With unemployment standing at 9.6%, it has been anything but a joyous Labor Day for workers in the U.S.
Economists, pundits and market watchers are making much of the desultory job creation in this (to date) lackluster economic recovery.
Numerous factors are at work, hindering new job creation, including (1) continued inventory reduction in the housing sector (2) ongoing deleveraging of consumers’ balance sheets (3) shrinking tax receipts and growing unfunded pension and other liabilities of Government – Federal, State and local, forcing spending cutbacks (4) the reluctance of the banking system to lend to worthy customers because of their own concern about existing loans on their balance sheets and, perhaps the most worrisome of all (5) the high cost of labor relative to capital.
Recessions almost always result from correcting excess inventory in the economy. During the last recession, about a decade ago, the glut was focused largely in the technology and telecommunications industries. The recession that we are now having such difficulty exiting was fomented largely by an excess in consumer debt levels. Much of that excess leverage on the consumers’ balance sheets represented mortgage debt, which created a secondary bubble in residential housing. Thus, we have experienced a major double whammy, resulting in a deep recession simultaneously in two very large sectors of the U.S. economy – finance and housing.
Many of the jobs created to support the expansion of those two industries during the ‘good times’ have now been lost permanently, or a least far enough into the future to seem permanent. Three years after the start of the recession, there is still far too much housing stock for sale and too few buyers willing or able to absorb it. In the world of finance, as financial institutions have reduced their own levels of debt, they have shed jobs that will not likely return for another decade.
The shortfall in tax revenues created by the recession has thrown Governments, most particularly many State and municipal governments which cannot simply print money, into their own recessions. Their fortunes will not turn until economic growth has rebounded significantly from current levels. In the meantime, they have no option but to cut spending, which means to lay off employees. It is a vicious cycle.
In the world of economics, the two main factors of production are capital (i.e. equipment) and labor (i.e. manpower). How those two are combined to generate output is a function of their cost. If the cost of capital is high relative to the cost of labor, management will choose to buy labor, and the converse is true as well. When capital is cheap versus the cost of labor, investment in equipment will increase to replace costly manpower.
Today, the cost of capital is far lower, and therefore relatively more attractive, than the cost of labor. With interest rates near zero percent, capital is as cheap as it was fifty years ago. The same cannot be said for labor, despite the high unemployment rate which logically should act as a catalyst to lower its cost.
We know why the cost of capital is cheap – the Federal Reserve is attempting to stimulate economic growth and is thus pushing money into the system, in the hopes that cheap money will be incentive enough for investment and spending. As companies take advantage of low interest rates and invest in capital equipment at the expense of hiring more people, they are enhancing productivity, and thus reinforcing the rationale for replacing labor with capital.
So why is the cost of labor so high? In part it is because, relative to a cost of near zero for capital, it is hard for labor to compete. So despite the fact that hourly wage rates received by workers have barely grown at all over the last several years, compared to the price of capital which has fallen dramatically, labor is in an unfavorable competitive position. In addition, the cost of labor is rising in real terms because of the growth in non-wage costs – those costs associated with health care, retirement funding and increased government regulation. When weighing the costs and benefits of spending money on capital or labor, it is little surprise that managements are choosing capital in favor of labor. It is cheaper and there are no hidden or unknown costs.
A generation ago, many economists subscribed to the Phillips Curve theory, which espoused the notion that there was a direct link between employment and inflation. Specifically, it stated that if unemployment fell too much, the cost of labor would soar leading to inflation. The ‘danger rate’ of employment was deemed to be 7.5%. That theory was almost universally discarded when during the 1990s unemployment in the U.S. fell below 4% without any negative impact on inflation. What the economists seemed to have overlooked was the beneficial impact of productivity gains which allowed wages to increase without impacting inflation.
So what will it take to get back to 7% unemployment? Will we ever see the ‘good old days’ of 4% unemployment again? Or will the U.S. be stuck with chronic high levels of unemployment such as seem to have become a part of the economic fabric of Europe today?
Despite the painfully slow decline in our domestic unemployment rate, I believe that the U.S. economic system still provides the raw ingredients for dynamic growth. Notwithstanding the rising costs imposed on the private sector by Government, the spirit and drive of entrepreneurism remains unabated in this country. There is a magnetic appeal in our way of life that lures aspiring entrepreneurs and capitalists from around the world. The opportunity and the freedom to follow one’s own dreams are still an integral part of the structure of our economy.
Unfortunately, it will take more time this go round to get back on our feet because restructuring the balance sheet of the consumer is a long and arduous task.