President Barack Obama talks with House Speaker Nancy Pelosi, D-Calif., and Assistant to the President for Legislative Affairs Phil Schiliro, left, following a meeting with bipartisan leaders of Congress in the Cabinet Room of the White House, July 27, 2010.

US job gains so far in this expansion have been atypically weak, especially considering the record depth of the employment downturn, according to Richard Berner, chief economist of US investment bank Morgan Stanley. He says assuming that the recession ended in June 2009, private non-farm payrolls have been flat over the past year, compared with a 2.3% gain in the first year of the past seven recoveries.  Clearly, much of that weakness is cyclical, reflecting the widely expected sub-par rebound.  In the MS view, however, structural culprits are also at work; of these, Berner says high and rapidly rising healthcare costs are one of the most important and certainly the most overlooked.  That's long been a key factor why job gains will remain tepid for now.   

US economist Daron Acemoglu, a professor at the Massachusetts Institute of Technology (MIT) writes on The Economist's site: "US structural unemployment is up. But this is not a recent turn of events. It is the continuation of an ongoing process. US employment and demand for labour have been undergoing profound changes over the last 30 years. While the demand for high skill workers, who can perform complex, often non-production tasks, has increased, manufacturing jobs and other 'middling occupations' have been in decline. Also noteworthy is that over the last 10-15 years, many relatively low-skill, low-pay service occupations have been expanding rapidly.

These patterns are not peculiar to the United States. They are visible in almost every West European economy as well. They result from changes in technology, which have enabled the automation of many manufacturing jobs as well as certain lower-end managerial routine tasks, together with offshoring and outsourcing of some of these tasks to China, India and elsewhere. As incomes have increased, the change in demand towards both high-skill (e.g., health and legal) and low-skill (e.g., cleaners and child care) services has continued and there has been an associated increase in the demand for service occupations, which are more difficult to automate and offshore.

Structural unemployment is up largely because men previously performing relatively well-paying manual tasks, manufacturing jobs and lower-end managerial jobs have been unwilling to take lower paying service jobs. In fact, current statistics mask the true extent of the unemployment problem. Labour force participation among men is down and many who would have been unemployed are now on Social Security and disability programs."

Richard Berner says weak employment gains don't condemn the economy to 1-2% growth, because a rising workweek is a powerful offset that spreads across the workforce.  For example, although private payrolls rose by only 0.6% in the six months ended in June, courtesy of the 18-minute rise in the workweek, private hours worked rose by 1.4%.  A similar percentage increase in private payrolls would average 256,000 monthly.  In addition, temporary hires testify both to the need for labour and to the desire to avoid a commitment to healthcare benefits.  In this recovery, temp hires have jumped 19.6% from the trough versus an average of 3% in each of the past two recoveries.  While payroll gains seem likely to increase to an average of 150,000 monthly in 2H10, hours worked may rise by more as companies continue to substitute increased working hours and temps for full-time hires until the economy is on firmer ground. 

The economist says to be sure, there are other structural hiring headwinds.  Among them: Mismatches between skills needed and those available; labour immobility resulting from negative equity in housing; and uncertainty around policies in Washington.  Along with rising healthcare costs, all will continue boosting the workweek for now. 

Working longer hours doesn't spread income directly to the unemployed, nor does it create the boost to consumer confidence that comes from stepped-up hiring.  But it does generate income that is helping to make the recovery self-sustaining.  That's evident in the strength of withheld tax payments through June, which are up more than 4% from a year ago.  And it does indicate that employers need more labour services - necessary for an eventual improvement in the employment outlook.

Structural problems surfaced a decade ago.  Healthcare costs have been high and rising for some time, and other structural issues aren't new.  So why are they suddenly a big deal in suppressing hiring?  Berner say that they are not.  In fact, for the past decade structural factors have been behind the shift from a "high-pressure" to a "low-pressure" economy, according to Treasury Assistant Secretary for Economic Policy Alan Krueger and Lawrence Katz, both noted labour market experts.  Krueger notes that:

"From December 1989 through December 1999, the economy gained 21.7 million payroll jobs.  By contrast, from December 1999 through December 2009, the economy lost 944,000 jobs.  This poor performance is not only due to the recession at the end of the decade.  Job gains in the 2000s are weak even if we exclude the losses that occurred during the recession: Over the first eight years of the 1990s, the economy gained almost 16 million jobs; during the first eight years of the 2000s, however, payroll employment rose by somewhat less than 7.5 million jobs, a little less than half of the previous decade's eight-year increase."

And Lawrence Katz documents the structural labour market problems glaringly apparent in the wake of the recession (with updated calculations):

"Two particularly worrisome signs suggestive of longer-term structural labour market problems and persistent costs of unemployment from this recession are the concentration of the rise in unemployment among permanent job losers and the huge increase in long-term unemployment.  Permanent job losers (job losers not on temporary layoff) increased from 1.7% in November 2007 to a peak of 5.6% in October 2009 and remained at 5.0% in June 2010. The number of long-term unemployed (those unemployed 27 weeks or longer) reached over 6.75 million in March 2010, representing 45.2% of the unemployed. The long-term unemployment rate (those unemployed 27 or more weeks as a share of the labour force) has increased from 0.9% in November 2007 to 4.4% in June 2010, well above the previous post-war peak of 2.6% in June 1983."

Discussing what must be changed in Washington to restore confidence and growth, with Richard Socarides, Democratic strategist and Peter Morici, University of Maryland:

‘Fixed' healthcare costs hobble job gains, boost hours and temps.  Berner says that still begs the question of whether healthcare costs or other structural hurdles are the reasons for limiting hiring.  In the MS view, healthcare costs are critical: Thanks to the high ‘fixed' costs of health and other benefits, and of taxes on labour to pay for the social safety net, US labour costs are out of line with other countries when adjusted for living standards.  He says ‘fixed' costs because benefit costs don't vary with hours worked; they are paid on a per-worker basis.  And healthcare benefit costs, which account for 8% of compensation, have risen by an average 6.9% annual rate over the decade (or nearly doubling over ten years) ended in 2008 versus 4.5% for wages and salaries.  As employers seek to cut the cost of compensation, therefore, these benefit costs drive a growing wedge between total compensation and take-home pay.  Unlike in other countries where healthcare benefits are not directly part of compensation, these rising costs likely have intensified employers' efforts to boost productivity by cutting payrolls.

Moreover, the role of healthcare costs as a brake on hiring intensified in recession, as the fixed or rising cost of healthcare collided with shrinking top- and bottom-line results.  Just as operating leverage crushes earnings in recession as fixed costs are spread over a smaller base, it also crushed employment as layoffs became the only way to cut the per-worker cost of healthcare.  For workers, the recession made the wedge between compensation and wages bigger, as cost-cutting private-sector employers cut take-home pay while leaving fixed-cost benefits intact.  Thus, US relative labour costs go up versus other countries while median pay suffers.

Not simply traditional cyclical behavior.  A rising workweek and stepped-up temp hiring are time-honoured leading employment indicators, so it could be that the recovery is simply tepid.  But this time, the strong gains in these two measures signal structural headwinds to full-time hiring.  As noted above, both have exceeded typical cyclical norms as health insurance costs rose.  Careful statistical work confirms that relationship.    

For example, Freeman and Rodgers note that the Kaiser Family Foundation found that between 2000 and 2003, employment for those at firms offering healthcare benefits fell by 2.8%, twice the decline in overall payrolls.  Sarah Reber and Laura Tyson also find support for rising health insurance cost as a deterrent to employment growth.  Katherine Baicker and Amitabh Chandra find that a 10% rise in health insurance premiums reduces the aggregate probability of being employed by 1.6% and hours worked by 1%, and increases the chance that a worker is employed only part-time by 1.9%. 

To be sure, three other structural factors represent hiring headwinds: Mismatches between skills needed and those available; labour immobility resulting from negative equity in housing; and uncertainty around policies in Washington. 

Obstacle 1. Skills mismatch.  The problem: For years, employers have complained that they don't find the skills they need in today's workforce.  Worker skills have greatly lagged technical change and tectonic shifts in the structure of the US economy.  Immigration restrictions and massive dislocations in several industries in recession have magnified that mismatch as workers who have been trained for one occupation lose their jobs.  A May 2010 Manpower research survey showed that even in recession, 14% of firms reported difficulty filling positions due to the lack of suitable talent available in their markets; in 2006 the same survey reported that 44% of firms couldn't find the skills needed.  That decline speaks to the depth of recession; it is clear that a large portion of the long-term unemployed lack requisite skills.  And even in healthcare, an oasis of job growth, there is a growing nursing and nursing skills shortage that requires new training facilities.   

Obstacle 2. Labour immobility resulting from the housing bust.  America's workers have always been footloose.  Even in the Great Depression, they looked for work wherever it was.  Today, however, about one in four homeowners is trapped in their house because they owe more than the house is worth, so they can't move to take another job - until they sell or walk away.  Unlike in the Depression, when homeownership was less prevalent, negative equity among a nation of homeowners leads to substantially lower mobility rates.  Owners suffering from negative equity are one-third less mobile according to one study.  That is leading to a wave of ‘strategic defaults', in which borrowers who can otherwise afford to pay decide to walk away.  Whether through foreclosure or default, this process is undermining the economic and social fabric of communities and reducing job opportunities. 

Berner says it's striking that the current policy debate in Washington and Wall St - - focused on whether and by how much to ramp up fiscal and monetary stimulus - - has overlooked the severe problems in housing that to MS pose the biggest downside risk to a cautiously optimistic outlook.  The economist says it is essential to reduce or refinance debt, writing off bad loans while not destabilizing the financial system.  Modifying existing mortgages seems appealing, but policies aimed at mitigating foreclosures under the Home Affordable Modification Program (HAMP) for borrowers whose homes are worth less than what they owe have not worked because they attempt to modify mortgage payments and not the amount of debt owed; re-default rates following modification are 50-60%.  And for the 75% of homeowners with equity in their homes, the refinancing process is blocked by high loan-to-value ratios and joblessness.

Obstacle 3. Policy uncertainty is a negative for the economy and markets.  The economist says America's long-term challenges - - healthcare, budget and tax reform, financial regulatory reform, retirement saving, infrastructure, education, energy, and climate change - - are not new.  Solving them is imperative, and major legislation to address them represents important steps toward those ends - - e.g., promoting increased access to healthcare and a safer financial system.  But the uncertainty around the costs of those policy changes and the uncertain magnitude of prospective tax hikes that will be required to address the fiscal problems is weighing on business and consumer decisions to hire, expand, buy homes and spend. 

The economist says recent work confirms this intuition, underlining how uncertainty produces negative growth shocks. Nicholas Bloom shows how a rise in uncertainty makes it optimal for firms and consumers to hesitate, which results in a decline in spending, hiring and activity.  In effect, the rise in uncertainty increases the option value of waiting as volatility rises.  Moreover, this line of reasoning suggests that uncertainty reduces the potency of policy stimulus.  That's because the uncertainty can swamp the effects of lower interest rates, transfers or tax cuts.  In effect, uncertainty raises the threshold that must be cleared to make a business choice worthwhile, and as uncertainty declines, the threshold falls with it.  This notion squares with MS' long-held view that policy traction from easier monetary policy, improving financial conditions and fiscal stimulus was lacking through much of last year, but improved as uncertainty fell. 

Market participants are used to thinking that political gridlock is good, that it prevents politicians from interfering with the marketplace.  The financial crisis clearly exposed the flaws in that reasoning with respect to appropriate financial regulation, whose absence allowed abuses.  Indeed, gridlock today is more likely to be bad for markets, as America's long-term economic problems are partly the result of past policies and can only be solved with political action, in the view of economists at Morgan Stanley. 

Implications of a rising workweek.  Working longer hours doesn't spread income directly to the unemployed, nor does it create the boost to consumer confidence that comes from stepped-up hiring.  But it does generate income that is helping to make the recovery self-sustaining.  And it does indicate that employers need more labour services - - necessary for an eventual improvement in the employment outlook.