Grating Expectations

Regular readers have probably noticed that Jim’s post, Jobs “Saved”, was one of the first waves in what is becoming a tsunami of questions about the validity of the administration’s claims of saving over 640,000 jobs. Jim’s critique and my comment on it dealt largely with the impossibility of identifying and measuring saved jobs. According to the Tuesday Wall Street Journal Opinion Page it turns out that the validity of the numbers is even worse than Jim thought.  On Thursday the WSJ’s Kim Strassel wrote a terrific send-up of the statistics and the planned jobs conference suggesting the need for a new “jobs czar”. Now that the game is joined, many more journalists and bloggers will be pouring over the numbers and finding errors and perhaps even prevarications.

The Employee Relationship as an Asset

“New” jobs depend on “new” investment. Only by increasing the community’s capacity to produce new value can we create new positions for people to work in that creation. For example, if a primitive farmer saved only enough seed to grow a crop equal to this year’s harvest he would not create any “new jobs”.  But if he expected the tribe’s growing population to warrant an increase in his output that would lead to greater profits he might save (invest) more seed to grow a bigger crop next year and consequently need more workers to plant, weed, and harvest the larger crop. But, the key word in this story is “expected” – people invest in light of their expected return.

In this post I would like to take the notion of investment a bit further and apply some of the thinking in our forthcoming book on intangible asset management. We all know that most employers hire for the future (net of replacement for departed or retired workers). Employers “create” new jobs when they believe that increased effective demand will be sufficient to justify and sustain the investment that accompanies those jobs. All new jobs require some new investment if only in search, background checking, training, and setting up accounting and payroll files.  In many cases, a new job may involve substantial capital investments such as a new lathe, truck, or computer.

Once hired, the employee relationship represents an asset to the firm. One of this year’s Nobel Laureates in Economics, O. E. Williamson, defined the various forms of employee relationships and contracting frameworks in terms of increasing degrees of employee and employer specificity or investment on a scale from spot to obligational to relational. Because spot employees are generally fungible and are easily replaced, it is the latter two and especially the relational positions that are most analogous to assets.

Like any asset, an employee relationship involves an expected net cash flow, an expected holding period or tenure, and a fair amount of uncertainty. The value of the employee relationship is equal to the NPV of the expected net cash flow over the expected tenure of the employee less any initial investments in any employee acquisition and training, etc.

The Job as an Asset to the Employee

The asset analogy is most easily recognized from the employee’s perspective. In many countries, it is so difficult to discharge an employee that they, in effect, have a property right to their job. Not surprisingly, employers are reluctant to make commitments they can’t change as conditions change.  Employee claims to property rights in jobs are most visible in highly unionized or public sector workplaces. The UAW famously negotiated an agreement with GM that paid laid-off workers 80 per cent of their wages. One often hears of “getting on the payroll,” an expression not of incurring an obligation to work for an employer but of locking-in a reliable flow of income and benefits. Dave Bing, the great Detroit Pistons guard and now Mayor of Detroit remarked about escalating union demands as the city plunges toward bankruptcy, “we are not a jobs provider, we are a service provider.”

Needless to say, the actions that employees will take to protect the value of their job asset are not always consistent with increasing the value of their relationship to their employer. We are all in this boat together but not always rowing for the same shore.

Employee asset valuation

Most of my friends are not economists but all are experts in economic policy. Many are distressed that jobs are not returning or being created fast enough, despite extraordinary stimulus expenditures.  Some are appalled that some firms are reporting improved earnings and increased executive compensation but not hiring workers. When I suggest that expected future conditions and uncertainty about them might not warrant creating many jobs, they point to the profits and bonuses as evidence that the “money is there” to rehire or hire workers. When I try to point out that profits belong to shareholders and quote my old friend, George Rifakes, a veteran senior executive, to the effect that, “customers are our only source of revenues” I am told that this is a “bad time” to be rewarding shareholders and executives and that resources should be focused on hiring people to get the economy back on track.

Let’s examine the outlook or expectations for the factors that determine employee relationship value. First, expected profitable employee tenure depends upon the expected timing and duration of increased demand. If creating a job involves a substantial up-front investment, employers need to be confident that demand for the output will persist long enough to justify the investment. The recession may have ended last quarter but continued GDP growth is forecast generally to be modest and won’t reach previous levels for some time. As a result it is difficult for most firms to take on a long-term employee commitment at this time. Until there is more evidence of a sustained increase in demand employers will try to use the spot or part-time employment markets to handle any short-term increases in demand.

Second, the net revenues attributable to employee effort (the primary incentive to hire) depend both on the prices received for employee’s output and the wages and other costs associated with producing that output. Prices and wages are likely to be held down by the current slack in U.S. capacity and competition from imports. But other employee costs are uncertain, especially those involving health care and taxes. Health care  insurance mandates for employers are possible and health care costs will probably rise.  No one knows how much of the burden will fall on employers. The Bush era tax reductions seem almost certain to expire at the end of 2010. Since most small employers combine firm and personal income and must pay a matching amount on employee income taxes, the net funds available for hiring and investment will be lower in most cases. Employees live off of their net income after taxes and when they see smaller paychecks, they will push for higher gross salaries to compensate. Not all will be successful but some will, further reducing the employee relationship value and the amount available for investing in new employee relationships.

My non-economist friends often deny the role expectations play in employers’ decisions. So far as I can tell, they reject the notion that the decision is as sophisticated as investing in an asset and indicate that the employers they know don’t conduct the sort of analysis required. But people often make major investments without explicitly considering the math. For example, choosing to have children involves a highly speculative investment over a long term. In poor countries, fertility is often very high because the children pay off relatively soon as workers (quasi employees) and later as old-age service providers. As countries become wealthier fertility declines, and parents reduce their family size. In making the most intimate of investments, economic expectations are a major factor as The Economist explains in a recent cover page article. If parents in an emerging country can make delicate investments based on their intuitive grasp of conditions, surely an employer in the United States can base his hiring decisions on a feel for his commercial prospects.

We just hope that the offspring of the parents’ investment find healthy employers and jobs when they are ready.

Posted by Bob


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