Inventories and sluggish recession recoveries

Economics and Politics - Paul Krugman Blog - NYTimes.com: It’s now looking like a reasonable bet that growth will turn positive later this year, mainly because businesses will decide they’ve cut inventories enough, and ramp up production again. Many will herald this as the end of our problems. But they’ll be wrong, for reasons I laid out during an earlier false dawn, back in early 2002 (the unemployment rate continued to rise for more than a year after that point). I still think this was a pretty good explanation:

Imagine a company that produces widgets (companies in these examples always produce widgets), normally selling 100 each month. The company tries to keep one month’s sales, 100 widgets, in inventory. But for some reason sales drop off, to 90 per month. And it takes a month before the company realizes what has happened.

At the end of that month the company, having produced 100 widgets but sold only 90, finds itself with 110 in inventory, but wants to hold only 90. To eliminate the excess inventory quickly, it might slash production to 70 for the next month, then bump production back up to 90. But unless sales increase again, that’s where it ends: production never recovers to its original level.

As go the widget-makers, so goeth the economy. When demand drops, inventories build up, then production drops sharply as businesses work off the overhang. Finally, there’s an “inventory bounce” when the overhang is gone. But the bounce doesn’t necessarily presage a true recovery. To get that, you need increased sales to final buyers.