The American labor market, business and the post-pandemic economy

INSIGHT ARTICLE  |  November 02, 2021

Widespread labor shortages are hampering companies’ ability to capitalize on an economy that is expanding as the country recovers from a devastating pandemic. Companies will not experience a return to the way things were in the labor markets before the pandemic.

The retirement of baby boomers, lingering challenges associated with the pandemic and a “you only live once” philosophy among many younger workers are driving a structural shift in the labor market away from the conditions that prevailed since the 1980s.

Now employers are wooing workers with improved pay, flexible work arrangements, state-of-the-art technology and better employee treatment. And these changes are just the beginning of what is a significant shift in the American workforce.

Middle market businesses across industries are finding themselves on the challenging end of the labor issue, as they try to ascertain how to navigate the shocks unleashed by the pandemic.

To understand these new dynamics, we have to examine the frictions in the labor market. That starts with the undeniable fact that not only are there not enough workers, but companies are also struggling with high turnover rates and constant employee poaching from competing businesses within market niches and those outside traditional  competitive ecosystems.

That dynamic is almost certainly organized around the growing role of technology inside the production of goods and provision of services that is transferring power away from management and to labor.

Although consumer demand and growth remain strong, middle market businesses should always prioritize operating based on the opportunity costs of not taking advantage of such demand and growth. Yet that key requirement also implies something of a radical transformation of those same middle market organizations.

Middle market businesses are finding themselves on the challenging end of the labor issue, as they try to ascertain how to navigate the shocks unleashed by the pandemic.

It is important not to become trapped in the idea that the labor market is simply about supply and demand. The labor market is far more complicated than a commodity market where prices can ultimately drive the final outcomes. Moreover, the premium placed on technological skill sets is transferring a form of bargaining power toward workers.

In many ways, this is the biggest change to the domestic economy since the automotive industry was forced to adapt to more dynamic foreign competition.

We argue that, on top of a pandemic-related deficit of the labor force, there has been a fundamental change in the structure of the labor market that compensation alone cannot explain. While improved wages are part of the equation to address labor shortages, they are not the sole solution.

This is the first in a series of works that will sketch out what we think will be a transformation of the American workforce that will alter the shape, composition, size and operational framework of the companies that constitute the beating heart and soul of the real economy.

This will be one of the significant managerial challenges of the post-pandemic economy that we expect will redefine the middle market and play a role in the reshaping of the contract between workers and organizations.

It is not about extended unemployment benefits

The pandemic-related unemployment benefits were a substantial addition to existing benefits. In places like Massachusetts and New Jersey, those benefits exceeded $1,000 a week, or about $25 per hour.

As of early September, those benefits had been rolled back in all 50 states as the special $300 per week expired.

So what does the early evidence indicate? The special unemployment benefit did not play a major role in employment decisions by workers. Economists have not shied away from showing robust evidence that extended unemployment benefits can contribute to increasing unemployment durations and reduce job application rates. But it is not a yes-or-no question regarding the impact of extended benefits on unemployment; rather, it is whether the impact is significant or not.

Most studies have shown that the negative effect of unemployment benefits is often small, especially when taking into account the strong positive effect on spending. Recipients of benefits tend to spend most of their unemployment payments, which drives up aggregate demand and in turn, leads to more hiring.

It is important not to become trapped in the idea that the labor market is simply about supply and demand.

A recent study from economists at the University of Chicago focused on pandemic-related unemployment benefits from April 2020 to April 2021. It found that the “disincentive effect of expanded benefits is quantitatively small” and that “unemployment supplements are not the key driver of the job-finding rate through April 2021.”

A recent analysis by The Wall Street Journal found that between April and July, payrolls expanded by 1.33% in benefit-cutting states and by 1.37% in benefit-maintaining ones. In a potential labor force in excess of 161 million, there is no significant statistical difference in employment outcomes based on the extension of unemployment benefits.

More important, especially for middle market organizations, this fact is also reflected when we look closely at the job vacancy-unemployed gap—which shows the difference between the number of job openings and the number of unemployed workers—by industry group.

The gaps are large not only in leisure and hospitality, and wholesale and retail groups, in which hourly wage rates are the lowest at $18.75 and $27.84, respectively, but also in professional and business services, education and health, and financial services, where the hourly wage rates are significantly higher.

Even if we use the highest unemployment benefit amount from Massachusetts or New Jersey to compare, which is $25 per hour, it is way below the $36.80 hourly wage rate in professional and business services, where the vacancy-unemployed gap ballooned to almost 1 million in July 2021. Any meaningful change in worker behavior around extended unemployment benefits is difficult to find.

Companies should expect that the current labor market frictions will endure past the end of the pandemic and be a persistent feature of the real economy.

Labor force deficit

The lack of labor falls heavily on the simple fact that workers are staying on the sideline and reluctant to return to the labor force. Of course, if one is not in the labor force, he or she is not eligible for unemployment benefits. We need to look at the size of the labor force deficit under current conditions.

Compared to the pre-pandemic level, as of August 2021, the labor force is down by about 3 million workers assuming that the labor force growth rate is virtually zero—a heroic assumption. Assuming a one-half percent growth in the labor force, that number is probably closer to 7 million. Our own “pandemic-adjusted unemployment rate” implies a real rate of closer to 8.4% compared with the official 5.2%, so we think that there is plenty of labor out in the market.

But are the workers going to come back soon? The short answer is yes, but only for some.

Older workers

The first group of workers that will likely stay out of the labor force permanently—and exit in larger numbers—are those born between 1944 and 1964. We suspect that many of them were forced to retire early not only for economic reasons but also because of health-related reasons from the pandemic. They also may have had difficulty adjusting to the technology-heavy “Zoom economy” that has characterized the pandemic economy.

Firms should expect that the current labor market frictions will endure past the end of the pandemic and be a persistent feature of the real economy.

The mini recession in 2020 had a big jump in those 55 or older leaving the labor force. Since then, this particular population trajectory has shifted north of the pre-pandemic long-term trend, without any sign of going back.

The shift explains about 1 million to 1.5 million of the total number of workers who might never come back. And many of them were well-trained and highly experienced people who will not be replaced easily.

Parents with children at home

The second group that has been on the fence includes people who have been affected by the lack of child care and the partial closing of schools. The labor force participation rates of mothers and fathers with children under 18 were both down 1 percentage point in 2020 compared to 2019, according to the Bureau of Labor Statistics.

We expect that this group will most likely return to the labor force in full as schools reopen and, more important, with payments from the newly enhanced child tax credit.
The delta variant and the challenges around getting people vaccinated are almost certainly going to result in a staggered and uneven return of those workers to the economy, which will delay the return of the full capacity of the economy to produce.

The solution to the labor shortage is to increase investment in automation, productivity-enhancing technology and adhering to ESG standards while demand is strong.

Moody’s estimates that the U.S. economy is operating at around 89% of capacity, which is down from the pandemic peak of 93% last summer.

The child tax credit has proven to be a lifeline for many parents to get some relief from the income pressure of the pandemic, and a game-changer for overall spending as it has helped increase spending on categories such as food, clothing and school supplies.

Immigrants and temporary workers

The last important group that has been largely ignored is new immigrants and nonimmigrant temporary workers. The pandemic has put constraints on the inflow of immigrants as government agencies have had their visa processes slowed, making it harder for applicants to enter the country.

Also, travel restrictions, the fear of contracting the virus, vaccination requirements and overwhelming uncertainties have held back the inflow of international workers who have contributed greatly to the U.S. labor market.

For temporary nonimmigrant workers alone, the total number of visa admissions in the third quarter of 2020 was down by roughly 750,000 compared to the last quarter of 2019, before the pandemic broke out.

Because of the spread of the delta variant, this group will continue to dwindle in number until vaccines become more widely accessible to every part of the world.

The recent commitment from the U.S. government to double its purchases of the Pfizer COVID-19 vaccine to 1 billion doses to donate to the world is a much-needed development that can surely help ease some of the labor challenges.

The ground has been shifting more quickly

Like it or not, the structural shift of the labor market has been accelerated by the pandemic, and the spike in early retirements is one example.

The other part, which is much more welcoming from a social planner’s standpoint, is the increase in labor-matching efficiency in some sectors of the economy.

The reason for this is that the pandemic has offered a rare opportunity to partly reorganize the labor market, where mass layoffs during lockdowns have helped workers find better employer matches.

This cost for workers to switch can be substantial, especially for low-paid workers who live paycheck to paycheck while relying on their employers for health insurance or child care benefits.

As a result, the voluntary job quit rate was historically high in April at 2.8%, prompting some to dub it “The Great Resignation.”

But where do those workers go after quitting? The data suggests that those workers have stepped up a couple of levels higher on the career ladders to be with better employer matches.

One example is the firm-size ladder. In late 2020 and so far this year, there has been a significant shift in the job quit movements across different firm-size groups.

On a six-month moving average, while job quits among all groups with fewer than 999 employees have been surging since late 2020, companies that have 1,000 or more employees have seen job quit numbers stabilizing around the pre-pandemic levels.

This suggests that workers have been moving up the firm-size ladder given the strong labor demand as the economy bounces back from the pandemic.

The middle market

To economists, this is not a surprise since it is well in line with economic theories on the labor market. But it has caught small and medium-size companies off guard as they scramble to retain workers while trying to hire more to meet demand.

This fact was reflected in our most recent RSM US Middle Market Business Index report when all surveyed middle market organizations indicated that they would increase hiring in the next six months, while 58% increased compensation to attract labor and 70% expected to do so going forward.

It is important to emphasize the impact of the pandemic because it has provided a well-suited labor environment for such rematching to happen, which was extremely hard to detect in the past when looking at the movements of job quits across firm sizes before the pandemic. They tended to move together most of the time.

Furthermore, expansionary monetary policies have been found to speed up the rematching process away from contracting sectors to expanding sectors by helping the expanding sectors widen the wage differences to attract better-suited workers, according to a highlighted academic paper featured in the recent Federal Reserve’s symposium.

That being said, many of the frictions in the labor market that remain because of social norms and outdated working models have been altered in some cases, and destroyed in others, by the pandemic. This revolution in work would simply not have happened so quickly without the intervening event of the pandemic within a framework of rapid technological change that was already in process.

And it is this particular set of conditions that has resulted in a period change that is not going to revert to the way things were before. Attempting to do so would be the managerial equivalent of attempting to put the toothpaste back in the tube.

It is not a coincidence when many companies have made the headlines by offering same-day signing bonuses to potential employees who decide to accept the job on the spot, or when a giant corporation like Amazon offers to pay college tuition for employees just to gain a competitive edge.

It is easy to understand that in a tight labor market, employee bargaining power is much higher than it is otherwise. But there has been a fundamental change in work preferences coming from the supply side of the labor market.

Workers are increasingly demanding better work environments, whether that is about the ability to work from home, flexible work schedules, or preferring that an employer prioritizes environmental, social and governance initiatives, which is altogether far more complex than higher wages when making work choices.

The Beveridge curve

Perhaps there is no better way to tie up our analysis on the structural change of the labor market than by showing the recent movement of the Beveridge curve—which plots job vacancy rates on the vertical axis and unemployment rates on the horizontal axis. The negative relationship between the job vacancy rate and the unemployment rate is one of the most robustly proven results in labor economics.

A clear shift of the curve to the right often indicates changes in the labor market as labor structural mismatches occur when the unemployment rate and vacancy rate are both elevated.

The curve made a small shift to the right in the aftermath of the financial crisis, but eventually went back to its starting point in December 2000.

The shift of the Beveridge curve since the pandemic has been nothing short of extraordinary. Some have attributed this significant shift to the unique nature of the pandemic recession. And recent data suggests that the curve might take a much longer time to stabilize as evidenced by a labor market that has been fundamentally altered.

Navigating the market

We cannot overemphasize the fact that the current labor market requires much more time and consideration than the focus on compensation from companies, especially middle market organizations that have been on the challenging end of the spectrum.

We believe that the solution to the labor shortage issue is to turn such a challenge into an opportunity to increase investment in automation, productivity-enhancing technology and adhering to ESG standards while consumer demand and growth are still strong.

We understand that this is no small matter and will require focus, effort and, above all, capital to deliver. But it is important to keep in mind that the market has always been kinder to early movers and harder on late adopters.

Still, it is also much more taxing on middle market businesses to compete in compensation with larger organizations, while there is nothing that can stop workers from moving up the career ladders. Yet workers are looking for more than just pay, and the alignment of workplace values with workers will result in better financial outcomes.

Instead of paying the soon-to-be-foregone expenses of attracting traditional employees, companies should be more strategic in their hiring plans so that they prioritize the matches between midsize businesses and employees and how those matches will complement the advances toward automation and technological adoptions within the organizations.