Posted by: Richard | May 31, 2010

Paul Donovan – UBS Chief Economist

I was fortunate enough to get to spend a lunch-hour learning from the Chief Economist of UBS – Paul Donovan.  It is rare that I come away from these presentations with more than a thought or two, however after this presentation I have over a page of notes.  This is a testament to the clear thinking of Mr. Donovan and his ability to present ideas.  I thought it would be interesting to share some of my notes and thoughts.

Talking about the recession, he made an interesting point that 70% of the drop in GDP in recessions is caused by inventory reduction / tightening.  This is what can make a small business cycle more dramatic, potentially becoming a major recession.  He discussed how the 1982 recession saw a dramatic drop in inventories held by big business coming out of the recession.  Pre-recession inventory levels never returned, as companies had developed tools (software, relationships with vendors) to keep lower inventory levels.

This recent recession is very different in that it is small business that is taking most of the pain.  This is important, as a majority of the economy is small business.  We can see this looking at the stock market, where big companies are bringing in strong profits.  What is happening is that liquidity has dried up for small business.  Banks are getting tighter on financing small business, making cash flow more important.  At the same time, suppliers (often big business) are tightening their financing of small business, reducing terms from net 90 to net 30.  All in all, cash is getting hard to come by, and one of the only ways to save on cash is to reduce inventory.  There is now a tremendous incentive to invest in technology that can better manage inventory.  Even where technology doesn’t exist, management can take a more active role in managing inventory to reduce cash tied up in the business.

What this means is that coming out of this recession, we may not see an inventory bounce back to pre-recession levels.  Much like big business never went back to their high-inventory levels post-1982, smaller business may also run leaner as a result of this recession.

Separate from the above, we looked at unemployment, which is good and bad news.  The good news is that confidence is improving, largely as a result of the fact that many unemployed are structurally unemployed. In Spain (which has 20% unemployed), the remaining 80% are quite confident, as they view unemployed as unemployable.  This obviously is a simplification, however the psychology is that growing unemployed cause fear (as it is happening and affecting you regularly), however the effect of long-term unemployed diminishes over time.

Further to this, demographics plays a role in the changing Western World, which is increasingly focusing on services and needs high quality labour.  As an example, in America 20% of the workforce has third world reading and 30% have third world arithmetic skills.  This contrasts with roughly 10% of European workers having third world reading and arithmetic skills. This semi-skilled part of the work force is finding it harder and harder to compete in labour markets where unskilled and semi-skilled labour has been outsourced to developing countries.

This leads to a frightening future for Western Societies, which start to develop into an active labour community and a disaffected long-term unemployed community.  Not only does this fracturing of a population into haves and have-nots reflect the failure of a country and a society to be inclusive and prosperous, but it also creates huge social tensions that will likely lead to significant long-term costs.  It is obviously critical to find the root causes in structural unemployment and build incentives for these marginalized groups to gain the skills required to rejoin the working class.  What these incentives are and how they are administered is far beyond my expertise, however I’m sure a good discussion could be had over several beers on a patio.

Ultimately, this presentation engaged me with new ideas and has me thinking of the implications of what is happening today on the future of our economy and society.

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