Businomics Blog

Economic Volatility: Expect More Business Cycles Than You Are Used To

I'm currently forecasting greater cyclicality in the economy than most people are used to. That's not an out-on-a-limb forecast, because we are just coming off the calmest period in American economic history. It may not have seemed calm at the time, but the era from 1983 through 2007 was indeed the least volatile on record.

Here's one measure of volatility. I look at a 20-quarter rolling standard deviation of changes in real gross domestic product.  That means that for every quarter, I calculate the standard deviation of the quarterly change in the economy over the most recent five years (20 quarters). Here's the picture:

Here's another way of thinking about it. Go back to December 1982 and imagine a business leader with 25 years of experience. That executive had managed through five recessions. Now fast forward to December 2007 and imagine the next generation business leader. In that person's 25 years of experience, he or she had managed through only two recessions--and those were two of the mildest recessions on record.

We only have official quarterly data since 1947, but with annual data we can go back to the 1890s:

So it's an easy forecast to say that the extremely low volatility we have recently experience won't last. But I actually have solid reasons, based on recent monetary policy. I'll address those in a later lecture.

The 1983-2007 era has been called by economists "The Great Moderation," and we've laid out several possible reasons for this benign era. Here are my favorite explanations:

1. Better monetary policy: the Fed chose a low-inflation policy, which reduced our tendency to have periodic anti-inflation recessions.
2. A shift of production toward services, which don't have inventory swings.
3. Better technology, allowing those companies that do carry inventory to avoid many of the large purchasing swings of past business cycles.
4. Globalization spread fluctuations more evenly
5. Good luck.

I think that much of the cause of the great moderation, reasons 2, 3 and 4, will continue. Eventually reason number 1, monetary policy, will get back to normal. For the next five to ten years, though, I expect monetary policy to add sharp fluctuations to the economy. I'll elaborate on that in my next post. We are not going to go back to the high cyclicality of the pre-World War II era, but neither will we be able to stay in the super-calm period.

Business leaders should understand that systems that were optimized for the 1983-2007 era are no longer in optimal condition. What you did in the past was fine, for the past. But what you do in the future has to be different. I'll talk about that, also, in future posts.

Economic Volatility: What I Told the Governor

Governor Kulongoski met with his Council of Economic Advisers last week. Here's what I told him:

1. The economy is becoming more volatile. The period 1983-2007 was the calmest ever in American history, in terms of macroeconomic fluctuations. This was also the period of time when today's leaders in business, government and non-profits learned how to be leaders. (I'll elaborate on my forecast of greater volatility in the coming decade in a future post.)

2. State revenues are inherently hard to forecast. Fluctuations are driven by corporate profits, proprietors' profits, capital gains, and sales people's commissions, much more than by total employment of salaried employees.

3. I advise business clients to tighten up the time lag between changes in underlying sales an the business reaction to increasing volatility. Companies should pay more attention to their sales pipelines, watch inventories carefully, etc. However, the Oregon legislature, like many other states, will begin debating in January 2011  a budget for the July 2011 - June 2013 period. That's a very long way into an uncertain future. Perhaps the state should budget based on the pessimistic forecast from the state economist, with some "if-funds-available" add-ons to be implemented over the course of the biennium.

4. In a more cyclical environment, businesses should run with more margin for error, meaning less leverage and more working capital. The state policy equivalent is to re-build up its rainy day fund as fast a possible.

Double Dip Recession? Merle Hazard's Take

I'm not a double dipper, but I won't deny the possibility. We have very little margin for error right now, so an external shock, such as a European recession, would probably send us into a second dip. The Business Planning Implication is to do some contingency planning.

Here's Merle Hazard's take on the double dip:

Good Book on Manufacturing Management: The Goal

The lessons of Eliyahu Goldratt's The Goal are broader than manufacturing management, but that's the context for the lessons. The book is fairly old, first published in 1984, and I'm not sure how I missed it. It's a very good read. The book is actually a novel, though shelved in the Business Management section of most bookstores. And in fact, it's got a clear business lesson. The author has used the fiction format effectively, though. He poses a problem for the protagonist, gives a little information, and invites the reader to solve the problem. Gradually, we see the point, and much more effectively than if we were presented with bullet points and diagrams.

The Goal introduced the world to Goldratt's Theory of Constraints. Here's the simple version: imagine a factory. Every factory has a bottleneck that limits production. Think of the bottleneck as a machine, though it could be any process, such as packing the finished product in shipping boxes. The value of operating the bottleneck is equal to its production rate (X widgets per hour) times the value of the final product (NOT the value of the widget produced by the bottleneck).

Example: you are making a $1000 electronic product. Each product needs an on-off switch, which you manufacture. If your switch machine is the bottleneck, then the value of each switch produced is $1000!It is the switch that enables the sale of the final product. With this insight, two operating practices are derived: 1) resources to support the bottleneck are tremendously valuable. For instance, adding a worker to ensure that the switch machine never lacks raw materials is worthwhile, given the high value of its output. 2) resources used in non-bottleneck processes are value-less, at least at the margin. Making another power supply does not add to your ability to sell another product, if the limiting factor is the on-off switch.

This all makes sense to me, who is definitely not a manufacturing guy, but it apparently flies in the face of some cost accounting practices commonly used in manufacturing.

Overall, it's a worthwhile read, with applicability to many other businesses.

A Man of Principle and Work: Dick Wendt

Dick Wendt, the founder of Jeld-Wen, passed away recently.

Back in 1996 I sat in Dick's office turning down a job offer.  He wanted me to go to work full time on  public policy issues. He emphasized how much good could be done for people through public policy changes. I looked out the window of his office and across the street to Jeld-Wen's large Klamath Falls plant, and remarked that a tremendous  amount of good was being done through providing people with quality doors and windows. I was trying to explain to a great capitalist the value of - - - capitalism!

Dick founded Jeld-Wen just a few years out of college, taking over the assets of a closed saw mill.  He spent 8 hours with his workers, and another 8 hours by himself doing set-up and maintenance so that his people would be as productive as possible.  The company grew to 20,000 employees and $2 billion in annual sales (accoridng to outside estimates). Dick appeared on the Forbes 400 list a few times, which embarrassed him greatly. On one of my visits to Klamath Falls, Dick drove me to lunch in an old Jeep Wagoner with a small dent in the front fender.

After building his company, Dick put a great deal of energy into public policy reforms that encouraged work and self-sufficiency. He sponsored Oregon's landmark welfare reform program. The value of that reform was told to me by a woman who had been on welfare. When she heard that I was a consultant to Dick Wendt, she grabbed my arm and said, "Tell him that he saved my life!" I looked surprised, so she explained that on welfare she had sat around watching television, embarrassed to have her son see her doing nothing, but with no idea how to change her circumstances. On her first visit to the welfare office after reform, she was told that she would have to find work. Her future was to be self-sufficient, whether she wanted that or not.  However, she was also offered help: workforce readiness assessment, child care services, training, job interview practice, and so forth. She found work fairly quickly, was soon promoted, and came home proud to support her son and her self. None of that would have happened but for Dick Wendt's commitment to helping people find work and self-sufficiency.

Although I declined his job offer, I became a consultant to Jeld-Wen and learned a great deal from Dick.  One lesson I'm about to share with an audience of industrial equipment manufacturers. An invoice for my consulting services had been lost at Jeld-Wen, while later invoices had been paid, so it took a bit of time with an adminsitrative assistant to sort out what I was owed. She told me that she would forward the paperwork to accounts payable and that I'd have a check in a week or so. By coincidence, I had a meeting with Dick the next morning.  As we walked into his office, he mentioned the late payment and said that he could have his treasurer cut a check that day if I needed it.  He mentioned that Christmas was in two weeks.  I told him that I could wait, but marveled that the CEO of a huge company was taking a personal interest in a late payment.  Later, another Jeld-Wen officer explained that Dick believed that prompt payment to vendors led to loyalty, and that the company benefited during times of tight supplies.  Dick would be a very hard bargainer on price, but always pay on time.

My hope for America is that there are a few young men and women just starting out who will combine  solid principles with a tremendous work ethic and duplicate the business success and philanthropic success of Dick Wendt.

Incentive Systems Can Be Counterproductive

I've written about incentive systems before, and about a closely related topic, feedback systems within organizations. I just heard  cute story about an incentive system that back-fired.

A youth soccer coach wanted his team to score more goals, so he got a bunch of silver dollars, and offered his team members a silver dollar for each goal he scored.  The less ambitious girls played as before, but those more in tune with the new incentive modified their play: they stopped passing to their teammates, preferring to try to dribble to the goal on their own.  A couple of the most aggressive and most talented players took to stealing the ball from their teammates so that they could try to score.

Could this happen is modern corporation?  I've seen sales representatives incented on volume, not profit.  They wanted to negotiate price cuts for most every customer.

I've seen business unit managers incented on profit margin.  They turned away opportunities to increase total profits when those opportunities would have lowered the average margin.  (Example: you have sold $1000 worth of stuff, with expenses running $900, for a 10% profit margin.)  You have the opportunity to sell another $100 worth of stuff, at an  expense of $95.  That additional sale has a profit margin of only 5%, so the manager declines it.  However, he's giving up an additional $5 of profit just to make his ratio look good.)

General rule: be very careful in designing an incentive system.  Assume that your people (especially your sales reps) will game the system.  As a general rule, measure and incent what you really want.  If you want profit, don't incent volume.

Bank Examiners Are Stifling Commercial Credit

My commentary on this topic was published in the Oregonian under the headline, "Small-business loans: When regulators go overboard, credit is choked off."

The New Fed Policy: Better Than Nothing

The Fed's decision today was mildly good news in terms of

1. the Fed's understanding of the sluggishness of the economy, and
2. the small change in policy.

For those of  you into original sources, here is the Fed's statement

The economy is certainly growing, but not fast enough to make up much of the ground lost in the recession.  We are still at least six percentage points below our potential, so the risk of going overboard on monetary stimulus is slight. The good news: the Fed is starting to understand this.

The second good news is that the Fed will stop allowing their credit to the public to contract.  Background: the Fed bought a ton of mortgage-backed securities to help that market, and the portfolio is slowly running off.  The change: the Fed will take the income and payoffs from that portfolio and use it to buy new Treasury securities, so their total impact on the economy will be unchanged.  You can see how the run-off was contracting their total credit:

Yes, you have to look closely to see the run-off.  In other words, this is a very, very minor adjustment.

It's a move in the right direction, but nearly enough to get this malaise over.

Passion In Your Business: Enthusiasm Breeds Success

The highlight of my current trip to New York is . . . Scott's Pizza Tour. Huh?  A pizza tour?  In the city of great museums, great theater, great music, great history, the highlight is a tour of pizzerias (and one restaurant supply store)? I'm not even a big pizza nut.  But Scott Wiener's enthusiasm for pizza was awesome and contagious.  While walking through Little Italy and Greenwich Village, we learned why some pizzas won't burn the roof of your mouth, how pizza originated, how it spread across America, and, well, another three hours of great information.  When we met Scott he asked us where we were from, then immediatley asked us if we had eaten at a certain pizzeria on our city.  He asked what else was good there, and why.  Every question brought out his child-like enthusiasm: "Great question!  You, see back in 1890, ..." and he would launch into a telling story.  He came prepared with a remote sensing oven thermometer (this oven is running at 700 degrees, but on a slow day may get up to 850), and plenty of visual aides, but without running through a dull PowerPoint presentation.

The lesson for business: enthusiasm is contagious.  I remember a presentation I heard at a fastener distributor convention.  It was about new performance standards for concrete anchor bolts. A real snoozer, right? Nope. The speaker really loved the topic, and he got the audience excited themselves.

Whatever you do, it's possible to find interesting information about history, applications, economics, colorful inventors, entrepreneurs and pioneers.  If you are not enthusiastic about your business, maybe it's time to retire.

Federal Debt & Fiscal Crisis: The CBO View

In a recent series of posts I commented on implication of the federal debt with respect to inflation, a debt crisis, and higher taxes.  Now the Congressional Budget Office has weighed in with an analysis of the risk of a debt crisis.  The key lesson that I had not mentioned: a debt crisis can sneak up and catch you by surprise.  A country may enjoy low interest rates when it goes to market with a new issue of bonds, then suddenly see appetite for the next series of bonds dry up.  It can happen in days, and then investors start dumping old bonds, further aggravating the crisis.

The CBO also emphasizes that debt crises most often occur during recessions, so fiscal austerity (cutting spending and raising taxes) comes at a difficult time.