Burnt-Out Workers Could Save the Economy

When Ben Bernanke said that today's economy is "unusually uncertain," he wasn't kidding. Consider these two quotes:

"The Economy Is Getting Killed by Too Much Productivity"
-- Business Insider, May 2010

"Productivity fell unexpectedly in the second quarter ... reflecting a slowing economy."
-- Associated Press, August 2010                  

This is why economics is considered an art, not a science. Nobody can agree on which way is up or down, but everyone tries. That includes me. I'm going to try to spend the next 90 seconds convincing you that the fall in labor productivity is unequivocally a good thing.

The big squeeze
Labor productivity is how much output companies can squeeze out of each worker, and it's exploded over the past year. This would usually be seen as a good thing, suggesting technological advancement and newfound synergies. Not this time.

Most economists agree that the recent productivity boom resulted from a push to sacrifice workers, in order to keep short-term profits intact amid falling sales. (I can't prove it, but I imagine this trend has blossomed as more executive pay gets tied to stock options.) This is part of the reason why corporate profits have rebounded to all-time highs, even as unemployment hovers around its own multidecade highs. Businesses have learned to make do with less.

But the tide is beginning to turn, with productivity sliding 0.9% in the second quarter. In general, I'd call that good news. This chart should help explain why:

Notice that productivity peaks tend to coincide with unemployment peaks. After all, there's only so much output you can squeeze out of employees. Once they're burnt out, employers have to hire more workers to expand. Thus, history suggests that high productivity is a sign of future hiring.

So the recent productivity drop should be encouraging for the unemployed. It's a sign that the productivity boom is over, and hiring may soon pick up. Great news, right?

Depends on who you ask
At least one argument says it's not. Remember, corporate profits have held up amazingly well, thanks to productivity's ascent. Take away that tailwind, and profits might falter, too. My colleague Alex Dumortier wrote fairly convincingly about this possibility: "[T]he consequence of this recovery in profits ... is that margins now have very little upside and plenty of downside."

It's hard to argue with that. Microsoft (Nasdaq: MSFT), for example, has higher net income today than it did two years ago, even as its workforce has shrunk. Harley-Davidson (NYSE: HOG) and General Electric (NYSE: GE) have reported strong earnings on the back of falling sales, thanks to cost-cutting. How long can that last? It's a good question that elicits few bullish answers.

Still, I'm not terribly worried, thanks to a neutralizing factor that could offset the impending squeeze on profit margins. I'll call it the Henry Ford principle. When Ford Motor (NYSE: F) was in its infancy, its visionary founder came up with a beautifully simple, powerfully logical concept: Ford employees had to be able to afford the cars they were making. If they couldn't, sales (and profits) would go nowhere.

Ford solved this by instituting the $5 workday -- more than double the going rate. The company flourished. As Ford demonstrated, if low margins caused by higher labor costs can be offset by higher sales, everyone wins.

That same logic applies today. Will rising productivity compress margins? Probably. But to offset that squeeze, we'll have more newly employed workers, once again able to buy what companies are selling. That could be a win for everyone.