U.S.: Can the New Economy Pass This Survival Test?
Thanks to slowing demand, falling employment, and sagging productivity, the New Economy finds itself in a crucible. The test: Can it withstand the heat from the business cycle? The results will say volumes about the long-term outlook for noninflationary growth, monetary policy, and future returns on investments.
The drop in payrolls--a shockingly large 223,000 loss in April after a March fall of 53,000--makes it clear that this 10-year expansion faces a perilous time. The job losses heighten the risks that the economy is near--or even in--a recession. Meanwhile, an unexpected dip in first-quarter productivity coupled with surging unit labor costs mean that corporate profits are getting squeezed as demand slips while labor costs rise.
Take a step back, however, and consider that the economy is pulled along by two different sets of trends. The short-term, cyclical ones depend on what demand is doing. The structural trends hang around awhile and reflect the major shifts in how the U.S. does business, such as using computers to handle information.
In the short span of a quarter or even a year, cyclical forces cause the economy to gyrate up and down around its longer-term structural trends. Right now, of course, the economy seems to be gyrating only in a downward direction. In fact, the last time payrolls fell off as dramatically as they did in March and April was back in the 1990-91 downturn.
But much has changed in the past decade, especially in the last few years. And those shifts, both cyclical and structural, mean that the current labor-market weakness does not necessarily signal that a recession is at hand. However, these changes do imply that the unemployment rate will rise for the rest of 2001, even if the economy avoids a recession.
THREE MAJOR CHANGES explain what's happening in the labor markets right now. First is the New Economy's dark little secret: In a highly productive economy, a business needs fewer workers for any given level of output. For example, over the past year, real gross domestic product grew 2.7%, down sharply from the 5.3% pace in the previous year. But growth in productivity--output per hour worked--held up remarkably well, slowing to 2.8% from 3.8% (chart). Thus, productivity gains accounted for all the economy's growth. So businesses have little need to add to their payrolls, and some are letting workers go.
On the plus side, higher productivity allows a more rapid response by policymakers. It has kept inflation low, enabling the Federal Reserve to slash interest rates. And it has helped to generate the surpluses that make tax cuts possible. Indeed, the Bush tax cut may turn out to be one of the most fortuitously timed fiscal policy actions on record.
To be sure, productivity will sag this year. It fell at a 0.1% annual rate last quarter. But even if productivity does not grow for the rest of 2001, its five-year growth rate will hold at a high 2.4% annually, compared with 1.7% in the previous five years. Plus, as the economy picks up in 2002, productivity will reaccelerate.
THE SECOND BIG CHANGE over the past decade is the reaction time of U.S. businesses to changes in demand: As seen with inventories and capital spending--and now labor costs--the adjustment process has been compressed. This has increased the importance of temporary workers who can be hired and fired easily and with less cost. Contingent workers have made the labor markets much more flexible. But in bad times, temps are the first to be let go, as recent data show (chart).
In fact, compared with the last recession, a disproportionately high percentage of recent job losers have been temps, not permanent staffers. During the nine months of the last recession, temp jobs dropped by 88,000, a mere 7% of private-sector losses. In only the past four months, temp jobs have declined by 234,000, while total payrolls have fallen by only 54,000. Excluding temps, who are only 3% of all nonfarm workers, payrolls are up 180,000.
However, many of these temp jobs may not return once the economy picks up, which reflects the third key feature of the economy in 2001: Even though the U.S. can now sustain a lower noninflationary jobless rate than in the past, that rate is a lot closer to 5% than it is to the expansion low of 3.9%. It was the unsustainable boom in demand in the late 1990s that drew the unemployment rate down to that level, which could not be maintained without giving rise to serious price pressures. And unemployment will continue to rise, as many marginal workers, who were pulled into the labor market by the spending boom, are now cut loose.
THE DANGER: Since consumers have provided the lion's share of economic growth in each of the past three quarters, the weak job markets could be the knockout blow for this expansion. Layoffs could kick consumers' income support away or drive confidence down so far that shoppers just stop spending.
But keep in mind that, at a 4.5% jobless rate, labor markets remain relatively tight. That's why pay and benefits are still rising smartly. The Labor Dept.'s productivity report showed that worker compensation grew at an annual rate of 5.2% in the first quarter, and it was up 6% from a year ago (chart). That pace is far faster than inflation, increasing household buying power. In April, average hourly earnings of production workers rose 4.3% from a year ago. Even with the energy-boosted 3% inflation rate, as measured by the consumer price index, real wages are still rising.
A worker's big pay raise, however, is the employer's rising labor cost. In the first quarter, that 5.2% rise in compensation meant unit labor costs jumped at the same rate, since there was no offset from productivity. And over the past three quarters, unit costs have risen at a 4.3% pace. That's the fastest rate in 10 years, and faster than businesses are able to lift prices. That has resulted in the current profit squeeze (page 82).
In an effort to revive productivity and trim costs, businesses are announcing more layoffs. What's uncertain is how much job-market weakness consumers can tolerate. So far, the data suggest only a very soft economy, as businesses adjust to a slower pace of demand. Second-quarter real GDP may even decline.
But that's not a recession. A recession is a unique economic event. It's like a coiled spring that suddenly snaps. The jolt causes an unwinding of economic activity, a weakness that feeds on itself across an array of sectors. The unwinding tends to require two or more quarters of contracting GDP before the forces of growth take over again.
But those growth forces have been especially strong in this expansion, mainly reflecting the economy's evolution during the past decade. Add in aggressive policy action, and the groundwork for stronger growth has already been laid.
By James C. Cooper & Kathleen Madigan