Rising Labor Costs: Are Declining Profits or Rising Inflation
the Inevitable Result?
Anton, welcome to the GADR thread. You write:
<< I believe that one often neglected
reason for the low inflation of the last few years has been
the overall flattening of health care costs. This has been
primarily due to price competition among health insurers and
the transition to managed care. As a result, most health
insurers, including the company I work for, are losing money.
Rates must and will go up, because cost cutting has been
taken as far as it can rationally go, and too far from some
perspectives. Rates for 1999 are currently being decided
upon, the only question is how much they will rise. This a
tricky proposition for the insurers; if you are too low you
will continue to lose money, too high and you will lose
market share. At any rate, health insurance costs are about
to start rising again, and this will affect the overall
economy in many ways. This is a major portion of labor costs,
and is another big factor that could result in an
acceleration of these costs and an uptick in inflation. >>
Conclusion
To begin with our conclusion, it seems doubtful that rising labor
costs, from whatever source, will either increase inflation, or
decrease profits. Because, to force price increases, labor would
have to have more bargaining power than consumers. Likewise, to
force a decline in profits, labor would have to have more
bargaining power than owners of capital. In the current
political and economic climate, it does not seem that labor will
soon gain.
Similar Tune; New Lyrics
Twice a year, Barron's "Roundtable" assembles some of Wall
Street's best known names to prognosticate about the Market, the
economy, the fate of the world, etc. One such guru has declared,
unequivocally, that inflation must rise for profits to rise.
Since the "new-era" Market's price levels are predicated on a
future with rising profits, but without rising inflation, there
will be trouble ahead.
That declaration came in early 1993. In the five years since,
profits, as measured by free cash flow, have skyrocketed -- and
inflation has collapsed.
We have been reading for a similar time span about NAIRU, the
unemployment rate below which wage pressures will cause inflation
to increase. Five or more years ago, NAIRU was supposed to have
been 6%, based upon (then-recent) historical precedent.
After several years of below-6% unemployment and falling
inflation, NAIRU is apparently 5%, or 4.5%, or maybe 4%. In
other words, even if one grants that there must be some point
below which less unemployment would result in higher prices, that
point can and does shift depending upon other factors. Further,
it is not a certainty that companies won't just stop hiring
before that point is reached (see below).
Similarly, though there must be some point above which rising
health costs create inflation in the rest of the economy, it
isn't clear that we are near that point, or that benefits won't
be capped below that point before it is reached.
Time to Take Away the Punchbowl, Lest the Poor Imbibe?
In the past year or so, there has been much alarm because
lower-income workers are beginning to enjoy increased prosperity.
The fear is that rising prosperity at the low end of the income
scale is inflationary, since the newest workers (mainly teens and
labor force re-entrants) are the least productive, yet are being
paid rising wages. Thus, rising wages at the lower rungs of
labor's ladder signal that wages are growing at a faster rate
than output is growing. Ergo, inflation must be on the way.
Hence, inflation hawks want the Fed to cool the economy now, lest
more poor people find jobs, and lest more of those who have found
work actually attain economic security.
That the compensation of red-hot (or even stone-cold) CEO's,
athletes, and movie actors has grown much faster than the overall
growth of economic output has not occasioned the same degree of
concern. According to some editorialists, when the CEO of
Microsoft is worth on-paper more than 3 times all the shareholder
profit the company has ever earned (even by the most generous
accounting standards), that's the free market doing its job.
But, the thought that a hamburger flipper or truck driver might
get a raise, or a health benefit, a hair's breadth above their
corresponding marginal value product requires the government to
intervene to correct Market "excesses".
Economics Nobel Laureate, John Kenneth Galbraith (in our view, a
much better moral philosopher than political economist), has
characterized this view as: The rich will not work harder unless
they are made richer; and the poor will not work harder unless
they are made poorer.
Rising Labor Costs: Higher Inflation or Lower Profit Margins?
In theory at least, profit margins and inflation can be viewed as
distinct categories, in relation to the total output of goods and
services.
In the case of profit margins, the question is: How, through the
interaction of firms, unions, government policies, and social
customs, will output be divided among consumers, workers, and
owners of capital?
In the case of inflation, the question is: Will the output of
goods and services be in equilibrium with the supply of money and
the velocity with which that money cycles through the system?
Higher Wages Can Result in Lower Profits, But Leave Inflation
Unchanged
If the goods and services represented by increased healthcare for
workers are offset by an equal decline in the value of goods and
services left over for the owners of capital, profit margins will
decline. But, in this simplified model, because the workers'
gain is equal to and offset by the loss to owners, there is no
increase in final prices, and, hence, no inflation.
If certain firms raise prices to maintain profit margins in the
face of rising costs for worker health coverage, consumers can
either reduce the amount of goods and services purchased from
those firms to maintain a constant percentage of their income
allocated to those firms, or they can purchase the same amount of
goods and services from these firms, and make up the difference
by reducing the goods and services demanded from other firms.
Or, consumers can do some combination of both. Again, there is
no necessary inflationary impact.
Inflation: Steady State vs. Expanding Universe
In the presence of a steady rate of inflation, prices and wages
rise in tandem. So, inflation is not so much a matter of the
differing shares between consumers, workers, and owners of
capital. Rather, it is more a matter of the differing shares
between borrowers and lenders. Hence, profit margins for many
companies can remain relatively steady if inflation remains
constant.
But, a shift in the rate of inflation has a tendency to also
shift the respective slices of output devoted to current
consumption of goods and services on the one hand, and
saving and investing for the future, on the other.
If price rises are accelerating, more resources will be shifted
away from savings and investment into consumption. It will pay
to consume sooner rather than later, since the value of
dollar-denominated assets will shrink at an accelerating rate.
As the value of money shrinks, lenders must be paid higher rates
of interest to compensate them for the decreasing value of future
payments of interest and principal. Therefore, the squeeze on
profit margins will be greatest on those industries that must
constantly borrow money to replace worn out plants and capital
equipment, because the cost of the equipment being replaced, and
the interest on the money borrowed to finance the purchases, are
rising also.
Inflation in the "Real" and the "Unreal" Economies
If the credit markets and the Fed do their job (a big "if"), the
money supply and transaction velocity of money will not rise
faster than growth in the output of goods and services, and so
inflation will not occur.
By some measures, like the increase in certain monetary
aggregates, the credit markets and the Fed have not been doing
their job -- and inflation is already here, in the form of a
financial-asset bubble.
In part, the recent surge in both stock and bond prices is a
response to the economic, and now political, turmoil in Asia. In
such conditions, wealth gets transferred from shaky regions into
regions with greater stability.
At the root of both the instability and much of the recent runup
in the U.S. securities markets has been the overextension of
credit in East Asia, in part to keep developing economies
growing, and in part to restart Japan's stalled economy. Instead
of being invested in profitless crony capitalism, a large chunk
of this money winds up being invested in U.S. securities markets.
This excess of money is not yet leaking into what economists call
the U.S.'s "real" economy. (Is anyone else troubled by the
implication that the financial markets are the "unreal" economy?)
The main reason for the disparity between rising securities
prices and flat or falling prices in the industrial sector is, we
think, due to the difference in supply characteristics between
the real economy and the securities markets.
In the economy for goods and services, there is tremendous supply
overhang in basic commodities like metals, chemicals, food, and
energy, as well as in consumer goods like autos, electronics
equipment, and clothing. So, prices are actually falling in a
number of these areas, in spite of the rise in the amount of
money available for buying them.
Whereas, oddly, in the 7th year of a Bull Market, the supply of
new securities is not yet overwhelming money demand. IPO's
notwithstanding, megamergers have taken a lot of equity shares
off the table. And, in the deleveraging of America, the falling
rate of issuance of government and corporate bonds is,
likewise, not keeping up with the demand for these instruments.
Hence, nominal interest rates continue to fall, thereby
increasing the relative attraction of equities.
Rest assured, Wall Street will find a way to increase the
supply of securities. But, in the meantime, sellers of
securities can continue to demand higher prices, while, on
average, sellers of goods and services cannot.
Who Has the Strongest Invisible Hand?
Absent the financial indiscipline that would lead to inflation in
the so-called real economy, the question then becomes: Is there
a way for labor to increase its share of the output of goods and
services (whether in the form of healthcare or otherwise), at the
expense of consumers and/or owners? Our best guess, as of this
writing, is that the answer to this question is "no".
It seems to us that it boils down to: Which of the 3, consumers,
workers, or owners, has the weakest hand in this particular card
game?
Consumers, we think, have the strongest hand. They can buy goods
from anywhere in the world. Services are harder for consumers to
import. But, for example, physicians can and do come from other
countries and practice medicine in the U.S., increasing choices
for consumers of healthcare services.
The second strongest hand, it appears, is held by owners of
capital. They can use immigrant labor locally, or they can move
production to another country.
Interestingly, output and profits have been rising in Germany at
the same time that unemployment also has been rising there (until
the last month or so). Much of Germany's increased output is
coming from setting up factories in foreign countries (like the
U.S.), or hiring immigrants as "guest workers". To cite one
anecdote, a piece in the New York Times quoted a German
construction contractor as saying he could get more work out of
one guest worker from Britain than 5 native Germans. (What a
difference in Britain's work ethic a generation of Thatcherism
has made.)
And, also anecdotally, several pieces in the Wall Street Journal
have reported, in passing, that small companies that cannot find
more workers at current wage levels wind up foregoing increasing
output, rather than raising wages to bid workers away from other
firms. These companies feel that paying higher wages to attract
more workers would be futile, since the higher costs cannot be
passed on to their customers. (Sometimes free markets actually
do reach equilibrium.)
Thus, consumers can avoid higher prices by shopping elsewhere for
goods and services. Owners can avoid raising wages faster than
profits by "shopping elsewhere" for workers. Admittedly, workers
can also "shop elsewhere" for jobs. But, it seems likely that
workers do not have as much flexibility in this regard as do
consumers and owners.
And, the decline in the percentage of the work force that is
unionized, and the inability of unions to organize office workers
(in part because many office workers can get health benefits
without unions), has also decreased the power of labor as a whole
to obtain a bigger slice of the economic pie.
Furthermore, the fact that the U.S. economy has created more jobs
since the 1980's than the rest of the economically developed
world combined is another factor in moderating wage demands. A
so-called "dead-end job" in the U.S. is not as much of a dead end
as sitting at home watching television, in Dusseldorf or Reims,
while waiting for the next unemployment check to arrive in the
mail.
In summary, we do not see how labor, at this time, could expand
its percentage of total economic output at the expense of either
consumers or owners of capital.
A Comment on Rising Healthcare Costs
The U.S. already spends a greater share of GDP on healthcare than
any other nation in the world (twice as much as, for example,
Japan). A lot of ink and toner have been spilled on the subject
of how the U.S. can wind up spending so much on healthcare, even
though it is still not universally available on anything like an
equitable basis (unlike, say, police and fire protection, and
education in grades K through 12).
Much of the blame has been assigned to greedy insurers and
plaintiffs' attorneys. But, greed isn't going away, and neither
are insurers or attorneys. And, if the truth be known, some
medical practitioners are not immune to economic incentives.
In his 1992 campaign for the presidency, then-candidate Bill
Clinton pointed out that the U.S. cannot allow the rate of
increase in health costs to continue to the point where the
entirety of future economic growth is consumed by rising health
costs. There is no theoretical limit to how much "necessary"
healthcare the population would consume, were it available.
Thus, like everything else in life (including necessary police
and fire protection), healthcare is, and will continue to be,
rationed. The question, therefore, is not whether, but
how.
Your Money or Your Life
Based upon sad historical experience, the dynamics of the
marketplace do not appear to require "doing the right thing"
(even the long-term economically right thing), when it
comes to health and safety. Conversely, politicians (never mind
"moralists" from the left or the right) have not proven overly
reliable about enacting that which is economically sustainable on
a long-term basis.
Right to Vote: The Dialectic of Democracy
It does not seem probable that health costs, on the whole, will
increase very much beyond their present 13% - 14% of GDP. There
are just too many demands for resources in other sectors of the
economy.
The twin drivers of political and economic democracy,
respectively, are one-person/one-vote and one-dollar/one-vote.
In the ongoing dialectic between the two, a balance will be
struck between what amount of healthcare spending is morally
necessary and what amount is economically practical. The likely
outcome is continuing adjustment in what the healthcare-related
percentage of GDP is spent on and how it is rationed, rather than
an increase in the percentage itself.
Therefore, we do not foresee healthcare costs as significantly
affecting either inflation or profit margins.
Stanley Roach on Profit Margins
Finally, a note on Morgan Stanley's chief economist, Stephen
Roach (see: lp-llc.com, whose views on
the subject of rising health costs (see:
www4.techstocks.com
occasioned your original comments.
Roach, to his credit, was one of those who foresaw early-on a new
era in the efficiency of corporate America. But, a few years
ago, he did a turnabout. The press clippings are not readily
available, so this is being written from memory. But, we recall
the press account (which may not have done justice to Roach's
actual thinking) as follows:
Roach was riding in the back seat of a car, on his way from one
appointment to another, typing at his laptop, in the midst of a
typical 15-hour workday. Suddenly, he had an epiphany: Rising
profits and profit margins were not coming from increased output
being sold into increasing customer demand. Rather, they were
coming from squeezing more working hours out of fewer workers.
He described this as "the hollowing out" of the work force. And,
since 15 hours is close to the limit for anyone's workday, the
process had to be close to an end.
To repeat, we do not follow Roach's writings regularly. So,
perhaps the following comments are more appropriately directed
at the author of the news account. But, at least as it was
reported, this was not an example of economic thinking at its
most insightful.
The steady rise in labor productivity of the current economic
cycle, or for that matter the past two centuries, has not come
primarily from increasing the length of the workday. It has come
from putting ever more productive capital equipment into the
hands of workers, and ever more specialization and division of
labor.
When Roach's laptop gets a wireless Internet connection (if it
doesn't have one already), watch his productivity increase,
without any increase in the length of his workday (once he
figures out how to get around the bugs).
As for division of labor, practically overlooked in all of the
discussion about the Daimler takeover of Chrysler is the fact
that Chrysler workers in the U.S. generate almost 4 times the
dollar-output of Daimler workers in Germany. It is true that
U.S. auto workers have to work far more hours per year than
German ones do. But, not nearly 4 times as many hours.
Part of the reason for the greater dollar-output of Chrysler's
workers is that Chrysler does a lot of outsourcing -- so much so
that some have described Chrysler as more of an auto design and
marketing firm than an auto manufacturer, as such. Regardless,
if one were to add back in the workers at the parts suppliers to
arrive at a truer picture of how many U.S. workers it takes to
make a Jeep Cherokee, one would find that the parts supply
workers have far better productivity ratios than those working
for the auto manufacturers.
In other words, dividing the auto making task more efficiently,
not lengthening the workday, has made the largest difference in
increasing labor productivity -- in the U.S. as well as other
countries where labor productivity is rising.
The case Roach has been making in recent years about wage costs,
and that longer-term pessimists have been making about the U.S.
economy generally, is that the economy, and therefore the Market,
is benefiting from short term phenomena that are near or at their
limit.
As examples, 1) falling taxes, 2) falling interest rates, 3)
declining labor militancy, 4) white collar layoffs, 5) decreasing
regulation, and 6) foreign willingness to hold Treasury Bonds, as
well as moderating health costs, are trends that have been
predicted to run out of steam in a matter of a few years.
But, the imbalances now being corrected were a half-century or
more in the making. Intuitively, we feel it unlikely that
undoing these imbalances will occur in just 4 or 5 years.
Taking these factors in order:
1. Now that the Federal budget is in balance (at least according
to GAFF: Generally Accepted Fudge Factors), there is more, not
less, room for cutting taxes.
2. Real interest rates (stated rate minus inflation) remain very
high by historical standards. There remains plenty of room for
them to fall further.
3. Unions continue to lose political clout. The Democrats have
found other constituencies more vital to their success. Clinton
has barely lifted a finger to help unions, yet remains very high
in the polls, a point not lost on other Democrats. And, as
noted, unions have made little progress in organizing the parts
of the labor market that are growing the fastest. Thus, the
decline in union bargaining power will also continue.
4. As mergers accelerate, so do the layoffs for now-redundant
layers of white-collar management. This week's Barron's
(5/18/98, p. 12) writes: "Outplacement firm Challenger Gray &
Christmas reported that M&A-related job cuts in April soared to a
32-month high of 8,420, or 17.3% of the total." (This implies
that the total management layoffs were 48,671, for one month.)
Interestingly, the most rapidly growing segment of the labor
force is not software writers or health workers. Instead, the
fastest growing category is white-collar managerial workers.
What is happening is that smaller firms with rapid revenue growth
are hiring faster than bloated large cap firms with sluggish
revenue growth are firing.
5. Deregulation, and the decline of statism generally, have far
from run their course. Privatization is progressing apace.
And, government is taking other cues from the efficiency school
of public policy. An anti-competitive proposed merger of AT&T
and SBC was blocked, while a merger between NYNEX and
BellAtlantic, that will surely streamline management at both, was
approved. Microsoft's profitability will decline under
government scrutiny, but the productivity increases at companies
operating on a more level playing field, we predict, will more
than make up the difference.
6. Foreign willingness to cover the U.S. trade deficit by buying
Treasury Bonds is primarily based, in our view, upon 2 factors:
a) If they don't, the dollar will lose value, and they lose their
trade surplus; and b) the U.S. economy has fundamentals that make
it appear that the debt can be repaid with money that has real
buying power, instead of with inflation.
In other words, buying Treasury bonds is one of the few
profitable investments these countries are making with their
capital. It now seems less likely, not more, that they can find
alternative uses that would be both safer and more
profitable, under current conditions.
In summary, these factors were a drag on productivity for many
decades. Removing these impediments to efficiency is likely to
continue for many years to come.
GADR Dow Value Portfolio
Moving from theory to practice, our Dow Value Portfolio (AT&T,
Boeing, GM, and IBM) exemplify the foregoing observations of
increasing efficiency as a long-term phenomenon. For some time
now, a number of analysts have expressed skepticism that GM and
IBM could continue to cut costs now that "the low-hanging fruit"
had already been picked. But, both companies shed costs
enormously in the past quarter. So did AT&T. Boeing is letting
go of more than 10,000 workers, with more cuts to come, and is
shuttering 15% of factory floor space.
As we have written elsewhere, cost cutting in corporate America
is no longer a temporary response to a business downturn. Xerox,
for example, is doing better as a business than it has in years.
Yet, not long ago, it announced 9,000 job cuts. Thus, cost
cutting has become as much a part of ongoing corporate business
plans as, say, marketing or research and development.
In summary, the cost cutting at AT&T, Boeing, GM and IBM (and
most of the rest of the S&P 500) is not yet near an end. On the
contrary, rising wages notwithstanding, it has only just begun.
*********
Reynolds Russell
web.idirect.com
"There are no sure and easy paths to riches in Wall Street
or anywhere else." (Benjamin Graham) |
