Now comes word that even though the economy powered through the third quarter at a 7.2% annual rate of growth, the strongest in 19 years, productivity accounted for all of that gain as well. Are we caught in a kind of productivity trap that will continue to rob job growth and thus hold back the recovery in 2004?
Hardly. It's just the opposite. It's the unusually robust productivity gains since the recession ended that are helping to lay the groundwork for the stronger demand that will justify next year's new hiring. And it's that same productivity growth that has helped to support overall demand at a time when a long list of other factors unrelated to productivity have suppressed it.
For example, because of the elimination of the late-1990s capacity and inventory excesses, the terrorist attacks, the corporate scandals, and the war, overall demand rose at an annual rate of only 2.2% from the recovery's start through the second quarter. With productivity rising at twice that pace, it's easy to see why companies have been able to satisfy that demand growth while cutting payrolls.
Now, however, as the third-quarter growth surge shows, these drags are either fading or gone. Consequently, 2004 will be the year when the benefits of the faster pace of productivity begin to lift demand across a broader swath of the economy. In short, both businesses and households will be winners next year, and more jobs will be one of the key results.BUT HOW DO WE GET there from here? To be sure, a faster long-run trend in productivity growth, now generally accepted to be about 3%, means the economy has to sustain growth of greater than 3% for payrolls to expand. But that's only part of the story. The more important part is that faster productivity growth boosts demand, by lifting profits and workers' pay. It also adds to wealth as a result of higher stock prices.
The crucial link between productivity and demand is income. Look at it this way: When an economy generates new output, measured by gross domestic product, it creates an equal amount of new income that is distributed either to workers as compensation or to businesses as profits. The key is that faster productivity growth allows the same workforce to generate more income, a process that in recent years has added handsomely to both business profits and to the real compensation of workers with jobs.
That's why, for the past three years, the overall growth of pretax income accruing to both workers and businesses has held up amazingly well, despite drags on demand. And that's irrespective of the 2002 and 2003 tax cuts. Increased productivity not only explains why corporate profits are beating all expectations this year (page 80), it's also the reason behind the economy's ability to lose 2.7 million jobs since early 2001 without one single quarterly decline in consumer spending. That's something that had never happened in a recession.
With demand now picking up strongly, free of its encumbrances, companies are responding by lifting output, even in the industrial sector (chart). That's creating new income at an accelerating clip that will begin to support new hiring. And because workers are more productive, each new hire will add more to overall purchasing power than in past recoveries, enhancing the classic virtuous cycle of growth. And since productivity has also helped to keep inflation low, the Federal Reserve will have extra leeway to keep interest rates down and allow the cycle to gather a good head of steam.SO FAR, PRODUCTIVITY GAINS have shown up most notably in corporate profits, which is the normal recovery pattern. When the Commerce Dept. reports its economywide roundup on Nov. 25, operating profits before taxes are expected to have soared about 30% from a year ago, after the second quarter's 14% advance. That would be the biggest gain since 1984.
Up to now, productivity gains have lifted profit margins by reducing the cost of making each unit of a product. Even though average product prices have increased by a scant 1% or so over the past year, unit labor costs have fallen by about 1%, meaning that margins are expanding. In fact, in the third quarter, margins appear to have approached levels not seen since the peak of the earnings boom in 1997.
Now comes the earnings bonanza. As demand kicks into a higher gear, not only are greater revenues boosting profits, but those past increases in margins allow more of each sales dollar to fall to the bottom line. Moreover, sales are now rising despite any real pickup in pricing power because companies are selling more units. Next year, as pricing firms up, sales and earnings will get a further lift.
Corporate America's new financial power, coupled with the need to boost output stemming from rising demand and low inventories, is already lifting capital spending, and that trend will continue in 2004 (page 40). In the past, profit gains, new business outlays, and additional hiring have gone hand in hand. Overall demand is now growing 5.6% from a year ago. For the first time in 2 1/2 years, that's enough to cover the current pace of labor costs, as well as some new hiring (chart).WORKERS WHO HAVE HELD ONTO their jobs have shared in the income that productivity gains have helped to create. Sure, compensation increases have been far less exciting than those of profits, but they have been steady. In the third quarter, the employment cost index, measuring hourly pay and benefits in the private sector, rose 4% from the year before. Real compensation, adjusted for inflation, is up about 2%. Since 1998, the annual pace has ranged between 1.5% and 3%, mainly reflecting the ups and downs in purchasing power caused by changing energy prices. Even in the aggregate, real household income before taxes has increased at a 1.5% annual rate since the recession ended, despite the decline in payrolls by more than a million workers. Given the cost savings from productivity gains, businesses can afford to grant real wage increases as profits recover. So far, the lion's share of new income has been going to profits. But with profit margins already back near their long-term trend, more of the income gains from faster economic growth soon will begin to flow to workers.
That's the essence of productivity gains: Both sectors win, as overall income expands. Remember, in the end it's income that determines economic performance, and that's why productivity gains won't hold back job growth and the economy in 2004. It'll spur them on. By James C. Cooper & Kathleen Madigan