Mark Thoma, cyclical unemployment & insufficient effective demand

Mark Thoma, professor at the University of Oregon,, posted an article about why labor markets are struggling, “What is driving changes in the job market?” at CBS Money watch.

He basically says that the labor market problems are cyclical, which means a Keynesian demand-deficient unemployment. There isn’t enough demand to allow unemployment to fall more rapidly. The normal Keynesian solution to cyclical unemployment is for the government to provide deficit spending and for the Federal Reserve to provide expansionary monetary policy. The idea behind deficit spending is that the government provides the demand that is lacking in the economy. The idea behind the expansionary monetary policy is that low interest rates will increase non-government spending.

And we see, Mark Thoma ended his piece in true Keynesian style…

“The main takeaway is that contrary to speculation about technological change and part-time work, most of the variation in part-time employment appears to be cyclical rather than structural.
That’s good news: it means policymakers, if they choose to, could use fiscal as well as monetary policy to bolster the recovery of the labor market.”

But there is a problem.

From my work on effective demand, I showed that a low labor share of national income actually lowers the equilibrium level of GDP using a circular flow model. In that model, investment is increased, as is the intention with expansionary monetary policy. Real GDP grows at a certain rate to a certain equilibrium level of GDP. But if we lower labor share of income at the same time, real GDP grows at a slower rate and consequently the equilibrium level of real GDP is lowered. In fact, labor share has fallen a full 5% since the crisis. The effect of this is greater than people realize apparently.

Expansionary monetary policy works against a very strong headwind, when labor share is falling at the same time. The Federal Reserve would have had to increase their expansionary policy even more because of the falling labor share.

We can see more energy in the headwinds when we include the debt overhang with low labor share. Paul Krugman recently wrote about debt overhang. But I want to focus on low labor share because it is a variable which nobody is recognizing explicitly.

According to the circular flow model, labor share could fall enough that the Fed rate would have to fall all the way to zero % just to maintain optimal employment. The idea is that the low Fed rate would increase investment against the headwinds of a falling labor share. The low Fed rate would inject more investment into the circular flow between households and firms. However, if the Fed rate goes to zero %, and full-employment is not reached, then it’s just like Keynes said. The economy can get stuck in a sub-optimal state where full-employment is not reached. Low labor share presents insufficient effective demand.

But now let’s step back for a moment and ask… If monetary policy on the zero % lower bound is ineffective against low labor share, then what about fiscal policy? Would deficit spending have a better chance to combat the lower labor share constraint on economic growth?

Both low interest rates and deficit spending are injections of money into the circular flow of money, goods and services between households and firms. The goal is to increase the liquidity between households and firms so that demand can be expressed.

We already know that monetary policy has reached its limits. Low labor share has undermined it for 4 years already. So now the idea is to increase deficit spending against the headwinds of low labor share. And this makes sense. But the combination of both monetary policy and deficit spending is necessary to overcome the headwinds. As Captain Kirk might say in Star Trek, “Scotty, GIVE ME MORE POWER!”

If the combination of expansionary monetary policy at full throttle, and strong deficit spending can raise real GDP to the optimal level of full-employment, then we have succeeded!

But would we have succeeded really, if labor share stays low? What if we went to all this effort and extra government debt to inject tons of liquidity into the economy and labor share didn’t rise? What if the result did not include a substantial rise in wages? Would we really have succeeded? …

No… No… I’ll explain why.

The sluggishness would still be there. The true lower equilibrium level of real GDP, which the injections would be covering over, would still be there. The artificially increased real GDP would be dependent upon the injections, like an addict, to overcome the true reality. If the economy were at full-employment, and the injections started decreasing, real GDP would fall to its real level and a recession would start. It would be like an addict going into withdrawals.

Labor share of income has fallen to a level that is toxic to the economy. Unless this toxicity is cleaned out, the economy will always need its regular injection of medication at high doses to feel a sense of normalcy. Yet, labor is sick, while capital is enjoying an increased share of income. As we see in the circular flow model, as GDP falls with a lower labor share, capital income actually increases. Those with capital must be experiencing a euphoria beyond normal drugs.

How much would labor share have to rise to clean out the toxicity? My calculation is at least 8%. More would be healthier. But it is a careful process of de-toxification, where there is always the urge to fall back into the addiction. And business has enjoyed the low labor share. Capital income has enjoyed a high at the expense of society. In addition, low wages maintain competitiveness. For example, France has a plan to lower labor costs 4% this year and 6% in 2014. If other countries compete with that, would the United States eventually have to compete with that?

If capital income has enough power to keep labor share low, society will be sick for a long time. Society will decay like the body and teeth of an addict. And no amount of monetary and fiscal policy will heal the underlying toxicity.

No matter what amount of liquidity is injected into the economy, capital will keep on receiving its high share. No matter how much investment is increased from expansionary monetary policy… no matter how much deficit spending is injected… capital will receive its toxic high share of it all.

If labor share had not fallen, the Keynesian approach with monetary and fiscal policy would take real GDP back to a normal equilibrium. Capital would receive a normal share in the process. Interest rates would return to normal levels. But the situation is different now. Effective demand, which is based on labor share, has fallen. The “normal” equilibrium of real GDP, which every economist seems to want to go back to, is actually above the new true level of real GDP as determined by the effective demand limit. Getting to that “normal” equilibrium would require too much Keynesian medication to overcome the effective demand limit. Therefore it is not the right medication.

Society has two choices… One, fight for substantially higher wages across the country. Two, accept the new normal of a sub-optimal economy where those with capital benefit inordinately and many people go marginalized from employment.

Like Keynes said in chapter 3 of the General Theory

“This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached.” (source)

The circular flow model using labor share shows how this happens. So, unless monetary and fiscal policy can raise labor share, effective demand will remain insufficient for full-employment.