Join our community of smart investors

Back to the 70s

Sometimes, ideas can persist for years after their economic justification has vanished. For example, staff bonuses in finance were sensible in an era when partners in stockbrokers and merchant banks needed them to stabilise their incomes, but they became dangerous when they incentivised risk-taking. And fiscal austerity was defensible in an era of high interest rates, but is less so in a world of negative rates and a safe asset shortage.

The same might now to be true of companies’ attitudes to inventories. Supply disruptions caused by a lack of parts or difficulties in finding HGV drivers highlight the dangers of having low inventories.

But how did we get here? Part of the story is that from the 1980s onwards, information technology allowed firms to better control stocks, giving rise to just-in-time production. IT, however, was only an enabler. There were two economic forces behind the long-term fall in inventories.

One was reduced economic uncertainty. In the 1970s and 1980s companies needed big inventories so they could fulfil orders if they were hit by strikes or if they got some unexpected orders. As economies became less volatile and strike-prone, however, the need for precautionary stocks of parts or finished goods declined.

The other was high interest rates. A full warehouse often means an empty bank balance or a big overdraft. When interest rates are high, therefore, companies have a big reason to cut inventories in order to reduce expensive borrowing.

These two forces contributed to a long-term fall in companies’ stockholdings. ONS data suggest that in the 1970s total inventories of materials, parts and unsold goods were equivalent to over 10 months of GDP. By 2013, they had dropped to under four months. A similar trend occurred around the world. Back in the 1970s and 1980s, economists fretted about the inventory cycle because it was a big cause of macroeconomic fluctuations. In recent years, nobody has much bothered with it.

Until now. Although the drive to cut inventories was sensible years ago, it is now no longer so.

Thanks in part to Covid-induced production shutdowns last year, shortages of parts are holding up production: companies are unable to make and sell £30,000 cars, for example, for want of £400-worth of semiconductors. Lack of inventories, however, doesn’t just mean lost or delayed sales. It also adds to costs of production: if you cannot meet new orders from inventory you often need to retool production from order to order, adding to costs and delays.

The volatility and uncertainty created by the pandemic have therefore shown the dangers of keeping inventories low. It means being less resilient to variations in supply and demand, leading to shortages and higher costs and prices.

At the same time, the benefits of low inventories are lower now than they used to be. At negative real interest rates, the bigger bank balances resulting from low stocks are of less use than they were in the 1980s.

In truth, companies had begun to realise all this before the pandemic. In the UK and US, inventories were rising relative to sales from the early 2010s onwards. That’s just what we’d expect to see when interest rates were low and uncertainty higher.

The current shortages might well cause firms to resume that trend, when they are able. That would mean that output would grow faster than demand. It would also mean a trend away from relying upon the logistics industry, and towards suppliers of warehouse space. In this respect, we’re going back towards the 1970s.