U.S.: Productivity Gains: The Good News and the Good News
The surge in productivity has been one hallmark of this recovery. According to the Labor Dept.'s latest data, output per hour worked at nonfarm businesses grew at an annual rate of 4% in the third quarter. For the past year, productivity rose a remarkable 5.3% (chart). That advance is faster than any yearly rate posted in the New Economy boom years of the late 1990s. In fact, you have to go back to 1971 to beat it.
Strong productivity gains create a positive fundamental for any economy. Higher efficiency can lift both profits and workers' incomes, and it keeps inflation low and borrowing costs affordable. As Federal Reserve Vice-Chairman Roger W. Ferguson Jr. said on Nov. 12: "In the long run, strong growth of productivity is unambiguously positive."
But what about the short run of, say, the next few quarters? In this case, productivity gains will boost the economic sector that needs it most: Corporate America. Greater efficiency will enable companies to make more money. Additional cash will give businesses the wherewithal to start investing in new equipment again. And a better profits outlook will also sustain the stock market rally.
CLEARLY, COMPANIES WILL NEED help to make an extra buck, especially in the fourth quarter. The latest data indicate that economic growth is slowing this quarter, perhaps to as low as 1%, after real gross domestic product grew at a solid 3.1% annual rate in the third quarter.
Given such an unpromising outlook, profits seem to be facing a rough period. After all, companies can fatten their bottom lines three ways: They can boost revenues by either marking up prices or selling more goods and services, or they can cut costs. But in today's sluggish economic environment, the first two strategies aren't helping much. The slowdown in domestic spending and weaker global economies mean revenues won't rise much this quarter. And since modest demand growth leads to intense competition for customers, pricing power remains a no-show.
That leaves cost-cutting as the main profit-booster. Companies are already announcing layoffs and holding down their capital budgets. They're also reluctant to spend money on rebuilding inventories. But bear in mind that those strategies cut a business' total costs, not necessarily the cost of making one item, and they usually give only a one-time lift to profits. Once the round of layoffs or capital-budget cuts is over, businesses have to cut payrolls or investments further to help the bottom line again.
But many companies are taking a smarter approach. In congressional testimony on Nov. 13, Fed Chairman Alan Greenspan noted that in the current business climate, "lowered costs are generally associated with increased output per hour." By boosting productivity, companies cut the cost of making one unit of product, be it a new computer, a stock trade, or a hamburger.
Lower unit labor costs have lessened the blow to companies' bottom lines from their lack of pricing power (chart). That's because falling unit costs increase the profit margin on each good or service sold. That will position companies to take full advantage of their more efficient operating leverage when demand growth turns around in 2003.
Of course, some of the recent jump in productivity is purely cyclical. That is, output per work-hour generally picks up at the start of a recovery because companies burned by the recession are slow to hire more workers when demand first turns around. But so far in this upturn, productivity's contribution to output has been twice as large as its average share in past recoveries. That suggests a substantial portion of the gain is the result of structural changes.
Greater use of technology and more efficient business procedures shift the long-term trend of productivity higher. As Greenspan has pointed out, over time, workers become more proficient with existing equipment and work processes, so productivity can continue to grow even if companies don't buy any new equipment.
THE UPTREND IN PRODUCTIVITY is no panacea for the business sector's current problems. First, at a time when people are worried more about deflation than inflation, companies would benefit from stronger pricing power. Second, productivity gains will do little to curtail executives' uncertainty caused by corporate scandals and the expected U.S. invasion of Iraq.
This hesitancy of businesses to move forward can be seen in the Fed's latest senior loan officer survey of bank-lending practices: The report says 53% of U.S. banks reported weaker demand for commercial and industrial loans from large and midsize companies in October, vs. 45% in August. Loan demand from small outfits also weakened. On balance, banks are still tightening their lending standards.
Productivity's large contribution to output growth also presents a negative for the economy, since private payrolls have been essentially flat this year, aggravating the decline in consumer confidence.
BUT JOB JITTERS haven't constricted consumer spending yet. That's because, amid rapid productivity growth, gains in profits don't have to come at such a heavy cost to workers as had been true in the past. Note that, even with little job growth, real incomes are rising about 3% this year. That increase in buying power reflects the paradox of falling unit-labor costs and rising worker compensation (chart). In a highly efficient business world, workers can receive healthy pay raises even as the companies they work for cut the labor cost of each unit of output.
In the third quarter, for instance, workers at nonfarm businesses saw their average hourly compensation rise by 3.3% from a year earlier, a 1.7% advance in buying power, after accounting for inflation. But because those workers produced 5.3% more output each hour than they did in 2001, businesses experienced a 2% reduction in their unit-labor costs.
The drop means that throughout the economy, third-quarter profit margins, which will be reported by the Commerce Dept. on Nov. 26, improved from a year ago. A larger profit margin means that, when demand picks up next year, the most productive businesses will earn more from each extra dollar of revenue, and that will translate into a sizable advance in total profits.
Can investors count on a return to 20%-plus earnings gains? Given the lack of pricing power, that may be too optimistic except for the hottest companies. But the latest numbers show that, even in an era of no significant revenue gains, companies are increasingly leveraging productivity to hold down costs and lift their profit margins. The overall benefits to the bottom line are already starting to show up, and the bounty will grow in the coming year.
By James C. Cooper & Kathleen Madigan