It's Not a Real Recovery

06/14/2010 1:30 pm EST

Focus: MARKETS

Gary Shilling

Columnist, Forbes

Gary Shilling, editor of INSIGHT, says the economic recovery is based primarily on inventory liquidation, not real growth in demand.

Historically, the liquidation of excess inventories accounts for major shares of the decline in economic activity in recessions. Around business-cycle peaks, the sales of manufacturers, wholesalers, and retailers begin to weaken, but their managers can’t tell whether that’s the beginning of a major drop in business or just a minor dip in an upward trend. So, they delay cutting production and orders until the downward trend is firmly established.

That appears to be the case in the Great Recession. The recession didn’t officially start until December 2007, [but] it wasn’t until late 2008 that the collapse in home equity as house prices nosedived, rising layoffs, and the drying up of consumer lending drove consumers into retrenchment. Consequently, the cuts in inventories to get rid of unwanted stocks were far and away the biggest in the post-World War II era.

Inventory liquidation is almost always the greatest at the bottoms of recessions. Then, as the rate of liquidation declines, the economy starts to recover even though inventories are still being reduced. At that point, more final sales are coming from increased production and less from inventory reduction.

The reduction in inventory liquidation has been key to economic growth starting in the second half of 2009. In the third quarter, it accounted for 32% of the 2.2% annual real [gross domestic product] gain and 68% of the fourth quarter’s 5.6% advance. The inventory building in the first quarter of this year was responsible for 55% of the 3% annual rate rise in real GDP.

Nevertheless, it’s one thing to complete the liquidation of unwanted inventories, but another to rebuild them significantly. The latter probably requires sales strength originating in other areas of the economy, and the other three cylinders of the economic engine aren’t providing it in meaningful ways, at least not yet.

In the second half of 2009 and first quarter of 2010, the unwinding of inventory liquidation accounted for 69% of the rise in industrial production. The economic revival through the end of 2009, then, was almost entirely due to the reversal in the inventory cycle directly and as the effects worked their way through the production system.

The modest pickup in consumer spending accounted for only 20% of the gains, and was only positive because of massive fiscal stimuli. The revival in equipment and software spending essentially was offset by weakness in nonresidential construction. Housing activity contributed almost nothing.

This analysis implies that much of the recent rise in domestic manufacturing and imports resulted from the effects of the inventory cycle working their way through the supply chain, not from a self-generating and self-sustaining pickup.

Furthermore, anecdotal evidence suggests that the strength in capital equipment spending is found in high tech and other areas that contribute to productivity enhancement and cost cutting, not to those that add to capacity.

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