Tanking Labor Productivity Could Lead to Stock Market Crash, Recession

How long does it take for a waiter to bring you your order? How many boxes can one Amazon worker fill in an hour? How many articles can I write a month? Just how efficient are America’s workers?

While these may seem like questions better suited for a performance-evaluation meeting, the efficiency of workers has huge implications for the economy. Productivity growth, the change in how much workers produce in an hour, has collapsed in 2022. If weak productivity continues, that will lead to higher costs, lower profit margins, and, ultimately, higher inflation — essentially, bad news for companies and the stock market.

Efficiency drag

Labor productivity is measured simply as total output per hour worked, but there is much more to it than that. Under the hood, the measure also accounts for things like the composition of the workforce — workers’ ages, education — as well as changes in the quality of the machinery, tech, and facilities workers have to use. The metric “total factor productivity” even adds in the intangibles that are not embodied in other factors, such as economywide technological progress. In all, productivity helps us define how efficiently a society uses its resources — and is an important signal of how quickly an economy will grow long term.

In the years before the pandemic, productivity was picking up. A tight labor market and increased competition for workers meant that firms invested more in their workforce. From 2017 to 2019, labor-productivity growth increased 1.6% a year, more than double the pace of the previous three years.

Many have been hopeful about productivity gains in light of pandemic-era time-saving changes like white-collar employees working from home instead of commuting. So far, however, labor productivity looks quite soft, and I see strong reasons to think it will stay that way.

On the output side, economic growth is looking weak. It was essentially flat in the first half of 2022 when taking an average of gross domestic product and gross domestic income. And it doesn’t look like much has improved in the third quarter: The Federal Reserve Bank of Atlanta’s GDPNow tracker is projecting just 0.3% growth. Despite this sluggish economic growth, employment growth has not really blinked. Total hours worked have increased at a 2.7% annualized pace in 2022, and nonfarm payrolls have grown by an average of 438,000 a month. This combination of less growth and more worker hours means productivity has declined sharply. The two-quarter drop of 5.8% is the deepest on record.

What’s behind this drop?

With productivity on the decline, the next question is obvious: Why are workers getting less efficient? What has changed that is making it so that employees need to use more hours to produce the same amount of output?

The answer is twofold. First, there has been a lack of capital deepening — investment by businesses in productivity-enhancing processes and technology. Capital deepening is straightforward; it is when investment — robots, software, machinery — rises more quickly than labor hours worked. From 1990 to 2010, capital deepening was an important driver of strong productivity growth but stalled for nearly a decade following the financial crisis. But by 2016, things started to turn around, capital deepening added about 0.7 percentage points to productivity from 2016 to 2021. However, in 2022, the contribution has tumbled to zero. And there doesn’t seem to be any reason to expect business investment to bounce back. Capital spending tends to follow the economic outlook, and with the chances of a recession on the rise, companies will be reluctant to make big investments in new equipment or facilities. The latest regional manufacturing Purchasing Managers’ Indexes — surveys of business managers in various regions across the country — offer a bleak outlook for productivity: Capital-spending plans have been seriously curtailed.

The second reason for the drastic fall off in productivity is the state of America’s labor market. Put simply, many workers don’t know how to do their jobs very efficiently right now. There is too much churn in the job market. A little bit of churn is good: Workers find a job that suits them better and get paid a bit more, and everyone wins. But right now, we have too much of a good thing. The quit rate remains higher than it has ever been. When a worker quits one job and starts a new one, it takes time for them to learn the ropes — the ins and outs that make them more efficient and able to produce at the highest level. At the same time, constant turnover means other employees have to take the time to train and cover for their new coworkers. The airline industry is a very prominent example: New workers are trying to get up to speed, and older workers are spending more time training their new counterparts. That leads to slower boarding times, longer waits for luggage, and spotty customer service.

Similarly, the workforce is getting younger, adding a crop of less experienced workers to the labor pool. The percentage of teenagers (16 to 19 years) in the workforce is at its highest level in over 10 years, while the participation rate for those ages 55 years and over has declined. Since February 2020, the teen labor force has expanded by 364,000, while the labor force for those over the age of 55 has contracted by 560,000. Older, more experienced workers are on their way out as inexperienced workers come in. While it’s nice to see teens working and folks enjoying newfound labor power, it’s foolish to argue that this trend doesn’t have negative side effects for productivity.

Bad for companies, the economy, and stocks

The slowdown in labor productivity has big implications. For companies, this means they need to spend more on inputs and labor to produce the same amount. These higher input and labor costs squeeze profit margins. Companies don’t like skinnier profit margins, so they will likely try to make up for the slower productivity in other ways, like higher costs for consumers or cuts to costs in other areas.

There is a big difference between a margin squeeze driven primarily by higher compensation and one driven mainly by weaker productivity. In the first scenario, firms can offset the higher costs for workers by producing more, generating more revenue, and keeping things in equilibrium. When labor costs rise, and workers aren’t able to produce more to make up for that, companies can’t make up for that shortfall.

These productivity-produced problems for companies are not a welcome development for stock markets. If higher labor costs are passed onto consumers, that will keep inflation higher for longer, forcing the Federal Reserve to continue to aggressively hike interest rates, which, in turn, dampens the outlook for the market. And if firms try to save costs by letting go of unproductive workers, total incomes will slow, and fewer households will have the cash to continue spending. Higher rates for longer and weaker consumer spending can add up to one thing: a recession. And stock markets don’t do well in recessions.

Neil Dutta is Head of Economics at Renaissance Macro Research.

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