The Price Of Efficiency

Stop blaming outsourcing. The drive for productivity gains is the real culprit behind anemic job growth

What on earth is going on in the U.S. labor markets? Demand for goods and services is the strongest in years, and profits are going through the roof. Companies are spending again on new equipment, while starting to restock their depleted inventories. Yet they are not hanging out the "help wanted" signs as they did in earlier economic recoveries. If past business cycles are any guide, by now robust GDP growth -- 6% in the second half of 2003, with 5% widely expected in the current quarter -- should be creating more than 200,000 jobs per month to help restore the 2.7 million positions lost since the recession hit in early 2001.

But check out the government's February employment report. Days before its Mar. 5 release, economists were confidently predicting an increase of 125,000 new payroll jobs -- a modest number, by the way, when compared with previous recoveries. Yet to the shock of almost everyone concerned, the U.S. created a measly 21,000 jobs last month. After more than two years of economic recovery -- and with only 364,000 new positions created since payrolls turned up last September -- the oft-repeated assertion that strong job growth is just around the corner is starting to ring hollow. Says Alan B. Krueger, a labor economist at Princeton University: "It's surprising that job growth has been so anemic."

So what accounts for the shortfall? To many Americans increasingly anxious about their prospects, the culprit is clear: the outsourcing, or offshoring, of manufacturing and, increasingly, white-collar jobs. And hardly surprising in a Presidential election year, politicians are throwing fuel on the fire. Even as they ratchet up the rhetorical attacks on outsourcing, many are racing to propose legislation that would make it more difficult and costly for companies to move jobs out of the U.S.

SURVIVAL OF THE LEANEST. But if the outsourcing of jobs to India, China, and other low-wage centers has caused some of the U.S. job losses of the past three years, it is hardly the primary explanation for the weak job market. Instead, the continued ability of U.S. companies to squeeze out productivity gains on the order of 5% annually, since the recession ended, is having a far greater impact on the jobs picture. What's more, thanks to a late-'90s binge on technology, a broader array of industries is now finding ways to eke out efficiencies from their workforces than in the past. That means that the dearth of hiring, long a fact of life in the manufacturing sector, is becoming a reality in the service businesses -- retail, finance, transportation -- that account for 80% of U.S. jobs. "Don't be surprised that people aren't rushing out to hire more as this economy expands," says Nickolas Vande Steeg, the chief operating officer of Parker Hannifin Corp., a Cleveland company that makes factory equipment for other manufacturers. Since 2000, his company has cut 7,675 jobs, by streamlining such things as procurement, even as sales have inched higher, resulting in a 14% rise in sales per employee in the last two years. "If ever there was a time to gain productivity," he adds, "it's now."

Other powerful, transformative forces are also at work, reshaping the economy and suggesting that job growth may not pick up to the degree it did following the recession of 1990-91. China's emergence as a low-wage powerhouse, for one, has stiffened global competition and forced U.S. companies to become even more efficient. At the same time, the demands for profits by a growing investor class have heightened the pressure on corporations to keep costs low. The soaring cost of health-care benefits is also making companies more hesitant to add workers. Finally, the political and economic shocks of the past three years -- the stock market bust, the terrorist attacks, the corporate scandals, and war in Iraq -- have generated unprecedented uncertainty and caution in the executive suite.

What's confounding economists is that high-growth, high-productivity periods in the past -- the mid-'60s, say, or the late '90s -- have coincided with robust job creation. Consider that from 1997 to 1999, the economy expanded an average of 4.5% annually, productivity growth accelerated sharply, and 264,000 jobs per month were created. So why isn't the same thing happening this time around?

Fact is, the U.S. economy has changed dramatically in the past decade. One of the key differences is the intensity and the breadth of the pressures on business. But even more important, new technologies have emerged that have given companies the tools to meet the new imperatives of competition and cost-cutting. As innovation has brought ever-cheaper computing power and new ways to make use of it, capital has become increasingly cheap relative to labor. The returns on investment in new labor-saving, high-tech equipment have soared. Given that labor accounts for about two-thirds of the cost of making and selling products, greater labor productivity in today's global economy is tantamount to corporate survival. As a result, productivity is growing even faster now than in the late 1990s. And it's a real job killer this time: A one-percentage-point increase in annual productivity growth costs about 1.3 million jobs.

Up to now, the pressures have been most evident in the manufacturing sector, at both old-line factories and New Economy giants. Increased foreign competition has forced the Big Three to design and engineer new cars on the cheap. General Motors Corp. (GM ) used to make midsize cars for different global markets using several platforms. Now, the auto maker builds four different midsize cars on one platform designed in Germany. So GM doesn't need to hire more designers and engineers in the U.S.; instead, it has slashed salaried U.S. staff in each of the past three years by 10%, to 40,000 currently. Meanwhile, tech-equipment maker Cisco Systems Inc. (CSCO ) is also boosting its productivity, increasing Internet-related savings from $650 million in 1999 to $2.1 billion in the latest fiscal year. Cisco says that only when it hits $700,000 in sales per employee -- it reached $632,000 per worker in its most recent quarter -- will it consider widespread hiring.

Now, a broad range of services industries, and even small businesses, are striving to make similar gains in efficiency. That is especially true in retailing, which employs nearly 12% of all U.S. workers. Retailers from department stores to gas stations to restaurants are now able to move a 35% greater volume of goods and services out the door per worker than they did five years ago, meaning far fewer workers are needed. To take just one example, Home Depot Inc. (HD ) has self-checkout counters in almost half of its 1,707 U.S. stores, allowing it to move as many as 1,000 cashiers to the sales floor. The shift helped drive sales per labor hour up 4% last year alone. Another big factor: the explosion in goods moved through e-tail sites, which have done away with salespeople, restockers, cashiers, and other posts required in traditional retailing.

CREATIVE DESTRUCTION. It's not only that companies are getting efficiencies from the equipment they have been laying in over the past year. More important, they're still squeezing productivity gains from the technology acquired during the '90s. Many continue to find new ways of integrating technology into their production and distribution processes, and of getting customers to tap into the technology to make their purchases. Southwest Airlines Co. (LUV ), which made major investments in new technology to upgrade its reservation system during the 1990s, is now eliminating three of its nine reservation centers as increasing numbers of fliers book their tickets online. Plus, those earlier outlays are now facilitating new investments in self-service kiosks. The result of such moves: Even as the discount carrier's fleet grew from 375 to 388 planes last year, its payroll fell from 33,705 to 32,847.

As for companies considering hiring, they increasingly face a situation that has long plagued their European rivals: The soaring cost of employee benefits is making companies increasingly hesitant to add workers unless absolutely needed. Benefits costs, fueled by sky-high health-care premiums and the need to restore underfunded pension plans, are up 6.5% from a year ago. After adjusting for inflation, that's the fastest clip on record. If a company can get three people to do the work of four, that's one less health-care premium it has to pay. Don Listwin, CEO of Openwave Systems Inc., a Redwood City (Calif.) wireless software company, says rising benefits costs are causing it to hold back hiring and to outsource work. Saving on benefits also helps explain why companies are leaning heavily on temp workers. In the past six months, temp jobs, which are less than 2% of all employment, have accounted for about a third of the increase in overall payrolls, according to the Labor Dept.

Increased use of temps also reflects the new flexibility of the U.S. workforce. Instead of "just-in-time" inventory management, companies are now talking about "just-in-time" labor. However, that increased flexibility, along with rapid technological change, is what facilitates the process of creative destruction -- destroying jobs in the short term but making the economy stronger over the long haul. Unlike in Europe, where greater union power makes labor markets more rigid, it is easier for U.S. companies to hire and fire. But in this business cycle, the patterns of gross firing and hiring, which result in the Labor Dept.'s net monthly job numbers, are dramatically different.

IDLE YOUTH. The problem isn't in the overall number of jobs eliminated; they are running no higher than in past cycles. Instead, far fewer jobs are being created to replace those lost in the job market's churning than would usually be the case. The implication: More of the productivity gains seen during and after the 2001 recession are permanent. Unusually strong productivity also partly explains why other labor market indicators, especially weekly claims for jobless benefits, have tended to overproject job growth.

Given a dearth of new jobs, why is the unemployment rate falling, from a peak of 6.3% last June to 5.6% in February? Chiefly, people are dropping out of the labor force, which has reduced the amount of job growth needed to push the jobless rate lower. The labor force participation rate -- the percentage of the working-age population that is either employed or seeking work -- has dropped to a level even lower than during the 1990-91 recession. However, almost all of the decline has occurred in the 16- to 24-year-old age group, while participation in the 25-and-older segment has held up.

Young, inexperienced people, who were sucked into the job market during the boom, are not what companies are looking for right now. That's especially true in finance. In this recovery, Wall Street firms are being more picky about their hiring, looking for experienced, highly productive bankers, traders, and brokers. "Usually, by this time in a recovery, the industry would be hiring thousands of young people," says Alan M. Johnson, founder of Wall Street compensation consultants Johnson Associates. "This time is dramatically different." Nowhere is that truer than in the technology area: Lehman Brothers Inc. (LEH ), like many others, is automating grunt work such as payroll and other administrative functions while moving software-maintenance and -testing jobs to India.

Which comes back to the vexing issue of outsourcing. No one doubts that it is having an impact -- though exactly how strong is hard to say since good numbers are unavailable. While some put the number higher, Forrester Research Inc. estimates that of the 2.7 million jobs lost in the last three years, only 300,000 have been from outsourcing.

However, the same issue came up in the 1990s jobless recovery. "My gut reaction," says Princeton's Krueger, "is that the amount of outsourcing hasn't changed dramatically, but what has changed is the types of occupations that are affected." Now, white-collar jobs are increasingly being outsourced -- something that didn't happen during previous business cycles. The fear is that as the trend spreads, many more jobs will eventually be at risk. Researchers at the University of California at Berkeley recently estimated that some 11% of the U.S. workforce is vulnerable.

Small businesses, which generate the lion's share of new jobs in the economy, are also getting in on the outsourcing act. More and more entrepreneurs use outside help these days. While exact numbers are hard to come by, a study by Cutting Edge Information Inc., a Durham (N.C.) consulting firm, found that 90% of all U.S. businesses now outsource some work -- though some of that is done locally. Some of that may be temporary, but most job watchers believe small businesses will continue to turn to outsiders even as the economy strengthens, because they face the same relentless pressure to cut prices as big companies do. "This is more than a temporary phenomenon," predicts Brian S. Wesbury, chief economist of the Chicago investment bank Griffin, Kubik, Stephens & Thompson Inc.

But if outsourcing poses potential challenges over the long haul, in the coming year productivity holds the key to the jobs outlook. The pace of efficiency gains always slows as a recovery picks up steam, but no one is really sure how much. The question is how long companies can meet this big increase in demand without expanding their workforces. "We're getting up close to the point where firms will of necessity have to hire additional people to sustain the growth they see in the demand for their products and services," Treasury Secretary John W. Snow told BusinessWeek. To judge by history, business cannot lean on the workforce so heavily for much longer. The problem, however, is that in this unusual business cycle, history has rarely proved a decent guide.

By James C. Cooper

With Kathleen Madigan and Emily Thornton in New York, Rich Miller in Washington, Michael Arndt in Chicago, Wendy Zellner in Dallas, Peter Burrows in San Mateo, Calif., Dean Foust in Atlanta, and bureau reports

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