Productivity is Demand Constrained

I was watching a video from the World Economic Forum 2013  in Davos, Switzerland. The video is a panel discussion on the subject, “No growth, easy money, the new normal”. The World Economic Forum 2013 took place in January 2013. It is basically a discussion of monetary policy in dealing with the crisis.

In the video (about 20 minute point), Ray Dalio who founded Bridgewater Associates says that future growth will have to be low-debt growth. The issue then becomes productivity and how countries become competitive. The next speaker, Brian Moynihan, CEO of Bank of America, then says that the labor force that an American business employs in the United States is not related to its business prospects due to the nature of globalization. Labor and sales are found globally. In effect, businesses can fulfill their demand and their general business plan globally.

After the 30 minute point, Brian Moynihan says the economic issue is really becoming a demand issue. There is plenty of liquidity within the financial sector, but the demand for production is not there. Ray Dalio then supports that idea by saying that the liquidity will somehow make its way into purchases… purchases of goods and services, equities, gold, you name it.

Ray Dalio (47 minute point) states 3 conditions for a good recovery that “debt doesn’t rise faster than income, that income doesn’t grow faster than productivity and productivity grows at a decent pace”.

Their argument is based on productivity increasing. But productivity is a complicated issue. Even in the United states, productivity has flat-lined for the past 3 years. Let’s look at some of the headwinds using 2 equations for productivity.

Productivity = National income / Total labor hours

We can see that if national income increases, then productivity will increase. But in order for productivity to rise faster than national income, total labor hours must increase but increase slower than national income. Thus economic growth will be productivity-led and not debt-led. This is what Ray Dalio describes.

There is a careful balance here between making the economy more productive with machines and computers, and also employing more labor. The tricky part is that machines and computers are requiring less labor. So certain companies may be more productive with machines, but if this becomes an overall trend, it may be very hard to increase total labor hours enough that growth will not be debt-led.

The second equation for productivity…

Productivity = Real hourly compensation / Labor share

There is a problem here. In order for productivity to increase, real hourly compensation must rise relative to labor share. They can both fall, it is just that real hourly compensation must then fall slower.

Can we even imagine wages and such falling more?… Yes.

At the 3:40 minute point, the panel member from France says that France is going forward with a plan to reduce labor costs by 4% in 2013, 6% in 2014, in order to be more competitive. The panel members generally agree that competitiveness is key to each country moving forward. We can assume that there is pressure to keep labor costs controlled in each country to maintain their competitiveness.

So, by looking at the second equation above, if real hourly compensation falls and productivity is expected to rise, then labor share would have to fall even further. The result would be more profits for corporations. But there is an even more troubling problem. If you lower real compensation, you tend to lower demand. Yet, they already said above that the issue going forward is demand.


OK… let’s hope that real hourly compensation rises at least in the United States. My view is that labor share has already anchored into an effective labor share of 73.4%. So labor share is now a constant. This is based on the following graph…

Monetary polciy 8
Graph #1

The lines come from an equation to analyze the relationship between labor share and the TFUR (labor utilization * capital utilization). The line goes to zero when effective labor share (els) and TFUR are equal.

Reflective Fed rate curve = els*(els-TFUR)/(1+TFUR)

The green line in graph #1 shows that effective labor share was anchored around 80% through all business cycles from 1975 to 2001. Since 2001, the line has shifted to the blue line, which now shows an effective labor share anchor of 73.4%. The point is that labor share is now anchored into the dynamics of the present business cycle and will be hard to shift up or down from here. The reason is competitiveness. As productivity grew, labor share dropped in order for business to stay competitive with real hourly compensation under control.

So, it will be hard to raise labor share due to a need for competitiveness. But then where is the demand going to come from? Ray Dalio (46:20 minute point) says that spending can be in money or credit. He says that if credit picks up, then money, meaning the liquidity in the system, can decrease. Central banks want to decrease the liquidity at some point to prevent inflation. While he says spending is the important thing, he basically says that the spending has to be balanced with the productivity growth rate. However, he also said that national income has to rise faster than debt. So there seems to be a problem in his argument, because he is pointing to the rise in credit/debt as part of the excess liquidity solution, but debt has to grow slower than income growth.

Now, if real hourly compensation has to be controlled for competitiveness, and labor share has already anchored in for this business cycle, then demand will somehow have to be increased with credit. However, as the economy starts to pick up, there will be a rise in some interest rates. We have already seen a rise in mortgage rates. A rise in interest rates related to purchases will be a headwind against demand.

Then, how does effective demand play into this? The problem is that effective demand is already putting a limit on productivity. I have already said above that labor share dropped so that productivity could be competitive by keeping real hourly compensation under control. Yet, there is a limit to how far labor share can drop, because effective demand also drops. And if effective demand drops all the way to real GDP, the economy will come to a screeching halt. Effective demand is already so low that we do have a new normal at a lower level of labor and capital utilization.

So labor share has found a niche to sit in… effective labor share anchoring in at 73.4% or so. The effective demand limit has anchored in. If labor share were to fall more, the economy would screech to a halt. If labor share were to rise, real hourly compensation would have to rise to keep productivity constant or rising. Yet, a rise in real hourly compensation will be difficult in an environment of high unemployment and global competitiveness.

Ray Dalio says that productivity must rise, but the only way to express an increase in productivity is through a rise in real hourly compensation. Labor share is already anchored in. Well then, this will be interesting. How many countries are going to raise their real hourly compensation?

In conclusion, there are many contradictions in what the panel members say. They are hopeful, but… the constraints of demand, credit, productivity, competitiveness and labor compensation are going to be very tricky to work out just right. The economy is in a delicate balance going forward. The question now lies in which countries will respond to social unrest with higher wages. And then how will business respond to maintain their competitiveness?

(Note: Competitiveness means profit maximization for corporations. Higher wages contradict maximum profits. Wages have been set according to the private costs of business, instead of the social costs of labor. Somehow societies will have to find a way to raise wages to a level corresponding to the social cost of labor. Meanwhile both Wal-mart and McDonalds are fighting the living wage.)



HODMRD. Davos 2013 Bloomberg) No Growth, Easy Money The New Normal. 7/18/2013. Retrieved from