Productivity Is Easing the Pain

Profits are healthier and job losses fewer than in previous downturns. The reason: Businesses' swift response to falling demand is making productivity unusually strong

The productivity revolution of the late 1990s changed forever the way U.S. businesses operate. Driven by technology and overseas competition, companies radically altered how they manage purchasing policies, inventories, production processes, and, perhaps most important, labor. The U.S. workforce has become much more flexible, allowing businesses to respond faster to changes in demand, to the benefit of businesses and workers. Even now, surprisingly strong gains in efficiency are playing a key role in helping the economy bear up under great stress.

Productivity, measured as output per hour worked in private nonfarm businesses, increased 2.8% through the second quarter from a year earlier. That's unusual on two counts. Efficiency typically slows when the economy weakens, but this time it has sped up, from 1.1% annually over the previous two years. Plus, given that hours worked have declined 1% over the past year, productivity gains have accounted for all of the 1.8% advance in economic growth.

Greater use of part-time workers, especially in manufacturing and retailing, is a big part of the job market's new flexibility and recent gains in productivity. From 1990 to 2000, the share of temporary workers on payrolls doubled, to about 2%. During the 2001 recession, temps accounted for 20% of payroll losses. So far this year, temp jobs have accounted for 40% of all losses. Also, businesses are showing a greater tendency to cut hours rather than lay off workers. So far this year, employees working part-time have jumped by nearly a million, and the number saying they are doing so because of slack business conditions has soared to a record level.

What does all this mean for the current business cycle? Prior to the 1990s, businesses could not adjust to a drop-off in demand as quickly as they can now. That delay resulted in lost productivity, as output fell but hours worked did not, which jacked up the labor cost of each unit of production. Higher unit costs dug deeply into profit margins, causing large-scale layoffs. A vivid example today is the U.S. auto industry, which never fully caught the productivity wave. Demand has crashed, but stiff labor contracts prevent companies from cutting workers or reducing work hours fast enough. Unit costs are soaring, and investors are hammering the companies' stocks.

Now, with many businesses able to adapt to weakness more flexibly, profit margins of nonfinancial companies—though well below their record levels of 2006—remain relatively high. Profits in this sector have not dropped as sharply as in past downturns, thanks in large part to booming export businesses, which tend to be very efficient.

Plus, faster workforce adjustments have helped keep payroll losses at less than half those in the early stages of the prior two recessions. Modest declines also reflect cautious hiring: Job growth since late 2001 has been the slowest in any business expansion since World War II. Conversely, payroll losses could end up the mildest of any postwar recession.

Productivity is also playing a role in holding down inflation and lifting the buying power of workers' pay. Despite a weak job market, labor compensation has grown 4.3% over the past year, slightly faster than during the two previous years. Greater efficiency has allowed businesses to grant steady pay gains without adding significantly to costs. Unit labor cost, which is wages and benefits adjusted for productivity, has risen only 1.5% over the year, since pay growth has been offset by the solid 2.8% increase in output per hour.

In fact, the biggest drain on real wages right now is not a weak job market but rising energy costs. With oil prices coming down and unit labor costs under control, the inflation outlook should remain tame. That means the Federal Reserve will feel less pressure to lift interest rates before the economy is healthy enough to handle them.

Productivity is no magic wand that can make today's economic weakness go away. But it is providing a key support that is lessening the pain.

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