FEDERAL RESERVE BANK OF DALLAS Issue 2 March/April 2005 Southwest Economy ...... Empty Spaces: Are Texas Office Markets on the Road to Recovery? Office markets are cyclical by nature, but in Texas the booms tend to be larger and the busts seem to last longer. In the past, Texas’ office con- struction was sometimes driven by external fac- tors—such as oil prices and tax law changes— in addition to economic fundamentals. However, beginning in the 1990s, Texas real estate was driven more by supply and demand. Economic prosperity in the 1990s, partly thanks to the high-tech boom, breathed life into Texas office markets that had been stagnant since the mid-1980s bust. Demand for office space rose strongly, rents increased at double-digit rates and construction cranes dotted the Texas skyline. The national recession that began in March 2001, along with the high-tech bust and cata- strophic events of 9/11, took a toll on the Texas economy, however. The downturn hit harder and lasted longer in Texas than elsewhere in the coun- try. As firms downsized, office vacancies in Texas markets climbed quickly and rents began falling. (Continued on page 2)

...... Supply Chain : The Science of Better, Faster, Cheaper INSIDE: Over the past 20 years, real GDP growth in the United States has become Domestic Policy strikingly less volatile. Extreme movements in output occur far less often today, and there have been only two relatively mild recessions since 1982. In No Match for Trade addition, about 10 years ago growth began to accelerate. The average annual productivity growth rate since 1995 is about double that ex- Stance of Central perienced from 1973 to 1995. Improved economic stability and accelerating productivity growth have American Countries important policy implications. Specifically, accelerating productivity ultimately leads to higher living standards and fewer and milder periods of declining output. This makes the economy more resilient and flexible. Together, rising (Continued on page 7) : The Science of Better, Faster, Cheaper (Continued from front page) productivity growth and a more stable Chart 2 economic environment give monetary policymakers more room to maneuver Productivity Growth Has Surged by allowing faster economic growth with (Output per hour, nonfarm business sector) less inflationary pressure. 5-year moving average (percent)*

The economy’s increased stability 4 and stronger productivity growth in recent years have intrigued economists 3.5 and policymakers (Charts 1 and 2). Sev- 3 eral competing explanations—which are not mutually exclusive and are likely 2.5 complementary—have been put forth. 2 Among the leading hypotheses are that monetary policy has been better in the 1.5

Volcker and Greenspan eras;1 that there 1 have been fewer shocks—or better luck—in recent years; that globalization, .5 trade and deregulation have become 0 more commonplace around the world; ’70 ’72 ’74 ’76 ’78 ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 and that businesses have radically im- *Four-quarter growth rate. proved their supply chain management SOURCE: Bureau of Labor Statistics. through the widespread adoption of new information technologies.2 This article focuses on one of these What Is Supply Chain how and where to store inventory; how explanations—improved supply chain Management? to distribute products in the most cost- management. I discuss important changes Supply chain management is getting effective, timely manner; and how and and emerging trends in management the right things to the right places at the when to make payments. practices and then present some of the right times for maximum profit. Many A typical supply chain is made up of evidence that has led analysts to believe important strategic decisions impact the many interrelated firms. As shown in that better supply chain management has supply chain: how to coordinate the pro- Chart 3, component and subassembly contributed to the nation’s improved duction of goods and services, including suppliers are upstream from the manu- macroeconomic performance. which suppliers to buy materials from; facturer. Further up the chain are the supplier’s suppliers, who provide raw materials. Downstream from the produc- Chart 1 ing firm are the warehousing and distri- Real U.S. GDP Growth Is More Stable bution channels, then the retail channels Quarterly percent change, annualized and finally the consumer. Thus, the sup-

18 ply chain encompasses the flow and 16 transformation of goods, services and 14 information from the raw materials stage 12 to the customer. 10 While supply chain management is 8 as old as trade itself, new information 6 and communications technologies have 4 made today’s supply chains better, faster 2 and cheaper. Information 0 that combines new information tech- –2 nologies with improved production, –4 inventory, distribution and payments –6 methods has revolutionized supply chain –8 ’59 ’62 ’65 ’68 ’71 ’74 ’77 ’80 ’83 ’86 ’89 ’92 ’95 ’98 ’01 ’04 operations.

SOURCE: Bureau of Economic Analysis. For example, one way to buy a computer is to get on Dell’s web site and

FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY MARCH/APRIL 2005 7

quantity. Significant lean Chart 3 ideas include six-sigma quality , The Supply Chain just-in-time inventory and total . (See the box titled “Lean

Retailers Manufacturing Lingo.”) W/D Suppliers’ Suppliers suppliers Mass Customization Era. Beginning around 1995 and coinciding with the commercial application of the Internet, Retailers Warehouses manufacturers started to mass-produce and distribution Suppliers Suppliers’ centers suppliers customized products. ’s famous Manufacturers statement “You can have any color Model T as long as it’s black” no longer applies. While Dell may be the most famous Retailers W/D Suppliers Suppliers’ suppliers mass customizer, the elimination of mid- dlemen (such as travel agents, ware- housers and salespeople) and the shar- ing of critical information in real time with key partners make this era signifi- configure and price a system exactly ones—can be shipped anywhere in the cantly different. Perhaps a more accurate as you want it. As soon as you submit world in seconds at virtually no cost. term would be the “information engineer- the online order, all of Dell’s global sup- And with digital products there are no ing” or “” era. pliers—those providing chips, monitors time-to-manufacture delays, inventory Firms are effectively using new and so on—are immediately notified of shortages or delivery problems. information technologies to improve ser- the sale and go to work so that you vice and delivery processes. Through receive your computer typically within Supply Chain Management Eras secure intranet systems and business-to- a week. Throughout history, new ideas and business (B2B) e-commerce platforms, Contrast this direct model with technologies have revolutionized supply firms focus on improving information yesterday’s supply chain. The old model chains and changed the way we work. required the customer to go to a store in Two hundred years ago, giant machines search of a product that the manufac- replaced manual labor to complete tasks turer thinks you want to buy. in large factories. Railroads, electricity Lingo But now, in some cases, the middle- and new communications media ex- Six-sigma: This idea was men between you and the manufacturer panded markets and made supply chains pioneered by Motorola as a way to improve can be eliminated. Moreover, in the better, faster and cheaper. processes that are already under control. direct sales model, the upstream suppli- Era. In the early The outputs of such processes typically have a ers play a key real-time role in keeping 1900s, Henry Ford created the first mov- normal distribution, and the process capability production and distribution flowing ing assembly line. This reduced the time is expected to be within plus or minus three standard deviations of the mean. Each standard smoothly. required to build a Model T from 728 deviation is one sigma, so the total process Better supply chain models help not hours to 1.5 hours and ushered in the capability covers . only manufacturers of goods, but also mass production era. Over the next 60 Just-in-time: This inventory management idea some service businesses, including those years, American manufacturers became was pioneered by Toyota to ensure that inven- requiring creativity, imagination and spe- adept at mass production and stream- tory in production systems would arrive in cialized knowledge. For example, using lined supply chains with the help of good condition exactly when needed: not too a virtual reality system and ultrasound scientific management methods and early and not too late. data sent through the Internet, a medical techniques. : This idea empha- specialist in Dallas can give an opinion Lean Manufacturing Era. But in the sizes multifunctional teams to solve quality- to a patient in New York…or London… 1970s, U.S. manufacturing’s superiority related problems. Such teams are trained to or Bombay. A virtual reality system worn was challenged. Foreign firms in many understand basic statistical tools and then collect and analyze data to resolve quality around the hand and arm allows a physi- industries made higher quality products problems. cian to feel pressure sensations from at lower costs. Global forced computer images and make an informed U.S. manufacturers to concentrate on im- Kaizen: This is a team approach toward incremental improvement to tear down and diagnosis in real time halfway around proving quality by reducing defects in rebuild a process layout to function more the globe. their supply chains. efficiently. Today’s most efficient supply chains Starting in the early 1970s, Japanese Kanban: This inventory management tech- use the Internet and associated tech- manufacturers like Toyota changed the nique uses containers, cards and electronic nologies to move information in real rules of production from mass to lean. signals to help production systems plan more time to those who need it. These bits of Lean manufacturing focuses on flexibility efficiently. data—digital strings of zeroes and and quality more than on efficiency and

8 FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY MARCH/APRIL 2005

management by integrating internal sys- Chart 4 tems with external partners. For exam- ple, through its web site, Amazon.com Reduced Bullwhip Effect for Durables gives customers the ability to track the Standard deviation (percentage points)* delivery status of their purchases. And 20

Wal-Mart routinely shares all sales data in 18 real time with its upstream suppliers and 16 Production growth volatility manufacturers. 14 Components of the Supply Chain 12 The supply chain has four basic 10 Sales growth volatility components: 8 • Production. Businesses focus on 6 how much to produce, where to pro- duce it and which suppliers to use. 4 • Inventory. Businesses decide where 2 to store their products and how much to 0 store. ’68 ’70 ’72 ’74 ’76 ’78 ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 • Distribution. Businesses address *10-year moving standard deviation of one-quarter annualized growth. questions about how their products SOURCE: Bureau of Economic Analysis. should be moved and stored. • Payments. Businesses look for the best ways to pay suppliers and get paid by customers. Production. One way to see the bull- mation technologies to bring significant The efficiency and effectiveness of a whip effect in production is to compare efficiencies to supply chain operations.4 supply chain is contingent on firms’ abil- sales growth volatility at the customer To reduce production growth volatil- ity to gather and analyze important infor- end of the supply chain with production ity at JCPenney, the company has imple- mation through these components. growth volatility at the opposite end. mented a revolutionary computer system Supply chains that use real-time informa- that directly captures sales data for each Information Distortions and tion effectively should have an informa- of its products at the cash-register level. the Bullwhip Effect tion distortion bullwhip that is shallower Rather than making forecasts on what Distorted information, or the lack of and less volatile. corporate managers think they will sell, information, is the main cause of the Chart 4 shows that for durable forecasts are now based on real-time “bullwhip effect”—the phenomenon goods, production growth volatility is point-of-sale data. whereby demand uncertainties and vari- now much closer to sales growth vola- For certain men’s dress shirts, ability are magnified as orders are placed tility. Both have declined since the mid- JCPenney has gone a step further and at each step up the supply chain from 1980s. Sales growth volatility has de- outsourced the sales and the customer to the raw materials sup- clined from a 10-year moving standard inventory management functions to the pliers. The bullwhip effect takes its name deviation of 13 percentage points in shirtmaker in Hong Kong. So now a sup- from the way the amplitude of a whip in- 1987 to about 8 percentage points today; plier thousands of miles away decides creases down its length. This effect has production growth volatility has dropped how many shirts to make and in what been observed in many industries and is from around 18 percentage points in styles, colors and sizes and then sends the main cause of supply chain ineffi- 1983 to 8 percentage points today. the shirts directly to each JCPenney ciencies.3 Several explanations are possible. store—bypassing the company’s corpo- Proctor and Gamble (P&G) execu- Deeper and more flexible capital mar- rate decisionmakers and warehouses.5 tives coined the term after studying the kets, better monetary policies or just Inventory. Information distortions demand for disposable diapers. As plain luck could have all helped to and the bullwhip effect also unnecessar- expected, babies use diapers at a fairly reduce the volatility of final sales, which ily increase inventory at all points along steady and predictable rate, and as a may have driven production volatility the supply chain. In many respects, result, retail sales are reasonably uni- lower. Nevertheless, while these and inventory is simply insurance against form. But P&G found that each retailer other explanations may have contributed supply chain uncertainties. Unused and based its orders on its own slightly exag- to supply chain improvements, better unsold inventory carries burdensome gerated forecast, thereby distorting infor- supply chain practices that use new in- costs, including those for holding, ware- mation about true demand. Wholesalers’ formation technologies also seem plausi- house and production-line storage, insur- orders to the P&G diaper factory fluctu- ble. Certainly, the dramatic reduction in ance, obsolescence and spoilage. At the ated more, and P&G’s orders to 3M and production growth volatility occurred as same time, however, sufficient inventory other materials suppliers oscillated even superior manufacturing and quality con- must be maintained to meet demand and more. trol processes combined with new infor- keep production flowing smoothly.

FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY MARCH/APRIL 2005 9

cent of the goods component of GDP Chart 5 in 1981 to around 26 percent in 2003. Inventory Management Continues to Improve Transportation costs declined nearly 4 per- Durable goods inventory/shipments ratio cent, whereas inventory carrying costs 2.75 dropped about 58 percent. While inven- tory carrying costs have been driven down 2.5 partly by lower interest rates, evidence shows that inventories are managed more 2.25 efficiently, which also contributes to lower costs. Warehousing expenses have gone 2 down as firms implement automated systems, and risks have been minimized 1.75 as third-party providers increas- ingly furnish specialized and customized 1.5 solutions that increase efficiency. For example, firms such as FedEx and UPS 1.25 now take on the entire logistics planning ’59 ’62 ’65 ’68 ’71 ’74 ’77 ’80 ’83 ’86 ’89 ’92 ’95 ’98 ’01 ’04 and fulfillment tasks for businesses of SOURCE: Census Bureau. all sizes. Perhaps the biggest distribution challenge is managing demand in a As shown in Chart 5, producers have until it receives an order. In 1996, Dell dynamic and uncertain environment. streamlined their supply chain operations held 31 days of inventory. It now holds Demand-based management that opti- to hold less inventory relative to sales. four days of inventory. mizes sales prices and shortens lead The inventory-to-shipments ratio dropped Distribution. Just about everything we times from design to delivery will likely markedly during the 1990s and is now consume is taken from the earth, pro- become the next major area of strategic near its all-time low. In essence, new cessed and transported, often requiring competitiveness in managing supply technologies have allowed firms to re- many stages before reaching consumers. chains. For example, by using real-time place inventory with information and then Today’s transportation and distribution sales data, Zara, a Spanish clothing com- use that information more productively.6 of goods often involve longer distances pany, streamlined its supply chain to Indeed, Dell has turned traditional and better coordination than in the past. introduce new products in stores within manufacturing thinking on its head by Yet, as Chart 6 shows, logistics costs three weeks of design. saying that it will not make anything trended downward from about 39 per- Payments. As technology costs have fallen and electronic connections between companies have increased, more firms are adopting digital technologies and Chart 6 eliminating paper transactions and human Logistics Costs contact. Automatic order placement, (As a percentage of the goods component of GDP) billing and payment can all be triggered Percent and performed by a computer without 40 human intervention and paperwork. And more and more companies have im- 35 plemented business-to-business e-com- merce systems to streamline payments 30 and enhance communications with sup- Total logistics costs pliers. Such systems also guarantee faster 25 collections and result in fewer losses.

20 Progressive Insurance, for example, can Transportation costs use satellites, camera phones and the 15 Internet to issue final settlement checks within minutes of being called. 10 Inventory carrying costs Better, Faster, Cheaper. All these im-

5 provements—reduced production vola- ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 tility, lower inventory levels, less expen- NOTE: For years 2001–03, manufacturing sector income data are grouped by the North American Industry Classification System; previous sive logistics and streamlined payments years use the Standard Industrial Classification. systems—have a common denominator: SOURCES: Bureau of Economic Analysis; “15th Annual State of Logistics Report,” by Rosalyn Wilson, Council of Logistics Management, June 2004. more efficient information management through better methodologies and tech-

10 FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY MARCH/APRIL 2005

that annual GDP growth is negative, Chart 7 which roughly corresponds to recession- U.S. Business Cycle Expansions and Contractions ary periods, is far less in the mass cus- Black = months in contraction tomization era than in the prior eras. And the percentage of time the economy experienced real GDP growth above 3.5 percent annually is greater in the mass customization era. Productivity growth tells a similar story: It has become less volatile and has trended upward for several years. As shown in Chart 9, during the mass cus- tomization era, productivity growth exceeds 2.5 percent far more often, and negative productivity growth occurs far less often than in the prior eras. As new technologies help companies streamline 1800s 1900s 2000s supply chain operations, it makes sense SOURCE: National Bureau of Economic Research. that productivity, measured as output per hour, will improve.9 We live far better than did earlier nologies. Successful businesses are reor- cycle expansions and contractions. Each generations because of the power of ganizing to take advantage of informa- black bar represents a recession: The fat- productivity. Our ability to innovate—to tion technology and rethink the way ter the bar, the longer the recession. The improve production processes, imple- work is done.7 The result, of course, is timeline starts in 1855, the earliest year ment new technologies, better manage that consumers benefit from higher qual- for such records.8 The large spaces on product and information flows, engage in ity products, a greater selection of goods the right side of the chart indicate that more specialization and trade, and fur- and lower prices. the U.S. economy is in recession far less ther upgrade our skills—allows us to get often today. more for less. Macroeconomic Performance Chart 8 indicates that GDP growth Across Supply Chain has been less volatile recently. The three The Power of Productivity Management Eras pie charts correspond to the three supply Further improvements are on the Chart 7 may look like an ordinary chain eras discussed earlier: mass pro- horizon. Other new information tech- bar code, but a closer scan reveals that duction, lean manufacturing and mass nologies, like the global positioning sys- it’s actually a record of U.S. business customization. The percentage of time tem (GPS) and radio frequency identifi-

Chart 8 Real GDP Growth Is Less Volatile Today

Mass Production Era Lean Manufacturing Era Mass Customization Era (1948–73) (1974–95) (1996–2004)

3%

13% 15%

37% 44% 54% 60% 34%

41%

Average growth = 4.1% Average growth = 2.9% Average growth = 3.4%

> 3.5% real GDP growth 0% – 3.5% real GDP growth Negative real GDP growth SOURCE: Bureau of Economic Analysis.

FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY MARCH/APRIL 2005 11

Chart 9 Productivity Growth Getting Stronger

Mass Production Era Lean Manufacturing Era Mass Customization Era (1948–73) (1974–95) (1996–2004)

3%

19% 24% 32% 26%

50%

31% 71% 44%

Average growth = 2.8% Average growth = 1.4% Average growth = 3.1%

> 2.5% productivity growth 0% – 2.5% productivity growth Negative productivity growth SOURCE: Bureau of Labor Statistics.

cation (RFID), will continue to improve Notes of Economic Research used different ways to choose prewar and post- supply chains. This is true not only in I am grateful to Mike Cox, Evan Koenig, Anil Kumar and Mark Wynne war business-cycle reference dates. Thus, the recession record shown manufacturing, but also in retail, insur- for valuable comments that improved this article. Dan Lamendola pro- here uses data that may exaggerate economic volatility prior to World vided excellent research assistance. War II. ance, health care and other industries. 9 1 Paul A. Volcker was chairman of the Board of Governors of the Federal Again, there are several explanations for the higher trend rate of pro- We are just beginning to see the power Reserve System from 1979 to 1987. Alan Greenspan has been chair- ductivity growth and the economy’s increased stability. And while it of productivity as firms effectively imple- man since 1987. seems plausible that improved supply chain management combined ment these new technologies. 2 For more on these explanations, see “Recent U.S. Macroeconomic with the effective implementation of new information technologies has For example, an RFID tag embedded Stability: Good Policies, Good Practices, or Good Luck?” by Shaghil contributed to the economy’s improved performance, there are difficul- ties in disentangling the impact of supply chain management. Even so, into a product allows it to be tracked and Ahmed, Andrew Levin and Beth Anne Wilson, The Review of Econom- ics and Statistics, vol. 86, August 2004, pp. 824–32; “Monetary Pol- the anecdotal and factual evidence presented here suggests that the to transmit predetermined information icy Rules and Macroeconomic Stability: Evidence and Some Theory,” technology-led New Economy paradigm that emerged in the mid- without physical scanning. The productiv- by Richard Clarida, Jordi Gali and Mark Gertler, Quarterly Journal of 1990s may be alive and well. ity gains from RFIDs could be substan- Economics, vol. 115, February 2000, pp. 147–80; “The Long and tial. Imagine wheeling a full grocery cart Large Decline in U.S. Output Volatility,” by Olivier Blanchard and John through checkout and receiving an instant Simon, Brookings Papers on Economic Activity, no.1, 2001, pp. 135–64; and “On the Causes of the Increased Stability of the U.S. total without scanning individual items. Economy,” by James A. Kahn, Margaret M. McConnell and Gabriel In our increasingly interconnected Perez-Quiros, Federal Reserve Bank of New York Economic Policy and interdependent global economy, the Review, vol. 8, May 2002, pp. 183–202. processes involved in delivering supplies 3 “Information Distortion in a Supply Chain: The Bullwhip Effect,” by and finished goods—including informa- Hau Lee, V. Padmanabhan and Seungjin Whang, , vol. 43, April 1997, pp. 546–58. tion and other business services—from 4 Kahn, McConnell and Perez-Quiros (2002) find that changes in inven- one place to another are mind-boggling. tory behavior stemming from improvements in information technology But through information engineering, have played a direct role in reducing real output volatility. supply chain improvements have resulted 5 “Made to Measure: Invisible Supplier Has Penney’s Shirts All Buttoned in a reduced bullwhip effect, lower in- Up,” by Gabriel Kahn, The Wall Street Journal, Sept. 11, 2003, p. A1. 6 Kahn, McConnell and Perez-Quiros (2002) examine the inventory-to- ventory levels, reduced logistics costs and sales ratio for durable goods against a target ratio extracted from a streamlined payments. These improve- smooth trend of the data and find evidence that firms are making ments have led to macroeconomic bene- smaller mistakes now than before the mid-1980s. They argue that this fits such as more stable economic output improvement could plausibly be linked to advancements in informa- and stronger productivity growth. tion technology. 7 “Where IT’s @: Technology and the Economy,” by Thomas F. Siems and Mine K. Yücel, Federal Reserve Bank of Dallas Southwest Econ- —Thomas F. Siems omy, January/February 2005, pp. 13–16. 8 The observation that post-World War II expansions are twice as long as prewar expansions has been questioned and investigated in “Busi- Siems is a senior economist and policy ness-Cycle Durations and Postwar Stabilization of the U.S. Economy,” advisor in the Research Department of the by Mark W. Watson, American Economic Review, vol. 84, March 1994, Federal Reserve Bank of Dallas. pp. 24–46. The most likely explanation is that the National Bureau

12 FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY MARCH/APRIL 2005