By David Bassanese

For America’s economic expansion – and hence the global bull market in stocks – to continue, the world’s leading economy will sooner or later need to produce something that has eluded it since the financial crisis: decent productivity growth on the back of labour-saving business investment.

The good news is that, given America’s ingenuity, I suspect this will be a natural outcome of growing labour shortages, which will give the expansion a second wind without overly stoking inflation.  

The bad news is that it could also mean the next equity market bust, when it comes, could reflect a valuation bubble. 

So far at least, America’s long economic expansion has been top heavy, with jobs growth rather than productivity growth – such that the unemployment rate has now dropped to a very low 4.3%.  

Non-farm business sector: Real output per hour of all persons 

 

Judging by business surveys, however, labour shortages across the economy are intensifying. Indeed, some of the slowing in employment growth in recent months likely reflects growing labour scarcity. Ordinarily, labour market tightness should result in higher wage growth – and hence higher inflation – which causes the Federal Reserve to more aggressively jack up interest rates and bring the economic expansion and Wall Street’s bull market to a shuddering halt. 

That might still be an outcome – but there’s little evidence of it yet. Indeed, last week’s May payrolls report revealed that average hourly earnings remained fairly benign, with annual growth steady at only around 2.5%. Due to the lack of pricing power it seems, few companies are able to attract the workers they need simply by jacking up wage rates.  

Another scenario is that America’s expansion simply exhausts itself – a victim of its own success. Unable to raises prices to pay higher wages and attract needed workers, corporate America’s might simply lower their ambitions. Given low US productivity growth and population ageing, only around 100,000 jobs a month going forward would be needed to keep the unemployment rate steady. That would represent a marked slowing in the pace of employment growth compared to what has been enjoyed in recent years, and could risk continued gains in corporate profits. And, given the way multipliers work through an economy, a modest scaling back in ambitions could result in a more serious slowdown. 

Neither rising inflation nor reduced corporate ambitions are desirable – and thankfully I don’t think likely outcomes. Given global competition and new technologies, it is hard to see corporate pricing power rise to an extent that America develops a serious wage and price inflation problem. But nor do I think American business will simply roll over and close up shop. Rather, given necessity is usually the mother of invention, it would not surprise me to see more labour-saving productive investment and/or “re-engineering” of business processes.  

Indeed, there are some suggestions that recent persistent low inflation and weak productivity growth already reflect such labour saving innovations in the services sector – only our old fashioned manufacturing-based means of measuring economic growth can’t properly capture it. If so, it could be that a further step-up in business labour saving innovation in fact results in lower inflation – which effectively continues to support economic growth by boosting the real incomes of workers. 

In Japan, for example, inflation remains very low even though the economy has been running ahead of potential and the unemployment rate is also very low. As for the Bank of Japan, such a development in the United States would leave the Fed in a quandary over whether to continue lifting interest rates or not. 

All up, either way America’s long economic expansion will end at some stage. It is said that expansions (and equity bull markets) rarely die of old age – rather higher inflation or a bursting asset bubble close the party down. Absent a decent rise in inflation, I suspect it will be an eventual asset bubble, likely in the tech sector again and helped by central banks wrongly fighting productivity-induced low inflation - that leads to the next global bust.  

The party could again eventually end in tears, but there seems a little more dancing to be had before then.