Recessions tend to be caused by policy error or by bubbles that burst. The damage when a central bank makes a mistake is fairly obvious. If bubbles are allowed to build, an economy is likely to experience strong growth then a sharp downturn. These things will still happen in the future. It is hard to see a global recession happening in the coming year, but, at some point, there will be a downturn.
How bad a recession is, and how good a recovery is, is partly due to the inventory cycle. Companies hold inventory—stock in warehouses, in the back rooms of small shops, and on the shelves—to be able to satisfy customer demand. However, if demand falls then companies will cut back on stocks. As companies reduce the orders they give their suppliers so as to use up unsold stock, their suppliers will react by reducing their stocks. Thus the fall in demand moves up the supply chain. When a recovery comes, the reverse happens. Shops start to order from their suppliers to replace stock sold, plus a bit more in the hope of better future demand.
In the global financial crisis, around 70 percent of the loss of real US GDP was due to companies reducing stocks. Stocks or inventories make economic cycles more volatile—the economic highs are higher and the lows are lower because of stocks. It is also vital to note that most stock is held by small businesses. The large listed companies of the equity market hold, perhaps, 30 percent of the stocks in an economy.
There are three reasons stock control may be less volatile in the future.
The first reason is that stock has ceased to exist for some products. Ten years ago most music was bought in the real world, as compact discs. Shops had to hold stocks of unsold CDs in case there was future demand. Now most music is virtual—downloaded or streamed. Music sellers do not need to hold any stock at all. The uncertainties of the inventory cycle have largely disappeared from the music industry.
Second, the amount of cheap credit that was used to fund small businesses’ stock holdings was reduced a lot during the global financial crisis. Small companies had relied on their suppliers giving them a grace period to pay for goods bought—something known as invoice credit. Small companies could buy now, pay later. This made holding stocks almost costless. As soon as suppliers started wanting cash up front, the cost of holding stocks rose. Small businesses had a powerful reason to be more efficient.
Third, technology has changed company cost control in recent years. Managing stock is cheaper to do with barcodes and online ordering systems. Software allows small businesses to predict demand patterns with greater accuracy. All of this allows small businesses to manage their stock as efficiently as large businesses. Technology is also helping local production; goods are produced a lot closer to the consumer. An in-store, computer-controlled, robot-run bakery baking bread in a local village shop is a good example. Making things close to the shopper is almost “on demand” production, and on demand production requires little inventory.
If stocks are less volatile, recessions will still happen. Stocks or inventories do not cause recessions. However, recessions are likely to be less recessionary. Similarly, economic recoveries are likely to be less booming. With stock control becoming more efficient, the recessions of the future may be less dramatic than the recessions of the past.
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Paul Donovan is the managing director and deputy head of global economics of Zurich-headquartered UBS. He is responsible for formulating and presenting the UBS Investment Research global economic view, drawing on the bank’s worldwide resources. Donovan took up philosophy, politics and economics at Oxford University. He holds an MSc in financial economics from the University of London. In the Philippines his
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