Productivity and Its Place In Our Story

The stock market is rising strongly today after yesterday’s plunge. I won’t bother to dignify this extraordinary oscillation with a comment other than to say that anyone who believes stock’s are “efficiently” priced has a lot of explaining to do. Precisely what, I wonder, is so positive today that it can offset yesterday’s negativity. More to the point, how come that positive news was unknown a mere 24 hours earlier? But as I said I won’t ask those questions.

What we can do, however, is to take a short break from bemoaning the absence of leadership in economic policy to reflect on yet another poor number: productivity seems to have tanked recently.

This morning’s data are far from rosy: productivity declined 0.3% in second quarter, while it was revised to a decline of 0.6% in the first quarter from what had originally been reported as a 1.8% gain. This is not good. This makes two successive quarters of decline which we hadn’t seen since 2008. Moreover, productivity has crawled up a mere 0.8% over the past twelve months, which is another bad performance and a sign of things being out of kilter deep within the economy.

The irony is that the weakness in productivity is coming from rising unit labor costs. Before you all fall off your chairs, let me remind you that unit labor costs are not simply a reflection of wages, but are, as they sound, a measure of the cost per unit of output – a ton of steel for instance. So if the labor effort rises more rapidly than output, productivity falls. In the longer term this cramps the space available for profit and wages, which is why we pay attention to productivity in the first place. But it is also something that is devilishly difficult to calculate, especially in service industries. Exactly how do we measure the unit cost of a legal brief? And what, exactly, is the output of a legal brief? Stop chortling, these are important things to consider, especially in an economy like ours which is heavily skewed towards service industries.

What appears to be going on at the moment, by which I mean the last six months, is that output has not risen as fast as the effort going in. And the cost of the effort going in is not a function of rising wages as much as it is a reflection of the extra hours being worked. In fact real wages – wages adjusted for inflation – are falling, by as much as 2.1% last quarter.

The problem with untangling the story from the numbers is that we can give two equally plausible accounts, but which contradict each other in a more general context.

First: productivity could be falling because businesses misjudged demand and over-hired relative to what they ended up needing to produce. According to this view we should expect that companies retrench and trim hiring to get back into a better, more profitable, balance. Or, second, businesses may have misjudged an increase in demand and have had to hire workers at a greater rate, implying that future productivity reports will reflect a better balance at a higher level of activity – the adjustment needed for those new workers to produce at an efficient level being the ongoing factor distorting productivity currently. This more positive view suggests we should see more hiring as businesses calibrate activity against unexpectedly large demand.

Naturally we need to look at other statistics in order to select which of these two narratives is the more likely explanation, and, unfortunately, I suspect we are led to choose the negative over the positive.

Why?

Because it fits well with our overall narrative that the economy has approached a stall velocity and that demand is weaker than many people – although not us – expected. As we slog through this part of the annual planning cycle in business we can surmise that the outlook for 2012 against which businesses will array resources is less hopeful than it was a year ago. This will exert caution. Budgets will be restrained, if not cut. New hiring will postponed as current staffing levels are re-assessed. And, in general, activity will be based against lower expectations.

Any economy wading its way through a major balance sheet adjustment, as ours is, will grow both fitfully and slowly. There will be many episodes of reappraisal as both households and business cast wary glances at each other. Households fear unemployment and face the risk generated by not being able to support debt loads. So they look for ways to trim expenses and pay off debt, rather than spend. Extra income is channeled towards debt reduction and does nothing to boost demand. This is a major factor why tax cuts have little stimulative impact: people save them. This attitude on the part of households causes business to predict weak demand, and so annual budgets reflect weak hiring and investment requirements. It may well be that, as is the case now, businesses are flush with cash. But they see no profitable investment opportunity other than to save labor costs by replacing labor with machinery. Cost cutting becomes even more a vogue in these circumstances and so households, in turn, worry even more. And so it goes.

Within this negative cycle there can often be moments of what appear to be recovery. Households and business both need to replace worn out things so not all spending can be postponed forever. Thus, even in a debt crippled economy, there can be quarters of growing demand. But that growth quickly dissipates as the longer term retrenching trend re-asserts itself.

It is this search for a solid footing with respect to debt levels that is dominating our economy. Our private sector is disgorging debt. It can do that through default which is the process we are still seeing in housing. Or it can take the much slower route and pay down debt from income, which is a trend we are seeing in aspects of consumer credit. This latter process is particularly difficult at the moment because incomes are not rising quickly, if at all, and inflation is very low, so the inflation burden of debt remains high. Getting average earnings to rise, or allowing a bout of inflation would both accelerate our recovery. Unfortunately neither looks likely.

Those of us who look at the economy through the prism of debt and balance sheet adjustment are not at all surprised by the recent string of bad news. It was always the more likely outcome. Policy has not been anywhere near sufficient to deal with the root causes of the crisis: not in terms of stimulus; not in terms of debt relief; not in terms of bank reform; and not in terms of enforced loss recognition. Policy makers seem to have viewed this recession/depression as yet another typical post-war recession. This was a gargantuan error. The accumulation of mistaken policy decisions, up to and including the US austerity effort, is making it harder to conclude the adjustment process. So we are faced with years of unnecessary malaise and uncertainty.

This narrative is a long way from the productivity report I began with, but, hopefully, you can see that, when viewed through the lens I have described, nothing in that report, or any of the other recent reports should be a surprise.

Expect more like them.