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.
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 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
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
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
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
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
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.
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