As go geese, so goes the economy

If you’ve ever noticed a flock of geese flying in V-formation, you can understand the microeconomic concept of complementary goods.

In a flock of geese, there may be 10 geese following the leader. In economics, there may be 10 different complementary goods the demand for which rises and falls with demand for the lead good.

Complementary goods are playing an important role in the economic downturn which surfaced this month. As subscribers to the current issue of my monthly investment newsletter, The Cohan Letter will see, as go lead goods automobiles, housing, and in an odd way oil; so go their complementary goods.

Let me expand on this point.

In April, GM and Ford reported that they expect significant declines in sales for 2005, specifically for gas guzzling SUVs and trucks. Every time someone buys a car, the auto’s maker needs to replenish its inventory of parts and steel – making these items the automobiles’ complementary goods. GM and Ford have responded to declining demand by squeezing their parts and steel suppliers. As a result, many auto parts suppliers have filed for bankruptcy and others – laden with debt – are suffering debt downgrades. S&P thinks that some of them will violate their debt covenants – a move that could send them into bankruptcy. Meanwhile, prices for rolled steel that goes into automobiles have declined and capacity utilization for US steel producers is tumbling.

Similarly, as housing prices have skyrocketed and housing affordability has tumbled, home foreclosures have spiked 50%. Whenever someone buys a new house, builders need to replenish their inventories of lumber and the home buyers need to buy furniture – making these items housings’ complementary goods. With the housing market peaking out, lumber prices are tumbling and furniture retailers are hurting.

Oil is a special case. When oil prices rise, so do gasoline prices. And when gasoline prices rise high enough, people stop buying other things – such as gas guzzling SUVs. Some even stop driving altogether and take public transportation. So oil is a kind of inverse complementary good. When its price reaches a certain level, people stop buying the complementary goods – such as big cars -- that they would have purchased if the price of oil was lower. According to the Dallas Federal Reserve, higher oil prices are likely to subtract 1.6% from the US GDP growth in 2005 and 2006.

That makes this inverse complementary good a pretty powerful economic factor. But it seems that there is an inherent time lag between when the lead good changes direction and the complementary goods follow that lead.

And my hunch is that this time lag suggests why the economy held up fairly well through the end of 2004; why it slowed down in the first quarter of 2005 and why that slowdown could intensify throughout 2005 and into 2006.