Real GDP has an appointment to keep with Effective Demand
The subject of potential real GDP is important. As Paul Krugman had a post entitled, “Potential Mistakes”. Today Dean Baker had a post entitled, “GDP Growth Remains Below Potential Growth”.
Paul Krugman said, “It is important to have an idea of how much the economy could and should be producing, and also of how low unemployment could and should go. For one thing, it’s important for fiscal policy; … But it’s also important for monetary policy…”
The key word in this quote is “could”. This post seeks to better define what the economy could produce.
We are living through unusual economic times. The bubble popped and labor share has fallen to levels not seen in a very very long time. Economists don’t quite understand that we are in a different economic reality. Constraints never seen before are now influencing the economy. It appears economists are being frustrated by these invisible constraints, and can’t coherently acknowledge them yet either.
My work in effective demand is revealing constraints not yet formally acknowledged.
It is generally viewed that potential real GDP is output at full-employment of all available labor and capital resources. My view is that potential real GDP is the output limited by potential demand, even if all available labor and capital resources are not employed. Thus, the economy “could” produce up to the potential demand limit.
For example, if you are determining potential production for your CEO, and you tell him that the factory can produce such and such amount at full-employment. Then the CEO asks another employee who did market research into potential demand, if there is sufficient demand for that level of production. And he says, “No, there won’t be demand to support that level of production.” Then the CEO wants to know what level of production “could” satisfy all the demand. It turns out that this level of production is less than you calculated. The CEO then says that the true potential production is the level constrained by demand and that this is the level around which the company will establish its policy and planned utilization of resources.
When economists determine potential real GDP they do not take into account potential demand. In all fairness, they have never had to until now. I will explain this at the end of the post.
First, I will calculate real output with a simplified model where productive capacity is multiplied by the utilization of labor and capital. (The utilization of labor and capital is determined by multiplying the utilization rate of capital, capacity utilization, by the utilization rate of labor, employment rate. I call it the TFUR, total factor utilization rate.)
Real output = productive capacity * TFUR
(Productive capacity is the total possible output using 100% of labor and capital resources.)
For example, with a productive capacity of $19 trillion, capacity utilization of 85% and labor employment of 94%, real GDP would be $15.18 trillion. (19*0.85*0.94)
Second, I calculate potential demand by multiplying real GDP by effective labor share divided by the TFUR. (Effective demand is potential demand.)
Effective demand is potential demand = Real GDP * effective labor share/TFUR
TFUR does not like to be above effective labor share. Thus, real GDP reaches effective demand when TFUR is equal to the effective labor share.
Now we substitute real GDP with the equation for real output… then cancel out TFUR.
Effective demand = productive capacity * TFUR * effective labor share/TFUR
Effective demand = productive capacity * effective labor share
Here is a graph based on a productive capacity of $19 trillion and an effective labor share of 74%. There are trillions of $$ along the y-axis and the TFUR along the x-axis.
Graph #1
In this simple model, output rises with more utilization of labor and capital. Then output reaches the effective demand limit and will stop, unless more labor and capital are added and/or productivity increases. According to this graph, potential real GDP would be $14 trillion, because effective demand limits output at that level. Effective demand is based on 74% effective labor share. So we see real output cross effective demand at 74%, where the TFUR equals effective labor share.
In a business cycle, real GDP rises as more labor and capital are utilized. When real GDP reaches the level of effective demand (potential demand), a recession would ensue. The economy will go through various changes between the time real GDP reaches effective demand and the start of the recession.
This is the basic model, but how does it behave in the real world? Well, let’s apply this model to five previous recessions and to the next recession not yet seen.
Leading up to the Recession of 1974
Graph #2
Graph #2 shows the quarters leading up to the recession of 1974. We see that real GDP rose as the TFUR rose. Then real GDP reached effective demand. Real GDP continued rising for 4 more quarters. The last dot is the start of the recession. Right before this particular recession, the utilization of labor and capital kept rising after the effective demand limit was reached, (TFUR kept rising), which produced some inflation.
Leading up to the Recession of 1980
Graph #3
Here again, we see that real GDP (green line) rose with a temporary jump up, until it reached effective demand. In this case, when real GDP exactly equaled effective demand, the utilization of labor and capital started to fall. But there was a false start of a recession. Even though utilization of labor and capital was falling, real GDP kept growing. The recession did not start until the TFUR had fallen from over 81% to below 79%. In some ways the drop in utilization of labor and capital was a recession but technically the recession hadn’t started yet.
How can real GDP keep rising as the utilization of labor and capital fall? Increased productivity, increased stock of capital, or even increased purchases of output in the face of higher unemployment.
Leading up to the Recession of 1991
Graph #4
Here again, we see real GDP was rising with the increasing TFUR. Then as the lines got close, the utilization of labor and capital fell, even as real GDP kept rising. This is similar to the case leading up to the recession of 1980 in graph #3.
Keep in mind that we are seeing the potential real GDP being reached in each graph. Once that potential is reached, the economy stops increasing the utilization of labor and capital, then goes into a recession. Real GDP might continue increasing, but combined utilization of labor and capital will stop increasing.
The almost Recession of 1994 and the Recession of 2001
Graph #5
Towards the bottom we see data for 1992. We can see that real GDP (green line) was rising with the TFUR. When real GDP reached effective demand (red line), the TFUR contracted. However, real GDP kept rising. It was a false start of a recession. Then real GDP started rising again with an increase in labor and capital utilization. Then the TFUR contracted again but real GDP kept rising. We can see that effective demand kept rising with real GDP too. Finally the TFUR fell from above 78% to below 70% during the 2001 recession. Yet, real GDP still did not fall.
Realize again that once real GDP reached effective demand at the end of 1994, from that point on for the following years, the combined utilization rate of labor and capital (TFUR) was blocked from rising much further. This is the consistent effect of the effective demand limit.
How can real GDP keep rising when real GDP is supposedly reaching its potential as constrained by potential demand? … Productivity increased tremendously from the first false start of a recession through the recession of 2001. The productivity increase came at the perfect time.
(note: Effective demand rose with real GDP as productivity rose)
Leading up to the 2008 Recession
Graph #6
Again, we can see real GDP was rising with the TFUR (labor and capital utilization). Then when real GDP reached effective demand, it looks as though real GDP was waiting for productivity to start pushing effective demand upward like in some previous recessions. Real GDP was blocked in a tight range for two years. Productivity did not come to the rescue. Productive capacity did not increase through productivity or increased capital. Effective demand was more solid this time.
For 2 years (8 quarters) we see that real GDP was hitting the effective demand limit. And then when it crossed the polynomial trend line the recession started. Some may ask why the recession started when it did. Well, effective demand was blocking further growth of the bubble and effective demand won. We need to understand why effective demand is becoming more solid.
Leading up to the next Recession… In other words, Real GDP has another appointment to keep with Effective Demand
Graph #7
This is a graph of the quarters after the 2008 collapse up to the 1st quarter of 2013. As we can see, real GDP is rising nicely with increased utilization of labor and capital (TFUR). Effective demand is coming down to show us where potential real GDP will be. Potential real GDP is somewhere between $14 trillion and $14.5 trillion, at which point a recession would ensue, unless policy can manufacture a rise in the effective demand limit with a bubble, cost-push inflation or a new surge of productivity.
Note too that the recession would take place at a lower level of TFUR (74%) than we have seen for over a half century at least. People say the economy is just depressed and needs more time to get back to trend. Be that as it may, effective demand is going to constrain real GDP at this depressed state. Economists don’t understand this yet.
What does the CBO say about potential real GDP? The CBO says it is now $14.6 trillion and still increasing. Thus, the CBO presents a potential real GDP much higher than the effective demand constraint, which is not increasing into the future. The $14.0+ limit of effective demand is stationary. In fact, effective demand is already undercutting CBO’s potential real GDP, as we can see in the next graph. Effective demand did not undercut CBO’s potential real GDP in any of the previous recessions. The next recession will be a first time that effective demand will constrain real GDP under CBO’s projection of potential real GDP. Economists have never seen this before and are not aware it is already happening.
Graph #8
Real GDP will not reach CBO’s projection unless the economy finds a way to push effective demand up. I won’t count on it, because the dotcom-bubble days of manufacturing inflated demand are over.
This is the moment to recall Paul Krugman’s key word “could”. This graph #8 is showing us what the current economy “could” produce within the constraint of effective demand. What the economy “could” produce is lower than what the CBO says.
We need to be aware that effective demand is more solid now because productivity has reached a plateau, investment has been lacking, cost-push inflation would be dangerous, labor share is low from low-wage jobs and unemployment is higher. Productivity tends to increase at lower levels of unemployment.
How will this recession play out? Real GDP will continue to increase on the trend line in graph #7, whether slowly or quickly. Eventually it will reach the effective demand limit. I do not foresee much of a rise in real GDP once the effective demand limit is reached. I foresee a contraction in the utilization of labor and capital. There are scarce policy alternatives now to fabricate a rise in productivity or easy credit.
Like Paul Krugman says, it is important to know what the economy is really capable of producing in order to set appropriate fiscal and monetary policy. And if my analysis above is correct, we should not set a potential real GDP above the effective demand limit. This is just like the CEO who takes into account the limit of potential demand to know the true reachable potential of production.
The potential upside of real GDP is too dangerous to get wrong. The global economy is hanging in the balance. The up-to-now invisible effective demand limit says that economists are getting it wrong.
Written by Edward Lambert
Edward:
Here:
“For example, if you are determining potential production for your CEO, and you tell him that the factory can produce such and such amount at full-employment. Then the CEO asks another employee who did market research into potential demand, if there is sufficient demand for that level of production. And he says, “No, there won’t be demand to support that level of production.” Then the CEO wants to know what level of production “could” satisfy all the demand. It turns out that this level of production is less than you calculated. The CEO then says that the true potential production is the level constrained by demand and that this is the level the company will shoot for.”
you are talking like I do about manufacturing. You are embracing the larger picture.
I would suggest economists never had to address the larger picture because the economy always was employing more and more Labor. The scenario has changed. With fewer people working, there is less demand creating a cost or drag to the economy.
Does an increase in wages result in an increase in effective demand?
Jerry … That depends. An increase in wages may not increase labor’s “relative” purchasing power for production, which is determined by labor’s share of income (labor’s income as a share of total output).
for example, here is one equation for labor share…
Labor share = real hourly compensation/productivity
If a raise in wages is matched by more productivity, labor’s relative purchasing power stays the same. In other words, labor share stays the same.
Another equation for labor share is this…
Labor share = unit labor costs/price level
If you raise wages along with inflation (price level), and this simply raises unit labor costs at the same rate, then labor’s relative purchasing power is unchanged.
The true test to know if a raise in wages has increased effective demand is whether labor share increased as a result.
I think that the relationship between effective demand and labor share of income will be flawed if it’s based on time periods when debt-financed consumption tended to mask otherwise weaker purchasing power by labor. In 1980 , we started out with low levels of both private and public debt/gdp , and with interest rates that would trend lower right up to the present. Now we’re faced with high debt/gdp levels across economic sectors and interest rates that have only one way to go : up. Over the medium- to long-term , we have to assume effective demand will be constrained by at least a constant debt/gdp level , if not one that’s declining. In any case , to be useful , I think that any model of sustainable effective demand should assume that growing demand arises only from growing incomes , without any debt boost.
I’d be interested to know if the output of your model changes much for recent years if you derive your functions using only data from pre-1980 , when total nonfinancial debt/gdp levels were relatively constant. ( Some part of the 1990’s might also be suitable in that regard. )
So a drop in productivity, with all else remaining constant, will increase labor share which will increase effective demand which in our current situation would be good for the economy. Correct? Does that mean people should work less effectively?
Jerry,
You have a wicked mind. It is true, if people worked less effectively, productivity would go down. And since wages are sticky, relative labor share would increase. Capital income would decrease.
Are you suggesting strikes and work slowdowns as a form of re-balancing the economy? 🙂
Marko,
So far the data says that the relative purchasing power of labor (labor share) determines the limit upon the utilization of labor and capital. Let me give you an idea to ponder on… For a moment, think of debt-financed consumption as exports. We are producing extra for an external demand. So think of debt-financed consumption as external demand. The income to purchase that consumption is not ours. It is like having an export market.
So far in the data, net exports does not affect the effective demand limit, which is determined by the internal dynamics of labor’s share of total output received as income. And remember, total output is determined by consumption, investment, govt expenditures and net exports. Labor takes on balance an average share of all those variables combined.
In the late 90’s when debt-financing began to take off, effective demand exploded upwards to bubble levels.
http://effectivedemand.typepad.com/ed/2013/05/update-on-potential-real-gdp-in-the-effective-demand-model.html
What caused effective demand to rise?
Did utilization of labor and capital decrease? No.
Did labor share rise? Yes.
Did real GDP rise? Yes.
At the same time, did productivity increase? Yes.
The real key to understanding this is that the utilization of labor and capital did not rise with debt-financed consumption over the effective labor share limit. This is going to be hard for many economists to wrap their heads around, but the data says it’s so.
And to your question about breaking the data up into time periods, look at this link.
http://effectivedemand.typepad.com/ed/2013/03/here-is-the-graph-showing-the-central-tendency-line-with-a-slope-of-078.html
The data before 1980 revolved around the central tendency line as it still does today.
There is still more to write on this subject.
Edward ,
This graph from the piece you referenced above provides a good basis for discussing my concerns :
http://effectivedemand.typepad.com/.a/6a017d42232dda970c0192aa83a723970d-pi
The white line shows your measure of effective demand. Although you note the area of the bubble economy , your effective demand line would have suggested at the time that all was normal , since we never approached the limit until around 2007. However , without the excessive debt-financed consumption , we would have stayed closer to the yellow long-term trend line and likely would have avoided the crisis.
I would argue that a useful effective demand measure would be one that signals a debt-financed boom , while allowing expansions based on income growth. The yellow long-term trend line is better , but also misleading , since the economy-wide leverage increases over the last 3 decades have artificially raised that line. Look at Japan pre- and post-1990 to see the expected result.
If labor share has any meaningful effect , it’s because labor income has a differentially larger effect on growth than capital income , at least when the economy is in a demand-contrained growth regime ( as we are today , clearly ). I believe that a good measure of effective demand would be one that shows when we are constrained by demand caused by low labor share , and does not allow itself to be fooled by the substitution of debt for wages. Your effective demand line provides no such guidance. I would expect a proper measure of “sustainable effective demand” to begin to fall below the yellow trend line post-1980 , as debt substitution for wages began , and which then exploded from the late 90’s.
Wouldn’t a work slowdown be more effective since a strike would result in a loss of income?
Also, prior to about 1980 salaries and productivity followed the same trend. Since 1980, productivity has continued to increase but wages have flatten out. Isn’t that counterproductive to good economic health in that it reduces labor share?
Interesting stuff. Not time for much comment, so just questions for this post.
Where is population growth? Not all of the real growth comes from productivity increase.
Your effective demand is dropping much faster this cycle than ever before. Given that it is somewhat an empirical number, does that not mean you are outside the limits of the historical data you used to establish the 0.78 multiplier? Too often people extrapolate after linearizing things that are not really linear.
Marko,
Effective demand only balloons like that during recessions. So, the ballooning of effective demand outside of a recession around 2000 is plenty evidence of a domestic bubble. The effective demand was not saying all was normal. It was saying something very abnormal was happening.
Also, I don’t see debt-financing as the only contributor to increasing effective demand. There was a euphoria over internet investment. There is a technical issue that as capital was increasing, labor share had to keep pace. The technical issue is that real GDP must stay indifferent to changes in effective labor share. So there were economic dynamics to raise labor share. I haven’t published this model yet. Still thinking it through.
I agree with you that the yellow line could be misleading as a measure. We could conceivably move off of that line in a sustainable way, but we didn’t.
The effective demand line does show a constraint on the economy. Look at the graphs above. Do you see how the tipping point of the TFUR keeps going lower from recession to recession? The tipping point was 82% in 1974. Now it is 74%. This is a result of lower labor share.
Also, effective demand cannot go below the yellow line unless real GDP does first. Keynes stated a basic principle of effective demand as the limit on the utilization of factors of production to limit real output. So real GDP must stay below effective demand based on that principle.
Jerry,
You are right. Productivity has increased as labor share has declined.
But now we see that productivity has hit a wall in the past 3 years. It has not increased. even though labor share has fallen 5%.
Arne,
Look at the equations at the beginning. Population growth increases productive capacity which is a basis for the equations that determine real GDP and effective demand. So population is incorporated.
Effective demand is falling faster due to the depth of the recession. Effective demand shot up because the utilization of labor and capital fell much more than real output. Output/income was maintained much better than labor and capital. From the start of the recession to 2nd quarter 2009, capacity utilization fell 16.5% and employment fell 4.7%. Real GDP fell 4.7%. So it is really the measure of capacity utilization that swung effective demand so high. Capacity utilization rebounded by 2010 and effective demand began to level off below $14.5 trillion.
It looks like a healthy economy needs effective demand need to be above real GDP to have a healthy economy. Can it be too far above real GDP?
Jerry,
Yes, if effective demand is far above real GDP, labor and capital is being underutilized. Unemployment will be up and capacity utilization will be down.
The economy does well when TFUR is 4% to 6% below the effective labor share limit. Businesses can grow together without crowding each other out for profits.
If only business would raise labor share of income at that point instead of when real GDP is closer to the effective demand. Oh well, they are working to increase profit rates at that sweet spot.
Why does population growth increase productive capacity? If there is no additional capital investment, population growth could simply decrease labor utilization. Yes, the reality is that capital expects demand to increase with population and so it does invest, but I do not see that in your model.
I also don’t see why you predict recession. Why is Real GDP just under Efective Demand as population increases not a stable equilibrium? I suggest that it is because humans respond to the rate things change (nearly always with overshoot), but I do not see rates in your model.
Arne,
Productive capacity is increased when there is more labor. Population growth gives more labor.
Let’s look at your scenario of no additional capital with population growth. In this case, productive capacity increases, but maybe if the employment rate decreases, real GDP may not increase like you say. But productive capacity will still increase.
If you read about what causes recessions, you will see many causes. Yet some economists simply say we don’t understand what causes a recession.
I say there will be a recession, because the place where the effective demand curve and the real GDP curve cross is the LRAS curve (long-run aggregate supply), natural real GDP at full-employment (NAIRU).
When the economy hits the LRAS vertical curve, putting more factors into production leads to inflation more than increased output. (I find it interesting still that inflation turned into a bubble in 1998 when the economy hit the LRAS curve.
I predict a recession because in one sense the economy is inflation and bubble phobic… Monetary policy will have to tighten, and that will bring down the global house of cards.
But you make a good point about why population increases couldn’t be a stable equilibrium. They can be. You are right. You might say that it is uncommon because humans tend to be able to “leave well enough alone”.
And i am not sure why you say you don’t see rates in the effective demand model. There are rates of labor and capital utilization, rates of labor share, rates of productivity, rates of inflation, rates of unit costs per labor.
Arne:
“Why does population growth increase productive capacity? If there is no additional capital investment, population growth could simply decrease labor utilization. Yes, the reality is that capital expects demand to increase with population and so it does invest, but I do not see that in your model.”
Increased Productive Capacity is not solely dependent on increases in Capital Investment. While it is true Population Growth = > Labor, it may not result in less Labor Utilization (I am assuming this was a definitive statement by you). Increased Population Growth could and should result in greater demand thereby requiring greater Capacity with maybe no neeed to invest in more Capital. In manufacturing, the increase in Capacity could be met by adding another shift of Production which would require more Labor and a greater utilization of Capital in place already. If you use up all of Capital’s Capacity in added shifts and the demand still increases, no amount of increased available Labor will decrease Labor Utilization. I fight this all the time with plant, press, and tool capacity.
Arne, you may have a broader concept than what I am picturing and my comment is not meant to gloss over it.