The Cost of Recalls and Lost Goodwill

Posted by PITHOCRATES - April 7th, 2014

Economics 101

Manufacturers make a Point of not Killing their Customers because it’s just Bad for Business

There have been some costly recalls in the news lately.  From yoga pants that were see-through.  To cars with faulty ignition switches that can turn the engine off while driving.  Disabling the power steering and airbags.  Resulting in the loss of life.  These recalls have cost these companies a lot of trouble.  Including financial losses from the recalls and lawsuits.  Being called to testify before Congress.  And possible criminal charges.

No surprise, really.  As those who distrust corporations would say.  For they believe they constantly put their customers at risk to maximize their profits.  Even if it results in the death of their customers.  Which is why we need a vigilant government to keep these corporations honest.  So they can’t sell shoddy and dangerous goods that can kill their unsuspecting customers.  Which they will do if the government doesn’t have strong regulatory powers to stop them.  Or so says the left.

Of course, there is one problem with this line of thinking.  Dead customers can’t buy things.  And when word spreads that a corporation is killing their customers people don’t want to be their customers.  Because they don’t want to be killed.  Manufacturers know this.  And know the price they will pay if they kill their customers.  So manufacturers make a point of not killing their customers.  Because it’s just bad for business.

The Longer it takes to Recall a Defective Product the Greater the Company’s Losses

Manufacturing defects happen.  Because nothing is perfect.  And when they happen they are both costly and a public relations nightmare.  As no manufacturer wants to lose money.  And, worse, no manufacturer wants to lose the goodwill of their customers.  Because it’s not easy earning that back.  Which is why executive management wants to acknowledge and resolve these defects as soon as possible.  To limit their financial losses.  And limit the loss of their customers’ goodwill.

Let’s illustrate this with some numbers.  Let’s assume a company manufactures 5 product lines ranging from low price to high price.  The lowest priced product has the greatest unit sales.  And the lowest margin. The highest priced product has the fewest unit sales.  And the highest margin.  The other three items fall in between.  Rising in price.  And falling in margin.  Summarized here.

Cost of Recall - Gross Margin per Product Line R1

So each product line produces a sales revenue, a cost of sales and a gross margin (sales revenue less cost of sales).  Adding these departmentalized numbers together we can get total sales, cost of sales and gross margin.  And subtract from that overhead, interest expense and income taxes.  Summarized here.

Cost of Recall - Net Profit

So on approximately $5.8 million in sales this company earns $312,414.  A net profit of 5.4%.  Fictitiously, of course.  Not too bad.  That’s when everything is working well.  And they have nothing but satisfied customers.  But that’s not always the case.  Sometimes manufacturing defects happen.  Which can turn profits into losses quickly.  And the longer it takes to address the defects the greater those losses can be.

Losing the Goodwill of your Customers will end up Costing More than any Product Recall

Let’s say Product 3 suffers a manufacturing defect.  By the time they identify the defect and halt production of the defective product they’ve produced 20% of the total of that product for the year.  Which they must recall.  Limiting their losses to 20% of the total of that product run.  Which they will have to refund the sales revenue for.  But they will have to eat the cost of sales for those defective units.  And despite the company’s quick response to the defective product and providing a full refund to all customers their goodwill suffers from the bad press of the recall.  Summarized here.

Cost of Recall - Recall

Refunding customers for the 20% of the line that was defective reduced net profits from 5.4% to 0.7%.  And when they lose some customers to their defect-free competition they lose some customer goodwill.  Resulting in a 15% drop in sales.  Leaving manufactured product unsold that they have to sell with steep discounting.  Bringing their sales revenue further down while their cost of sales remains the same.  Turning that 0.7% annual profit into a 2.8% loss.  But as time passes they recover the lost goodwill of their customers.  Limiting these losses in this one year.  Now let’s look at what would probably happen if the company had a ‘screw you’ attitude to their customers.  Like many on the left fervently believe.  Summarized here.

Cost of Recall - Loss of Goodwill R1

The company did not recall any of the defective products.  As word spread that this company was selling a defective product sales of that product soon fell to nothing after selling about 50% of the annual production run.  The other half sits unsold.  Even steep discounting won’t sell a defective product.  And seeing how they screwed their customers on the defective products sales fall on their other products (in this example by 30%).  As they don’t want to suffer the same fate as those other customers.  So what would have been only a $159,929 loss with a recall becomes a $1,494,344 loss.  Over nine times worse than what it could have been without a large loss of customer goodwill.  And this is why executive management moves fast to identify and resolve defects.  Because losing the goodwill of their customers will end up costing more than any product recall.  As it can take years to earn a customer’s trust again.

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The BLS Employment Situation Summary for November 2013

Posted by PITHOCRATES - December 9th, 2013

Economics 101

There was Much Spending in November where People Gathered to Celebrate the Thanksgiving Holiday

The Bureau of Labor Statistics November’s Employment Situation Summary is out.  The government is trumpeting the 203,000 jobs created and the fall in the unemployment rate from 7.3% in October to 7.0%.  Proof they say that the economy is turning around.  And that their economic policies are working.  So everything is coming up roses.  If you stop reading the Employment Situation Summary there, that is.  For if you read further the economy is still horrible.

A big part of this improvement was the furloughed federal workers returning to work after the government shutdown.  And the Thanksgiving Holiday.  With retail hiring seasonal employees and stocking their shelves for the kick off of the Christmas shopping season.  This year starting on Thanksgiving Day for many retailers.  So you would expect a gain in employment connected to the Christmas shopping season.  Which there has been.  Retail trade employment added 22,000 jobs.  And leisure and hospitality, employment in food services and drinking places added 18,000 jobs.  And air transportation added 3,000 jobs.  Thanks to the biggest travel day of the year falling in November.

So there was much spending where people gathered with friends and family to celebrate the Thanksgiving holiday.  And the mad rush to the stores to begin their Christmas shopping.  There was much traveling, shopping and dining in November.  As there always is.  Though some years are better than others.  There was also new hiring in the automobile and construction industries.  Probably more due to the near-zero interest rates thanks to the Federal Reserve’s quantitative easing.  Basically printing money to drive down interest rates.  To encourage people to buy big ticket items like cars and houses.  Even though they had no plans to do so.

It is only the Decline in the Number of People in the Labor Force that gives us an Improving Unemployment Rate

So new jobs in these areas don’t reflect on the overall economic climate.  Because once Christmas is over business will lay off those they hired for those seasonal jobs.  And once the Federal Reserve stops ‘printing money’ those interest rates will rise.  Perhaps compounded by runaway inflation from so much printing.  So these aren’t good indicators of the economy.  We can gain a better understanding by looking at the higher stages of production.  Where there are large capital outlays required to hire and expand business.  Industries that look at the long-term.  So if they’re not hiring they’re not optimistic about the long-term economic picture.

A lot of economic activity has to happen before a retail store can sell anything.  Raw material industries have to pull resources out of the environment.  Industrial processors have to transform these raw materials so manufacturers can use them.  And once manufacturers build things wholesalers buy them and resell them to retailers.  That’s a lot of costs these industries have to incur to produce things that may sell 6-9 months later.  Or longer.  And if the economy is looking anemic to them they are not going to incur these costs.  Which is what happened in November with some of these higher stages of production.  Mining, logging and wholesale trade showed little to no change.

The civilian labor force declined by 720,000 in October.  With the government shutdown blamed for a lot of these lost jobs.  So when the government opened for business again in November we should have seen a large increase in the civilian labor force.  But we didn’t.  The civilian labor force only increased by 455,000 in November.  Which means that if you factor out the government shutdown there was still a decline in the number of jobs.  And it is only this decline in the number of people in the labor force that gives us an improving unemployment rate.  For once people give up and quit looking for a job because the economy is so bad the Bureau of Labor Statistics (BLS) stops counting them.  Skewing the real unemployment rate.

The Current Economic Recovery is a False One created with the Smoke and Mirrors of Low Interest Rates

This gets to the crux of the Obama economic recovery.  Or, rather, the absence of any recovery.  The government trumpets the creation of 195,000 new jobs per month this year.  But they don’t tell us how many jobs we lost per month this year.  Which we can calculate.  In January of this year there were 89,009,000 people not in the labor force.  In November that number rose to 91,273,000.  A total loss of 2,265,000 jobs this year.  Or a loss of 205,909 each month.  So while they cheerfully report the creation of 195,000 new jobs per month we actually lost 205,909 jobs each month.  If you count those people who left the labor force the BLS doesn’t count when calculating the unemployment rate.  In fact, if you look at the trends this year you can see the trends are going in the wrong direction.

Those in Labor Force vs Unemployment Rate thru November 2013 R1

The most shocking thing about this chart is that there are over 91 million people not in the labor force.  The labor force is the sum of the employed and unemployed persons.  So these are people who could be in the labor force but aren’t.  Because they don’t have a job.  For whatever reason.  On welfare, collecting disability, early retirement, just can’t get a job because the economy is so bad, etc.  So there will always be people out of the labor force.  And a large number is bad.  Because these people aren’t helping to create economic activity.  Which is why the Obama recovery is so anemic.

What’s also shocking about this chart are the trends.  The official unemployment rate has been falling.  Good news, yes?  Well, as it turns out, no.  Because the number of people not in the labor force has been rising during the decline in the unemployment rate.  Making the unemployment numbers questionable at best.  For you can’t have less unemployment if people continue to leave the workforce because they can’t get a job.  And the employment picture isn’t getting better.  It’s getting worse.  And it’s going to keep getting worse until those higher stages of production start hiring.  Which they won’t do until they see a real economic recovery.  And not a false one created with the smoke and mirrors of low interest rates.

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Inventory to Sales Ratio and Labor Force Participation Rate (1992-2013)

Posted by PITHOCRATES - November 12th, 2013

History 101

Just-in-Time Delivery lowers Inventory Costs but risks Manufacturing Interruptions

Carrying a large inventory is costly.  And risky.  First of all you have to warehouse it.  In a secured heated (and sometimes cooled) building.  With a fire alarm system.  A fire suppression (i.e., sprinkler) system.  A security alarm system.  You need lighting.  And people.  Safety training.  Safety equipment.  Forklifts.  Loading docks.  Delivery trucks.  Insurances.  Property taxes (real and personal).  Utilities.  Telephone and Internet.  A computer inventory system.  Etc.  It adds up.  And the larger the inventory the larger the cost.

Then there are the risks.  Fire damage.  Theft.  Water damage (say from a fire suppression line that freezes during the winter because some kid broke a window to let freezing air in that froze the water inside the sprinkler line with the expanding ice breaking the pipe and allowing water to flow out of the pipe onto your inventory).  Shrinkage (things that disappear but weren’t sold).  Damaged goods (say a forklift operator accidentally backed into a shelve full of plasma displays).  Shifts in consumer demand (what was once hot may not be hot anymore which is a costly problem when you have a warehouse full of that stuff).  Etc.  And the larger the inventory the greater the risks.

In the latter half of the 20th century a new term entered the business lexicon.  Just-in-time delivery.  Or JIT for short.  Instead of warehousing material needed for manufacturing manufacturers turned to JIT.  And tight schedules.  They bought what they needed as they needed it.  Having it arrive just as it was needed in the manufacturing process.  JIT greatly cut costs.  But it allowed any interruption in those just-in-time deliveries shut down manufacturing.  As there was no inventory to feed manufacturing if a delivery did not arrive just in time.

A Rising Inventory to Sales Ratio means Inventory is Growing Larger or Sales are Falling

There are many financial ratios we use to judge how well a business is performing.  One of them is the inventory to sales ratio.  Which is the inventory on hand divided by the sales that inventory generated.  If this number equals ‘1’ then the inventory on hand for a given period is sold before that period is up.  Which would be very efficient inventory management.  Unless a lot of sales were lost because some things were out of stock because so few of them were in inventory.

Ideally managers would like this number to be ‘1’.  For that would have the lowest cost of carrying inventory.  If you sold one item 4 times a month you could add one to inventory each week to replace the one sold that week.  That would be very efficient.  Unless four people want to buy this item in the same week.  Which means instead of selling 4 of these items you will probably only sell one.  For the other three people may just go to a different store that does have it in stock.  So it is a judgment call.  You have to carry more than you may sell because people don’t come in at evenly spaced intervals to buy things.

We can look at the inventory to sales ratio for the general economy over time to note trends.  A falling ratio is generally good.  For it shows inventories growing as a lesser rate than sales.  Meaning that businesses are getting more sales out of reduced inventory levels.  Which means more profits.  A flat trend could mean that businesses are operating at peak efficiency.  Or they are treading water due to uncertainty in the business climate. Doing the minimum to meet their current demand.  But not growing because there is too much uncertainty in the air.  A rising ratio is not good.  For the only way for that to happen is if inventory is growing larger.  Sales are falling.  Or both.

The Labor Force Participation Rate has been in a Freefall since President Obama took Office

When inventories start rising it is typically because sales are falling.  Businesses are making their usually buys to restock inventory.  Only people aren’t buying as much as they once were.  So with people buying less sales fall and inventories grow.  Rising inventories are often an indicator of a recession.  As unemployment rises there are fewer people going to stores to buy things.  So sales fall.  After a period or two of this when businesses see that falling sales was not just an aberration for one period but a sign of worse economic times to come they cut back their buying.  Draw down their inventories.  And lay off some workers to adjust for the weaker demand.  As they do their suppliers see a fall in their sales and do likewise.  All the way up the stages of production to raw material extraction. 

Retailers typically carry larger inventories than wholesalers or manufacturers.  To try and accommodate their diverse customer base.  So when their sales fall and their inventories rise they are left with bulging inventories that are costly to store in a warehouse.  They may start cutting prices to move this inventory.  Or pray for some government help.  Such as low interest rates to get people to buy things even when it may not be in their best interest (for people tend to get laid off in a recession and having a new car payment while unemployed takes a lot of joy out of having a new car).  Or a government stimulus program.  Make-work for the unemployed.  Or even cash benefits the unemployed can spend.  Which will provide a surge in economic activity at the consumer level as retailers and wholesalers unload backed up inventory.  But it rarely creates any new jobs.  Because government stimulus eventually runs out.  And once it does the people will leave the stores again.  So retailers may benefit and to a certain degree wholesalers as they can clear out their inventories.  But manufacturers and raw material extractors adjust to the new reality.  As retail sales fall retailers and wholesalers will need less inventory.  Which means manufacturers and raw material extractors ramp down to adjust to the lower demand.  Cutting their costs so their reduced revenue can cover them.  Which means laying off workers.  We can see this when we look at inventory to sales ratio and the labor force participation rate over time.

(There appears to be a problem with the latest version of this blogging software that is preventing the insertion of this chart into this post.  Please click on this link to see the chart.)

(Sources: Inventories/Sales Ratio, Archived News Releases

Cheap money gave us irrational exuberance and the dot-com bubble in the Nineties.  And a recession in the early 2000s.   Note that the trend during the Nineties was a falling inventory to sales ratio as advanced computer inventory systems tied in over the Internet took inventory management to new heights.  But as the dot-com irrational exuberance came to a head we had a huge dot-com economy that had yet to start selling anything.  As their start-up capital ran out the dot-coms began to go belly-up.  And all those programmers who flooded our colleges in the Nineties to get their computer degrees lost their high paying jobs.  Stock prices fell out of the sky as companies went bankrupt.  Resulting in a bad recession.  The fall in spending can be seen in the uptick in the inventory to sales ratio.  This fall in spending (and rise in inventories) led to a lot of people losing their jobs.  As we can see in the falling labor force participation rate.  The ensuing recession was compounded by the terrorist attacks on 9/11.

Things eventually stabilized but there was more irrational exuberance in the air.  Thanks to a housing policy that put people into houses they couldn’t afford with subprime mortgages.  Which lenders did under threat from the Clinton administration (see Bill Clinton created the Subprime Mortgage Crisis with his Policy Statement on Discrimination in Lending posted 11/6/2011 on Pithocrates).  Note the huge spike in the inventory to sales ratio.  And the free-fall of the labor force participation rate.  Which hasn’t stopped falling since President Obama took office.  Even though the inventory to sales ratio returned to pre-Great Recession levels.  But there is so much uncertainty in the economic outlook that no one is hiring.  They’re just shedding jobs.  Making the Obama economic recovery the worst since that following the Great Depression.

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Housing Boom, Bubble and Bust

Posted by PITHOCRATES - April 15th, 2013

Economics 101

Building and Furnishing Houses creates Great Economic Activity

Central to any booming economy are healthy home sales.  For home sales unleash great economic activity.  From the first surveys of a new subdivision.  To the new sewers and water systems.  Gas and telephone.  Cable television and broadband Internet.  Concrete for basements, driveways and sidewalks.  Structural steel (that beam in the basement and steel poles holding up the house).  Rough carpentry.  Electrical work and plumbing.  Drywall, windows and roofing.  Painting, flooring, doors and hardware.  Heating and air conditioning.  Lighting and plumbing fixtures.  Brick, siding and landscaping.  Etc.

All of this takes manufacturing to make these construction products.  All these manufacturers need raw materials.  And raw material extraction needs heavy equipment and energy.  At all of these stages of production are jobs.  Extracting raw materials.  Processing raw materials.  Manufacturing products out of these raw materials.  Building this production equipment.  Interconnecting these stages of production is every form of transportation.  Rail, Great Lake freighter, river barge and truck.  Requiring even more jobs to build locomotives, rolling stock, ships and trucks.  And jobs to operate and maintain them.  And build their infrastructure.  Filling all of these jobs are people.  Earning a paycheck that will let them buy a house one day.

Then even more economic activity follows.  As people buy these homes and furnish them.  Washers and dryers.  Refrigerators, stoves, microwaves, food processors and coffee makers.  Furniture and beds.  Light fixtures and ceiling fans.  Rugs, carpeting and vacuum cleaners.  Telephones, televisions, music systems, modems and computers.  Curtains, drapes, blinds and shades.  Shower curtains, bath mats, towels and clothes hampers.  Mops, buckets, cleaning supplies and waste baskets.  Lawnmowers, fertilizers, hoses and sprinklers.  Snow shovels and snow blowers.  Cribs, highchairs, diapers and baby food.  Etc.  All of these require manufacturers.  And all of these manufacturers require raw materials.  As well as transportation to move material and product between the stages of production.  And to our wholesalers and retailers.  More jobs.  More people earning a paycheck.  Who will one day buy their own home.  And create even more economic activity.

Bill Clinton pressured Lenders to Lower their Requirements and Subprime Lending took Off

This is why governments love housing.  And try to do everything within their power to increase home ownership.  Which is why they changed the path to home ownership.  After World War II when the building of subdivisions took off there was the 3-6-3 savings and loan.  Where savings and loan paid 3% interest on savings accounts.  Loaned money to home buyers at 6%.  And were on the golf course by 3 PM.  And the mortgage was the 30-year conventional mortgage with a 20% down payment.

The conventional mortgage was the mortgage of our parents.  Who had no problem putting off their wants to save money for that 20% down payment.  They prioritized.  And planned for the future.  But the conventional mortgage has an obvious drawback.  It limits home ownership to those who can save up a 20% down payment.  Pushing home ownership further out for some.  Or just taking that option away from a large percentage of the population.  So the government stepped in.  To help those who couldn’t save 20% of the house’s price.

Mortgage Qualification Decreasing Down Payment

As we lowered the down payment amount it allowed lower-income people the opportunity of home ownership.  But it didn’t get them a lot of house.  That is, those who could afford a 20% down payment could buy more house for the same monthly payment than those who couldn’t afford it.  And a house in a better neighborhood.  Which some said was unfair.  Some in government even called it discriminatory.  As Bill Clinton did.  Who pressured lenders to lower their lending requirements to qualify the unqualified.  His Policy Statement on Discrimination in Lending helped to fix that alleged problem.  And kicked off subprime lending in earnest.  Leading to the subprime mortgage crisis.  And the Great Recession.

Conventional Wisdom was to Pay the Most you could Possibly Afford when Buying a House

But lowering the down payment wasn’t enough.  Even eliminating it all together.  The people needed something else to help them into home ownership. And to generate all of that economic activity.  And this was something the government could fix, too.  By printing a lot of money.  So banks had a lot of it to lend.  Thus keeping interest rates artificially low.  And we can see the effect this had on home ownership combined with a zero down payment.  It allowed people to buy more house for the same given monthly payment.  Even more than those buying with the 3-6-3 conventional mortgage.

Mortgage Qualification Decreasing Mortgage Rate

Falling interest rates bring in a lot more people into the housing market.  Which is good for sellers.  And good for the economy.  A lot more people than just those who could afford a 20% down payment can now buy your house.  As people bid against each other to buy your house they bid up your price.  Raising home prices everywhere.  Increasing the demand for new housing.  Which builders responded to.  Creating a housing boom.  As builders flood the market with more houses.  At higher prices.  That new homeowners move into.  And max out their credit cards to furnish.  Creating a lot of debt people are servicing at these artificially low interest rates.  But then the economy begins to overheat.  And other prices begin to rise.  Leaving people with less disposable income.  The housing boom turns into a housing bubble.  House prices are overvalued.  Those artificially low interest rates created a lot of artificial demand.  Bringing people into the market who weren’t planning on buying a house.  But decided to buy only to take advantage of those low interest rates.

Conventional wisdom was to pay the most you could possibly afford when buying a house.  For all houses gained value.  You may struggle in the beginning and have to make some sacrifices.  Say cut out steak night each week.  But in time you will earn more money.  That house payment will become more affordable.  And your house will become more valuable.  Which will let you sell it for more at a later date letting you buy an even bigger house in an even nicer neighborhood.  But when it’s cheap interest rates driving all of this activity there is another problem.  For printing money creates inflation.  And inflation raises prices.  Gasoline is more expensive.  Groceries are more expensive.  As prices rise households have less disposable income.  And have to cut out things like vacations.  And any discretionary spending on things they like but don’t need.  Which destroys a lot of economic activity.  The very thing the government was trying to create more of by printing money.  So there is a limit to the good economic times you create by printing money.  And when the bad consequences of printing money start filtering through the rest of economy the government has no choice but to contract the money supply to limit the economic damage.  And steer the economy into what they call a soft landing.  Which means a recession that isn’t that painful or long.

The Price of Artificially Low Interest Rates is Inflationary Booms, Bubbles and Great Recessions

As interest rates rise home buying falls.  Leaving a lot of newly built homes unsold on the market.  And that housing bubble bursts.  Causing home values to fall back down from the stratosphere.  Leaving a lot of people owing more on their mortgage than their houses are now worth.  What we call being ‘underwater’.  And as interest rates rise so do the APRs on their credit cards.  As well as their monthly payments.  And those people who paid the most they could possible afford for a house with an adjustable rate mortgage saw their mortgage interest rates rise.  As well as their monthly payment.  By a lot.  So much that these people could no longer afford to pay their mortgage payment anymore.  As a half-point increase could raise a mortgage payment by about $50.  A full-point could raise it close to $100.  And so on.

Increasing Monthly Payment dur to Increasing Mortgage Rate

With the fall in economic activity unemployment rises.  So a lot of people who have crushing credit card debt and a house payment they can no longer afford lost their job as well.  Causing a rash of mortgage foreclosures.  And the subprime mortgage crisis.  As well as a great many personal bankruptcies.  Causing the banking system to struggle under the weight of all this bad debt.  Add all of this together and you get the Great Recession.

This is the price of artificially low interest rates.  You get inflationary booms.  And bubbles.  That burst into recessions.  That are often deep and long.  Something that didn’t happen during the days of 3-6-3 mortgage lending.  And the primary reason for that was that the U.S. was still on a quasi gold standard.  Which prevented the government from printing money at will.  The inflationary booms and busts that come with printing money.  And Great Recessions.

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Economic Stimulus

Posted by PITHOCRATES - November 5th, 2012

Economics 101

Prices match Supply to Demand letting Suppliers know when to bring more Goods and Services to Market

There is a natural ebb and flow to the economy.  Through good times and bad.  And you can tell which way the economy is heading by prices in the market place.  When prices are rising times are typically good.  As people are gainfully employed with money to spend.  As they compete with each other for the goods and services in the market place demand rises.  Growing greater than the supply of goods and services.  So prices rise.  Because when there are fewer goods and services they are worth more money.  For those who have them to sell.  Because demand is so great people are willing to pay top dollar for them.  To get them while supplies last.  This attracts the attention of other suppliers.  Who want to cash in on those high prices.  So they bring more goods and services to market.

In time supply catches up to demand.  And passes it.  Suddenly the market has more goods and services than people are buying.  As inventories grow retailers stop buying so much from their wholesale suppliers.  Who in turn stop buying so much from their manufacturers.  Who in turn stop buying so much from their raw material suppliers.  And manufacturers and their raw material suppliers begin laying off workers.  So there are fewer people gainfully employed with money to spend.  The fewer gainfully employed buy less than the more gainfully employed.  Causing inventories to grow larger as more goods are going into them than are coming out of them.  So they start cutting prices.  To unload these inventories before people start buying even less.  Because they spent a lot of money to build those inventories.  And it costs to hold these items in warehouses and stockrooms.

And that’s the natural ebb and flow of the economy.  What economists call the business cycle.  That goes from an expanding economy to a contracting economy.  From boom to bust.  From inflation to recession.  Something normal.  And natural.  Though it could be unpleasant for those who lose their jobs.  But it’s something that must happen.  To correct prices.  You see, prices make all of this work automatically.  They match supply to demand.  Letting suppliers know when to bring more goods and services to market.  And when they’ve brought too much.  When the economy goes into recession prices fall.  Which tells suppliers that supply exceeds demand.  And that anything additional they bring to market will not sell.  As they incur costs to bring things to market this is very good information to have.  So they don’t waste money.  Leaving their businesses short of cash.  Possibly causing their businesses to fail.

Whenever we Devalue the Dollar with Inflationary Monetary Policy Prices Rise

No one likes losing their job.  Because they need income to pay their bills.  And the government doesn’t like people losing their jobs.  Because they tax those incomes to pay the government’s bills.  And unemployed people pay no income taxes.  So the government tries to tweak the economy.  At the federal level.  To extend the inflationary periods of the business cycle.  And they do that with inflationary monetary policy.  Using their monetary powers to keep interest rates below the true market interest rate.  Hoping it will encourage suppliers and consumers to keep borrowing and spending money.  Even though supply had already caught up to and passed demand.  Such that everyone that wanted to buy something could.  While every supplier that wanted to sell something couldn’t.

Some people take advantage of these lower interest rates.  Some people will remortgage their homes to lower their monthly payment.  Which will give them a little more disposable cash each month.  Which they may use to buy more stuff.  But other people will take this opportunity to buy a large house just because of the low interest rate.  As some businesses may borrow to expand their business just because of the low interest rate.  Not for unmet demand.  These actions may not help the economy.  In fact they may hurt the economy in the long-term.  When the inevitable recession comes along and they are so overextended they may not be able to pay their bills.  They may lose their house.  Or their business.  For the worst thing to have whenever you suffer a reduction in revenue or income is debt.

But there is an even worse effect of that inflationary monetary policy.  When you increase the money supply you increase the total amount of dollars in the economy.  But they’re chasing the same amount of goods and services.  Which makes each dollar worth less.  Requiring more of them to buy the same things they once did.  Which is why whenever we devalue the dollar with inflationary monetary policy prices rise.  So, yes, there may be an initial expansion of economic activity.  But some people will have inflationary expectations.  That is, they know prices will go up in the very near future.  So they won’t increase production.  Why?  While an initial burst of economic activity may draw down those bloated inventories those coming higher prices will increase business costs.  Which businesses will have to pass on in the prices of their goods.  And how do higher prices affect consumers?  They buy less.  So manufacturers are not going to expand production when price inflation is going to reduce their sales in the long run.

Cutting Taxes and Reducing Costly Regulations have Stimulated Economic Activity every time they’ve been Tried

Perhaps the worst effect of inflation is the false information those higher prices give.  When consumer demand rises so do prices.  And it’s a signal to suppliers to bring more goods and services to market.  But when prices rise because of a depreciated dollar and NOT due to higher consumer demand, some may bring more goods and services to market when there is no demand for it.  So you have rising prices.  And expanding production.  Producing more goods than the market is demanding.  Creating a bubble.  Adding a lot of stuff to the market place at very inflated prices.  That no one is buying.  Then the bubble bursts.  And recession sets in.  As businesses lay off workers to adjust supply to meet actual demand.  And those inflated prices fall back to market values.  The higher inflationary monetary policy pushed those prices up the farther they have to fall.  And the more painful the recession will be.

You see, inflationary monetary policy interferes with the natural ebb and flow of the economy.  And the automatic price mechanism that matches supply to demand.  By trying to expand the inflationary side of the business cycle, and contract the recessionary side, governments make recessions longer.  And more painful.  Which is why Keynesian stimulus policies (lowering interests rates and deficit spending) don’t stimulate long-term economic activity.  Yet it is what most governments turn to whenever the economy slows. While there is another way to stimulate economic activity.  One that is not so popular with most governments.  Across the board tax cuts on business and personal incomes.  And reducing costly regulations on businesses.  These make a more business-friendly environment.  Encouraging businesses to expand and hire people.  Because these actions will have a positive impact on a business’ long-term outlook.  And with consumers having more disposable income (thanks to the cuts in personal income tax rates) businesses know there will be a market of any increase in production.

So there you have two ways to stimulate economic activity.  One way that works (tax cuts and reducing costly business regulations).  And one that doesn’t (lowering interest rates and deficit spending).  So why is the one that doesn’t work chosen by most governments over the one that does?  Because governments like to spend money.  It’s how they build constituencies.  By giving generous benefits to voters.  But to do that they need tax revenue.  Lots of tax revenue.  Produced by increasing tax rates as often as they can.  So they cannot stand the thought of cutting taxes.  Ever.  Which is why they always choose inflationary policies over tax cuts.   Even though those policies fail to stimulate economic activity.  As proven throughout the era of Keynesian economics.  While cutting taxes and reducing costly regulations have stimulated economic activity every time they’ve been tried.

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Stages of Production

Posted by PITHOCRATES - July 16th, 2012

Economics 101

People used their Human Capital to Transform Raw Materials into Something Valuable

As we unleashed our human capital civilization advanced.  Our food needs taken care of thanks to advances in agriculture we used our new free time to think.  To think about transforming the world around us.  By exploring our world.  And the stuff that made it.  Great civilizations rose and fell throughout history.  But the ones that really advanced the world were those in northern Europe.  The people who conquered the oceans.  The Portuguese.  The Spanish.  The Dutch.  The French.  And the British.

As these great European powers set out to explore the world they established colonies in faraway lands.  To gather the raw materials available.  And to ship them back to their mother countries.  Where their advanced civilizations would transform those raw materials into higher value finished goods.  And then export them throughout the world.  Including their colonies.  This was mercantilism.  Establish colonies.  Ship raw materials to the mother country.  Export finished goods.  And Import bullion accepted in payment for those finished goods.

It’s not a good economic system.  Mercantilism.  But it did create the United States.  Which started out as a British colony.  But as a colony of a mercantilist country the Americans had to follow the rules of the mother country.  First of all they had to understand their place.  And purpose.  They were subordinate to the mother country.  And their only purpose was to procure raw materials and ship them to the mother country.  They couldn’t open trade with other countries.  Everything that left the colonies had to go on a British ship to a British port.  Where British manufacturers would transform those raw materials into finished goods for export.  The British did this because finished goods were more valuable than raw goods.  And sold for much higher prices than the raw materials sold for.  So Britain did the manufacturing.  While their colonies fed their manufacturers with raw material.

The Stages of Production is the Economic Activity that happens to bring Finished Goods to Market

The British eventually abandoned mercantilism and adopted free market capitalism and free trade.  And the British Empire went on to rule the world for a century or so.  This after losing the American colonies in the Revolutionary War, losing about half of their empire.  So free market capitalism is clearly superior to mercantilism.  But for a couple of centuries mercantilism built empires.  And provided an excellent example of the stages of production.

Raw materials mean little to consumers.  What we like are the things that people with human capital transform them into.  The things we go to the store to buy.  Such as a smartphone, for example.  Whenever a new model comes out we flock to our favorite retail store to buy it.  The retail store has it to sell because they bought a shipment from their wholesaler.  The wholesaler had it to sell because they bought it from the assembly plants that assembled them.  The assembly plants could build them because they bought the components (displays, hard cases, antennas, keys, circuit boards, etc.) from various manufacturers.  And the various manufactures bought raw materials from those who extracted them from the ground.  Interconnecting all of these is ship, rail and truck transportation.  Even planes.  Not to mention an extensive cellular network to make these smartphones work.  As well as all the software applications they run.  Adding value at every stage along the way.

There is much economic activity that happens to bring that smartphone to your favorite retail store.  Throughout these stages of production.  Note how everything else has to happen before you buy that smartphone.  Going all the way back to the extraction of raw materials from the ground.  All of these stages have to happen before you buy that phone.  So the payment for the phone follows much later than all of these other stages.  Introducing a very important element in the stages of production.  Time.  It takes time to bring things to market.  And because it takes time it also takes money.  Everyone working from raw material extraction to the salesperson selling you the phone earns an income.  And their employers pay them before you buy your phone.  Some a lot earlier than others.  Also, all of these people either work in a building.  Or in the field with equipment.  Things that others have to build first before we can even begin our raw material extraction.  Requiring an enormous capital investment before anyone earns a dime of revenue on the sale of a smartphone.

The British Empire went on to Rule the World for a Century or More because they let the Market Manage their Economy

To bring a smartphone to a retailer near you requires people to risk their money by investing in something that may earn a profit.  Investors.  And bankers.  As people saved their money they created large pools of capital for businesses to borrow.  Venture capitalists bankrolled promising entrepreneurs.  And the big corporations turned to the equity and bond markets to raise their capital.  Individuals worked hard and saved money to put in their savings account.  Or to buy stocks and bonds.  Because they did there was money to borrow.  Or to invest.  And because there was money to borrow and invest the stages of production could begin.

In the days of mercantilism the government controlled much of this.  Even providing some of that early capital.  But as the economy grew more complex it was too complex for government to manage.  Which is why the British Empire went on to rule the world for a century or more.  Because they let the market manage their economy.  A myriad of people in the market place pursuing their own interests.  Pursuing profits.  Which is why free market capitalism works.  For no one person could know enough to manage all of the stages of productions to bring a smartphone to market.  And the beautiful thing is in free market capitalism no one person has to.  For when people throughout the stages of production pursue profits smartphones arrive at a retailer near you.  At reasonable prices to boot.

So the next time you pick up a smartphone at a retailer think of everything it took to bring it to your hands.  And everything it takes to operate it as you wish.  Hundreds of thousands of people pursuing profits.  Most of which have no idea what they’re doing will allow you to hold a smartphone at your favorite retailer.  Because in the stages of production everyone does their part.  Without any consideration of what their part is in the big picture.  Which is why it works so well.  Thanks to people thinking.  And unleashing their human capital to create great things throughout the stages of production.

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The Chinese Government invests in LED Chips poorly causing Over Expansion, Price Deflation and Factory Closures

Posted by PITHOCRATES - May 27th, 2012

Week in Review

China’s formula for success is to partner government with business.  Like they did in Japan during the Eighties.  Before Japan’s Lost Decade.  And their deflationary spiral.  China is using the same formula.  Having government invest in corporations to expand production to dominate the market.  And, of course, create some bubbles along the way (see Analysis: Falling prices to kill off half of Chinese LED chipmakers by Leonora Walet and Twinnie Siu posted 5/27/2012 on Reuters).

In China, surplus capacity and sliding prices are sounding the death knell for half of the companies making light emitting diode (LED) chips used in Samsung television panels and Sharp computer monitors, with only the large, state-backed players likely to pull through.

Sluggish global sales of TVs and computers may further cut LED chip prices by 20 percent this year, and consolidation or closure are the only options for China’s smaller LED players, analysts say.

By contrast, Sanan Optoelectronics Co Ltd, China’s top LED chipmaker with a market value of $2.8 billion, and Elec-Tech International Co Ltd will be among a handful of large companies that will survive as they continue to receive subsidies and incentives from the government, according to analysts…

For the majority of LED firms, the government is slowly rolling back incentives, including tax breaks, free land and more than $1.6 billion in cash to buy LED chip-making equipment, that had helped sustain the industry for more than three years.

Proview International, whose Shenzhen-based unit is battling Apple Inc over the iPad trademark in China, is grappling with slumping LED prices and fierce competition that have dragged down earnings for other LED companies including Hangzhou Silan Microelectronics Co and Foshan Nationstar Optoelectronics…

Many LED companies are operating their factories at 50 percent capacity in China, with up to half of the 700 or so chip-making machines purchased with government money during the boom years in 2009 and 2010 left idle, industry watchers say.

In the past year, overcapacity has shut hundreds of small Chinese makers of LED lighting, according to analysts.

“China’s financial policy is not giving enough support to mid-tier and smaller enterprises,” said Bao En Zhong, executive vice chairman of the semiconductor lighting association in Shenzhen, one of China’s largest production bases for LED lighting. “We may see more factory closures…”

So the secret to success in China is government incentives, tax breaks, free land and lots and lots of cash.  If you can get this from the government you, too, can flood the market with product.  Sending your prices into a tailspin.  Then all you have to do is be one of the lucky few the government bails out so you can flood the market with more of your product.  Sending your prices into a tailspin.  Again.

People say this type of dumping of low-priced products onto the market hurts consumers.  I never understood that.  Here the Chinese helped to bring the cost of televisions down by making the chips that make them work so dirt cheap that they shuttered hundreds of Chinese manufacturers.  And chip prices may fall by another 20%.  I just don’t see how the consumer loses here.  It looks like the losers are the hundreds of shuttered businesses.  And the Chinese government who invested so much into those businesses.

This is state-capitalism.  Where businesses make bad decisions because of the free government handouts.  If it weren’t for those free government handouts these businesses wouldn’t have produced so many chips that they put themselves out of business.  You add up all of this bad government investment throughout China and it says only one thing.  A day of reckoning is coming.  If the Chinese don’t believe it they can ask the Japanese.

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Mercantilism, Royal Navy, Napoleon, Pax Britannica, Corn Laws, David Ricardo, Comparative Advantage, European Union and NAFTA

Posted by PITHOCRATES - May 22nd, 2012

History 101

Mercantilism gave Britain the Royal Navy which Ushered in the Pax Britannica

Great Britain had a rough go of it at the end of the 18th century.  They lost their American colonies in the American Revolutionary War.  A war that started over the issue of taxation to pay for the previous Seven Years’ War.  So instead of securing new revenue to pay down old debt they incurred new debt.  The French Revolution closed out the century.  Causing concern for some in Britain that their monarchy may be the next to fall.  It didn’t.  For the constitutional monarchy and representative government in Britain was a long cry from the absolute monarchy that they had in France.  So revolution did not come to Britain.  But war did.  As the French expanded their revolution into a European war.  Pulling the British back into war with their old enemy.

With a large conscripted French Army and the concept of total war France made total war.  Napoleon Bonaparte won a lot of battles.  Conquered much of Europe.  Even marched back and conquered Paris.  Proclaimed himself emperor of France.  And continued waging war.  Including an ill-conceived invasion of Russia.  Which marked the beginning of the end for Napoleon.  And the French Empire.  Weakened from war France saw her old nemesis, Great Britain, rise as the first superpower since the Roman Empire.  And like the Romans’ Pax Romana Britain entered a century of peace.  Pax Britannica.

The reason the British could do this was because of their mercantile past.  They set up colonies and international trade networks.  And they used the proceeds from that lucrative trade to finance the greatest naval power then in the world.  The Royal Navy.  And the Royal Navy would help keep the peace in the Pax Britannica.  She became the world’s policeman.  Making the world safe for trade.  Especially on the high seas.  But then something interesting happened.  She broke from her mercantile past.  Because they saw the shortcomings of mercantilism.  One of which produced wealthy landowners at the expense of a hungry population.

When the British repealed the Corn Laws in 1846 Food Prices fell and the Standard of Living Rose 

The British Corn Laws were a series of laws protecting those who grew cereal crops.  The stuff we grow that has edible grains.  Corn, rice, wheat, barley, etc.  What we call staple crops as they form the basic sustenance of humans everywhere.  We grow these in greater abundance than all other foods.  And when you look at the grain size you come to one realization.  It takes a lot of land to grow these crops.  And who owns large tracts of land?  The landowning aristocracy.  A small group of people with a lot of wealth.  And a lot of political influence.  Hence the Corn Laws. 

The Corn Laws were legislation with one goal.  To prevent the British people from buying less expensive food.  By either forbidding any importation of cheaper grains until the domestic price had reached a certain price level.  Or adding tariffs to the less expensive imports so the landowners could still sell their grains at higher prices.  Thus preserving their wealth.  And they made specious arguments about how lower-priced food was actually bad for the people.  For it was just a way for manufacturers to maximize their profits.  For if food was cheaper they could pay their workers less.  Being the greedy bastards that they were.  So the only fair thing to do was to keep food prices high.  To keep the living wage high.  To force manufacturers to pay their workers more.  You see, the only way to help the poor and middle class was to let the wealthy landowners become even wealthier.  By keeping the price of the food they sold high.

Opposition grew to the Corn Laws.  People studied the works of their fellow countrymen.  Adam Smith and David Hume (both Scottish).  And the Englishman David Ricardo.  All great economists and thinkers.  Who were all proponents of free trade.  Ricardo’s Comparative Advantage basically proved the case of free trade over the protectionism of mercantilism.  Eventually the political power of the landowners could not overcome the economic arguments.  Or a famine in Ireland.  And, in 1846, they repealed the Corn Laws and adopted free trade.  Food prices fell.  Leaving people with more disposable income.  To purchase the goods the Industrial Revolution was making.  Increasing their standard of living.  While small famers had to leave their farms being unable to farm efficiently enough to pay their bills at the prevailing prices.

The Success of NAFTA proves David Ricardo’s Comparative Advantage

Mercantilists and other opponents to free trade like to point at the human costs.  Small farmers losing their farm.  Just so they can preserve some semblance of privilege to protect the high prices in their industry.  But it was becoming more and more difficult to make the argument that the masses were better off paying higher prices.  Because they’re not.  Lower consumer prices increase the standard of living for everyone.  Higher living standards create healthier living conditions.  And reduces child mortality.   For the greatest killer of children in the world is poverty.

The British were both a military and an economic superpower during the 19th century.  But someone was chasing her.  The Untied States.  Who was feeling her economic oats.  Her economy would catch up and surpass the British.  Making it the mightiest economic power of all time.  How did this happen?  Two words.  Free trade.  The United States was the largest free trade zone in the world.  The economic advantages of all those states trading with each other freely across their state borders made Europe stand up and take notice.  And in response created treaties that ultimately led to the European Union and the Eurozone.  To replicate the large free trade zone of the United States.

Back across the Atlantic the Americans, Canadians and the Mexicans took it up a notch.  And created the North American Free Trade Agreement.  NAFTA.  Extending the free trade that existed in each of their countries across their international borders.  The mercantilist fought against this.  Because protectionism, restrictions and tariffs helped the privileged few protect the high prices in their industry.  In America they talked about a great sucking sound as all American jobs went to low-wage Mexico.  Some manufacturers did move to Mexico.  Primarily because like the small farmers in Britain after the repeal of the Corn Laws they could no longer sell at prices to meet all of their costs.  But it was not as the mercantilists predicted.  Yes, imports increased.  In 2010 they were up 235% from pre-NAFTA 1993.  But exports were up, too.  Some 190% for the same period.  Proving Ricardo’s Comparative Advantage.  By focusing on what we do best and trading for everything else all countries do better.

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Price Inflation has led to Wage Inflation in the Eastern Manufacturing Cities in China

Posted by PITHOCRATES - December 25th, 2011

Week in Review

Inflation has arrived in China.  Wages are going up.  Increasing the cost of their manufactured goods.  And the cost of living (see China province raises minimum wage by 23% posted 12/22/2011 on the BBC).

Sichuan province in southwest China has increased the minimum wage sharply to try and attract workers amid a rapidly rising cost of living.

Sichuan raised the minimum monthly wage by 23.4% starting on 1 January, state news agency Xinhua said on Thursday…

Severe labour shortages in Chinese cities have prompted wage rises in many provinces this year and last.

An example of the role prices play in supply and demand.  Life is good in the Eastern manufacturing cities.  So good that there is a lot of economic activity.  And prices are rising to allocate scarce resources that have alternative uses.  Even labor.  But inflation isn’t always good.  Higher prices eventually will lower sales as people can’t afford to buy as much as they once did.  And those cheap exports become not so cheap.  Which means those factories eventually will cut back on production.  As a recession settles in to readjust those prices.

Rising wages have prompted analysts to predict that China, previously known for its low cost of labour, could lose its edge as a manufacturing hub.

Manufacturers could look to countries such as Vietnam, Bangladesh and Cambodia where wages are still low.

However, Chinese authorities have been trying to boost domestic consumption and be less export dependent, and a rise in wages will encourage spending.

Before China it was Mexico.  Remember that great sucking sound as all those American jobs went to Mexico?  Mexico was chopping in high cotton for awhile.  Until they heard that great sucking sound as their jobs went to China.  And now China may hear it next.  As some of their jobs go to Vietnam, Bangladesh and Cambodia.  Who will lament one day the loss of their jobs to some other low-wage country.

This is economics.  And consumerism.  Consumers are always looking to get the most value for their money.  So manufacturers are always trying to undercut the competition to give these consumers what they want.  Good for consumers.  But not good for countries whose poor get a taste of the good life.  And don’t want to be poor anymore.  Thus raising the cost of production.  And eliminating their low-cost advantage.  At least for their export markets.

Eventually all emerging economies will be emerging no more.  And the low-cost advantage will not be attained the easy way.  With cheap labor.  For these once emerging economies will go to the next step in their economic development.  Capital investment in plant and equipment.  To lower their cost of production through economies of sales.  By doing more with less people.  With people leaving the low-skill assembly jobs in massive factories.  And instead design, build, run and maintain the equipment that replaces them at their old jobs.

Socialists and communists (as well as Big Labor) say this is a bad thing.  Replacing people with machines.  Even though they help to relieve chronic labor shortages that labor just can’t meet.  Lowering the cost of living for everyone.  And increasing the standard of living for everyone.  It’s happened everywhere through history.  And it now appears to be happening in China.  Which should ultimately be a good thing for the Chinese.  Especially for the masses who don’t live and work in the Eastern manufacturing cities.

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The Great Depression

Posted by PITHOCRATES - December 20th, 2011

History 101

The  Roaring Twenties were a Time of Unprecedented Innovation and Manufacturing

The Roaring Twenties were good times.  Kicked off by the Warren Harding administration.  Thanks to one of the few honest guys in his administration besides Harding.  Andrew Mellon.  Secretary of the treasury extraordinaire.  Some say the best secretary of the treasury since our first.  Alexander Hamilton.  High praise indeed.

So what did Mellon do?  He did some research that showed rich people paid less in taxes the higher the tax rates were.  The higher the rate the less they invested in plant and equipment in America.  Instead they invested their money out of the country.  In other countries’ plant and equipment.  So Mellon was a tax-cutter.  And that was his advice to Harding.  And that’s what Harding did.  And Calvin Coolidge continued.  Kept taxes low.  And kept government out of the business of business.

And how business responded.  The 1920s were a time of unprecedented innovation and manufacturing.  Low taxes, little government spending and limited government produced record employment.  Record upward mobility.  And record per capita income.  Gains in the decade touched 37%.  How?  I’ll tell you how.

The auto industry was booming thanks to Henry Ford’s moving assembly line.  Everyone was driving who wanted to drive.  The car companies sold one car for every 5 people.  This production created a boom in other industries to feed this industry.  And cars did something else.  They gave people mobility.  And opportunity.  People left the farms in droves and drove to better jobs.  Which didn’t hurt the farmers in the least as mechanization on the farm put more land under cultivation with fewer people.  Housing and cities grew.  Radio debuted.  And radio advertising.  Motion pictures went from silent to talkies.  Telephones became more common.  New electric utilities brought electricity to homes.  And new electric appliances filled those homes.  Including radios.  New electric motors filled our factories, increasing productivity and slashing consumer prices.  More people than ever before flew.  An increase of nearly 1000%.  It’s nowhere near today’s number of flyers but it was a reflection of the new industrial dominance of the United States.  There was nothing we couldn’t do.  And Europe was taking notice.  And not liking what they saw.  And talked about a European union to compete against the Americans.

Businesses scaled back Production in Anticipation of the Smoot Hawley Tariff Act

So the spectacular economic growth of the Roaring Twenties was solid growth.  It wasn’t a bubble.  It was the real deal.  Thanks to capitalism.  And a government willing to leave the free market alone.  It was so dominating that the Europeans wanted to stop it anyway they could.  One way was protective tariffs on farm imports.

American farm exports boomed during World War I.  Because most of Europe’s farmers were busy fighting.  With the end of the war the Europeans went back to their farms.  Which reduced the need for American farm imports.  And the tariffs compounded that problem.  To make things worse, prices were already falling thanks to the mechanization of the American farm.  Producing bumper crops.  Which, of course, dropped farm prices.  Good for consumers.  But bad for farmers.  Especially with the Europeans shutting off their markets to the Americans.  Because they paid for a lot of that land and mechanization with borrowed money.  And this debt was getting harder and harder to service.  Throw in some weather and insect problems in some regions and it was just too much.   Some farms failed.  Then a lot.  And then the banks that loaned money to these farms began to fail.

We created the Federal Reserve to increase the money supply to keep pace with the growing economy.  By making money cheap to borrow for those businesses trying to expand to meet demand.  They weren’t exactly doing a stellar job, though, in keeping pace with this economic expansion.  And when the bank failures hit the money supply contracted.  Thanks to fractional reserve banking.  All that money the banks created simply disappeared as the banks failed.  Starving manufactures of money to maintain growth to meet demand.  Things were getting bad around 1928.  The Fed did not intervene to save these banks.  Worried that investors were the only ones borrowing money for speculation in the stock market, they shrunk the money supply further.  About a third by 1932.  Manufacturers had no choice but to cut production.

While businesses were dealing with a shrinking money supply they had something else to worry about.  Congress was moving the Smoot-Hawley Tariff Act through congressional committees in 1929 on its way to becoming law in 1930.  This act would add a 30% tax on most imports.  Meaning that the cost factories paid for raw materials would increase by up to 30%.  Of course, sales prices have to include all costs of production.  So sales prices would have to increase.  Higher prices mean fewer sales.  Because people just can’t afford to buy as much at higher prices.  Businesses knew that once the tariff was passed into law it would reduce sales.  So they took preemptive steps.  And scaled back production for the expected fall in sales.

It was Government Meddling that Turned a Recession in the Great Depression

This brings us to the stock market crash.  The Roaring Twenties produced huge stock market gains as industry exploded in America.  Things grew at an aggressive pace.  Stock prices soared.  Because the value of these manufacturers soared.  And investors saw nothing to indicate this growth was going to stop.  Until the contraction of the money supply.  And then the Smoot-Hawley Tariff Act.  Not only would these slow the growth, they would reverse it.  Leading to the great selloff.  The Great Crash.  And the Great Depression.

As feared the Europeans responded to the Smoot-Hawley Tariff Act.  They imposed tariffs on American imports.  Making things worse for American exports.  Then President Hoover increased farm prices by law to help farmers.  Which only reduced farm sales further.  Then the banking crisis followed.  And the Fed did nothing to help the banks.  Again.  When they did start helping banks in trouble they made public which banks were receiving this help.  Which, of course, caused further bank runs as people hurried to get their money out of these troubled banks.  Tax revenue plummeted.  So Hoover passed a new sales tax to raise more revenue.  Which only made things worse.

Hoover was a Republican.  But he was a Big Government progressive.  Just like his successor.  FDR.  And all of their Big Government Keynesian solutions only prolonged the Great Depression.  It was government meddling that turned a recession into the Great Depression.  And further government meddling that prolonged the Great Depression.  Much of FDR’s New Deal programs were just extensions of the Hoover programs.  And they failed just as much as they did under Hoover.  The Great Depression only ended thanks to Adolf Hitler who plunged Europe back into war.  Providing an urgency to stop their government meddling.  And to let business do what they do best.  Business.  And they did.  Building the arsenal that defeated Hitler.

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