Fiscal stimulus was both enormous and necessary when the Covid crisis hit last year, and it successfully prevented the structural damage that weighs down recoveries. But even as the economy was on a better-than-expected rebound, the Biden administration and Congress opted for an additional stimulus package, in the hope of delivering a booming economy that will boost workers’ fortunes in the post-Covid economy. The downside to this stimulus bet is the risk of imbalances, such as inflation or asset bubbles, as the economy “overshoots.” In this article, the authors offer four scenarios that sketch the interaction of wage growth, productivity growth, and policy management and what it means for workers, firms, and policy makers.
As an extraordinary recovery is underway, it won’t be long before business leaders face a perennial political economy question: With wages rising and workers’ claim on economic output growing, will firms’ profits come under pressure?
With tight economic conditions all but guaranteed, there are multiple scenarios of how output will be shared between workers and firms in the post-Covid expansion. The policymakers who have placed the big stimulus bet also will have to negotiate the path ahead.
We’ve identified a small number of plausible scenarios that sketch the interaction of wage growth, productivity growth, and policy management. While workers and policymakers can live with several of the scenarios, only one will be truly appealing for firms.
The Ongoing Stimulus Bet
Fiscal stimulus was both enormous and necessary when the Covid crisis hit last year, and it successfully prevented the structural damage that weighs down recoveries. But even as the economy was on a better-than-expected rebound, the Biden administration and Congress opted for an additional stimulus package, in the hope of delivering a booming economy that will boost workers’ fortunes in the post-Covid economy. The downside to this stimulus bet is the risk of imbalances, such as inflation or asset bubbles, as the economy “overshoots.”
In the below exhibit, we summarize four ways in which this bet may play out — and who wins and loses. Let’s look at each of these scenarios, before asking which one is most likely and what that means for business leaders.
1. Win-win: Wage gains are paid for by firm productivity growth.
The Goldilocks scenario is where workers, firms, and policy makers all win in the post-Covid cycle. Firms don’t lose out from higher wages if they’re paid for by productivity growth. And policy makers prefer this dynamic because there are no current or latent inflationary pressures as the potential of the economy expands.
However, this combination of wage and productivity growth is not a given. The period that most resembles this scenario was the late 1990s. U.S. wage growth was very strong, but so was productivity growth, which muted the impact on corporate margins. Companies were happy to ride the wave of strong economic growth, itself driven by strong wage growth in a virtuous cycle.
In the post-Covid world there is a credible expectation of some higher productivity growth but whether it can be enough to meaningfully offset wage pressures remains to be seen.
2. Win-lose: Workers gain at the expense of firms — reversing a longstanding trend.
If productivity growth falls behind wage growth in the post-Covid world, firms will be faced with cost pressures. If they’re unable to pass them on to consumers (see Scenario 3), their margins will be compressed and workers’ share of economic output would grow at firms’ expense, reversing a multi-decade trend.
Across recent business cycles we have seen strong wage growth when the labor market is tight and firms’ margins fall.
Keep in mind that firms’ profits may continue to grow in this scenario, as the strong economy drives top-line growth that can offset margin pressures. But it’s a less attractive scenario than the first one because we don’t see as much overall economic growth.
Policy makers would approve of this scenario, not only because of their policy objective to raise wages but also because firms’ absorbing wage pressures in margins means less inflationary pressure. However, their approval would be qualified, as rising wages cannot be sustainably absorbed in firm margins indefinitely, eventually leading to inflation.
3. Lose-lose: Inflation threatens the cycle as policy makers deal with a losing bet.
If wage pressures are not offset by productivity growth, and firms have the pricing power to pass them on to consumers, then inflation will result.
If this occurs at a modest pace (say 2%) policy makers may be satisfied. But if it drives inflation sharply higher for some time, policy makers will have lost their stimulus bet. Faced with too much inflation, they would have to raise interest rates and risk a recession — a lose-lose all around.
Such a “policy error” occurs when the Fed has to move faster and stronger than anticipated to catch up with realized inflation. While an error, it remains the desirable course of action, because ignoring emerging pressures has the potential to deliver far worse than a cyclical downturn.
4. Lose, then lose again: Policy makers double down on a losing bet, leading to disaster.
The disastrous scenario is that monetary policy makers don’t raise interest rates even when prices are rising faster, and lawmakers push for even more fiscal stimulus in a quest to extend the cycle.
The ugliness in this scenario is that cyclical pressures can break the structural foundations of the inflation regime when pressure is high and sustained. Such a “regime break” is a higher bar and takes more time than just a few quarters or even years. But it can happen, and it has happened before — last time in the late 1960s, leading to a period known as “the Great Inflation.”
If this scenario happens, the outlook wouldn’t just be a single short recession, but more frequent recessions, low asset valuations, higher rates, and a painful process of re-anchoring inflation expectations.
Which Scenario Is Most Likely?
While scenarios are a necessarily stylized version of the future (not the messy reality), there are reasons to be optimistic.
With wage pressures almost certainly building, the good news is that productivity growth is likely to absorb some of it — as the Covid crisis has facilitated new business learnings — but not all, so margins will be pressured to absorb some of it. If there is enough of these two outcomes, monetary policy makers can raise interest rates slowly without killing the cycle — a relatively good outcome for workers, firms, and policy makers.
If price pressures are passed through and too-high inflation does result on a sustained basis — which we view as less likely — policy makers stand a chance to avoid a recession, even though that window could be quite narrow. An early and well-balanced policy intervention can deliver a “soft landing,” where the economy cools down just enough, but not enough to push it into recession.
Only if inflation starts a fire that needs to be put out rapidly and policy makers deliver a recession is it a clear lose-lose bet. (Although conditions could change, we view this as unlikely.) Yet, this remains preferable to the structural inflation break (very unlikely in the near term) where policy doubles down on a losing bet and undermines the inflation regime.
What It Means for Firms — and What They Can Do
Stakeholders in the macro economy have different interests in the scenarios we laid out above. Workers are fine with scenario 1 or 2, and some politicians might even prefer scenario 2 where labor’s share most clearly rises. Policy makers would prefer scenario 1, but they would be satisfied with scenario 2 as well. They may also be willing to push the cycle if that scenario develops.
Firms, on the other hand, will strongly prefer scenario 1 and that means they have to deliver higher productivity growth in the post-Covid cycle.
It’s difficult to overstate the importance of productivity growth to firms. Passing on wage pressures to protect margins is only a winning strategy if other firms can’t do the same. If all firms can and do so, the inflationary outcome will drive up interest rates and thus be a headwind to growth. In aggregate, therefore, for firms to win they must deliver on productivity growth.
So, what are firms to do? Productivity growth, in essence, is about producing more with existing inputs, or producing the same with fewer inputs. That almost always is easier said than done, particularly when the pandemic has already put enormous strain on the workforce, but here are some key levers to do so sustainably:
- Seize on the specific learnings from the crisis. Covid has forced many firms to survive and adapt to new realities, often by exploring new, digital, and often more efficient processes and channels.
- Institutionalize the learning process from the crisis. Covid also forced firms to try things they wouldn’t have otherwise tried, often at surprisingly little cost. Now is the time to build processes that generate these learnings in more normal environments.
- Understand that the old playbook of plugging gaps by hiring the next worker will be hard. Thus focus must shift to improving existing worker productivity through new technologies. In particular, the ongoing “digital transformation” of incumbent businesses has at worst the potential to increase the cost of doing business, and at best could drive both growth and productivity. In this respect, the biggest gains will be if business models are reimagined in the context of new needs and new possibilities, rather than merely incrementally enhanced.
- Yet don’t ignore existing technologies. Often their use can be deepened today since previously the tradeoff between incremental labor or capital investment was less favorable.
- And lead effectively. Leadership that gets everyone pushing in the same direction (ranging from the operational to the inspirational type) can unlock productivity gains as well.
Avoiding paying higher wages in the post-Covid cycle will be a losing strategy. Instead, making your firm more productive so that workers’ additional value creation pays for their higher remuneration is how firms can turn the post-Covid cycle into a win-win scenario.