Viewpoint: Economic Recovery Through Supply Chain Reasoning
By Manmohan S. Sodhi and Chritopher S. Tang
With economic gloom spreading globally, governments are under pressure on many fronts: families want relief on mortgages in the United States, the auto industry wants help in western countries, and banks need more help despite questionable results thus far. The economy itself is a complex network that defies a clear starting point. How should governments develop and explain an integrated set of initiatives as they face a growing number of demands? Businesses too have to make sense of the apparent potpourri of government initiatives.
We advocate approaching economic recovery from a supply chain perspective.
A Supply Chain of Sectors
Viewing the economy as a supply network of industry sectors harks back to the late 1940s when Wassily Leontief, a Nobel Laureate in Economics, proposed input-output modeling. Each sector receives flows from other sectors and transforms them into flows for other sectors. The well-being of any sector is connected to that of other sectors in this supply chain flow:
when demand for one sector falls, derived demand falls like dominoes for upstream nodes in the supply chain.
Consider the retail sector in the United States. In January 2009, Circuit City, the second largest consumer electronics retailer in the U.S., announced the closure of all 567 stores. This closure creates 18 million square feet of vacant retail space in an already faltering commercial real estate market. General Growth Properties, one of the largest owners of 200 shopping malls in the U.S., issued a warning in January 2009 that it may seek bankruptcy court protection due to problematic debt payments and carried out the filing in April. The closing of Circuit City alone has caused a reduction in 5 percent to 10 percent advertising revenue for certain newspapers. As a result, many newspapers are cutting back on their news coverage, which causes the readership to decline. Newsstand sales of single-copy magazines such as Sports Illustrated and Cosmopolitan in the U.S. had already fallen 11 percent in the second half of 2008 from a year earlier so the drop in advertising revenue may push various newspaper and magazine companies over the edge to bankruptcy. On Feb. 23, 2009, the Wall Street Journal reported the weekend bankruptcy filings of Philadelphia’s two major newspapers and Journal Register Co., publisher of the New Haven Register and 19 other dailies. Finally, there is significant loss in account receivables for struggling vendors who supply goods to failed stores.
Consider also that to help the auto industry, the U.S. government is helping out the entire supply chain. On Dec. 19, 2008, the Bush administration announced a short-term loan of $13.4 billion to General Motors to tide it over for a few months. GM then asked the U.S. government to bail out its finance arm, GMAC, and on Dec. 29, 2008, the government approved a short-term loan of $5 billion. On Feb. 4 of this year, 400 auto suppliers, including the giant auto suppliers American Axle and Visteon Corp, asked for $25.5 billion of federal aid because of cash flow problems caused by the delayed payments from the U.S. automakers and asked the government to ensure that payment terms are 10 days rather than the usual 55+ days. Car dealers are also considering requesting federal aid to stay afloat. In late January 2009, two city governments in California approved loans to their local car dealers. Finally, on Feb. 4, the U.S. Senate voted for a tax deduction for sales tax and car loan interest for purchasing a new car under $49,500 between Nov. 12, 2008 and Dec. 31, 2009.
Although any supply chain is in reality an inter-connected network of enterprises without an obvious starting point, it helps to think about it in terms of demand, processing and supply. We can do likewise with the economy or any part of it. To revive the economy, any government should: 1) stimulate demand from consumers, exports and the public sector; 2) improve the economy’s processing including financial transactions; and 3) help improve supply by lowering the cost of inputs.
1. Stimulate demand.
To increase consumer demand, companies offer lower prices. Lowering the value-added-tax (VAT) from 17.5 percent to 15 percent in the United Kingdom amounted to a 2.1 percent price drop for most products and services. However, some retailers have simply maintained the post-VAT price, thus pocketing the reduction rather than passing it on to consumers. Lowering withheld taxes, as effective in the U.S. starting April 1 in accordance with the stimulus package passed in February 2009, also lowers prices as a percentage of disposable income.
Companies can generate new demand for products that are more attractive to end-customers than existing products. For example, U.K. supermarket Tesco’s has introduced discount brands to better fit the consumer’s recently revised budget. Some businesses have instead increased prices for existing products to compensate for fewer customers, suggesting a short-term outlook.
The government can support companies to meet future demand by supporting research into new technologies. Both the U.S. and U.K. governments have stated their interest in doing so. These governments can also help companies with retraining of employees in order to meet the changing demand. However, helping sectors continue making products whose underlying demand has fundamentally declined cannot improve economic flows.
As regards the government’s demand through public spending, an example is investing in infrastructure. Such investment may not “cost” much if these are projects that the government was going to do so anyway and is only bringing that investment forward.
Upgrading the electricity grid in the U.S. as part of a stimulus package is an example. Although public expenses go up, in the long run this may benefit the economy if the infrastructure is truly necessary.
Finally, governments can also seek to enable an increase in exports through export guarantees, especially for medium-sized companies. The U.K. government could extend the existing range of support services to U.K. businesses exporting to other countries through the Export Credits Guarantee Department (ECGD) and the U.K. Trade & Investment. Removing sanctions selectively on countries like Cuba or Iran, while controversial, can also help save jobs in the countries that maintain these sanctions.
2. Improve processing.
Based on size, the auto sector and the banking sectors are critical to the U.K. economy. However, from a productivity perspective, the ratio of outputs to inputs for these two sectors are lower than for other sectors in the U.K. such as sporting goods, toys, tobacco products and alcoholic beverages. Providing additional input and support to these two sectors then could generate far less output than if the aid were given to the other sectors. At the very least, the government should impose productivity improvement conditions in bailing out the banking and the auto industry.
In any supply chain, the availability of credit and cash is essential for transactions to take place. However, banks in both the U.S. and the U.K. have created roadblocks for transactions by providing neither credit guarantees for buyers nor adequate lending for working capital for sellers. In the U.K., despite government guarantees to small and medium enterprises to the tune of £1 billion, banks had barely lent 1 percent of that amount as of mid-February 2009.
To get credit flowing, governments may have to break banks up by asset types or to create new institutions altogether. The Royal Bank of Scotland, with the U.K. government as its majority owner, is separating out 20 percent of its assets, so-called toxic ones, this way. More needs to be done to reduce complexity and get credit flowing again regardless of whether large banks in the U.S. and U.K. are nationalized or not. While Prime Minister Gordon Brown has ruled out a “rigid divide” between retail and corporate deposits on one side and international investment banking and trading on the other, he has opened the possibility of the “reinvention of the traditional savings and mortgage bank in Britain.” Given the sizes of stimulus packages worldwide, creating new institutions like a World Bank for businesses could also be considered.
3. Improve supply, reduce input costs.
There is no shortage of supply given lackluster demand, but input costs could certainly be lower overall. Although prices of oil and many commodities are down, steel prices are beginning to go back up despite low demand from the auto sector. There is also the cost of labor. This is already getting lower, for instance, in the construction sector in the U.K. Governments in the developed world can lower wages, the argument being that a lower-paying job is better than a non-existent one – recall former CEO Lee Iacocca’s challenge to the unions to keep Chrysler alive. Countries like France could lower the cost of business by making it easier to hire and fire workers rather than stipulate aid to automakers on the basis of not laying off any workers. Moreover, there is the issue of unemployment benefits: if the difference between wages and unemployment benefits becomes too low, the labor pool may shrink. Thus, lowering wages is tied to lowering unemployment benefits.
Investment in infrastructure can help if it lowers the cost of doing business as part of the input prices. For instance, infrastructure development could help lower costs in countries like China and India; despite a bumper wheat crop this year, prices may not come down too much in India due to poor storage and transportation infrastructure. Indeed, China’s $586 billion package announced in November 2008 for housing, infrastructure and post-earthquake reconstruction over two years received warm support from equity markets. However, infrastructure spending may not help much in the United States or in France to reduce costs for businesses unless it is work already planned for the future that will be implemented earlier.
A key input for most businesses is the cost of financing, and governments can help reduce that as we discussed earlier.
Focus on Flow
Stimulating the economic flows along a supply chain without improving the final demand is worse than rearranging the chairs on the deck of the doomed Titanic – there is no benefit despite considerable investment. Some aspects of stimulus packages in western countries could lead to such a situation. For instance, governments could help auto companies make cars that do not find buyers. Banks taking money from the government to improve their balance sheets and to give themselves bonuses, contractual or not, without helping to get economic transactions going again are simply moving the money from government coffers to their own. Retailers who pocket the decrease in VAT-rate reduction in the U.K. similarly defeat the purpose of stimulating consumer demand.
Thus, governments need to look carefully at their plans to see if the benefits might just be one-offs rather than steady improvements to flow in the supply chain all the way from importers through manufacturers and retailers to household consumption or exports.
ManMohan S. Sodhi (M.Sodhi@city.ac.uk) heads the Operations Research group at the Cass Business School, City University London, London. Christopher S. Tang (email@example.com) is the Edward Carter Professor of Business Administration at the Anderson School of Business, UCLA, Los Angeles.