If companies keep hiring, the economy will hang in there just fine. There’s something counterintuitive about that proposition, and repeating it often enough (it’s one of economists’ favourite palliatives) doesn’t make it true. I mean, businesses don’t hire out of the goodness of their heart or to earn humanitarian awards. Quite simply, they hire people to produce the goods and services consumers want to buy, hopefully turning a profit in the process.
Companies would prefer to do it all with machines, which don’t get paid holidays, a lunch hour or sick days (well, maybe some mechanical downtime now and then). Industrial equipment doesn’t need health insurance, complain about the boss or file sexual harassment suits. Most businesses, however, can’t function without humans, at least not yet. So they hire the minimum number of workers they need to earn the maximum possible profit. It may be crass, but that’s how it works.
So, what to say when you read comments that distort the natural order of things? For example, following news on 27 July that the US economy expanded at a real 3.4% rate in the second quarter, up from 0.6% in the first, an economist told the Wall Street Journal that “the real risk for consumer spending is if for some reason companies slam on the brakes and stop hiring”. In other words, if businesses just keep adding to their payrolls, the consumer will keep on spending his wages. The catalyst in this model is business hiring.
The problem with this line of reasoning is that business executives don’t wake up one morning and arbitrarily decide to lay off 10% of the workforce. They take their cues from something else, and that something else is demand. Relying on business hiring to support consumer spending is one of those chicken-and-egg issues, except in this case, the egg (demand) clearly comes before the chicken (hiring).
“Before every recession, people are earning income but choosing, for various reasons, not to spend quite as much,” says Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago. “A lot of people cut back a little bit, and there’s a multiplier effect on the economy.”
They do this before the unemployment rate starts to rise. In fact, “that’s why it starts to go up,” he says. Having a job and earning a salary is no guarantee of future spending. If it were, an expansion would be infinite.
One of the mysteries of the current business cycle has been how well employment has held up relative to economic growth. Real gross domestic product growth slowed to 1.8% in the year ended June, yet the unemployment rate refused to budge. It’s been stuck in a 4.4% to 4.6% range for almost a year, something that creates inflation angst at the Federal Reserve because of the “high level of resource utilization.” (Central bankers never say that too many people are working; it’s politically incorrect, and maybe it sounds as silly to them as it does to me.)
Meanwhile, consumer spending has decelerated. In the second quarter, real spending rose 2.9% from the same quarter a year earlier compared with a peak of 4% in the first quarter of 2004. On a quarterly basis, spending dipped to 1.3% in the April-to-June period from 3.7%. One quarter does not make a trend, of course, but the third quarter started out with dismal results from auto manufacturers. The annual selling rate fell to 15.5 million in July, the seventh consecutive monthly decline.
Consumers’ other big ticket item, the house, isn’t doing so well either. Rising delinquencies and default rates in the subprime sector have spilled over to mortgage loans to folks with a good credit history. Lenders are raising rates and instituting stricter standards. Home prices are falling on a year-over-year basis. The fallout is affecting a broad spectrum of risky assets, especially in the opaque arena of structured finance (collateralized debt and loan obligations), not to mention the share prices of the firms that create them.
It’s no surprise that employers are starting to get the message. A decline in government jobs lopped 28,000 off July payroll growth, producing a modest increase of 92,000, the labor department reported last week.
Getting rid of the ebb and flow of civil servants, private payroll growth has slowed to an average of 120,000 a month this year from 169,000 in 2006 and 198,000 in 2005. That may be a rounding error in a workforce of 138 million, but it is a discernible trend.
Consumers cutting back on their spending send a powerful message to business. It also sends a subtler message to the Federal Reserve.
“When the supply of credit from households increases”—when the consumer saves more—“the structure of interest rates falls,” Kasriel says. “The short rate can’t go down” because the Fed props it up. “So, the only way to keep it from falling is for the Fed to slow down the provision of the credit it creates,” he says.
When the raw material of credit creation slows, consumers cut back on their spending. That’s when employers get the message, not the other way around.
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