Dow Jones has moved into Zone of Palpable Financial Instability
I have seen the top of the Dow Jones index as 16,800, but when the ECB loosened monetary policy to an extent never before seen last week, the Dow Jones lofted over 16,800. It is now hovering below 17,000, but there are concerns that it should not loft higher.
I refer to an article by David Weidner at Market Watch, 3 Reasons the Dow doesn’t Deserve to be at 17,000. He gives 3 very fundamental reasons…
“There are many reasons this rally feels empty.”
- “No one is really buying.”
- “Corporate earnings are flat.”
- “There are no alternative investments.”
Welcome to the end of the business cycle as determined by Effective Demand. Keynes wrote about effective demand and profit rates.
“Now if for a given value of N the expected proceeds are greater than the aggregate supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to increase employment beyond N and, if necessary, to raise costs by competing with one another for the factors of production, up to the value of N for which Z has become equal to D. Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.” (source)
What is Keynes describing? When the expected proceeds (D) of employment (N) equal the supply price (Z), profits will be maximized. This point is called effective demand.
I have an equation for effective demand that predicted this moment of flat corporate earnings.
Effective demand >= Real GDP output * (effective labor share)/(composite rate of utilization of labor and capital)
Thus, when, effective labor share = (composite rate of utilization of labor and capital), profits will be maximized.
In other words, when output is equal to effective demand, the business cycle has reached its top. This has been the pattern for all decades that we have consistent data for.
In the past 6 months, effective labor share was still a bit greater than the composite utilization of labor and capital. But they are now equal. Once again, the aggregate signal for profit levels, namely stocks, is running out of steam at this effective demand limit.
Stocks could move higher if monetary policy continues to loosen to greater levels or effective demand rises, but we are now pushing palpable levels of financial instability. Further loosening of monetary policy only makes the eventual fall that much harder.
Didn’t corporations increase their profits in the recession by cutting costs (laying off workers)?
Doesn’t flat profits then mean that they’re out of workers they can lay off and now must expand (hire workers) rather than cut?
Won’t that lead to more demand, as more people employed means higher sales?
HI Axt113,
Corporations certainly increased profits by cutting labor share. That is very true.
You are right. When labor share stopped dropping, profits tended to flatten out and then fall. So increasing labor hours can raise profit rates again as long as unit labor costs are held steady, and they have been held steady.
Yes, if you employ more people, aggregate demand will increase. So everything you say is true.
However, effective demand will not increase. If the rate of labor share stays the same as you hire more people, the effective demand limit stays the same in relation to the utilization of labor and capital.
So what happens?
As more labor is employed, capacity utilization slows down and eventually falls at the effective demand limit. That is how profit rates are maintained. It happened before the last two recessions So watching capacity utilization going forward is important to gauge effective demand.
People may be happy if unemployment keeps coming down, but if they ignore a stalled capacity utilization, they miss the deeper story.
Isn’t effective demand in the overall economy equal to aggregate demand?
Looking at Wikipedia:
en.wikipedia.org/wiki/Aggregate_demand
“This is the demand for the gross domestic product of a country. It is often called effective demand, though at other times this term is distinguished.”
en.wikipedia.org/wiki/Effective_demand
“In the aggregated market for goods in general, effective demand is the same thing as aggregate demand”
This seems to imply that when discussing the economy as a whole, they are the same thing
Axt113,
They are not the same. There is no aggregate demand limit. Keynes made the distinction from an aggregate demand in agreement with Say’s law… and the effective demand which rejects Say’s law. You can read that in Chapter 3 of Keynes’ General Theory.
No one has ever found an equation that describes Keynes’ vision of an effective demand limit when looking at the data. The equation I work with is hard for others to get their head around. They don’t understand how labor income and capital income make any difference for demand. They see a dollar spent by labor as the same as a dollar spent by capital. They miss the point.
Capital needs to make their profits off of labor and capital, the factors of production. When profits rise, capital consumes more. There comes a point where profits peak. Capital will continue to spend. But more labor is required to maintain profit rates. As more labor is employed, labor costs rise and there are diminishing returns to labor. So there comes a point where profits start to decrease. Then capital backs off from spending as labor is increasing their spending. The data shows that this happens around the effective demand limit.
As you can see, this description of effective demand is nothing like how people describe aggregate demand. They see aggregate demand as simply increasing with more labor employed, end of story. But it is not the end of the story. Effective demand completes the story of demand.
Okay, I found the section, it says:
“The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.”
Okay, so effective demand is the equilibrium point of aggregate supply and aggregate demand, but that implies that shifts to aggregate demand and aggregate supply ( in the short run), will change effective demand.
So wouldn’t increasing aggregate demand, by higher wages shift effective demand upwards?
Axt113,
Don’t confuse the AS-AD model that we normally learn with the model that Keynes is presenting in that section.
The normal model puts AS = AD at any point in time. The lines always cross. What is consumed equals what is supplied.
Now Keynes model puts demand above supply at any point in time. Demand above supply gives entrepreneurs incentive to employ more labor and capital. Yet, the difference between demand and supply gets smaller as more labor and capital are utilized. So imagine two lines that meet at some distant point. One line is demand above the other line of supply. The point at which these two lines meet is effective demand. If we see the point as stationary, then as you employ more labor and capital beyond the point, demand will go below supply. Then entrepreneurs will un-employ labor and capital.
So the normal model has AS and AD moving together. In Keynes model, the economy is moving toward a “fixed” long run equilibrium state between supply and demand.
Now, you are asking if increases in wages can shift that stationary point of effective demand… I would say Yes, as long as labor’s share of national income rises.
Let me explain my model… put price on the y-axis to show what is supplied and demanded. But on the x-axis put the utilization of labor and capital. The x-axis now represents how the economy grows by utilizing more labor and capital. As you move right on the x-axis, you utilize more labor and capital with the demand line higher than the supply line. Eventually you reach the equilibrium point between supply and demand. The equilibrium level of effective demand on the y-axis is the top side of potential GDP. That is the effective demand point that Keynes describes…. beyond which employment of more labor is not wanted by firms.
For me, that equilibrium point is determined by labor’s share of national income… Not by labor’s total income, but by labor’s % share. Very different concept.
Now what could shift that equilibrium point upward? There are many ways… I will give 2.
1. We could raise labor’s share. That would shift the demand up, sliding the equilibrium point up and to the right along the supply curve. ultimate potential GDP is raised and the natural rate of unemployment is raised.
2. We could just raise wages. But now that would shift the demand curve to the right, but also shift the supply curve to the left. So you may end up simply increasing the total amount at the equilibrium point as seen on the y-axis. Yet, the top limit for utilizing labor and capital seen on the x-axis has not changed. Your level of full employment has not changed.
What can cause that equilibrium point of effective demand to fall?
This is what happened after the crisis… labor share fell. The demand curve shifted to the left. The result was that the equilibrium point now reflects a lower total value of the economy (GDP on y-axis) and a lower full employment level of labor and capital (higher natural unemployment and lower capacity utilization on x-axis). Potential GDP also fell.
OK… now does raising wages raise the effective demand limit? That depends on how you measure the effective demand limit, either by the y-axis or the x-axis. You could see GDP increasing (y-axis), but the natural level of unemployment has not changed (x-axis).
For me, effective demand must be primarily determined by the x-axis. The x-axis reflects Keynes’ focus in Chapter 3 on the rate of employment of labor to describe the effective demand limit.
So when you say that raising wages should raise the effective demand limit, we need to study the effect to know how. Did potential GDP rise? Did the natural rate of unemployment rise? You could get different answers to those questions.
Okay, I think I understand what you are discussing in your model, but I see some reasons why hitting that ceiling via wage increases would not be a bad thing, nor would it be the maximum of utilization.
First wouldn’t the higher wages trigger more tax revenue and likely more fiscal investment such as infrastracture and capacity, as well as private sector investment in order to keep up with demand for goods?
I would think it would lead to more roads, bridges, factories and the like, wouldn’t that shift us right ward on the x axis as well?
Wouldn’t that increase the capacity, meaning you didn’t hit the maximum utlization?
Also, If we assume that natural level of employment is around 6-7% unemployment ( by which I include those not in labor force, but who want a job now, as part of the unemployment measure)
If we achieved that level, which was around the level we achieved during the peak of the dot Com boom of the.90’s, would that be a bad thing even if we couldn’t push the natural rate of employment any higher?
I mean that is about the best level we’ve gotten even on booms, seems to me that if you could keep it at or near that level while still getting GDP growth (which has occurred before), where is the economic danger?
Axt113,
You are describing Say’s law… Keynes did not believe in Say’s law. This is from Chapter 3.
“Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment.”
Keynes saw that there was an effective demand limit upon full employment. Modern economists still do not know how to deal with this concept. But they will learn.
At the end you are describing an economy that can sustain full employment at effective demand. It should happen that way. Then why do recessions occur? Many point to monetary policy tightening. Others point to rising labor costs. Still others points to various shocks. Still others point to psychology.
Where is the economic danger? The answer is knowing true financial instability. We must be very careful of China at the moment. The weaknesses in the US economy are partly caused by China’s staggering growth with an extremely low labor share. The US financial system is tied into China. China is severely unsustainable. Thus, the risk to the US is greater than people seem to acknowledge.
I hear your words now, but I imagine listening to your words in 1 years time, and 3 years time… Then I reflect back on what you are saying now. And what you say makes sense for now, because the economy seems to be expanding again. but when you know more about the economy in a year’s time, you should look back on what you are writing. You might realize that you were focusing on the wrong issues.
Labor share is not going to be rising much at the moment. Labor share tends to stabilize at an anchor point toward the end of a business cycle. If it does start to rise and the utilization of labor and capital does not follow, a recession is coming. That has been the pattern for decades.
You want to see the economy expand safely. You want to see that it can happen now. From my point of view, there is way too much financial instability to even dream about it.
From this point forward, financial instability will grow. Who will collapse first? and When?
This is an important time to read everyday about the economy. We will see in real time how views slowly change about the future of the economy from optimistic to concerned.