Flostock News#5 Five years after Lehman
Panic after the bankruptcy of Lehman Brothers
There was panic in the corridors of DSM and many other companies towards the end of 2008, when turnover was dropping week after week in an alarming rate and the newspapers were full of bankrupt banks, insurance companies and car sellers. Commodity prices were dropping like a stone. Politicians were in disarray. Nobody knew whether the banking system as a whole would survive. As a strategy director I was not directly involved in the business, but I knew that we had very long supply chains, and I knew that we were supposed to steer on cash, meaning that we were reducing inventory. I also read in the newspaper that retail and construction were doing quite ok and unemployment was not increasing yet. I combined these facts in an hypothesis that cumulative de-stocking, triggered by the panic after the Lehman bankruptcy was the cause of the 50% sales dip. Through 50 telephone interviews with friends, family, customers, retailers, distributors and suppliers I was able to confirm early 2009 that many companies were trying to reduce stocks, and that the dip was deeper towards the beginning of the supply chain. This –in hindsight-- was the beginning of Flostock.
The Lehman Wave
Once de-stocking had been identified as the probable cause of the sales dip in late 2008, and we expected that it would recover, we wanted to quantify it. How deep would it go? And how fast would it recover? Some preliminary modeling showed that it would be too complex for Excel. An old article described how bullwhipping could be demonstrated by a ‘Beer distribution game’, but my colleagues stubbornly refused to play it for a 100 rounds to quantify the crisis. Then professor Jan Fransoo of Eindhoven University of Technology suggested to use system dynamics to model it. Before the end of January 2009, postgrad Maxi Udenio built the first model that calculated the dip and the recovery. A few months later we gave the wave a name: the Lehman Wave. Looking back now we know that the model forecast was 95% correct, 2 ½ years into the future, that DSM gained some 15% market share and enjoined 250 million euro extra turnover, thanks to these models. DSM and Flostock published this together in two articles in ECJ. We're proud that this month our first publication on this subject was quoted again in an article in Supply Chain Management Review titled "5 Lessons for Supply Chains from the Financial Crisis".
The Housing Bubble as a cause of the crisis
From a system dynamics point of view housing bubbles are transparent: if people compete for a scarce commodity, the price will increase until it is no longer affordable. That means that the pricing bubble in housing, and thus the bubble in construction of houses, was made possible by easy availability of money, i.e. mortgages. Over the past 30 years in the Netherlands it became custom to count the income of both partners in the max mortgage calculation, and the multiplier was increased from 3 to 5 (!) and more. This allowed the great bubble to develop. The Dutch government now seems to understand this, but still they started taking credit-restricting measures in the downturn and not in the upswing, so both in a pro-cyclical way. In the UK on the other hand, the branch organization RICS suggested recently that the government should restrict the availability of money when house prices rise too fast, and they are inspired by the currently developing new pricing bubble in the UK. Flostock supports this advice: the availability of money should be restricted when the prices rise too fast. Money should not be restricted when the prices are still declining as they are now in the Netherlands.
Inventory is the link between Industrial Production and Consumption
Flostock has found that changes of inventory can explain most of the differences between the growth of industrial production and the consumption of the products from that industry, including retail, investments and construction. In a moderate economic cycle this means that industrial production is simply more volatile than consumption: production is “waving” around consumption. In the financial crisis after Lehman, active destocking in the long supply chains caused a severe contraction of the industry, which since has recovered slowly. This additional wave is a specific species of what we call the Lehman Wave. This insight was published as an article in Dutch on www.mejudice.nl , and as an article in English in Chemistry Today.
Replacement of capital goods is installed capacity divided by its life time, according to Flostock's Fifth law.
In the previous newsletter was described that demand for capital goods can be split in demand for growth (which was discussed as law 4 in the previous newsletter) and demand for replacement. Demand for replacement means existing capacity is at the end of its practical life time. It is simply equal to the installed capacity, divided by the average life time. The installed base is equal to the cumulative inflow minus cumulative outflow. In most markets and business columns the total installed capacity of a good is known or can be estimated, as is the average life time. We like to refer to such installed base as a Fleet. Examples are the machinery fleet, truck fleet, and airline fleets. Also all non-residential construction can be considered a Fleet, and all office furniture and all office coffee dispensers and all printers. All mobile phones in the world are a fleet, as all ballpoints in use and the sum of all traffic lights. The replacement flow for these fleets of capital goods is more stable than the flow of buying capital goods for growth (which, remember, is the first derivative of underlying demand, according to our 4th law). There is one complication: under stress people sometimes decide to wait with replacement. This can result in what we call Aging Fleets which will be described in the next Flostock News.