Money & Markets: Just in time processes boost profits – until something goes wrong

When I was a kid, I started a computer games business, and with what amounts to a bunch of runaway children, we had a pretty good go at being some of the pioneers of the Sinclair home computing era.

A business was a marvellous toy and a very severe education. In that very adult world, there were all sorts of financial concepts that a bootstrapping business with zero capital, at the birth of a new industry, with an average employee age just above the minimum school leaving age, had no conception of. One was Return On Capital Employed (ROCE). If you are a private equity firm putting the wealth of the hyper rich to work, this is a key number, because you are looking at the world as an offset proxy of a US treasury bond. If you can find a business that looks like a bond and has a yield interestingly above that of a US treasury bond, then you get very interested. As such, you love infrastructure and businesses that need a lot of capital but don’t need a lot of those pesky employees. Property fits that bill; infrastructure fits that bill. Anything that needs a big block of capital and thereby has a high barrier to entry and predictable income is an enterprise you want to land on, and key is Return On Capital Employed.

When you have just started a computer games company with a bunch of feral proto-nerds with no capital, your ROCE is tremendous, tending to infinity, and I remember reading a report on my little business which ranked it as a colossus of ROCE, while in effect it was just a room full of children – many of whom were still unwelcome in a pub – that had no capital and a great growth rate.

Emerging from the importance of ROCE is ‘just in time’ processes invented originally by Toyota to streamline the incredibly complicated business of assembling cars. From a financial point of view, operational efficiencies aside, if you operate with your inputs arriving as you need them, you can slice off layers of capital and boost your ROCE. The less capital employed for a quantum of profit, the better.

A business like a car company has a vast amount of capital employed and at risk. Cash, which has been morphed into ‘liquidity’ in the minds of such engineering empires, is no longer the worry it was. Cash can be magicked up at will from the financial system. Instead of worrying about cash, the prime directive is increasing efficiency and lowering capital employed to get ROCE up as one of the key deliverable and incredibly lean ‘just in time’ processes that have been built to drive ever more refined efficiencies.

This all works brilliantly until something big and systemic goes wrong. The credit crunch of 2007-08 came to a head when cash suddenly could not be magicked out of the financial system on a Thursday to pay the wages on Friday, a reason colossus engineer GE had their ‘commercial paper’ bailed out by the US government at the pit of that crash, because the banks that swapped cash for GE overnight paper suddenly couldn’t and wouldn’t do it.

The government had to step in and bail out the whole US corporate system that had become reliant on ‘cash on demand’ from the market. Paying wages just in time was an incredible, lean way to do business and extremely resilient, until the system broke.

So today, inflation is with us, and if you were studying a high school book on economics you would (newly educated in economics) say we have inflation because governments have dramatically increased the money supply while supply of goods has not increased and may have even fallen back. Passing the buck, central banks point to ‘supply chain issues.’ If you are a ‘just in timer’ car maker and you can’t get any one of untold parts that used to get delivered to your door in the morning, you are in trouble. It could be because they weren’t made, they weren’t shipped, they weren’t unloaded in the port, or there was no lorry driver to ship them to you. In any event, you are going to have a difficult time making that vehicle at previous volumes.

Hearing Steve Jobs explain how Apple engineered its manufacturing processes to force their suppliers to deliver their production components with what sounded like split-second timing filled me with a feeling of shock and awe. What would happen if that finely balanced piece of clockwork went wrong?

Well, here we are, and it’s ugly.

Yes, supply disruption is causing inflation, but it is more a symptom than root cause. It won’t be long before the supply chain is straightened out and there will still be inflation. Production will continue to spin up, shipping will find other ports to unload at, and rail and roads will find new employees and systems to unblock the supply chain.

However, there will still be inflation, and the money-printers will point in other directions to explain it away. Then they might go Japanese and simply throw their hands up and say: “Well that’s amazing, we don’t know what’s causing inflation, it’s a puzzle and everyone else around the world also can’t seem to bring inflation down either. We are working on it.” Do not be fooled; inflation is always policy.

When economies have rebalanced their economies by boosting economy activity and nominal tax revenues, and debasing their debts back to a sustainable level of GDP to public debt, they will suddenly know the secret of bringing inflation down, and they will act.

That is going to be quite some time into the future.

Meanwhile, any asset you can swap for your liquidity is going to go up in price and even value, because one thing is for sure, money is going down in value for a long time.