Balancing Act for Employers in Today’s Labor Market

Keen competition in times of low inflation and low unemployment.

Global competition and increasing technology suggest new ways of viewing how the economy works.

How low can it go? That’s the question many economists are asking about U.S. unemployment rate, which is currently at its lowest level in 30 years. In June, the rate stood at a remarkable 4.3 percent. It is remarkable given that inflation is also at historically very low levels, currently standing at 2.0 percent. The following graph details this data:

U.S. Unemployment and Inflation Rates, 1970-99
Source: US Bureau of Labor Statistics http://www.bls.gov/

As this graph shows, there is usually a tradeoff between unemployment and inflation. This tradeoff can be explained as follows: as the money supply increases, there is an increase in business activity, since there is more money for consumers to make purchases. This increased business activity causes firms to hire more workers, reducing unemployment. At the same time, production costs are increased as firms are pushed closer to capacity, and firms have to raise the prices of their products-this results in inflation. Thus, higher inflation occurs along with lower unemployment. Note however, the above graph reveals two exceptions to this rule. From 1973-75, and again from 79-81, inflation and unemployment both increased, a phenomenon known as stagflation. During these two periods there was an increase in energy prices. Increases in energy prices raises costs for firms, who respond by increasing the prices for their products and laying off workers.

Another exception to the inflation-unemployment tradeoff has occurred since 1992, during which time inflation and unemployment have both fallen. This period of economic prosperity has lasted long enough that some are proclaiming the business cycle dead. Although the phenomenon of falling inflation and unemployment can be explained by traditional economic theories (more on this later), there is a new group of economists who believe a new set of theories is needed to describe the economy as it now exists.

New Economy?

A growing number of economists, business leaders, and journalists have become proponents of a “new economy” view. A major tenet of this new thinking is that the old rules of the economy no longer apply, and there no longer exists a reason to believe there is a tradeoff between inflation and unemployment. The economy has fundamentally changed, proponents of the “new economy” argue, with the rapid increase in technology and globalization. Increases in technology allow the economy to grow much faster than ever before, creating more jobs, and keeping unemployment low. Increased globalization forces fierce competition among firms, which keeps prices and inflation low. Thus, in the optimistic “new economy,” low inflation and unemployment coexist in harmony.

The “new economy” view sounds appealing, given its inherent optimism regarding the future. And, its increasing popularity among economists rivals the growth of supply-side economics in the early 80’s. However, a couple of cautions are in order. First, although few economists would argue that technology is advancing rapidly, some would claim that it is difficult to match the technological growth that occurred in the first half of the 20th century. Consider the following inventions between 1900-50: the airplane, the jet engine, television, radio, plastic, the transistor, and nylon. Since 1950? Certainly the personal computer, the cellular phone, and World Wide Web, along with other inventions such as the optic fiber, have strongly impacted the economy, but only time will tell whether these technological advances will match or exceed those that occurred in the first half of this century. Second, although the impact of globalization is increasing, the percentage of American industry that is directly impacted by global competition, is, by conservative estimates, 25-30%. The majority of the service sector, for example, is largely unaffected by global competition. Has your hair stylist complained about competition from Bangkok lately?

What’s to be made of the “new economy” view? Most economists would agree that the forces making the greatest impact on our economy are the revolution in technology and globalization of commerce. However, the majority of economists would contend that “new economy” theorists overstate the impact of these developments. In addition, in order to explain the current trend of falling inflation and unemployment, most would call the “new economy” theorists back to “old” economic theories, which for decades have reliably predicted economic events. Thus, although the economy is rapidly changing, the business cycle still looms, and fluctuations in both unemployment and inflation will occur in the future. In other words, the tradeoff between unemployment and inflation is alive and well.

How do economists use traditional economic theories to explain the phenomenon of falling inflation and unemployment since 1992? These trends suggest that the tradeoff between inflation and unemployment is improving, a counterpart to the periods in the mid 70’s and early 80’s when the tradeoff was worsening under stagflation. In other words, there is still a give and take between inflation and unemployment, but at lower levels for both economic variables (a “reverse stagflation” if you will). Though the trade-off has changed, the economic laws remain intact.

What has brought about this more favorable tradeoff? The same phenomenon that “new economy” theorists stress: globalization and technology. Indeed, increased globalization has brought about fierce price competition in many markets, in addition to creating more jobs than it has destroyed (although they are not necessarily the same types of jobs or in the same geographical areas). The digitization of information has boosted productivity, facilitating e-commerce and bringing about more competitive markets and lower prices. In addition, technological growth has opened up employment opportunities that didn’t exist 10 years ago.

It should also be noted that falling energy prices have contributed to the “good times” since 1992. Just as rising energy prices can result in the stagflation described earlier, falling energy prices can result in an “reverse stagflation”, or falling unemployment and inflation. The Asian crisis has also contributed to low inflation, as falling prices for imports benefits American consumers. The excellent management of the economy by Federal Reserve Chairman Alan Greenspan must also be acknowledged. To Greenspan’s credit, he has resisted increases in interest rates in recent years, trusting that productivity gains and the effect of the Asian crisis would offset the pressures of a tight labor market. The recent increase in interest rates by the Federal Reserve appears, at least at this point, to be a minor correction rather than the beginning of a long-term trend of increasing rates.

How Low Can It Go?

To answer the question we started with: not much further, at least without igniting inflation. As the labor pool continues to shrink, there will be more competition for good workers. Those workers, in turn, are likely to demand higher wages. Although firms do face an environment of strong price competition, costs are still an important variable in pricing decisions. If costs rise, increases in prices are likely to follow.

Up to this point increases in the compensation paid to workers have been held to relatively low levels. In the first quarter of 1999, increases in employee compensation, which includes benefits and wages, were only 3% greater than the prior years’ level. Annual increases in the variable have been held to less than 4 percent since 1992. The following graph details this data:

U.S. Employment Cost Index Increases
Source: US Bureau of Labor Statistics http://www.bls.gov

Walking the Tightrope

How is it that firms, in an environment of increasingly tight labor markets, have been able to hold the line on compensation increases? There are several factors that explain this phenomenon. First, the increased use of managed care in the 90’s kept the lid on medical insurance costs, although recent reports suggest those savings have run their full course. Second, in tight labor markets, workers are more likely “jump ship” to other firms. If a worker moves from one company to another for a higher salary, that increase in pay won’t be picked up in the Employment Cost Index (ECI). The ECI also doesn’t pick up pay increases due to promotions within firms, or signing bonuses, or stock options. These last few factors suggest that increases in labor costs actually have been greater than suggested by the ECI.

However, it’s important to note that many firms have found creative ways to offer low-cost benefits to their employees. From the worker’s perspective, pay isn’t everything, and if firms can offer nonmonetary benefits that employees perceive as real and valuable, the situation can be a win-win scenario. The offering of stock options and flexible work schedules are examples of benefits firms can offer that cost less than straight increases in salary. In addition, in an environment of corporate restructuring and downsizing, workers may find job security more valuable than increases in compensation. Domestic labor markets are going to continue to be squeezed for the foreseeable future, challenging firms to be creative in finding ways to compensate workers in ways that don’t put a squeeze on profits.

Competitive Pressures

Up to this point, the majority of firms have been able to keep price increases for their products in the 1-2% range, while labor costs have increased 3-4%. How have they been able to do this without taking a hit on the balance sheet? One word: productivity. Over the last four years labor productivity, defined as output per worker per hour, has increased by about 2 percent per year, nearly twice the rate that occurred during the previous 20 years. If workers are able to be more productive, firms can pay them more, and still resist increasing the prices for their goods and services. Looked at from another perspective, given current competitive pressures, workers will only receive more pay if they become more productive.

Productivity growth is the genie that produces positive economic results all across the board: for employees, workers, and consumers. In the absence of productivity growth, standards of living stagnate. What brings this genie out of the bottle? That is an open question for economists, as well as managers who strive to foster a more productive work environment for their employees. It is thought that one likely contributing factor to recent productivity gains is increased business capital investment, especially in computers. Increased usage of computer technology and networks has resulted in productivity gains throughout the economy.

The Future

Most economists would take as extreme the suggestion of “new economy” theorists to completely abandon traditional ways of thinking about how the economy works. However, the “new economy” view does make an important contribution since it stresses the main factors that have contributed to the period of economic prosperity since 1992: globalization and technology. The challenge for managers is that due to growth in these factors markets have become more competitive. Thus, firms must strive for ways to keep price increases in check. By fostering a productive work environment, and finding creative ways to compensate their employees, firms have been able to walk the tightrope so far. Current economic conditions suggest they must continue to walk this line into the foreseeable future.

Authors of the article
David M. Smith, PhD
David M. Smith, PhD, , is associate professor of economics at the Graziadio School of Business and Management at Pepperdine University. His economic expertise includes the areas of labor pay and productivity, forecasting, and analysis of specific labor markets. A labor economist with an applied focus, Dr. Smith has published numerous articles that have appeared in both academic and practitioner journals. In addition, he has a chapter in an edited volume, a monograph, and published book reviews to his credit. His research on credit unions research has been used in arguments before the US Supreme Court as well as in state legislative hearings. Dr. Smith closely follows current economic trends and has appeared on radio and television and in several newspapers and magazines, including most recently the London Times, the Los Angeles Times, USA Today, the New York Times, and the Investor's Business Daily.
Terry Young, PhD
Terry Young, PhD, , has over 15 years of business experience in Asia and the United States. Thoroughly versed in international economics, Dr. Young has extensive knowledge of the global marketplace, with primary emphasis on Asia. Her consulting expertise includes global sourcing, business start-ups and management in such industries as food distribution, the textile and garment industries, agriculture, electronics, and real estate development. Dr. Young's 20-year university teaching experience includes assignments at the University of Southern California, at two California State University campuses, and a full-time professorship at Pepperdine University's Graziadio School of Business and Management where she received the Luckman Distinguished Teaching Award in 1994.
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