Paul Krugman posted an article today… “What Janet Yellen — And Everyone Else — Got Wrong“. But there is something he is getting wrong too, or at least, doesn’t seem to be aware he is getting it wrong.
He talks about the economic recovery having been so sluggish. And he offers this explanation…
“The best explanation, I think, lies in the debt overhang… And I would argue that this debt overhang has held back spending even though financial markets are operating more or less normally again.”
There is a deeper cause that he is not mentioning. What appears to be low demand is actually the symptom of lower labor share muting the money multiplier effect of investment. Paul Krugman knows that the “financial markets are operating more or less normally again”, as he says above. Yet, he seems unaware of how lowering labor share will lower the equilibrium level of real GDP, thus muting the ability of investment to expand through the economy.
I argue that the explanation has to do with labor share falling 5% since the crisis. I provided a simple model yesterday showing the dynamic of how a lower labor share leads to a lower equilibrium level of GDP… “Labor share affects the potential of investment to raise GDP“. The lower equilibrium level of real GDP creates a condition where investment returns to business with a smaller money multiplier. What we see then is sluggishness in the economy even though the financial markets are working fine.
Apart from lower labor share undermining the ability to pay down the overhang of debt, it also causes an “apparently” unexpected dampening effect upon monetary policy. Banks can loan money, but the economic returns on the loans are muted by a low labor share. The dynamics of low labor share are too obvious to overlook. On twitter, Frances Coppola responded to my article yesterday by saying, “that’s a brilliant post. Explains so much that I intuitively knew but hadn’t actually modeled.”
I think, Paul Krugman is simply unaware of the effect that the current lower labor share is having. But once he is aware of it, I have faith he won’t get it wrong.