William H. Peterson is the John David Campbell Professor of American Business, American Graduate School of International Management, Glendale, Arizona.
This article is from a paper delivered before a symposium of the Academy of Political Science at Columbia University, November 11, 1974, under the overall topic of "Inflation, Fiscal, Social and Economic Impacts." Data herein on the 1974-75 recession have worsened since this paper was given.
Recession, I submit, is the unwanted offspring of inflation. Inflation is of course the all too familiar problem of too much money (demand) chasing too few goods (supply), with the upshot of prices and expectations everywhere tending to rise higher and higher.
How should business managers cope with inflation? This paper seeks answers to that question.
To do so we should define our terms. What is management? What is business? And what is at stake in the onslaught of inflation?
A reading of Peter Drucker’s new book, Management: Tasks, Responsibilities, Practices, leads me to the following in answer to the question, What is management?
The answer is manifold. Management is planning. Management is organization. Management is responsibility. Management is profitability. It is also leadership, discipline, practice, performance, accounting, marketing, tasks, communication and information. Management is — in the final analysis — decision-making.
But making decisions on whose behalf? Management’s? The employees’? The shareholders’? The community’s? The business’ as a whole? Not really.
For what is business? Business is service. Or, to put it baldly, business is a hired servant. Hired by whom? The consumer. Yes, business is guided ‘by profitability, by its own self-interest; yet it is subject to the sovereignty of the consumer. As Ludwig von Mises pointed out, "Production for profit is necessarily production for use, as profits can only be earned by providing the consumers with those things they most urgently want to use."
So the test of a manager’s decisions is profitability — the extent to which he increases revenues and cuts costs. Business management is profit management. Consumers reward efficient management with profits and penalize inefficient management with losses.
Now, what is at stake when we weigh the impact of inflation on management? Remember that business — or, more broadly, the private sector — is the principal source of jobs: Of our total labor force of about 94 million, government furnishes only 16.5 million jobs. This includes more than two million members of the armed forces. With 5.5 million presently unemployed, this means that business, including agriculture and the professions, furnishes the remainder — around 72 million jobs. Business is also the source of most economic output. Thus it generates the bulk of real income in our society — food, clothing, shelter, transportation, medicine, information, and the like.
So what is at stake in the onslaught of inflation? Nothing less than the survival of the business system itself. Note that while I tick off the inflationary distortions on management decisions, I reserve the greatest distortion until last — the possibility of a sharp recession or even a depression.
Managers can get a fast overview of the problem of coping with soaring prices by simply noting how the process of inflation distorts the traditional functions of money.
Impact on Functions of Money
Money, we were told in Economics 101, is first and foremost a medium of exchange. Quite obviously, then, under inflation the purchasing and employment managers will find that, economize though they may, more and more money is required to buy the same amount of goods and services, including labor. The pricing manager also must be quick on his feet to avoid a cost-price squeeze; hence he must seek to keep his prices ahead of costs as far as competition and other factors allow.
Ironically, money has become such a "hot potato" that some managers, especially those involved in international transactions, don’t want to hold it and prefer goods instead. Indeed, some managers trade raw materials for finished goods and vice versa. Thus, through swap arrangements, they alleviate shortages while retreating from money as a medium of exchange.
Too, Eco. 101 reminded us money has a store of value function —the retention of purchasing power over time. Inflation, however, is a thief of that power. The financial manager is thereby under pressure to put his liquid assets to work as rapidly as possible. Bluntly, he must hedge against inflation, balancing his choice of investments between yield and risk. He will also seek to expedite the collection of accounts receivable, exacerbating the general squeeze on liquidity.
Again, money is a standard of value — a unit of account, a yardstick for relative prices. Inflation similarly distorts this function of money by shrinking this key accounting measurement. A dollar is no longer a dollar over time; it is no longer predictable; it no longer permits accurate economic calculation; it is 80¢ or 700 or 60¢ and so on, depending on the length of time and the pace of inflation; and all historical financial records thus call for careful interpretation. The usual tool to accomplish such interpretation is the concept of constant dollars which allows some comparability among accounting periods.
I say "some comparability" for changes in the Consumer Price Index, the Wholesale Price Index and the GNP Implicit Price Deflator can still not be considered scientific measurements of inflation. Inflation is notoriously uneven, with some prices advancing rapidly, some moderately and some lagging behind.
Constant dollars are an especially inadequate tool for multinational corporations. They use different currencies, each with a different history of inflation. Also, rates of inflation and rates of exchange in money markets vary, rendering translation of foreign currencies into U.S. dollars for consolidated financial statements much more difficult.
Lastly, Eco. 101 assigned a fourth function to money—a standard for deferred payments. One of inflation’s most bitter repercussions is that it warps all debtor-creditor relations. In other words, money as a standard for deferred payments has all too often become a shrinking standard. The borrower is thereby able to repay his debt with cheaper money than that he initially borrowed. In other words, inflation fleeces the creditor. This hard fact of our inflationary era means financial managers have to adjust their lending activities, such as acquiring commercial paper and certificates of deposit. By the same token, financial managers have to adjust their borrowing activities, such as getting bank lines of credit and issuing corporate bonds. Lending or borrowing, financial managers should recognize that the largest single element in the height of interest rates today is the level of inflation, currently at a two-digit level.
The foregoing section points up some current monetary distortions. My purpose in this paper is to give some perspective to the management side of inflation and to detail some ramifications of the impact of inflation on the decision process. In particular, I wish to briefly examine the distortions of inflation in the decision areas of profits, inventory, capital investment, wages, international operations, price controls and the business cycle.
The overriding distortion is informational. Good decisions are dependent upon good information. Much if not most of that information, however, is undermined both quantitatively and qualitatively by inflation. It therefore behooves managers to seek to correct, as best they can, their information for inflation.
Impact of Inflation on Profit Calculations
In 1974 people in high places have been charging that corporate profits are "excessive," "unconscionable" and even "obscene." These adjectives sound hollow against the backdrop of a disastrous stock market. The words sound even more hollow when corrections of profit figures are made for inflation.
Dramatic results are obtained with three major corrections:
1. Underdepreciation of plant and equipment, due to depreciation allowances based on original cost rather than replacement cost. This practice has long led to a general overstatement of corporate profits, with consequent overpayment of corporate income taxes and even overpayment of dividends. These result in diminution of potential capital formation. Tax authorities have recognized this problem and have dealt with it to some extent by setting up investment tax credits and accelerated depreciation methods. Financial managers have taken advantage of these provisions to varying degrees. Yet these provisions have proven to be inadequate in view of our two-digit inflation. Both tax authorities and financial managers would be well advised to recognize this depreciation deficiency and the drag it imposes on economic growth — on the economy as a whole and on each individual enterprise. The average age of American plant and equipment continues to lag behind that of our major industrial competitors overseas, and behind what is needed to meet the expectations of our growing population. So still more realistic and competitive depreciation methods are clearly needed.
2. Allowance for the inflation that has diminished the profit dollar. Inflation has eroded the purchasing power of the dollar by more than 40 per cent since 1965. So on this count alone, and despite more than a trillion dollars (in today’s prices) poured into plant and equipment, corporate profits have shown but minor increases since 1965 in real terms. For as sensible is the conversion of money wages into real wages, so financial managers can sensibly convert money profits into real profits.
To be sure, second quarter results in 1974 were about 25 per cent ahead of those of the second quarter of 1973. But price controls came off completely April 30, 1974, allowing many firms to catch up with true supply and demand. Moreover, if the spectacular gains of some basic materials industries are excluded, along with the atypical profits of the auto industry, the bulk of industrial companies made only a moderate increase of 10 to 11 per cent in the first half of 1974 — just about equal to the rate of inflation.
In any event, corporate financial and public relations managers may want to deflate their profit figures and remind the public of the corporate return in real terms. Yet these managers are frequently reluctant to do so, beholden as they are to shareholders and given to pointing with pride to "record" profits. The economy therefore suffers because of management’s desire to show good earnings during an inflationary era.
3. Overstatement of profits because of the understatement of inventory values. Some authorities call inventory gains "phantom profits," which disappear the moment inventory is replaced. The magnitude of inventory profits can be seen in the Commerce Department calculations of $37.9 billion annual rate in the second quarter of 1974, up from $31 billion in the first quarter and $20 billion a year earlier. For perspective, after-tax corporate profits ran at a seasonally adjusted annual rate of $85.6 billion in the second quarter of 1974, up only $500 million from the first quarter, despite $6.9 billion of inventory profits.
To put their own corporate profits in a truer light, quite a few financial managers are switching from first-in, first-out (FIFO) to last-in, first-out (LIFO) for more accurate inventory valuation. It’s about time. In an editorial on October 1, 1974, the Wall Street Journal criticized those financial managers who got caught up in the earnings-per-share mystique and used FIFO to that end. With rising inventory prices, FIFO permitted higher reported earnings all right, but it also permitted —in fact, required — higher taxes on those earnings. Indeed, FIFO thereby fostered less capital to invest for long run returns. Capital markets don’t ignore such unrealistic accounting. The Journal referred to a study by Shyam Sunder, an accounting professor at the University of Chicago graduate business school, in which 118 LIFO firms listed on the New York Stock Exchange outperformed the market in stock price appreciation by 4.7 per cent.
Economist George Terborgh of the Machinery and Allied Products Institute in Washington, D.C. has made all three of the foregoing adjustments to 1973 corporate profits. He found that such adjusted profits came to less than 60 per cent of what they were in 1965. Retained earnings, he found, were down even more significantly; they were but around $3 billion, or 16 per cent of what they were in 1965. The portent for real capital investment and real economic growth in the immediate future is hence not very great, mainly because of the disastrous inflation we have been incurring for the past two years.
Impact on Inventory Planning
Inflation also muddies inventory planning, as can be gathered from my references to LIFO-FIFO accounting methods. Ideally, the inventory-sales ratio should be kept as low as feasible so as to minimize the cost of storage and the cost of money tied up in inventory.
But inflation creates all manner of uncertainties because of rising prices in raw materials, semi-finished and finished goods. As these prices rise, purchasing managers naturally undergo temptations to "beat the gun" by accelerating their forward buying. The purchasing manager of course realizes that his cost of storage and tied-up money will thereby go up. But he may hold that these costs are more than offset by being able to obtain inventory at lower prices than he could later. Too, with a surge of buying he may also begin to worry about availability and delivery delays. So, he inadvertently adds to speculative activity and puts pressure on prices, as he accelerates his forward buying. With all this, however, his inventory-sales ratio may not advance if other purchasing managers adopt the same hedging behavior and also increase their forward buying; the result is that as his inventory climbs, so do his sales. This would be especially true if the purchasing manager is in a basic materials industry. But such inventory build-up behavior, stimulated by surging demand, tends to be short-lived.
For on this score alone, inflation may be contributing to a key factor in the business cycle — inventory buildups, which can lead to a boom, and inventory liquidations, which can lead to a bust. Ironically, the liquidations in effect contribute to deflationary pressures on the very price-inflated commodities and goods that brought on the inventory build-up in the first place.
Impact on Capital Planning
In like manner, inflation disrupts capital planning. Business may be good and the backlog long, but the long-run outlook remains unclear. The planning manager is thus put in the same quandary as the purchasing manager. On the one hand, he doesn’t want to tie up his financial resources in the fixed costs of under-utilized plant and equipment and incur the burden of unnecessary overhead. On the other hand, he is lured by the possibility of obtaining capacity at a significantly lower cost than he could in later stages of inflation; and, he hopes, maybe his order backlog won’t evaporate.
This quandary is especially visible in the basic materials industries such as energy, metals, paper, chemicals, and so on. These industries are extremely capital-intensive. Moreover, because these industries lend themselves to significant economies of scale and require long lead times for new facility construction, new capacity demands tend to come in lumps rather than in evenly spaced-out requirements.
The process is exacerbated by inflation and the business cycle which give wider swings and a feast-famine aspect to the capital goods industry. This aspect is inherent in the capital goods industry anyway, as the accelerator theory of J. M. Clark demonstrates. This theory says that a change in demand for consumer goods tends to have an accelerated change in the demand for capital goods, assuming that the economy is operating at full capacity. Inflation accentuates the problem of the accelerator by giving exaggerated indications of consumer and capital goods demand.
Inflation and the business cycle itself seem to be initiated by credit expansion and artificially low interest rates, both aided and abetted by the central bank. The low interest rates give businessmen false signals of genuine capital availability made possible by savings when the fact of the matter is usually a central bank speedup of money supply growth. The speedup provides the familiar scenario of too much money chasing too few goods, winding up in "stagflation" — a combination of inflation, extremely high interest rates and economic stagnation. (The cyclical process is spelled out more fully at the close of this paper.)
The scenario comes at a bad time. Capital formation has lagged for a long time in America. The American economy must modernize and expand its plant and equipment to accommodate its growing labor force, to reach its energy and ecological goals and to compete in an increasingly competitive one-world economy.
International competitiveness has been rising at the same time that the U.S. has been lagging behind its major overseas competitors in the pace of investment. Here are comparative rates of capital investment for 1973, using gross private domestic investment as a percentage of GNP:
United States 16 per cent
West Germany 26 per cent
France 28 per cent
Japan 37 per cent
So U.S. capital needs are enormous. The New York Stock Exchange has just completed a careful technical study on the capital needs and savings potential of the U.S. economy through 1985. The study aimed at developing realistic projections of U.S. capital supply and demand over the next 12 years. For this period the study came up with the following quantitative conclusion:
Saving potential $4,050,000,000,000
Capital requirements —4,700,000,000,000
In other words, the numbers suggest that the present estimated saving potential in the American economy through 1985 — from all domestic sources — is slightly better than $4 trillion. At the same time, capital demand or requirements will possibly hit a grand total of $4.7 trillion, or more than three times the rate of the previous twelve years in current dollars. The painful indicated capital gap — fraught with human misery — is hence estimated at $650 billion or $54 billion a year. Continued inflation can only compound this problem, impeding, as it does, the two critical processes involved in capital formation: saving and investing.
Impact of Inflation on Wages
Wages constitute some three-quarters or more of all industrial costs, or much more than most businessmen seem aware, inasmuch as a large fraction of this amount is paid indirectly in the form of purchased goods and services. These goods and services, in other words, themselves embody much labor cost.
The point is that cost-push inflation is largely wage-push inflation. So, to quite an extent under the doctrine of "full employment," as wages go so goes inflation. In any event, given the state of our relatively one-sided collective bargaining today in what Sumner Slichter of Harvard called our "laboristic" economy, the industrial relations manager can not do a great deal to soften the terms of the labor contract, other than to inform his opposite-number union negotiators of the state of the industry and his company, the competitive realities and the stage of the business cycle. Also, he can advise top management whether the company should accept a strike as a way of winning more amenable terms.
With all this, however, the traditional collective bargaining areas of wages, hours and working conditions will likely be set in contract provisions not entirely to the industrial relations manager’s liking. Inflation tends to induce work laxity. Working conditions, for example, may be characterized by restrictive work practices, which of course hamper labor productivity improvement — practically the only source of real wage gains. Lessened productivity, in turn, contributes to the inflationary situation of "too few goods."
Some of these restrictive work practices are obvious and direct. For example, size restrictions on the width of paint brushes and rollers, a 150-mile definition of a "day’s work" for trainmen, a limit on the size of cargo slings used by longshoremen, a typographers union requirement that "bogus type" be set as an offset to the use of advertising mats. Some restrictive work practices are indirect and not so obvious. For example, hiring hall arrangements in some fields of employment and control of the labor market by limiting entrants to a particular labor force such as construction.
Importantly, too, the wages provision of the labor contract is similarly inflationary when agreed-upon wage increases exceed productivity gains and worsen the unit labor cost picture of the firm. The firm is thereby under pressure to recoup the added cost burden from its customers. It will unquestionably do so if the union contract is in the industry pattern and if the banking system has in effect accommodated the higher wages with greater demand.
If the accommodation isn’t made, unemployment will likely expand. Even with such accommodation, unemployment will still ultimately expand because of the additional demand pressures created by the new money leading to uneconomic higher unit labor costs. Demand by employers is likely to falter anyway as inflation brings about excessive minimum wages and labor union settlements over and above market demands. In any event, the long-run correlation between increases in unit labor costs and the rate of inflation is unmistakable.
At the same time inflation tends to give management a cost-plus mentality with regard to these-settlements. If demand is rampant, the employer may shrug his shoulders at the otherwise exorbitant wage demands, yield to them and raise his prices accordingly — a scenario that works in the early stages of inflation. The scenario is accentuated by inflated expectations on the union’s part. Not so many years ago a 4 or 5 per cent wage increase demand was workable. Now the teamsters or the plumbers or the coal miners or the phone workers demand 20 to 30 per cent and settle for 10 to 15 per cent. Thus in the third quarter of 1974, according to the Labor Department, the average wage increase for new major union contracts came to 11.3 per cent, up from 10 per cent in the second quarter. These increases add fuel to expectations and the inflationary process, in light of the historical postwar labor productivity improvement factor in the U.S. of around three per cent a year.
The process is exacerbated, I submit, by the use of cost-of-living escalator clauses. Some five million members of the labor force are covered by such clauses and this number is growing. Escalator clauses tend to be little engines of inflation since they push up wages and unit labor costs as "the Consumer Price Index rises, and thereby tend to push prices and the CPI even higher, or create unemployment and pressure for monetary expansion. In other words, the escalator clauses act as a built-in wage-price spiral as well as a built-in worker disemploying agent.
Impact on International Operations
Decisions in the international area are greatly influenced by inflation. Corporate money managers, for example, have had to deal in recent years with "hot money" around the world. They have had to hedge against threatened currencies to protect their accumulated investment funds from erosion because of inflation or devaluation. Currencies have been not only devalued but upvalued, floated and repegged. The United States dollar itself has undergone two devaluations since December 1971, causing quite a turmoil in the currency portfolio of virtually every multinational corporation. Quite a few multinational corporations, including banks, have had to absorb significant losses from currency fluctuations. A prime example is the Franklin National Bank failure. Corporate money managers have therefore found it necessary to increase their hedging and swap arrangements to minimize these losses.
Again, the quadrupling of oil prices via the OPEC cartel has led to some second thoughts in corporate board-rooms on industrial expansion projects here and abroad. Energy the world over has become not only very expensive, but has become tied up in political problems involving its basic availability. Indeed, there is even a growing possibility of further nationalization and expropriation, although this possibility is also brought about by general inflation and other factors.
The high cost of oil and almost every other basic commodity, including wheat, rice, sugar, zinc, tin, aluminum, steel, and the like, has worsened the balance of payments positions of virtually every major industrial country. The result is that these countries are now tending to discourage non-energy imports while pushing their exports harder to offset higher oil prices. Accordingly, corporate money managers will probably find export credit financing sweetened by government agencies in all the countries in which their companies do business, and new barriers to entry for the goods they wish to import into those countries. The effect of all this is to increase trade restrictions — to narrow world markets while ironically accelerating world competition.
Another result stemming from the OPEC model is the incentive for other developing nations to exploit the basic commodities with which they are blessed. The bauxite countries, notably Jamaica and Guyana, have already sharply raised prices to the aluminum companies. Rumblings of like action have been heard from the copper-producing, coffee-producing and tin-producing countries, among others.
So we begin to see how inflation more and more disrupts normal international economic relations for multinational corporations. The years since World War II of harmonious trade and international division of labor, so conducive to world peace, seem to be coming to an end. We are apparently entering an era of economic isolationism wrought by the internationalization of runaway inflation.
Impact of Price Controls on Management
One impact of inflation is political — a tendency for governments to react to inflation with wage and price controls. The irony of such government reaction is twofold: First, government itself is overwhelmingly responsible for the inflation it seeks to correct; and second, wage and price controls treat symptoms, not causes; they repress inflation, mask it, causing shortages and distortions while allowing inflationary forces to become even more virulent. The period of the "New Economic Policy" from August 15, 1971 to April 30, 1974 is a case in point.
Corporate managers in this period generally experienced a cost-price squeeze. In other words, they found their prices lagging behind their costs, chiefly labor and interest costs. In such a squeeze, many of them fled the regulated domestic market and shipped to unregulated markets abroad. This situation merely worsened the distortions in relative prices and the shortages endemic to the entire wage-price control era. Besides shortages, corporate managers had to contend with rampant demand, shipment delays, quality lapses, multiplying bureaucratic interferences and, ultimately, breakdown of the controls themselves. This breakdown in turn led to a rash of "catch-up" wage and price increases, which haunt us down to this very hour.
The controls led not only to a profit squeeze, but to a capital investment squeeze. Many basic materials industries, for example, knew that they had exhausted their capacity limits and that their backlogs could be measured not in months but in years. Yet they still could not set aside expansion funds by the retained earnings route, with earnings so squeezed; they could not raise equity funds with their stock prices so depressed; and they could not go to the bond market, with inflated interest rates reaching double-digit levels. The upshot was that supply became tighter and tighter across the country.
Inflation and Business Cycle
Of critical concern to management is the turn of the business cycle. Should the company expand operations or retrench? What lies ahead: boom or bust? Management is helpless in doing anything about the cycle; like death and taxes it is there, stark and inexorable. Or so it seems.
About all management can do is to try to forecast the turn and act accordingly. But forecasting, even by elaborate computerized econometric models, has proven woefully ineffective over recent years. It has shown itself to be anything but a science. It is an art, and a dubious art at that, as the record of business forecasts sadly evidences. As Walter W. Heller, chairman of the Council of Economic Advisers under Presidents Kennedy and Johnson, declared at the December 1973 meeting of the American Economic Association meeting in New York:
"Economists are distinctly in a period of re-examination. The energy crisis caught us with our parameters down. The food crisis caught us, too. This was a year of infamy in inflation forecasting. There are many things we really just don’t know."
But why is it that practically the entire business community is suddenly thrust into a huge crop of sharp profit setbacks or outright losses? Why is it that even blue-chip managements, noted for their track record of achieving profits and shunning losses, suddenly find their order backlog fading, the more so for capital goods managements?
I believe inflation is at the root of the business cycle, as Ludwig von Mises and 1974 Nobel Prize winner Friedrich von Hayek have long pointed out. Specifically, they have observed that the appearance of the business cycle roughly coincided with the origins of the fractional reserve banking system along with central banks. They have criticized credit expansion (not based upon actual savings) and the doctrine of easy money —ready availability at artificially low interest rates. They have also criticized central banks for aiding and abetting the process by pumping in additional bank reserves and becoming lenders of last resort. And they have criticized central banks for becoming giant printing presses through monetizing government deficits.
For management the process looks like this. Credit expansion puts pressure on resource prices but profits boom. Capacity is strained, so new capital expansion projects are launched. Cost-price squeezes develop. Inflation leaps ahead. Interest rates soar. The stock market falls. Consumers retreat. Businesses fail, especially as their debt structure becomes unserviceable. Expansion slows down, and the recession begins. The recession, if allowed to run its course and if inflation slows down, becomes part of the cure. If these two criteria are not met, the recession can turn into a depression.
In sum, the impact of inflation on management decisions is all-pervasive. There is no handy escape hatch. Losses for management — and for society! — are almost inevitable due to the deterioration of economic calculation, the increase of uncertainty, the evaporation of purchasing power, the damages of recession. The best remedy for inflation is to get at its taproot — deficit spending and excessive money creation. As good citizens, corporate managers might well remember the observation of Dante:
"The hottest places in hell are reserved for those who, in a period of moral crisis, maintain their neutrality."