Stephen King: US economy is doing better but the benefits are definitely skewed

For George Bush, it's not enough to have rising business confidence. He also needs votes

"It's the economy, stupid!" Yes, as we move inexorably towards another American presidential election year, these words will doubtless prove popular once more. The phrase is a bit more catchy than "It's winning the peace in Iraq, stupid!" even though this is likely to be another big political issue in the months ahead - particularly if the Democrats have their way.

When it comes to the economy, though, even if you're not stupid, you might still be a little puzzled. According to the stock market, we're back to the glory days. A quick glance at recent performance shows that, over the past six months, the S&P 500 index of leading US stocks has advanced at its fastest rate - adjusted for inflation - in the last half-century. According to companies, the world is now a better place. Business surveys in the US of manufacturers and service providers have swiftly recovered in the past quarter. Productivity is surging and profits have also risen quickly.

All of this is good news. For President George Bush, though, it's not enough to have higher profits, rising business confidence and rapidly rebounding stock prices. He also needs votes. The voters, though, are not looking quite so happy. Last week's employment report provided further confirmation of a worrying trend: the labour market is getting progressively weaker. Employment continues to fall and wage growth continues to be squeezed. Although consumers are still spending freely - helped along by tax cuts and, until recently, by falling mortgage rates - they continue to show distinct unease about their own economic prospects. Consumer confidence is not far away from rock bottom.

The economy is certainly doing a lot better than it was. But to date the benefits have fed through in a decidedly skewed manner. If you're a shareholder or a director of a company, you're likely to be feeling rather relieved: Armageddon appears to have been avoided. If you're a worker, though, you're likely to be rather worried: if the economy is recovering, why on earth are you in danger of losing your job?

My charts provide some clues as to what is going on. This is, in part, a story about slices of cake rather than the size of the cake as a whole. The left-hand chart shows US productivity growth - output per hour for the non-financial corporate sector, for those that are interested in precise definitions - tracked against the growth rate of labour compensation per hour, adjusted for inflation. This chart has two interesting features. First, in the late 1990s, strong productivity growth went straight into the pockets of workers: companies expected to make decent profits but, in the cold light of day, they didn't. More recently, a different picture has emerged. Productivity growth has surged - it's now even stronger than in the "new paradigm" years of the late 1990s - but labour income growth has dramatically slowed.

By implication, this means that the benefits of productivity growth have, this time around, accrued to companies, not consumers. The right-hand chart shows what's been happening. I've shown the US inflation rate and the growth rate of US unit labour costs - effectively wages adjusted for changes in productivity. Other things being equal, the faster wages rise, the quicker unit labour costs rise and the faster productivity rises, the quicker unit labour costs fall.

Recently, unit labour costs have started to fall rapidly - a combination of rapid productivity growth and persistent downward pressure on wages. With inflation not falling as quickly, the implication must be that lower costs have given rise to higher profit margins.

In part, companies have benefited at the expense of consumers.

The story does not quite end there, however. By any standards, the recent growth rate of productivity has been extraordinary. Part of this growth can be explained by a "batting average" effect - if you make your marginally less productive workers redundant, it's likely that the average productivity of your remaining workers will go up. I'm not sure, though, that this is the full story. In the early 1990s, companies similarly took it upon themselves to rebuild profits by cutting costs - giving rise to the so-called "jobless recovery" - but, back then, the impact on consumers was considerably worse. Adjusted for inflation, workers' compensation per hour fell. This time around, the growth rate of workers' compensation per hour has merely slowed.

Put another way, companies may have got a larger slice of the national cake but the cake as a whole is still expanding rapidly enough to prevent a complete collapse in consumer incomes, despite the savage nature of the ongoing restructuring. Why might this be? One possibility is that we're entering a second phase of the new economy. The first phase was characterised by rapid growth of technology producers who eventually found themselves with excessive capacity and collapsing prices. If we are now entering a second phase, it might be one associated with greater knowledge on behalf of technology users: they've learnt how best to use the new technologies to improve their workplace practices and, as a result, are able to extract extraordinarily rapid productivity gains.

It may also be the case that companies are better able to make profits - perhaps through being forced to make productivity gains - when the economy is weak.

Look at the right-hand chart again. In the second half of the 1990s, the US economy was booming - high levels of capacity utilisation, a very low unemployment rate - and the benefits of economic growth went to workers.

Now, with the US emerging from recession with low levels of activity and a weak labour market, the benefits of higher growth are, instead, going to companies.

Why should this be? The answer may have something to do with the linkages between globalisation and new technologies. Together, they have reduced the pricing power of individual companies and nations as a whole. Companies and countries are increasingly price takers, not price setters. At the same time, domestic labour costs are still primarily influenced by the changing level of domestic demand - relative to trend - through the course of an economic cycle. When the level of demand is strong, workers win. When the level of demand is weak, companies win.

In other words, if companies have lost pricing power, the only way in which they can influence their own profit margins is through costs. Costs are easier to bring down when demand is weak than when demand is strong. One implication is that profits may be a lot more cyclical today than in the past. Pricing power has gone and the ability of companies to influence costs depends critically on where they are in the economic cycle.

The productivity story is undoubtedly good news. Other countries - the UK, members of the eurozone - can only look at the US with envy as it, once again, shows how to use resources in the most efficient way. To suggest, however, that the rebound in profits is unambiguously good news for the US economy is to ignore the cyclical tug-of-war that is being played out between companies and workers. George Bush should take note: the profits rebound may mean that the economy is healthier but next year's voters may not be able to get their fair share of the spoils.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com