Diane Coyle: Just-in-time decisions offer US a lifeline

The pause in American growth will be short-lived compared with past slowdowns
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The Independent Online

Will the American economy plunge into recession or not? It is one of those questions on which different pundits have equally strong but completely contradictory views. While experts always disagree and economic prospects are always uncertain, there are, however, intriguing reasons for finding it hard to predict the future in the New Economy.

Will the American economy plunge into recession or not? It is one of those questions on which different pundits have equally strong but completely contradictory views. While experts always disagree and economic prospects are always uncertain, there are, however, intriguing reasons for finding it hard to predict the future in the New Economy.

I lean firmly towards the view that the pause in US growth will be short-lived compared with past slowdowns, for two reasons. One is that the underlying improvement in productivity growth is genuine and has much further to run. American corporate managers are cautious about the current state of demand, but remain hugely upbeat about the long term. Paul O'Neill, the new Treasury Secretary, drew on his experience as an executive at Alcoa - hardly a company at the coalface of the New Economy - to argue that only 20 per cent or so of the potential productivity gains driven by adaptation to new technologies has yet been exploited.

The second is that one of the adjustments to new technologies has been just-in-time management. Over the past decade and a half businesses have reduced radically the level of inventories they hold as a proportion of total sales. Although the approach pre-dated the information technology revolution, it has been vastly extended by the use of cheap computers and telecommunications. The chart shows the extent of the fall in the inventory-sales ratio in the US.

This was a point emphasised by Alan Greenspan in his recent Congressional testimony. He noted that the ratio has climbed during the most recent quarters. "Inventory-sales ratios rose only moderately; but relative to the levels of these ratios implied by their downtrend over the past decade, the emerging imbalances appeared considerably larger... As a result a round of inventory rebalancing appears to be in progress," he said.

This would go a long way to explaining the sharp halt in US growth at the end of 2000. However, because the level of inventories held is now so much lower than in the past, the ability of this very volatile component of GDP to cause big swings in overall growth is more limited. An article in the American Economic Review* looked at variations in US growth since the early 1950s, confirming there has indeed been significantly less volatility since the early 1980s. What's more, the explanation for the reduced growth volatility is exactly the reduction in the proportion of output - especially of durable goods such as cars, machines, computers or other big-ticket consumer items - accounted for by inventories.

This means there are good grounds for being optimistic about the ability of the US economy to bounce back later this year. As the Fed chairman went on in his recent comments: "A couple of decades ago, inventory data would not have been available to most firms until weeks had elapsed, delaying a response and, hence, eventually requiring even deeper cuts in production." Companies' reactions now are swifter and therefore ultimately less drastic.

Consumers are probably also reacting faster to variations in the economic climate. One obvious mechanism is the importance of stock market wealth to US households, nearly half of which own shares. Lower corporate profits in the year ahead are transmitted very quickly to consumer spending decisions via lower share prices. Thanks also to the popularity of individual shareholding, consumers are very aware of business developments through the extensive media coverage of the stock market in the US.

In general, faster adjustment in the economy should be beneficial because it will not need to be as deep as a slower correction. However, as Mr Greenspan pointed out in his characteristically fascinating comments, there is one worry. If companies and individuals are responding rapidly to the same information, their decisions will be more closely aligned than in the past. "The result is not only a faster adjustment but one that is potentially more synchronised."

The danger, then, is the economic equivalent of the severe wobble in London's Millennium Bridge whenever the pedestrians crossing it marched too closely in step. Mr Greenspan explained: "While technology has quickened production adjustments, human nature remains unaltered. We respond to heightened change and its associated uncertainty in the same way we always have. We withdraw from action, postpone decisions and generally hunker down." In effect, a sudden retrenchment by many firms and many households responding to adverse economic signals can have a damaging and self-fulfilling effect on confidence and thus on investment and consumer spending.

So there is reason to feel slightly cautious about feeling cheerful about prospects for the American economy this year. But only slightly, for growth variations were four times higher from 1953-83 than from 1983-1999. There is now nearly two decades' worth of evidence that reduced inventory levels have had a genuinely benign effect on economic fluctuations.

* "Output Fluctuations in the United States: What Has Changed Since the Early 1980s?" by Margaret McConnell and Gabriel Perez-Quiros, American Economic Review, December 2000.

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