Monday, October 11, 2010

ISM September: Structural Rigidity in the Manufacturing Sectors.

In the blog category of a "Macro View of the Markets", I have been discussing structural rigidity. So when economists on the blogosphere started talking about structural concerns, that peaked my interest. Even Paul Krugman is getting into the fray with a blog post titled Structural Impediments. There he tries to create a simple dichotomy that the economy is either signified by a weak aggregate demand or that the only problem with the US economy is structural rigidity. In later posts he backs away from a strict either or, but still insists that increasing demand, with any means necessary, is the only way out of the present extremely weak market economy. This is how he sets up the analysis:
What he doesn’t say explicitly, although it’s clearly implied, is that these two theories have very different policy implications. If it’s aggregate demand, we should be doing everything we can to raise demand, including fiscal expansion and unconventional monetary policy. If it’s mishmash mismatch, we should do nothing, because any effort to create jobs leaves part of the work of depressions undone. {emphasis added}

But it should be clear that the two approaches are not mutually exclusive. Sector impediments by its very nature would lead itself to having discussions of the microeconomic effects of government at all levels. Laws and regulations should be considered in the context of whether they hinder the markets unduly. This still leaves room for aggregate demand stimulations including monetary and fiscal policy instruments. The US government could even include subsidies and direct support for sectors that it finds the economy having bottlenecks in.

Presently, the US already has an implied industrial policy with the Federal government focusing on renewable energy resources. The problem is whether this is the direction that the markets are creating or just the government is "picking winners" for the mean time but ultimately those industries fail in the long-run. There are plenty of white elephants that governments have supported. Cellulosic ethanol has been subsidized for over 30 years, but the US still has no substantial growth in this sector of the economy.

Paul Krugman: Spend, Spend, Spend like it's 1945.
Paul Krugman, at the opinion piece titled Structure of Excuses, provides his opinion about how to solve our present high levels of unemployment.
I’ve been looking at what self-proclaimed experts were saying about unemployment during the Great Depression; it was almost identical to what Very Serious People are saying now. Unemployment cannot be brought down rapidly, declared one 1935 analysis, because the work force is “unadaptable and untrained. It cannot respond to the opportunities which industry may offer.” A few years later, a large defense buildup finally provided a fiscal stimulus adequate to the economy’s needs — and suddenly industry was eager to employ those “unadaptable and untrained” workers.

But now, as then, powerful forces are ideologically opposed to the whole idea of government action on a sufficient scale to jump-start the economy. And that, fundamentally, is why claims that we face huge structural problems have been proliferating: they offer a reason to do nothing about the mass unemployment that is crippling our economy and our society.

So what you need to know is that there is no evidence whatsoever to back these claims. We aren’t suffering from a shortage of needed skills; we’re suffering from a lack of policy resolve. As I said, structural unemployment isn’t a real problem, it’s an excuse — a reason not to act on America’s problems at a time when action is desperately needed.

Krugman is using a logical fallacy by assuming that the economy of the 1930s is identical to what it is now. He could even be correct that the USA is in a "liquidity trap", but there clearly must be more than one answer to the questions facing the US presently.

The experts might have been right back then, especially concerning the constraints they were living under and thus the basis for their assumptions. It was only the declaration of war that allowed the political economy to have the will to make the radical structural adjustments. It is hard to believe that Krugman can not in fact recognize the major structural adjustments that go into changing from a peace time economy to a full fledged war economy. It is pretty obvious that putting 12.5 million men in uniform and increasing the female labor force by 6.5 million is a major structural change.

The question that Krugman should be asking is what is the role for government if each of respective models are believed. He rejects anything can be done if structural rigidity is the problem. But as above, this could mean an active industrial policy is needed, and especially with respect to training or retraining the work force for new jobs. If Krugman's scenario is correct, that the only way to exit this recession is to do something similar to what the US did during WWII, then we would need to make the necessary, structural {although temporary} adjustments. Some of the steps might include, taking workers out of the work force by violent means if necessary, having these workers produce nothing of real value to society, rationing consumption items, and thus having a forced high savings rate. Steps that would be antithetical to his major push for spending by all segments of the economy, even if it means higher debt levels.

Most of these discussions are centered on the labor markets. While it is true that this is of most vital concern especially since unemployment is staying at such high levels, but structural rigidity may be present in any market. One reason to consider all the other markets is that if the needed inputs for the "new economy" {undiscovered country} are in short supply or increasing in relative price terms then the jobs that would have been created become lost opportunities. Human capital is very important in a developed economy but it is not the only input. Human capital is much like any other input, there are many complementary inputs that are needed also for production. If any are in short supply or rising too fast in price then risk taking entrepreneurs or even corporations may not risk capital to increase output.

This discussion was a prelude to the prime purpose of this post, which was to look at the ISM report on manufacturing. That is to see if the report may show signs of this "structural rigidity".

Structural Rigidity and the September Manufacturing ISM Report.
The ISM manufacturing index for September was "still quite positive" at 54.4 percent. MarketWatch calendar reported their consensus at 54.0% and Econoday reported it as 54.5% with a range of 53 to 55.5%. Econoday gives a good summary of the report as follows:
New orders are decelerating, and perhaps abruptly, while inventories climb and hiring slows. The ISM's new orders index, in prior months having already showed signs of slowing, fell two full points to 51.1 to indicate only mild month-to-month growth. Inventories, which had already been going up, really spiked, up more than four points to 55.6. This will raise concern that a significant part of the inventory build is more and more unwanted. Employment, which had been very strong, fell nearly four points to 56.5.

Backlogs are another bad sign, falling five points and showing month-to-month contraction at 46.5. The headline composite of 54.4 is still solid but orders are now a central concern for the manufacturing outlook. This report may prove to be a negative for today's stock market.

If it was taken as negative news, then the report proved only to be headwinds as the Wall Street Journal noted that the ISM Report Keeps Leash on Dow. Steven Russolillo stated the reaction to the reports as "jittery" and some of the data points were showing weakness. Let's now look at these data points more closely.

The index with the largest percentage point change was the price index. It jumped a whopping 9 percentage points to 70.5%. This is not to say this is unfamiliar territory for the index, as it was over 70% for March, April and May of this year at 75, 78, and 77.5 respectively. Only 4% of firms are reporting lower prices and 45% reporting higher prices. On an industry wide basis, it is not much better with no industries reporting lower prices and 13 reporting higher prices.

Higher prices could definitely signal structural rigidity by preventing the free flow of resources to the most efficient uses. Price changes {especially suddenly} can alter the input factors of production, which in turn raises uncertainty in the markets. Just as in March, April and May, the higher price indexes were accompanied by more commodities up in price, with 13 more commodities added to the list, and more commodities in short supply, with 4 more added to the list. One respondent from the Food, Beverage and Tobacco Products industry stated that, "Commodities continue to be the main concern heading into 2011." It is one thing to have an inelastic supply curve for inputs but also facing shortages could lead to rigidity in changing output patterns.

The second most dramatic percentage change in the report was "backlog of orders" with a 5% decrease to 46.5%. The story looks like the manufacturing sector is overestimating the rate of growth in their respective markets. They are ready for increased levels of orders with the number of backlogs being lower and inventories building which increased 4.2% to 55.6%. They also believe that their customers have too low of inventory which dropped another percentage point to 42.5%. A respondent in the Transportation Equipment summed this up as, "Customers seem to be pulling back on orders."

The third most dramatic percentage change was "supplier deliveries" which just edged out the absolute percentage change of inventories with a 4.3% decrease to 52.3%. Not only are prices rising for the manufacturing industries and commodities are increasing in short supply, but the suppliers were slower in delivery to the manufacturing organizations.

Structural Rigidity conclusion.
All this spells out structural rigidity in the manufacturing sectors and very little to do with labor market rigidity. If it actually became a problem with labor, manufacturing could in fact use some of the H1B visas that were unfilled. One of the things government could in fact do is to reconsider the lists mentioned about before:
Commodities Up in Price
Aluminum; Caustic Soda (2); Copper (2); Corn; Corrugate; Corrugated Containers (7); Lubricants; Plastic Resins; Polyethylene; Polypropylene; Rubber Products; Stainless Steel; Stainless Steel Sheets; Steel*; Sugar; and Wheat.

Commodities in Short Supply
Capacitors (3); Cocoa Powder; Electronic Components; Lubricants; and Titanium Dioxide.

Some of the inputs constraints are in raw resources. China has busy trying to secure raw resources all over the world. It might be time for the US to consider opening up more resource development here. If the US wants high paying jobs here, then not many jobs pay as well as minerals and raw resource extractions for semi-skilled labor than those sectors.

Even if the US does not have a policy of "Drill, Baby, Drill", there could still be an industrial policy to address bottlenecks for the manufacturing sectors. Waiving our collective hands and dreaming that spending will solve all these problems, is not the solution. Good ideas should be the driving force in politics now and not some analogy about the R and D on a car stick shift.

September 2010 Non-Manufacturing ISM Report On Business®

Econoday Report: ISM Non-Mfg Index October 5, 2010

Consensus Consensus Range Actual
ISM Mfg Index - Level 54.5 53.0 to 55.5 54.4


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