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.