When an update to Labor share of national income is released by the Bureau of Labor Statistics, it does not make headlines. Yet, it gives insight. The BLS released today their revised Productivity and Costs report for 1st quarter 2014.
In the 1st quarter of 2014, the non-farm Business Sector Labor share index was revised up from 97.2 to 97.5. When labor share rises, the implication is that profit rates decline. Here is how I see profit rates. The most recent data shows that profit rates fell, but they have been holding fairly steady near the peak since 4Q-2011.
Even though the BLS report does not mention labor share directly, there are other data given... (% is for change since 1st quarter 2013)
- Productivity... rose 1.0% over the past year.
- Output... rose 2.8%.
- Labor hours... rose 1.7%.
- Real hourly compensation... rose 0.9%.
- Unit labor costs... rose 1.2%.
Unit labor costs = Real hourly compensation/productivity
Change in Labor share = change in unit labor costs - change in inflation
Since unit labor costs rose less than inflation over the past year (1.2% to 1.5% respectively), labor share actually fell over the past year.
- Labor share... fell 0.23% from 1Q-2013 to 1Q-2014.
Profits have been good for business with a 2.8% rise in yearly output and a 1.2% rise in unit labor costs.
What do I expect going forward?
Productivity will not rise much because it is against the effective demand per labor hour limit. Real hourly compensation is rising very slowly (only 0.4% annual rate from 4Q-2013 to 1Q-2014). So unit labor costs may tick up slightly. I foresee inflation staying steady or even ticking down a bit toward 1.3% on a quarterly basis. Thus labor share will continue to rise mildly.
So what will happen to the profit rates?
Profit rates have hit their maximum for the past 2+ years. But will they go down? Well, looking at labor costs, higher profit rates will hold steady. But let's break this out.
Profit rate = (1 - labor share)*GDP Output/Capital
Profit rate = (1 - unit labor costs/inflation)*productivity * labor hours/Capital
- As unemployment comes down, labor hours should go up. That increases the profit rate holding all else equal.
- As unit labor costs rise slowly and inflation falls slowly, profit rates decrease.
- Since productivity is constrained by the effective demand per labor hour limit, it will not give much of a boost to profit rates.
- If capital can be contained, profit rates would tend to rise. So there is an incentive to control expansion of capital, unless capital can lower unit labor costs and increase productivity.
Considering 4 things...
- Profit rates have peaked
- Labor share has bottomed out
- Productivity has stalled
- Capacity utilization is low
... increases in capital will not be made profitable by lower labor share as they have in the past. So, the key to profit rates now is to raise labor hours holding all else fairly constant. Thus firms have an incentive to hire in an atmosphere of controlled unit labor costs, stable inflation and constrained productivity. Unemployment is coming down but unit labor costs are being strictly controlled and productive capital investment is moderate.
The important thing here is... How long can firms keep unit labor costs controlled? The protests for higher wages are growing.
What is the problem that can bring down profit rates?
Firms do not want to see their profit rates fall... even though their aggregate profit rates are very high already. If profit rates start to fall, asset prices will fall. This will have a cascading effect to investment and consumption. The problem is that asset prices are dependent upon very high profit rates which are based on a historically very low labor share. This situation is unsustainable. People are demanding higher wages because they are struggling terribly. Moreover, government assistance increases to make up for low wages. There are calls for higher taxes on capital.
Even if labor share rose and profit rates were to back down from 9% to a more sustainable 8% (which is still high historically), asset prices would fall and there would be a negative cascading effect upon the economy.
Profit rates just simply went too high and labor share went too low. Bringing these back into a sustainable balance will trigger an unstable financial situation, which would likely produce a recession.