happens, and not only does it never work, but it always has the opposite effect.

It is all so predictable.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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