The Mixed Blessing of Soaring Productivity

The increased efficiency of U.S. businesses will limit profit losses but cost millions of jobs, and it may delay hiring when demand picks up

U.S. businesses are a lot more nimble than they used to be. In recessions prior to the boom in information technology in the 1990s, companies were almost always a step slow in adjusting to sudden weakness in demand. Not anymore. Armed with sophisticated real-time systems for monitoring sales, purchasing, and inventories, companies began trimming payrolls, adjusting inventories, and paring capital spending more than a year ago, when the economy began to slow. Now, as the drop-off in demand has accelerated, so has the pace of cost-cutting. The downside is clear from the more than 2 million jobs lost since only September, including January's steep 598,000 decline, along with the intense pressure those losses are putting on consumer spending.

But there may be an upside to this new agility. The same technological progress that helped lift productivity during the 2001 recession appears to be at work in this downturn. Productivity is booming even though the economy is in a recession. Last quarter, output per hour worked in the nonfarm business sector increased at a 3.2% annual rate, even as output plunged 5.5%. Why? Businesses cut overall hours worked even more than they did production, by a staggering 8.4%, the most in 30 years.

In the past, productivity typically fell in a recession as businesses were slow to adjust hiring and production. That caused inventories to surge, ultimately requiring a steep liquidation of stockpiles that made the downturn worse.

Today, faster reaction by companies will put businesses in a good position to respond quickly to an increase in demand when it comes. Accelerated cuts in payrolls, capital spending, and inventories are expected to continue in early 2009. However, in the second half, economists estimate that the boost to consumer and business spending from fiscal stimulus alone will add about 2.5 percentage points to economic growth.

Dramatic efforts to control labor costs, while painful now, will limit losses in corporate profits and mitigate the squeeze on profit margins, which is sure to remain intense in the first half. Over the past year, output per hour has grown a solid 2.7%, a pace that offset most of the additional labor cost arising from the 3.5% increase in workers' pay and benefits. As a result, the labor cost of producing a given item, on average, rose only 0.7%, while prices rose by a faster 1.8%. This trend suggests businesses are working hard to protect their margins.

Service-sector companies should be especially well-positioned. As a result of solid gains in productivity, they appear to be doing a far better job of defending their profit margins than manufacturers are doing. Over the past year, output per hour among factories has fallen 1.4%, the first such drop on record, as output has slumped much faster than hours worked.

Yet real gross domestic product per worker among service industries has been accelerating for the past three years, reaching a 2.6% pace last year. That speedup suggests gains in service-sector efficiency have fully offset the added labor cost of the 2.6% yearly growth in service-sector pay and benefits.

Much of the recent productivity jump in services reflects unusually steep payroll cuts. Over the past three months the private service sector has shed nearly a million jobs, a 3.9% annual rate that is the fastest such pace in any recession since the 1950s. Even so, real GDP in the sector in the fourth quarter grew 1.7% from a year ago, meaning productivity growth accounted for all of the gain in output.

As the economy begins to recover, strong productivity growth could be a mixed blessing. As happened after the 2001 recession, businesses may try to squeeze whatever output they can from their slimmed-down payrolls before beefing them up again, a strategy that would send productivity growth even higher. That pattern is great for controlling costs and boosting profits, but, as in 2002, it might also result in a "jobless recovery."

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