The degree of freedom in this case is to lay off workers while cutting prices. Since layoffs occur more slowly than the reduction in output, productivity suffers and unit labor costs rise cutting further into profits. If, as currently seems to be the case, the belief is that the economic slowdown will be brief or V-shaped, firms will retain most of their workers in the hope of responding quickly to the pickup in demand that is expected in a few months. If the resumption in demand growth does not occur, however, perhaps because analysts and policymakers expected just a brief V-shaped recession and therefore did not respond sharply to the capital goods inventory overhang, the requisite level of layoffs later will be all the greater. In short, the danger of insisting that an incipient recession will be brief and shallow lies with the delay in reducing costs by enough to deal with a more serious slowdown in demand growth.
Households also adjust inventories during economic slowdowns.
For households, the main inventory is the stock of durable goods that they own. That stock represents a storehouse of the services that the goods provide, such as the services provided by automobiles and appliances. During especially favorable economic times, households add to or replace their stocks of durables, thereby reducing the average age of the equipment that they own while simultaneously making it possible to delay the purchase of new equipment should incomes fall. The retail sales data suggest that households have sharply reduced spending on durable goods, with outlays falling at a 1.6 percent annual rate during the three months ending in January after having risen at a remarkable 11 percent rate during 1999. The sharp drop in consumer confidence with higher layoffs and lower equity prices suggests that the weakness in spending on durable goods may accelerate in coming months while spending on nondurables will continue to slow.