Taming the Tiger

It isn’t often that you encounter genuine insight in a newspaper column but Andy Kessler may have revealed something crucially important in his latest Wall Street Journal column. In Keynesian business cycle theory, the business cycle, the periodic transition from expansion to contraction (recession) in the economy, is caused by variations in the rate of investment in turn caused by changes in the marginal efficiency of capital (expected profits) throughout the cycle. In the theory after a period of expansion the high efficiency of capital in the early part of the expansion is succeeded by lower efficiency because of shortages or bottlenecks in materials or labor or excessive outputs causing profits to be reduced.

It used to be the prevailing wisdom that the business cycle was roughly four to five years. Over the last thirty years that has expended to eight, then ten, and now who knows how long? The present expansion has been continuing for more than ten years.

Here’s where Mr. Kessler’s insight comes in. What if the increasing length of the cycle and the decreasing amplitude of its peak are due less to bankers’ cleverness in manipulating the interest rate (the cost of money) than in more effective and timely management of inventories and profits?

Did you ever wonder why we are enjoying a decadelong run? What changed? Everyone wants credit. Was it the Federal Reserve and its relentless stimulus? Nope. The Fed creates the money the economy needs, but not the need itself. Obama or Trump policies? A divided Congress? Demographic shifts? A strong or weak dollar? Actually, none of the above. The answer is just-in-time. You can thank all those freshly minted consultants you see in premium economy crisscrossing the country with their AirPods and Allbirds and airy attitudes.

In the previous era, before pervasive computing, economies would live and die by inventory cycles. Heck, biblical times record seven years of feast and seven of famine. The expansion starts, consumers buy, investment and hiring ramp up, wages and prices rise, inflation emerges, consumers buy ahead of price increases, investment peaks, inventories build, consumers are tapped out, recession starts, inventories are drawn down, and layoffs begin—then start all over every four years. Until recently, price signals didn’t travel very fast, and inventory tracking used clipboards.

In a micro version of this cycle, the videogame industry had a huge bonanza in the early 1980s that ended in ’83 with bust of the highly anticipated “E.T. the Extra-Terrestrial” game. Warner Communications literally buried about 700,000 unsold cartridges of “E.T.” and other titles, and lost more than $500 million. The semiconductor industry got stuck with loads of chips in inventory that had to be written down. It was ugly. After a similar inventory mess related to then-newfangled personal computers, the tech world started implementing just-in-time delivery. Companies like Compaq would ask for chips to be delivered Tuesday for PCs shipped on Wednesday. This gradually smoothed out the cycles of a very volatile industry.

Thirty-six years later, much of the global economy has perfected this just-in-time supply chain. Digital cash registers and bar codes log consumer purchases. Logistics software allows manufacturers to track every production detail everywhere on the globe. Data is fed into giant databases that forecast demand. Manufacturing, transportation and retail are a highly choreographed water ballet of delivering inventory right before it’s needed. Exactly the right amount of toothpaste is magically dropped onto Walmart shelves each night.

Software is now a mind-bending cornucopia of supply-chain management, enterprise-resource planning, business-process re-engineering and decision-support systems—all of which barely existed 30 years ago. But here’s the dirty little secret: Enterprise software from Oracle and SAP and just about everyone else is notoriously hard to use, nasty to implement, and a royal pain to maintain. That means a virtual Full Employment Act for consultants—tens of thousands are hired yearly by PwC, Deloitte, KPMG, Ernst & Young—add BCG and McKinsey too—to customize and implement business processes.

That ties the observed lengthening and flattening of the business cycle, the relatively low rate of capital investment compared to the past, and, possibly, even the slower rate of new business formation into one neat package. I would also observe that companies like Google, Facebook, or Goldman-Sachs aren’t much dependent on inventories. Or Disney for that matter.

Predictions of the repeal of the business cycle have always been harbingers of doom. I do not believe the business cycle will ever be repealed. But it may become a lot less cyclical than it used to be, more dependent on natural or, more likely, manmade disasters for its impetus. What may be the case is that the Keynesian theory of the business cycle is a lot less relevant to the modern economy than it was when heavy manufacturing formed the base of the economy. It would be interesting to study business cycles in the pre-industrial period. Where we are and where we’re going may be a lot more like 1730 than it is like 1930.

9 comments… add one
  • Another prospective explanation is that we’ve been in a global depression for the last ten years due to enormous Chinese over-production, most of the effects of which have been hidden within China. I think we’d’ve seen more discontent in China were that the case.

  • steve Link

    “Where we are and where we’re going may be a lot more like 1730 than it is like 1930.”

    Think weather and agriculture were more important back then so you could have pretty rapid changes. Otherwise, interesting piece. Just in time supply has been a big factor in our drug shortages, so I am just a bit leery about this, but it sounds good.

    Steve

  • TastyBits Link

    The economy has not contracted, but it has not expanded, much. Rather than quickly write-off or write-down malinvestments, the Fed is absorbing them (QE1, QE2, …, QEn), but this has not instilled enough confidence for investors to risk large sums of money.

    I did see an article about PE Investors beginning to deploy their “dry powder”, but I am not sure how accurate this is. Our in-house PE Investor would have better insight.

  • Maybe I should be clearer about what I meant. Many types of business cycles have been identified. The “Kitchin cycle” AKA the inventory cycle seems to be what Mr. Kessler is referring to. That may be gone completely for the reasons he describes.

    Then there’s the “Juglar fixed investment cycle”. If that’s obsolete, too, which it could be due to more efficient use of capital that would greatly change the picture. And it might also explain why the 18th century economists rejected the very idea of business cycles—they might not have had them in the same sense as we did in the 19th and 20th centuries. It may not just be a coincidence that the earliest recorded cyclical recessions were in the second and third decade of the 19th century.

    Rather than quickly write-off or write-down malinvestments, the Fed is absorbing them

    which is something I’ve been complaining about. I’m concerned that strategy is like a ballbearing rattling around in a housing—it’s going to do a lot of damage while it’s rattling around which is hard to predict until you open the housing.

  • PD Shaw Link

    I think four or five years ago I watched a video explaining the business cycle as explaining the 2008 recession that was pretty much manufacturing-centric, which could be extrapolated to some other industries like oil and mineral extraction, but seemed quite adrift from today’s economy. Being from a town called Caterpillar, I intuitively understand the roll-off effects of a plant slowdown or shutdown, because the impacts flow to all parts of the economy that provide goods and services directly or indirectly, including government. But that town is not common anymore, what all towns have in common potentially is real estate as a form of investment.

  • Guarneri Link

    JIT inventory, which quickly evolved into full on supply chain management, was being discussed in business schools and the business press as an attenuator of the business cycle in the early 80s. Derived from Japanese manufacturing techniques, the notion was that excess and volatile inventory (buffer stocks) was an indicator of out of control processes. It was being implemented, by people like me, by the mid-80s.

    A less asset intensive economy (service) will naturally be less volatile.

    The notion that the central banks have developed a steady hand on the till is ludicrous.

    Tasty – I don’t know what publication you’ve been reading but investment pace has had absolutely no lull and accumulation of dry powder, even though the pricing environment would suggest it would be prudent.

  • TastyBits Link
  • Guarneri Link

    Tasty –

    I see what they have done. The second and third graphics tell the real story. Huge and rising transaction volume at what I consider outsized prices and over leveraged multiples. 10x is a common purchase multiple and 6x is a common debt multiple. (I remember the days of 6/3,4).

    Dry powder is a term of art. We have to divert a second here. Most partnerships have a 10 year term, with a 5 yr investment period and 5 yr harvest period. (It’s a bit more complicated, but…). So you have 5 years to deploy the funds; that’s your “dry powder.” A use it or lose it mentality unfortunately grabs GPs in years 4 and 5.

    That’s not really what is happening today. It’s the amount of new money being raised and deployed that is driving things. It is somewhat just semantics. The result is the second two graphics. The scary thing is competing down risk adjusted returns because of what I call yield chase. Pensions, endowments etc are underwater and prevailing fixed income rates are low. So the pension managers are overweighting alternatives in an attempt to get to required funded levels. IMHO it’s somewhat of a river boat gamble.

  • TastyBits Link

    @Drew

    Thanks. I was not sure if it was correct.

    Now, it was my understanding that you are a mindless minion of ZeroHedge, and you get your marching orders from them.

    (For those who do not follow ZeroHedge, most of their posts are actually reposts, but this post was by somebody from the site.)

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