‘V-shaped’ recovery?

Paul Krugman thinks there is little chance of a vigorous (‘V-shaped’) recovery. There are arguments to counter this, and they have to do with supply-chains and inventories, as Krugman doesn’t seem to be completely abreast of the latest macro-economic effects of logistics and changes in supply chains…

First, you can read Krugman’s assessment of a possible recovery here. In April, he was a bit more specific on how at least a temporary recovery might be brought about, because of an “inventories bounce:”

  • When demand drops, inventories build up, then production drops sharply as businesses work off the overhang. Finally, there’s an “inventory bounce” when the overhang is gone. But the bounce doesn’t necessarily presage a true recovery. To get that, you need increased sales to final buyers.

He actually argued the same thing in 2002, and turned out to be right.

However, inventory behaviour have a lot to do with supply-chains, how these are organized and managed. This played a big part in discussions about the so called ‘new economy.’ New technologies (supply chain software) and practices (‘just-in-time’ production) were supposed to reduce inventories and hence the importance of inventory corrections, both on the upside and on the downside, smoothing the business cycle (reinforced by the increasing importance of services, which cannot be produced for inventory at all).

Now, logistical experts have noted the following:

  • Logistical chains have lengthened considerably due to increasing specialisation (‘core competencies’) outsourcing and globalisation
  • These developments have increased, rather than reduced the need for inventories (especially because of globalisation, as this quite increases order lead-times)
  • There exists a ratchet effect in supply chains, these are cumulative upstream (as any intermediary producer not only wants to reduce his inventories, but is also confronted with the consequences of inventory reductions to the parties he sells to)
  • The further away from end markets, the more pronounced these inventory correction become, so the lengthening of supply chains lead to a more pronounced the effects upstream (in basic materials etc.)
  • The credit crisis has made cash king, so companies did indeed desire for lower inventories, irrespective whether the end-markets were contracting or not.

Since it seems that there was only a pronounced decrease in end-market demand in the car and housing markets, the possibility is open that the sharp recession was at least in part brought about by reducing inventories and the magnifying effects this had in the earlier stages of supply chains.

Equally, when that inventory correction has worked itself through the system (it usually doesn’t take long to do that), we might actually see that sharp V shaped upturn, which will be accompanied by an upturn in credit demand and demand for services.

If this magnified inventory cycle coincides with the bottoming of the car and/or housing markets, we could be on for something surprising…