The mother of all inventory corrections is not the same as re-stocking

Submitted by Edward Harrison of Credit Writedowns

Back in April I told you I anticipated an uptick in GDP in part because of changes in inventories – massive change in the inventories. At the time, I thought I was going out on a limb by suggesting we could see positive GDP numbers in Q3 and Q4.  However, this is now the consensus. My calculations were not aggressive enough, if anything. The economy has definitely picked up considerably.

But, I am still worried about consumption growth because of the poor employment picture.  I could see a scenario where we have a relapse into recession because of weak consumer demand which fails to justify an increase in output or inventories. And we are definitely seeing output rise.

As a result, I have written about the present business cycle as the mother of all inventory corrections.  Erroneously, I suggested we were going to see a re-stocking of inventories. That’s overstating the case. What I meant to say was that inventories were being purged so much in the first half of the year that it would lead to GDP growth even in the absence of re-stocking. This is something I stated correctly in May.

Thinking about production as opposed to sales again, you have to look at inventories.  The NBER is not fooled by inventory builds because they look at both industrial production and retail sales.  But, since GDP is a pure production statistic, inventory builds distort the picture.  For example, say your economy produces $980 worth of stuff one quarter that gets sold. But it also sells a lot of stuff, $20 worth, out of inventory.  If next quarter, you need to sell just as much stuff ($1000), guess what, GDP growth goes up automatically (Remember, we are not talking about GDP, but GDP growth). The inventory purge means you are producing less to meet demand than you would otherwise need to. So, when comparing one quarter to the next, unless you purge just as much stuff or unless demand goes down, you need to produce more. Therefore, you get an automatic uptick in GDP growth.

This is what is happening now.  The positive impact that inventories is having on GDP growth has to do with the fact that GDP growth is a first derivative statistic where even subtracting a less negative number is positive.

Let me give you an example to illustrate.  Let’s say you are running a road race and you do a bunch of practice runs with a coach who docks you seconds for not keeping a consistent pace or having bad form.  After your first run, he docks you 35 seconds.  In the second run, you have the same time. But, you make a concerted effort to stick to your pace and form. So the coach docks you only 15 seconds. Your time is the same but you are now subtracting a less negative number. The net effect is a better time.  That’s what is happening with inventories.

So, after a massive inventory purge in Q1 and Q2, inventories are set to add to GDP growth in Q3 and Q4 regardless of whether inventories are restocked or not.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. Edwardo

    What appears “less bad” as a result of certain, shall we say, idiosyncratic calibrations of the sort you have described, has been, by hook and by crook, portrayed by the MSM as economic recovery. It would seem that such a conclusion is false.

    1. Edward Harrison Post author

      Edwardo, we are talking about a technical recovery ONLY here. In my opinion, a real recovery doesn’t happen until we are nearer to the level we reached before the recession began in Dec. 2007. That’s why 2010 will not feel like we’re going gangbusters even if we are out of recession.

  2. donna

    With some products, it’s possible to reduce production costs and then as the old inventory is sold, the new inventory is actually profitable. I think we’re seeing a lot of that here. For instance, hubby works for PS3, and the first gens were very expensive and sold at break even or a loss. Now, they have production costs down enough to profit on every unit even with the lower prices. So it becomes profitable instead of a loss. Other industries are undoubtedly doing the same, as they trim costs wherever possible.

  3. Jonathan

    Ed, I don’t often agree with you, but in this case, I’m seeing subjectively a very large pickup in the number of trains coming by.

    The railfax report is already showing some improvement, and I’d also expect to see port numbers improve further.

    Let’s hope that it’s not just consumers bouncing back, but also manufacturing!!

    best wishes,

  4. Vinny G.

    Good illustrations.
    I think Christmas sales are likely to be the wake up call and the canary in the coal mine that we are in a depression and things just won’t return to “normal” anytime soon, if ever. This country has just too many problems to fix with a stimulus plan or two.

    Vinny G.

  5. run75441


    Sounds like you have yourself the old “catch-22.” Gotta reduce that inventory so the companies can place orders and get manufacturing going, correction place orders to China and Asia manufacturing and get some new inventory and get their labor back to work. Wait a minute, what do we do with the hundreds of thousands of US Labor who are on the sidlines out of work and buy the stuff that is manufactured in China? Your equation only has meaning if it impacts US Labor. If US Labor does not go back to work, there will be no increase in demand.

    W$ has picked up considerably while the rest of the nation is still in bed sick from W$’s flu. Have you looked carefully at those BLS numbers and seen who has been hit the hardest? Those under workers who are male, those workers who are under 20 years of age, those workers who are uneducated, those minorities who found a higher standard of living through working in manufacturing, thosee college educated who would support the manufacturing process, etc. These are some sizeable numbers and are “probably” in the millions today.

    If US manufacturing/production has learned anything from the last decade, it is not to over build and to make it up in overtime as DIRECT LABOR is the cheaper of the three costs of manufacturing (Labor, Overhead, Materials). I suspect they probably have not learned how to build to pull-demand yet and will continue along the push-demand cycle of manufacturing/production. I hope they do not build up inventory in Q3 & Q4. If demand develops, they can call more people back to work then.

  6. zinc


    You seem to be addressing the economy in a manner that relates to the prices of stock. There really is no correlation. The stock market is a different animal, all together. The current value of the “stock” market is determined as one would buy a used car. How much would you pay for the stock of companies ?

  7. K Ackermann

    The market has strong growth priced in. The level of growth that it has priced in is not yet in evidence.

    When looking for where the growth will come from, it is not irrational to conclude the expected growth may be suspect.

    ZIRP pushes money into the market, but at some point the market is overbought, and maybe strongly so, and that can make investors quick to pull the trigger en masse.

    With high unemployment, contracting credit (and unwillingness to take on debt), and with a large amount of activity being conducted with government backing or stimulus, a big move down in the markets could have a nasty psychological impact.

    It could cause companies to dig in for the long haul, and cause a further spike in unemployment. I don’t know where that point is, but there is a point where deflation becomes a cyclical process.

    Many, many indicators in this recession were the same magnitude as during the Great Depression. The Great Depression was not a 2-year event.

    Hopefully we will pop right out, and if anyone knows where growth will come from, please let me know.

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