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Services Sector Continues to Hold Back Economy

Friday, 18 Feb 2011 | 10:57 AM ET

If you're wondering why the majority of Americans still think the economy is in recession—20 months after it supposedly ended—take a look at the condition of the services sector.

By most measures, including key ones such as sales and jobs growth, the great growth engine of the American economy in the past four decades is still in a recovery mode—not an expansionary one.

"Our respondents say it will be slow incremental growth," says Tony Nieves, chair of the Non-Manufacturing Business Survey Committee for the Institute of Supply Management. "My own observation is that we have to see how it trends out and if it truly sustainable."

The ISM's closely watched survey of the services sector has been in a growth mode since December 2009, but unlike the group's manufacturing index as well as key government barometers like industrial production and the Philadelphia Fed's factory index, is still well below its pre-recession level. Never mind its record high of 2004.

What's more, some economists say the ISM survey, being a diffusion index, may be overstating the condition of the services sector.

"It reflects breadth not strength per se," says Robert Brusca, chief economist at FAO Economics, who has been pointing to the service sector's lagging performance for the past two years.

"It does closely track GDP," adds Nieves, a lodging industry veteran. "but is more reliant on the employment segment."

Though the U.S. has long been described as a services driven economy, a quick data snapshot of the sector shows just how integral it is, and why its weaker-than-usual performance is so influential.

During the 1990-2000 period—the longest peacetime expansion in U.S. history—services counted for some 80 percent of net private sector payroll growth. Some five million were in professional and business services; another 3.8 million were in education and health related.

In the most recent expansion, the economy added more than 6 million service jobs in the 2003-2007 period, but lost 2.5 million manufacturing ones.

As telling as that is, job-loss data during economic downturns is even more illustrative of the current environment.

In the four recessions prior to the recent one, the number of services jobs held steady or rose slightly. In the Great Recession, some 3.4 million were lost. Some industries—financial, travel and leisure, information—just recently bottomed out, lagging the overall employment trough of February 2010.

"It's goods producing (sectors) that are usually the most cyclical," says Heidi Shierholz, a labor market economist with the Economic Policy Institute. "Services are more sheltered from shallower downturns."

Even still, job growth in the service sector has been anemic in the last year at just under 900,000, with the majority evenly split between two groups—education and health care and professional and business services, according to BLS data.

Brusca's analysis shows three other groups—trade and transportation, finance, insurance and real estate, travel and leisure and payrolls—have seen contractions in payrolls versus average increases of 2.5-5.0 percent in recovery periods.

"Travel was one of the areas that came back strongly in the past," says Brusca.

Payrolls in the construction sector—which has close connections to many service sector industries—are 9-percent below their recession-ending level.

Spending and sales data are equally disappointing.

According to Brusca's analysis, spending on services is up 1.2 percent since the recession's end, versus the 6.1-percent average; meanwhile, the overall GDP increase—powered by consumer goods—is 4.5 percent, compared to the 6.4-percent historical average.

Data from the financial analysis firm Sageworks shows various service sector categories below pre-recession levels.

"It doesn't surprise me given the top line growth trends across all industries," says Sageworks chief administrative officer Will Boland. "I wouldn't be surprised if spending never reached pre-recession levels."

What ails services?

Data from Sageworks, whose biggest client base is small and medium businesses, shows 2010 sales-rate increases for a diverse group of businesses—advertising, dry cleaning, dining, travel—are below those of 2007 and 2008, even though almost all the categories suffered stunning annual declines in 2009.

"I think business are looking for ways to grow," says Boland. "They've cut the expenses they can and are selectively coming back."

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The big question about the services economy—which accounts for 69 percent of al jobs—is whether the adjustment is cyclical, structural or both—similar to the rust belt recession of the late 1970s and early 1980s and the ensuing shrinkage of the manufacturing sector.

What's ailing the services sector, say observers and players, is certainly a combination of evils: the indebted consumer, the real estate recession, state and local budget cuts, and government policy.

Government policy—from the new health care law to taxes to regulations—is often cited as the most powerful depressant on job creation, especially with small businesses.

"Hiring people has become too expensive," says Brusca, citing new burdens from health care and financial services reforms.

In addition, private sector economists and business leaders say tax policy is misguided.

Government policy has to has to "focus on investing in small business," billionaire entrepreneur Robert Johnson told CNBC Thursday from the Business Council Conference in Florida.

Policy critics say a lack of tax incentives or the wrong ones—tax credits, for instance—are not encouraging risk, investment and expansion.

"There's a lot of money piled up on the sidelines," said Johnson, founder of the RLJ Companies and best known for the Black Entertainment Network.

Meanwhile, cash-strapped state and local governments are responsible for a double whammy. Many have raised property taxes and fees, which has raised the cost of doing business for small service-oriented firms, which might otherwise spend the money on wages, goods and services.

More obvious are spending cuts that have reduced services, some of which were subcontracted to private firms years ago.

"Where there's been a big purchase of outsourced services, if you see a shrinking of the budget, the services sector will show that," says Boland.

The real estate slump—now in its fifth year—has also played a big part, affecting a variety of white-collar and blue-collar businesses.

"There was a big drag on the sector," says Nieves of the ISM.

Tied to all this is the great retrenchment of the American consumer, after two or three decades of debt-based spending.

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"A lot of it is sliding down the affluence curve; you do more things yourself," says Brusca, who adds that there is less of that today than there was in 2009.

"Consumers are a heck of a lot poorer than they used to be," says Shierholz.

In the case of small businesses, the mentality gets compounded because it is often hard to separate the consumer from the employer.

"Business and consumers have meaningfully adjusted their spending habits," says Boland. "They realize we may not need to spend or employ the services we have in the past."

Boland and Nieves both add that the services sector has undergone a long needed period of productivity enhancement, helped partly by affordable technology.

"Some of these jobs aren't coming back," says Nieves.

Much like the spending.

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