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The inventory cycle in the United States
Engineering Cosrs and Production Economics,
I 5 ( 1988)
Elsevier Science Publishers B.V., Amsterdam -
93-
IO0
93
Printed in Hungary
THE INVENTORY CYCLC IN THE UNITED STATES Michael C. Lovell Wesleyan University. Middletown.
Let me discuss the inventory cycle in the United States-the reversals in business conditions that repeatedly interrupt the expansionary path of the American economy.
I EVIDENCE
Tables I and II summarize the essential elements of the inventory cycle over the years since World War II. Recorded on tne left-hand column on Table I are the peak and through dates demarcating each downturn. Observe that while the downturns generally last about a year, they do vary considerably in length as well as intensity. While most recessions are over within a year, some have persisted for as long as sixteen months; the 1980 inventory slump lasted only six months. But the periods of expansion between successive downturns are not only longer than the contractions; they vary much more in length. Since World War II it has been relatively safe to predict that prosperity is just around the comer; the wider variations in the span of time from trough ‘. to peak mean that predicting the upper turning point is more difficult. Selecting the downturn phase of the business cycle as the focus of analysis invokes a time-unit-ofaccount that varies considerably in length. While this is appropriate for the study of the inventory cycle, for other purposes it might be better to use a decade time unit of account or focus on the fouryear term of presidential office. Indeed, presidents are fortunate if they escape having one or more inventory cycles christened in their name-there were Eisenhower, Nixon, Carter, Ford and Reagan
USA
inventory recessions. But it should be observed that the dating of the turning points is more of an imprecise art than exact science. A committee of distinguished scholars of the National Bureau of Economic Research is charged with the responsibility of identifying business cycle turning pointsthis can not be done with much confidence until well after the fact, and the dates are subject to substantial revision because additional evidence ,accumulates with the passage of time. let me warn in advance that it may be dangerous to read too much into the evidence on the tables because a minor shift of a few months in the turning-point dates might alter the magnitude of certain of the figures rather substantially.
II THE ESSENTIAL FEATURES OF THE DOWNTURN
Before focusing on the details, let us look at certain of the fundamental features of the inventory cycle. The first column of Table I shows that although each downturn is characterized by a reduction in GNP, some are more severe and some are quite mild. The recessions at the beginning and end of the decade of the 1960s were particularly mild; the more recent recessions involve a more substantial loss of output. Since the GNP data are corrected for the distoring effects of inflation, output being measured in dollars of 1972 purchasing power, the increase in magnitude is not to be attributed to inflation. It may be partially explained by the secular expansion of the economy-the trend level of total output grew three-fold over the period
94 TABLE
I
Contributions
of inventory
Turning
disinvestment
point date
Gross national
(Year & Quarter)
product (1)
Peak:
194834
497.9
Trough:
1949q4
490.8 -7.1
Change: Peak
:
Trough: Change:
1953-q2
628.3
1954q2
608.1 - 20.2
to postwar
(Non-res-
investment
(3)
738.4
Change: Peak
:
Trough: Change
196-4
I ,085.6
197O-q4
LO84.7 -.9
:
(8)
315.4
32.8
91.6
322.5
37.7
98.1
- 13.0
- 8.4
2.8
7.1
4.9
6.5
5.1 -4.1 -9.2
-9.9
737.7 - .7
(7)
26.9
- 18.6
l%lql
(6)
exports
24. I
-6.2
196o-q2
consumption
(5)
Net
goods JL services
51.9
669.9
:
consumption
(4)
Government
personal
43.5
688.5
:
Durable
Personal
7.7
195743
Peak
Resident
of 1972 dollars)
5.3 -
195832
Trough
in GNP (billions
investment
idential)
(2)
:
Change:
reversals
Fixed inv
Inventory
Trough:
Peak
cyclical
3.7
3.3 -4.1 - 7.4 7.0 1.4 - 5.6
9.7 7.4 -2.3
55.9
28.2
364.6
41.9
170.2
4.4
54.8 - I.1
29.0
366.2
41.4
155.6
6.7
.8
1.6
- .5
- 14.6
2.3
67.3
28.9
48.0
58.8
28.2 - .7
161.6 168.7
II.9 5.6
7.1
- 6.3
-8.5
415.2 414.7
44.5
-.5
-3.5
67.8
34. I
454. I
52.3
172.4
65.2
32.9 - 1.2
454.0 -.I
47.7 -4.6
179.4
6.8 10.4
7.0
3.6
-2.6 117.4
40.5
663.8
91.3
255.0
1.8
110.3 -7.1
44.5
673.9
84.8
4.0
IO. I
-6.5
251.0 -4.0
3.6 1.8
:
197-4
1,266.l
23.7
766.7
117.2
256.4
21.2
197-l
1.204.3
- 14.3
140.7 120.7
57.4
Trough:
39.4
763.3
106.5
263.0
32.1
-61.8
- 38.0
- 20.0
- 18.0
-3.4
- 10.7
6.6
10.9
1.496.4 1464.2
-.5
171.8
53.0
938.3
145.2
284.0
49.8
- IO.1
163.6
284.0
53.4
-9.6
-8.2
929.4 -8.9
135.6
- 32.2
44.0 - 9.0
17.5
178.2
42.8
955.7
- 6.4
163.9 - 14.3
36.8 - 6.0
964.2 8.5
143.5 139.3
Peak
Change: Peak
:
Trough
l98O-ql
:
198O-q3
Change: Peak
:
Trough: Change: Definitions Market produced
1.522.1 1,477.l
198143 1982-q3
-45.0
- 23.9
of variables: value (using
4 Residential 1972 prices) of all goods and services
by the economy
Inventory investment Fixed investment, gross private
non-residential
covered by the table. In terms of the shortfall in output as a percentage of previous peak GNP, the “Gerald Ford” (or OPEC?) recession of 1974-75 was clearly the most severe that the US economy has experienced over the years since World War II. Part of the social costs of inventory recessions is revealed by the data on the unemployment rate reported in the first column of Table II. Unemployment rises in each inventory recession. The unemployment rise was most substantial in the 1949 slump; the 197475 recession takes second place.
investment,
-9.6
-4.2
287.4 292.8 5.4
3.6 40.6 25.7 - 14.9
gross private
5 Personal
consumption
6 Durable
good consumption
7 Government 8 Net exports
.O
expenditure expenditure
purchases of goods and services of goods and services
The unemployment rate is a useful social indicator of economic malaise--rising unemployment is generally accompanied by an upswing in such indicators of social malignancy as the proportion of the population living in poverty, in the incidence of malnutrition and the suicide rate. It should also be noted that the decline in GNP reported on the table understates the output foregone in each recession. To illustrate, the drop l>f $45 billion for the most recent downturn, while constituting a decline of only 2.1% from the previous
95 TABLE
II
Some salient features
of inventory
Turning point date (year&quarter)
cycles
Unemployment rate
Price level
(1) Peak
:
Trough: Change: Peak : Trough:
:
Trough
:
:
Trough Change:
:
Peak : Trough:
:
Trough: Change:
(5)
(6)
deficit (billions)
(7)
(8)
- 1.7
I.1
15.3
47.5
2,321
3.3
.O 1.7
1.0 -.I
15.9
48.4
4.1
23.4 - .4
.6
.9
2,251 -70
-4.1 - 7.4
195-2
2.9
25.9
.O
2.1
24.3
- 6.3
5.9
26.3 .4
1.5 1.5
.8 - 1.3
28.7 4.4
57.6 58.1
2,520
1954q2
2,453 -67
-6.7 - .4
45.8 42.3
1957-q3
4.1
29.2
4.2
3.4
1958q2
7.4
29.6
1.4
1.1
3.3
.4
-2.8
-2.3
-3.5
.5 62.3
2,666 2,617
63.7
1.4
2.8 -11.8
-49
- 14.6
196O-q2
5.2
30.9
.O
3.2
55.7
67.5
2,722
1961-ql
6.9 1.7
31.0 .I
.O
2.4
62.2 6.4
68.1 .6
2,703
-4.3
-19
-8.5
196944 197wl4
3.5 5.9
40.6
5.1
7.7
91.1
87.8
4.8
5.3
84.3
89.2
3,600 3,669
4.3 - 20.4
-.3
- 24.7
.O
-.8
4.2
2.4
42.7 2.1
1.4
69
1973-q4
4.8
51.2
10.0
7.9
102.0
98.8
4,106
1975-ql
8.6
57.7
5.5 - 2.3
83.8
3,928 - 178
-45.2
-2.4
-6.8
- 1.8
3.8
6.5
10.3 .3
- 18.3
93.8 -5.0
1980-q]
6.3
82.7
8.7
12.0
110.9
99.4
4,524
- 37.8
198-3
7.8
86.5
9.3
8.1
119.8
99.2
4,469
1.5
3.8
.6
-.2
-55
- 75.0 - 37.2
Change: Peak
(4)
Govern
23.8
Change: Peak
(3)
Real income per capita
7.9
Change: Peak : Trough:
rate
Labor productivity
3.8
Change: Peak
rate
S&P 500 (stocks)
1949-q4
3.0
:
TBill
1948-q4
Change: Peak : Trough
(2)
Inflation
-3.9
9.0
-47.0
1981-q3
7.2
94.9
9.4
14.7
129.1
101.3
4,593
-62.5
198243
10.7
100.8
5.8
8.0
138.1
loo.3
4,548
- 158.8
3.5
5.9
- 3.6
- 1.0
-45
- 96.3
Definition of variables: 1 Percentage of the civilian labor force, 16 years and over, that is unemployed 2 Implicit
price deflator
3 Annual 4 Interest
percentage change in the GNP implicit rate on three month Treasury Bills
for gross national
product,
1982= 100 price deflator
GNP peak, understates the output lost in each recession. Similarly, the $61.8 billion decline in the 1973374 recession, a drop of 4.8% from the previous peak, does not fully reveal how much output was sacrificed because full-employment was not sustained. Because of the secular expansionary forces of population and productivity growth, potential output is higher at the end than at the beginning of each recession. The rise in unemployment understates the serious-
-6.7
9.0
5 SBrP 500 common stock price index, 1941-43= IO 6 Output per hour, all persons, business sector, 1977 = 100 7 Disposable
(after tax) personal
income
per capita
8 Federal government receipts less expenditures, All data taken from the CITIBASE data tape.
(1972 = 100)
current
dollars
ness of each inventory recession. When unemployment increased from 7.2% to a post World War II peak of 10.7% in the Reagan recession of 1981-82, the loss in output was more than proportional to the 3.5% increase in the unemployment rate-Okun’s Law (named for the late Arthur Okun, who served as Chairman of President Johnson’s Council of Economic Advisors) suggests that the percentage shortfall in GNP resulting from a recession involves a loss in output on the order of two or three times the
96 rise in unemployment-this translates into a drop in output of between 7% and 10% for the Reagan recession. Much of the two or three fold Okun’s Law magnification factor comes about because firms are unwilling to shed labor in proportion to the reduction in output in part because of the continued need for supervisory personnel, maintenance workers, and so forth and in part because of the desire to retain workers with considerable on the job training rather than incur the costs of screening, hiring, and training new workers when prosperity returns. In addition, the discouraged worker effect helps to explain why output declines by more than the rise in unemployment-when workers become so discouraged that they give up the search for work and leave the labor-force they are no longer counted among the unemployed. Once Okun’s law is applied it becomes clear that the cyclical reversals that repeatedly interrupt the secular expansion of the American economy involve a serious sacrifice of potential output.
III A CLOSER
LOOK
Let us look more closely at the GNP accounting evidence recorded on Table I. In interpreting the table it is important to keep in mind the fundamental GNP accounting identity: GNP is the sum of Investment plus Consumption plus Government spending on goods and services plus the excess of Exports over Imports : GNP = I+C+G+X-M
(1)
As applied to the table, this accounting identity means that for each time period (e.g. row 1948q4) the entry in column (1) is the sum of the entries for Inventory Investment in column (2), Fixed NonResidential Investment in column (3), Residential Investment in column (4), Personal Consumption in column (5), Government Spending on Goods and Services in column (7) and Net Exports (X- M) in column (8); column (6) is a component of (5). Since this identify holds for each peak and trough year, it must also hold for each recessionary downturn of GNP as recorded in the Change row-in each recession the decline in GNP is partitioned into its
components by the entries to the right on the same row (again excluding column 6). This GNP accounting identity helps make clear why the postwar cyclical reversals in the pace of economic activity that have marred the expansionary path of the American economy deserve to be called “inventory recessions”. As a rule, the decline in inventory investment in each recession is larger than the decline of any other component of total spending. To take but one example, inventory investment at $17.5 billion at the 1981 peak was only about 10% as large as the fixed non-residential investment figure of $178.2. But while inventory was dwarfed by investment as a component of total demand, its dramatic swing to a negative $6.4 billion when manufacturers and distributors liquidated stocks in the recession meant that the decline in inventory investment totaled $23.9 billion. This compares with a decline of only $14.3 in investment in plant and equipment (non-residential fixed investment). The one recession since World War II that was not dominated by inventory disinvestment is the post Vietnam war recession of 1969-70. Let us look more closely at the longest expansion, from the first quarter 1961 through to the fourth quarter 1969. Before what was heralded while still underway as the “longest peacetime expansion in U.S. history” turned into the “Vietnam War boom”, the unprecedented expansion was frequently cited as evidence that macroeconomic science had advanced to the point where it was possible to tame the business cycle. And in the spirit of the times the Deparment of Commerce changed the title of its monthly chart book of economic indicators from Business Cycle Developments to the more neutral “Business Conditions Digest”.* That the claimed demise of the inventory cycle was premature is incontrovertibly demonstrated by the three post Vietnam recessions.
* My former colleague Martin Bronfenbrenner edited book of papers on economic fluctuations with the rhetorical title, Is rhe Business Cycle Obsolete?
97 IV HISTORICAL
ANTECEDENTS
How do the post World War II cycles compare with the prewar experience, analyzed so meticulously by Abramovitz [1950]? On one point the record is unambiguously clear. Relative to the 1930% the U.S. economy has done very well in recent years. In 1933 the unemployment rate had climbed to 25%-one fourth of those willing and looking for work could not find jobs. Many at the time viewed the Great Depression as the fundamental crisis of capitalism-some thought the revolution was at hand. It is clear that the coilapse from 1929 to I933 was quite different from any of the downturns we have so far experienced in the post World War II period. For one thing, in the Great Depression the collapse of confidence helped bring fixed private investment spending to a halt. In contrast, during inventory recessions fixed investment is subject to only moderate declines, as can be seen from Table I; by helping to sustain effective demand, the persistence of fixed investment in inventory cycles helps save the economy from more fundamental decline. Some business analysts worry that the crisis of the 1930s arose as a result of the Kondratief Cyclethese Cassandras warn that we may be ripe for another Kondratief downturn. I doubt that there is much in the post World War II story that would surprise R. G. Hawtrey [1928], John Maynard Keynes, Eric Lundberg [1937], Joseph Schumpeter and other scholars who were writing in the 1930s about the role of inventories in the business cycle. In broad outline, the post World War II recessions have not been all that different from earlier downturns, although they have been characterized by greater price stability. And a variety of structural shifts in the economy do not appear to have had much effect on the basic features of the cycle. It is safe to predict that when the next inventory recession gets under way at least one newspaper columnist will explain that the current cycle is different from its predecessors because of the spread of scientific techniques of inventory control, and/or the computer. The recent decline in the inventory/sales ratio is often cited as evidence of the fundamental significant of modern techniques of inventory control. But as can be seen from the
graph, when viewed over the entire period since Wortd War II, there has not been marked downward trend in the inventory/sales ratio. There have been major changes in the structure of the American economy over the last half century, but the rather remarkable thing is that they have not had more effect on the inventory cycle.
V CAUSES OF THE INVENTORY
CYCLE
The fact that wide swings in the rate of inventory accumulation and liquidation are a major feature of every inventory cycle does not mean that inventories must be regarded as the primary causal factor. The ambiguity in the concept of causation is illustrated by Aftalion’s famous rocking horse analogy: he explained the presence of recessions in capitalistic economies by comparing them to a rocking horse that moves to and fro when its master hits it with a stick. While it is obvious that the way in which the horse rocks in response to the blow will be influenced by the shape of the rockers, it is not clear whether it is correct to say that the horse’s protracted rocking is caused by the shape of the rockers or the blow from the stick. The inventory cycle mode1 developed by Lundberg [1937] and Metzler [1941] explains an inherent tendency for the capitalistic system to generate periods of booms and bust in terms of the efforts of entrepreneurs to preserve a desired ratio of inventory to output in the face of incomplete knowledge about future sales. The parameters of the model-the marginal propensity to consume, the desired inventory-output ratio, and the expectations coefficient-determine whether there is cyclical rather than monotonic movement, the periodicity of the cycle if one is generated, and the speed of convergence. These factors determine the shape of the rockers, so to speak, but a blow from the sticka shift in government spending or a change in the marginal propensity to consume is required to disturb the model from equilibrium and get the process of over-accumulation and’ expectational error underway. There is no shortage of alternative explanations of
98 T
P
T
I
3.2
2.6
2.4 1950 Fig. 1. Real inventory
1965
1955 sales ratio,
nonform
1970
1975
1
business
the cycle. The evidence on Table I is perfectly compatible with the monetarists’ argument that the cycle arises primarily as a response to the misguided if well-intentioned “Stop and Go” blunders made by central bankers in attempting to stabilize the economy-inventory investment can be regarded as a part of the response mechanism rather than the fundamental cause. But it is also said that some of the recessions, such as the 1969-70 downturn, should be called “Engineered Recessions” in that they were deliberately brought about as an unfortunate but unavoidable side effect of hefty doses of anti-inflationary medicine applied by the fiscal and monetary authorities who viewed the threat of protracted inflation as more serious than a transient rise in unemployment. And it is sometimes said that we have a “Political Business Cycle”, the timing of recessions being influenced by the President’s desire to apply the deflationary medicine early on in the administration in order that the economy will have recovered in advance of the next election-the Carter administration certainly cannot be accused of successfully manipulating the inventory cycle. But it is not necessary to argue that recessions are made in Washington, either by error or design. One might follow Eugen Slutsky, the great Soviet statistician, who argued that business cycles are caused by the summation of random causes-inventories are a part of the moving average structure, so to speak, rather than being one of the numerous small erratic shocks that are smoothed by the system into a quasicyclical path. The models of Lundberg and Metzler
explain the self-generating inventory cycle. It may well be that inventory cycles are inherent in the system, but with their timing, intensity and distinguishing characteristics tempered by the activities of policy makers.
VI LESSONS What have we learned about the cycle from recent experience? A wealth of additional evidence accumulates with the passage of each year, and the art of the empirical research has been greatly advanced by the development of improved estimation techniques, modern computers and data banks. Nevertheless, many of the issues that were recognized by economists writing on inventory cycles in the 1930s remain unresolved. There has been progress: Holt and Modigliani [1961] showed how both the flexible-accelerator buffer-stock inventory model and the productionsmoothing delayed adjustment mechanisms could be derived from the assumption of maximizing behaviour. And when I disaggregated the Lundberg-Metzler model of the inventory cycle into a multi-sector input-output model I found that.& delayed adjustment mechanism was required to generate a stable cycle for reasonable parameter values. On the empirical front, a number of investigators have found that the flexible accelerator model survives empirical test and replication on a wide range of observations over varying time frames
99
and in different countries without the introduction of speculative or interest rate effects. The evidence suggests that expectational errors play less of a role than is attributed to them by Lundberg and Metzler in their model of the inventory cycle. It is fair to say that the vast majority of empirical investigators tried to estimate the impact of interest rates on desired inventories-most of the attempts went unreported because they were unsuccessful (an unfortunate practice of applied econometrics is to neglect mention of failures). F. Owen Irvine, Jr. [1981] may have been more successful than anyone else in mustering evidence that monetary conditions influence inventory investment. But while there has been substantial progress, in terms of the acid test of policy effectiveness, I think it is safe to say that policy makers have not become more successful in recent decades at stabilizing the economy.
VII INVENTORY IN PERSPECTIVE
CYCLES
In conclusion, I wish to stress that while the inventory cycle is a serious phenomenon, there are three other problems that are ofgreater significance: First, there is the slowdown in the rate of growth in workers productivity that has been plaguing the U.S. economy, and indeed much of the industrialized world. Since 1973 output per worker has grown at an annual rate of about 1.14%, down from a previous 3.1% trend rate-a 2% drop in the rate of productivity growth may seem small, but it compounds out over the years to a shortfall in output of 24%; if we had sustained the higher rate of productivity growth, the same number of workers that we have on the job today would be producing 24% more output! Second, there is the profound problem of income inequality-by most measures there has been little or no movement toward income inequality in the recent decades: the most disadvantaged 20% of the United States population receives only 4.5% of total income; the 5% at the top of the economic pyramid commands 16% of the total. It is
generally recognized that the principle of progressive taxation has not been effectively implemented in the Federal Income Tax code-the flat-rate tax reform movement of 1986 recognized this reality in abandoning the pretext of redistribution. Thirdand perhaps foremost is the threat of secular inflation. We know how to control inflation, but with contractionary medicines-tight monetary and fiscal policy. High unemployment is the unfortunate side-effect. The only politically feasible technique for containing inflationary pressures is to maintain the unemployment rate at a “natural” or “full employment unemployment rate” (a.k.a. the “non-accelerating inflation unemployment rate of NAIRU) that is now estimated to be about 6% or 6.5%, substantially above the 4% interim unemployment target that was deemed appropriate by the most influential of leading American economists in the early 1960s. These problems are not unrelated to inventory investment. Thus, when the Central bank tightens up on the economy in an attempt to forestall inflation, the resulting movements in inventory investment are part of the process by which tight money contributes to the decline in effective demand, to rising unemployment, and a resulting reduction in wage pressure. And of course, more efficient management of inventories, an essential element of the “just-in-time-system”, will contribute to increased productivity growth. While inventories may not be of paramount concern, they are a part of the problem and an element of the solution.
REFERENCES
Abramovitz,
Moses (1950) Inventories and Business Cycles, New
York: National Bureau of Economic Research. Hawtrey, R. G. (1928) Trade and Credit, London:
Longmans,
Green & Co. Holt, Charles C. and Franc0 Modigliani (1961) “Firm Cost Structure and the Dynamic Responses of Inventories, Production,
Work
Force
and Orders
to Sali
Fluctuations”
in
100
Inventory
Fluctuations
and
Economic
Stabilization,
Economic committee, U.S. Congress. Irvine, F. Owen, Jr. (1981) “Retail Inventory Cost of Capital”, Kondratief,
American
Economic
and the
A Multi-Sector
Econometrica.
Life”,’
Statistics.
Lovell, Michael C. (1962) “Buffer-Stocks, Analysis
Sales Expectations of the Inventory
Lundberg, Eric (1937) Studies in the Theory Expansion, London: P. S. King and Sons. Metzler,
Lloyd
Cycles,”
Review.
N. D. (1935) “The Long Waves in Economic
Review of Economic Stability:
Investment
Joint
and
Cycle”,
(1941) “The Nature
Review of Economic
of Economic
and Stability
of Inventory
Statistics.
Slutsky, Eugen (1937) “The Summation
of Random
Causes as the
Source of Cyclical Processes,” Econometrica. Stanback, Thomas J. Jr. (1962) Postwar Cycles facturers’ nomic
Inventories,
Research.
New York:
National
in Manu-
Bureau
of Eco-
I 5 ( 1988)
Elsevier Science Publishers B.V., Amsterdam -
93-
IO0
93
Printed in Hungary
THE INVENTORY CYCLC IN THE UNITED STATES Michael C. Lovell Wesleyan University. Middletown.
Let me discuss the inventory cycle in the United States-the reversals in business conditions that repeatedly interrupt the expansionary path of the American economy.
I EVIDENCE
Tables I and II summarize the essential elements of the inventory cycle over the years since World War II. Recorded on tne left-hand column on Table I are the peak and through dates demarcating each downturn. Observe that while the downturns generally last about a year, they do vary considerably in length as well as intensity. While most recessions are over within a year, some have persisted for as long as sixteen months; the 1980 inventory slump lasted only six months. But the periods of expansion between successive downturns are not only longer than the contractions; they vary much more in length. Since World War II it has been relatively safe to predict that prosperity is just around the comer; the wider variations in the span of time from trough ‘. to peak mean that predicting the upper turning point is more difficult. Selecting the downturn phase of the business cycle as the focus of analysis invokes a time-unit-ofaccount that varies considerably in length. While this is appropriate for the study of the inventory cycle, for other purposes it might be better to use a decade time unit of account or focus on the fouryear term of presidential office. Indeed, presidents are fortunate if they escape having one or more inventory cycles christened in their name-there were Eisenhower, Nixon, Carter, Ford and Reagan
USA
inventory recessions. But it should be observed that the dating of the turning points is more of an imprecise art than exact science. A committee of distinguished scholars of the National Bureau of Economic Research is charged with the responsibility of identifying business cycle turning pointsthis can not be done with much confidence until well after the fact, and the dates are subject to substantial revision because additional evidence ,accumulates with the passage of time. let me warn in advance that it may be dangerous to read too much into the evidence on the tables because a minor shift of a few months in the turning-point dates might alter the magnitude of certain of the figures rather substantially.
II THE ESSENTIAL FEATURES OF THE DOWNTURN
Before focusing on the details, let us look at certain of the fundamental features of the inventory cycle. The first column of Table I shows that although each downturn is characterized by a reduction in GNP, some are more severe and some are quite mild. The recessions at the beginning and end of the decade of the 1960s were particularly mild; the more recent recessions involve a more substantial loss of output. Since the GNP data are corrected for the distoring effects of inflation, output being measured in dollars of 1972 purchasing power, the increase in magnitude is not to be attributed to inflation. It may be partially explained by the secular expansion of the economy-the trend level of total output grew three-fold over the period
94 TABLE
I
Contributions
of inventory
Turning
disinvestment
point date
Gross national
(Year & Quarter)
product (1)
Peak:
194834
497.9
Trough:
1949q4
490.8 -7.1
Change: Peak
:
Trough: Change:
1953-q2
628.3
1954q2
608.1 - 20.2
to postwar
(Non-res-
investment
(3)
738.4
Change: Peak
:
Trough: Change
196-4
I ,085.6
197O-q4
LO84.7 -.9
:
(8)
315.4
32.8
91.6
322.5
37.7
98.1
- 13.0
- 8.4
2.8
7.1
4.9
6.5
5.1 -4.1 -9.2
-9.9
737.7 - .7
(7)
26.9
- 18.6
l%lql
(6)
exports
24. I
-6.2
196o-q2
consumption
(5)
Net
goods JL services
51.9
669.9
:
consumption
(4)
Government
personal
43.5
688.5
:
Durable
Personal
7.7
195743
Peak
Resident
of 1972 dollars)
5.3 -
195832
Trough
in GNP (billions
investment
idential)
(2)
:
Change:
reversals
Fixed inv
Inventory
Trough:
Peak
cyclical
3.7
3.3 -4.1 - 7.4 7.0 1.4 - 5.6
9.7 7.4 -2.3
55.9
28.2
364.6
41.9
170.2
4.4
54.8 - I.1
29.0
366.2
41.4
155.6
6.7
.8
1.6
- .5
- 14.6
2.3
67.3
28.9
48.0
58.8
28.2 - .7
161.6 168.7
II.9 5.6
7.1
- 6.3
-8.5
415.2 414.7
44.5
-.5
-3.5
67.8
34. I
454. I
52.3
172.4
65.2
32.9 - 1.2
454.0 -.I
47.7 -4.6
179.4
6.8 10.4
7.0
3.6
-2.6 117.4
40.5
663.8
91.3
255.0
1.8
110.3 -7.1
44.5
673.9
84.8
4.0
IO. I
-6.5
251.0 -4.0
3.6 1.8
:
197-4
1,266.l
23.7
766.7
117.2
256.4
21.2
197-l
1.204.3
- 14.3
140.7 120.7
57.4
Trough:
39.4
763.3
106.5
263.0
32.1
-61.8
- 38.0
- 20.0
- 18.0
-3.4
- 10.7
6.6
10.9
1.496.4 1464.2
-.5
171.8
53.0
938.3
145.2
284.0
49.8
- IO.1
163.6
284.0
53.4
-9.6
-8.2
929.4 -8.9
135.6
- 32.2
44.0 - 9.0
17.5
178.2
42.8
955.7
- 6.4
163.9 - 14.3
36.8 - 6.0
964.2 8.5
143.5 139.3
Peak
Change: Peak
:
Trough
l98O-ql
:
198O-q3
Change: Peak
:
Trough: Change: Definitions Market produced
1.522.1 1,477.l
198143 1982-q3
-45.0
- 23.9
of variables: value (using
4 Residential 1972 prices) of all goods and services
by the economy
Inventory investment Fixed investment, gross private
non-residential
covered by the table. In terms of the shortfall in output as a percentage of previous peak GNP, the “Gerald Ford” (or OPEC?) recession of 1974-75 was clearly the most severe that the US economy has experienced over the years since World War II. Part of the social costs of inventory recessions is revealed by the data on the unemployment rate reported in the first column of Table II. Unemployment rises in each inventory recession. The unemployment rise was most substantial in the 1949 slump; the 197475 recession takes second place.
investment,
-9.6
-4.2
287.4 292.8 5.4
3.6 40.6 25.7 - 14.9
gross private
5 Personal
consumption
6 Durable
good consumption
7 Government 8 Net exports
.O
expenditure expenditure
purchases of goods and services of goods and services
The unemployment rate is a useful social indicator of economic malaise--rising unemployment is generally accompanied by an upswing in such indicators of social malignancy as the proportion of the population living in poverty, in the incidence of malnutrition and the suicide rate. It should also be noted that the decline in GNP reported on the table understates the output foregone in each recession. To illustrate, the drop l>f $45 billion for the most recent downturn, while constituting a decline of only 2.1% from the previous
95 TABLE
II
Some salient features
of inventory
Turning point date (year&quarter)
cycles
Unemployment rate
Price level
(1) Peak
:
Trough: Change: Peak : Trough:
:
Trough
:
:
Trough Change:
:
Peak : Trough:
:
Trough: Change:
(5)
(6)
deficit (billions)
(7)
(8)
- 1.7
I.1
15.3
47.5
2,321
3.3
.O 1.7
1.0 -.I
15.9
48.4
4.1
23.4 - .4
.6
.9
2,251 -70
-4.1 - 7.4
195-2
2.9
25.9
.O
2.1
24.3
- 6.3
5.9
26.3 .4
1.5 1.5
.8 - 1.3
28.7 4.4
57.6 58.1
2,520
1954q2
2,453 -67
-6.7 - .4
45.8 42.3
1957-q3
4.1
29.2
4.2
3.4
1958q2
7.4
29.6
1.4
1.1
3.3
.4
-2.8
-2.3
-3.5
.5 62.3
2,666 2,617
63.7
1.4
2.8 -11.8
-49
- 14.6
196O-q2
5.2
30.9
.O
3.2
55.7
67.5
2,722
1961-ql
6.9 1.7
31.0 .I
.O
2.4
62.2 6.4
68.1 .6
2,703
-4.3
-19
-8.5
196944 197wl4
3.5 5.9
40.6
5.1
7.7
91.1
87.8
4.8
5.3
84.3
89.2
3,600 3,669
4.3 - 20.4
-.3
- 24.7
.O
-.8
4.2
2.4
42.7 2.1
1.4
69
1973-q4
4.8
51.2
10.0
7.9
102.0
98.8
4,106
1975-ql
8.6
57.7
5.5 - 2.3
83.8
3,928 - 178
-45.2
-2.4
-6.8
- 1.8
3.8
6.5
10.3 .3
- 18.3
93.8 -5.0
1980-q]
6.3
82.7
8.7
12.0
110.9
99.4
4,524
- 37.8
198-3
7.8
86.5
9.3
8.1
119.8
99.2
4,469
1.5
3.8
.6
-.2
-55
- 75.0 - 37.2
Change: Peak
(4)
Govern
23.8
Change: Peak
(3)
Real income per capita
7.9
Change: Peak : Trough:
rate
Labor productivity
3.8
Change: Peak
rate
S&P 500 (stocks)
1949-q4
3.0
:
TBill
1948-q4
Change: Peak : Trough
(2)
Inflation
-3.9
9.0
-47.0
1981-q3
7.2
94.9
9.4
14.7
129.1
101.3
4,593
-62.5
198243
10.7
100.8
5.8
8.0
138.1
loo.3
4,548
- 158.8
3.5
5.9
- 3.6
- 1.0
-45
- 96.3
Definition of variables: 1 Percentage of the civilian labor force, 16 years and over, that is unemployed 2 Implicit
price deflator
3 Annual 4 Interest
percentage change in the GNP implicit rate on three month Treasury Bills
for gross national
product,
1982= 100 price deflator
GNP peak, understates the output lost in each recession. Similarly, the $61.8 billion decline in the 1973374 recession, a drop of 4.8% from the previous peak, does not fully reveal how much output was sacrificed because full-employment was not sustained. Because of the secular expansionary forces of population and productivity growth, potential output is higher at the end than at the beginning of each recession. The rise in unemployment understates the serious-
-6.7
9.0
5 SBrP 500 common stock price index, 1941-43= IO 6 Output per hour, all persons, business sector, 1977 = 100 7 Disposable
(after tax) personal
income
per capita
8 Federal government receipts less expenditures, All data taken from the CITIBASE data tape.
(1972 = 100)
current
dollars
ness of each inventory recession. When unemployment increased from 7.2% to a post World War II peak of 10.7% in the Reagan recession of 1981-82, the loss in output was more than proportional to the 3.5% increase in the unemployment rate-Okun’s Law (named for the late Arthur Okun, who served as Chairman of President Johnson’s Council of Economic Advisors) suggests that the percentage shortfall in GNP resulting from a recession involves a loss in output on the order of two or three times the
96 rise in unemployment-this translates into a drop in output of between 7% and 10% for the Reagan recession. Much of the two or three fold Okun’s Law magnification factor comes about because firms are unwilling to shed labor in proportion to the reduction in output in part because of the continued need for supervisory personnel, maintenance workers, and so forth and in part because of the desire to retain workers with considerable on the job training rather than incur the costs of screening, hiring, and training new workers when prosperity returns. In addition, the discouraged worker effect helps to explain why output declines by more than the rise in unemployment-when workers become so discouraged that they give up the search for work and leave the labor-force they are no longer counted among the unemployed. Once Okun’s law is applied it becomes clear that the cyclical reversals that repeatedly interrupt the secular expansion of the American economy involve a serious sacrifice of potential output.
III A CLOSER
LOOK
Let us look more closely at the GNP accounting evidence recorded on Table I. In interpreting the table it is important to keep in mind the fundamental GNP accounting identity: GNP is the sum of Investment plus Consumption plus Government spending on goods and services plus the excess of Exports over Imports : GNP = I+C+G+X-M
(1)
As applied to the table, this accounting identity means that for each time period (e.g. row 1948q4) the entry in column (1) is the sum of the entries for Inventory Investment in column (2), Fixed NonResidential Investment in column (3), Residential Investment in column (4), Personal Consumption in column (5), Government Spending on Goods and Services in column (7) and Net Exports (X- M) in column (8); column (6) is a component of (5). Since this identify holds for each peak and trough year, it must also hold for each recessionary downturn of GNP as recorded in the Change row-in each recession the decline in GNP is partitioned into its
components by the entries to the right on the same row (again excluding column 6). This GNP accounting identity helps make clear why the postwar cyclical reversals in the pace of economic activity that have marred the expansionary path of the American economy deserve to be called “inventory recessions”. As a rule, the decline in inventory investment in each recession is larger than the decline of any other component of total spending. To take but one example, inventory investment at $17.5 billion at the 1981 peak was only about 10% as large as the fixed non-residential investment figure of $178.2. But while inventory was dwarfed by investment as a component of total demand, its dramatic swing to a negative $6.4 billion when manufacturers and distributors liquidated stocks in the recession meant that the decline in inventory investment totaled $23.9 billion. This compares with a decline of only $14.3 in investment in plant and equipment (non-residential fixed investment). The one recession since World War II that was not dominated by inventory disinvestment is the post Vietnam war recession of 1969-70. Let us look more closely at the longest expansion, from the first quarter 1961 through to the fourth quarter 1969. Before what was heralded while still underway as the “longest peacetime expansion in U.S. history” turned into the “Vietnam War boom”, the unprecedented expansion was frequently cited as evidence that macroeconomic science had advanced to the point where it was possible to tame the business cycle. And in the spirit of the times the Deparment of Commerce changed the title of its monthly chart book of economic indicators from Business Cycle Developments to the more neutral “Business Conditions Digest”.* That the claimed demise of the inventory cycle was premature is incontrovertibly demonstrated by the three post Vietnam recessions.
* My former colleague Martin Bronfenbrenner edited book of papers on economic fluctuations with the rhetorical title, Is rhe Business Cycle Obsolete?
97 IV HISTORICAL
ANTECEDENTS
How do the post World War II cycles compare with the prewar experience, analyzed so meticulously by Abramovitz [1950]? On one point the record is unambiguously clear. Relative to the 1930% the U.S. economy has done very well in recent years. In 1933 the unemployment rate had climbed to 25%-one fourth of those willing and looking for work could not find jobs. Many at the time viewed the Great Depression as the fundamental crisis of capitalism-some thought the revolution was at hand. It is clear that the coilapse from 1929 to I933 was quite different from any of the downturns we have so far experienced in the post World War II period. For one thing, in the Great Depression the collapse of confidence helped bring fixed private investment spending to a halt. In contrast, during inventory recessions fixed investment is subject to only moderate declines, as can be seen from Table I; by helping to sustain effective demand, the persistence of fixed investment in inventory cycles helps save the economy from more fundamental decline. Some business analysts worry that the crisis of the 1930s arose as a result of the Kondratief Cyclethese Cassandras warn that we may be ripe for another Kondratief downturn. I doubt that there is much in the post World War II story that would surprise R. G. Hawtrey [1928], John Maynard Keynes, Eric Lundberg [1937], Joseph Schumpeter and other scholars who were writing in the 1930s about the role of inventories in the business cycle. In broad outline, the post World War II recessions have not been all that different from earlier downturns, although they have been characterized by greater price stability. And a variety of structural shifts in the economy do not appear to have had much effect on the basic features of the cycle. It is safe to predict that when the next inventory recession gets under way at least one newspaper columnist will explain that the current cycle is different from its predecessors because of the spread of scientific techniques of inventory control, and/or the computer. The recent decline in the inventory/sales ratio is often cited as evidence of the fundamental significant of modern techniques of inventory control. But as can be seen from the
graph, when viewed over the entire period since Wortd War II, there has not been marked downward trend in the inventory/sales ratio. There have been major changes in the structure of the American economy over the last half century, but the rather remarkable thing is that they have not had more effect on the inventory cycle.
V CAUSES OF THE INVENTORY
CYCLE
The fact that wide swings in the rate of inventory accumulation and liquidation are a major feature of every inventory cycle does not mean that inventories must be regarded as the primary causal factor. The ambiguity in the concept of causation is illustrated by Aftalion’s famous rocking horse analogy: he explained the presence of recessions in capitalistic economies by comparing them to a rocking horse that moves to and fro when its master hits it with a stick. While it is obvious that the way in which the horse rocks in response to the blow will be influenced by the shape of the rockers, it is not clear whether it is correct to say that the horse’s protracted rocking is caused by the shape of the rockers or the blow from the stick. The inventory cycle mode1 developed by Lundberg [1937] and Metzler [1941] explains an inherent tendency for the capitalistic system to generate periods of booms and bust in terms of the efforts of entrepreneurs to preserve a desired ratio of inventory to output in the face of incomplete knowledge about future sales. The parameters of the model-the marginal propensity to consume, the desired inventory-output ratio, and the expectations coefficient-determine whether there is cyclical rather than monotonic movement, the periodicity of the cycle if one is generated, and the speed of convergence. These factors determine the shape of the rockers, so to speak, but a blow from the sticka shift in government spending or a change in the marginal propensity to consume is required to disturb the model from equilibrium and get the process of over-accumulation and’ expectational error underway. There is no shortage of alternative explanations of
98 T
P
T
I
3.2
2.6
2.4 1950 Fig. 1. Real inventory
1965
1955 sales ratio,
nonform
1970
1975
1
business
the cycle. The evidence on Table I is perfectly compatible with the monetarists’ argument that the cycle arises primarily as a response to the misguided if well-intentioned “Stop and Go” blunders made by central bankers in attempting to stabilize the economy-inventory investment can be regarded as a part of the response mechanism rather than the fundamental cause. But it is also said that some of the recessions, such as the 1969-70 downturn, should be called “Engineered Recessions” in that they were deliberately brought about as an unfortunate but unavoidable side effect of hefty doses of anti-inflationary medicine applied by the fiscal and monetary authorities who viewed the threat of protracted inflation as more serious than a transient rise in unemployment. And it is sometimes said that we have a “Political Business Cycle”, the timing of recessions being influenced by the President’s desire to apply the deflationary medicine early on in the administration in order that the economy will have recovered in advance of the next election-the Carter administration certainly cannot be accused of successfully manipulating the inventory cycle. But it is not necessary to argue that recessions are made in Washington, either by error or design. One might follow Eugen Slutsky, the great Soviet statistician, who argued that business cycles are caused by the summation of random causes-inventories are a part of the moving average structure, so to speak, rather than being one of the numerous small erratic shocks that are smoothed by the system into a quasicyclical path. The models of Lundberg and Metzler
explain the self-generating inventory cycle. It may well be that inventory cycles are inherent in the system, but with their timing, intensity and distinguishing characteristics tempered by the activities of policy makers.
VI LESSONS What have we learned about the cycle from recent experience? A wealth of additional evidence accumulates with the passage of each year, and the art of the empirical research has been greatly advanced by the development of improved estimation techniques, modern computers and data banks. Nevertheless, many of the issues that were recognized by economists writing on inventory cycles in the 1930s remain unresolved. There has been progress: Holt and Modigliani [1961] showed how both the flexible-accelerator buffer-stock inventory model and the productionsmoothing delayed adjustment mechanisms could be derived from the assumption of maximizing behaviour. And when I disaggregated the Lundberg-Metzler model of the inventory cycle into a multi-sector input-output model I found that.& delayed adjustment mechanism was required to generate a stable cycle for reasonable parameter values. On the empirical front, a number of investigators have found that the flexible accelerator model survives empirical test and replication on a wide range of observations over varying time frames
99
and in different countries without the introduction of speculative or interest rate effects. The evidence suggests that expectational errors play less of a role than is attributed to them by Lundberg and Metzler in their model of the inventory cycle. It is fair to say that the vast majority of empirical investigators tried to estimate the impact of interest rates on desired inventories-most of the attempts went unreported because they were unsuccessful (an unfortunate practice of applied econometrics is to neglect mention of failures). F. Owen Irvine, Jr. [1981] may have been more successful than anyone else in mustering evidence that monetary conditions influence inventory investment. But while there has been substantial progress, in terms of the acid test of policy effectiveness, I think it is safe to say that policy makers have not become more successful in recent decades at stabilizing the economy.
VII INVENTORY IN PERSPECTIVE
CYCLES
In conclusion, I wish to stress that while the inventory cycle is a serious phenomenon, there are three other problems that are ofgreater significance: First, there is the slowdown in the rate of growth in workers productivity that has been plaguing the U.S. economy, and indeed much of the industrialized world. Since 1973 output per worker has grown at an annual rate of about 1.14%, down from a previous 3.1% trend rate-a 2% drop in the rate of productivity growth may seem small, but it compounds out over the years to a shortfall in output of 24%; if we had sustained the higher rate of productivity growth, the same number of workers that we have on the job today would be producing 24% more output! Second, there is the profound problem of income inequality-by most measures there has been little or no movement toward income inequality in the recent decades: the most disadvantaged 20% of the United States population receives only 4.5% of total income; the 5% at the top of the economic pyramid commands 16% of the total. It is
generally recognized that the principle of progressive taxation has not been effectively implemented in the Federal Income Tax code-the flat-rate tax reform movement of 1986 recognized this reality in abandoning the pretext of redistribution. Thirdand perhaps foremost is the threat of secular inflation. We know how to control inflation, but with contractionary medicines-tight monetary and fiscal policy. High unemployment is the unfortunate side-effect. The only politically feasible technique for containing inflationary pressures is to maintain the unemployment rate at a “natural” or “full employment unemployment rate” (a.k.a. the “non-accelerating inflation unemployment rate of NAIRU) that is now estimated to be about 6% or 6.5%, substantially above the 4% interim unemployment target that was deemed appropriate by the most influential of leading American economists in the early 1960s. These problems are not unrelated to inventory investment. Thus, when the Central bank tightens up on the economy in an attempt to forestall inflation, the resulting movements in inventory investment are part of the process by which tight money contributes to the decline in effective demand, to rising unemployment, and a resulting reduction in wage pressure. And of course, more efficient management of inventories, an essential element of the “just-in-time-system”, will contribute to increased productivity growth. While inventories may not be of paramount concern, they are a part of the problem and an element of the solution.
REFERENCES
Abramovitz,
Moses (1950) Inventories and Business Cycles, New
York: National Bureau of Economic Research. Hawtrey, R. G. (1928) Trade and Credit, London:
Longmans,
Green & Co. Holt, Charles C. and Franc0 Modigliani (1961) “Firm Cost Structure and the Dynamic Responses of Inventories, Production,
Work
Force
and Orders
to Sali
Fluctuations”
in
100
Inventory
Fluctuations
and
Economic
Stabilization,
Economic committee, U.S. Congress. Irvine, F. Owen, Jr. (1981) “Retail Inventory Cost of Capital”, Kondratief,
American
Economic
and the
A Multi-Sector
Econometrica.
Life”,’
Statistics.
Lovell, Michael C. (1962) “Buffer-Stocks, Analysis
Sales Expectations of the Inventory
Lundberg, Eric (1937) Studies in the Theory Expansion, London: P. S. King and Sons. Metzler,
Lloyd
Cycles,”
Review.
N. D. (1935) “The Long Waves in Economic
Review of Economic Stability:
Investment
Joint
and
Cycle”,
(1941) “The Nature
Review of Economic
of Economic
and Stability
of Inventory
Statistics.
Slutsky, Eugen (1937) “The Summation
of Random
Causes as the
Source of Cyclical Processes,” Econometrica. Stanback, Thomas J. Jr. (1962) Postwar Cycles facturers’ nomic
Inventories,
Research.
New York:
National
in Manu-
Bureau
of Eco-