by Mario Rizzo
The reader of newspapers may be confused about the newly published growth figures for the US economy. We are told that the growth rate for the fourth-quarter of 2009 was 5.7%. But when the inventory effect is taken into account it was only 2.3%. What is going on?
Consider a simpler case in which the inventories that firms hold are unchanged. Let’s us assume that firms intentionally leave them unchanged. They desire to continue the current level of inventories. At the same time, they produce 5% more stuff for the market (perhaps because they foresee a temporary increase in demand). Then real resources, including labor, must be used to accomplish this. Production has increased.
Now consider a case in which inventories intentionally rise by 2%. Firms produce more but do not sell the output but they are expecting to sell it later.
Put both cases together and the production of stuff will increase (roughly, if everything is proportional) by 7%.
But now imagine a world where inventories have been intentionally declining as firms use up existing production to sell, but are not confident enough in future demand to produce more real stuff. Now because of a change in expectations, these firms reduce the rate of decline in their inventories. But as a substitute for even more inventory decumulation, they produce more real stuff.
The first part (the slower rate of inventory decumulation) is a function of what firms expect future conditions to be. In itself, it involves no current increase in real stuff. Only the associated increase in output does. The latter part of the aggregate statistic is what most of the public is thinking about – increased output produced by using factors of production.
The other part (decreased rate of inventory decumulation — not inventory accumulation) is an expectational component. It is an artifact of the expectations of firms that future sales will be better than current sales. They could be wrong. Nevertheless, it is not about now, but, at best, about later – more exactly, the expected-later.
I am not saying that this component of the aggregate “growth” figure is meaningless. But it is not the same thing as, say, intentional inventory accumulation. Real stuff is not being produced now to the extent that inventories are falling, but at a lower rate.
There have been other historical cases where GDP growth had been dominated by changes in inventory decumulation followed by only weak growth. So the connection between reduced rates of inventory decumulation and future growth in real production is not automatic, by any means.
To summarize, these data are not brute facts. They are an aggregate of empirical observations collected on the basis of a theory of what these observations portend for the future.
Therefore, I prefer that the GDP growth without inventory change be the headline figure, with the currently-touted figure being the secondary or supplementary figure. The former is closer to what most of the public thinks the combined figure is.
More Technical Addendum: One of the complications in the analysis of inventory changes is the distinction between intentional and unintentional changes. Inventories could rise because firms believe that sales will soon rise and they want to be prepared (intentional). Or they could rise because sales are unexpectedly low and inventories pile up (unintentional).
Something similar is true for changes in the rate of decumulation. Suppose we are coming from a period in which firms intentionally allowed their inventories to fall because sales were falling. For a time, sales continued to fall and so inventories continued to fall at a particular rate. We can then imagine a later time when these firms believe that sales will fall, but at a lower rate. So then they intentionally allow their inventories to fall also at a lower rate.
In the current circumstances why would firms both let their inventories fall at a lower rate and increase their production of real stuff?
First, we are dealing right now with aggregate figures. Some firms may be letting their inventories decline at the lower rate but not increasing real output; some may be actually adding to inventories, not decumulating them.
However, one can imagine a firm both decumulating at a lower rate to satisfy current demand which is still not that great and raising production to satisfy expected future demand (that cannot satisfied by existing inventories alone).
If this lower decumulation is intentional that is because demand is expected to pick up relative to the declining trend of the previous months. Inventories are held in the expectation of a certain rate of sales.
Increased production of real stuff – using resources now – is also in anticipation of a certain (higher) rate of sales. There will be an effort to restore inventories to an appropriately higher level. This is the so-called inventory “bounce.” It is a temporary phenomenon.
(If, on the other hand, the lower decumulation is unintentional, it would be because the firms were confronted with demand falling more than they had expected. This does not seem plausible as a general phenomenon right now.)
The key questions are: (1) to what extent is the reduction in the rate of inventory decumulation based on overly optimistic expectations? If so, inventories will be higher than desired later; (2) to what extent might the increased production also be based on overly optimistic expectations? If so, this will also wind up increasing inventories later, unintentionally.
Such mistakes could be generated by uncertainty (“noise”) with regard to both fiscal and monetary policy or simply as a consequence of uncertainty. If either were the case, the factors constituting the fourth-quarter’s growth will be offset to the degree necessary, once the mistakes are realized, by decreased production of real stuff.
So we must stay tuned. But that is exactly my point. The “facts” are not what they may seem.