What Paul Krugman is getting wrong…
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.
It all comes back to people having money in their pockets to spend; no money, no spending, no demand.
Good post. I want to ponder a potential cause.
If we look at the labor share decline in terms of Net Private Savings, we see a pattern. But, we need to also keep in the backs of our minds the condition of state budgets too. Net Private Savings growth has been mostly stagnant since 1990 with a brief upturn in 2000, and a bigger upturn since Obama’s stimulus. Not we are turning back down. See chart:
http://research.stlouisfed.org/fredgraph.png?g=liQ
Remember When the government is in deficit, ignoring for a moment the foreign sector, this means that the private sector’s income exceeds its spending.
The opposite when the government is in surplus the private sector must be in deficit, with income less than spending. This latter process started in the mid 90’s and continued with a brief interruption.
What happens when people’s income is less than spending? They borrow, and they did until they could not around 2007-2008. In that same time frame we ran a tiny budget deficit and a huge trade deficit, which triggered the whole 2008 mess. Also if incomes don’t exceed spending, and one cannot borrow any longer – well that hurts aggregate demand and regular folks incomes.
Now look at a chart of net private savings along with working age population in the united states and ask the question “How can wages go up if the population is growing, and there is not enough money supply (adequate deficit spending adding to private savings)?”
http://research.stlouisfed.org/fredgraph.png?g=liT
Wages will not go up unless the fiscal stance changes for some time, and unemployment stays low for a period of a few years. My guess is that we need deficits of 5-7% of GDP for the next few years if you want to change the ships direction. State fiscal policy has also been a drag, but data there is tougher for me to get at.
Marko,
Look at a log graph of real GDP and real GDI…
http://research.stlouisfed.org/fredgraph.png?g=lj1
Do you see how they level off before each recession? Each time, the leveling off corresponds to reaching the effective demand limit. It is the equilibrium level of GDP in the circular flow model I posted yesterday on labor share.
The implication is that the economy can work through any imbalance, any obstacle, until it reaches the effective demand limit.
So no matter what private savings is doing, or the budget deficit, the economy can still grow… but when it reaches the effective demand limit, real GDP will slow down and tip us into recession.
Real GDP will start leveling off within the year… increasing or decreasing injections and leakages from the circular flow will not change the dynamic of labor share limiting utilization of labor and capital.
The only way to change that dynamic is to raise labor’s share of income. There is no way around the basic importance of paying labor a socially beneficial wage. The effective demand limit is tied to that, and that alone.
Ed, I agree with your statement:
“So no matter what private savings is doing, or the budget deficit, the economy can still grow…”
This growth can come from:
– Private borrowing
– Trade surplus
– Local level spending (to a lesser extent)
I am arguing in aggregate there is not enough “fuel” to get the labor market tight enough to see low unemployment and higher wages. If aggregate demand is inadequate you will not get socially beneficial wages. To raise labor’s share of income, unemployment needs to come way down through fiscal injections that get us to effective demand. My opinion is that fiscal injections have been inadequate since the mid 90’s. Given a growing working population that is a problem. SO I guess we have different takes on how we get labor’s share of income up – I say fiscal policy that results in sustained low unemployment.
Matt
Just to be clear those 3 growth items above are in addition to fiscal policy in the form of deficits.
They level off before each recession because investment it at its peak and employment has reached a level where it is not cheap anymore.
The Y2K boom was indeed a “boon” to labor share because the market was tight and finding good available help was not easy. So you had to pay.
John,
You are absolutely right about the labor market in 1997-1998, the economy actually hit the effective demand limit then, but labor share and wages started to climb and the effective demand limit rose averting a recession for a couple years.
And you describe how Keynes viewed effective demand. Profits, employment and marginal efficiency of capital would all hit their peaks at the effective demand limit, and that is what we see.
Matt’s point about “fiscal injections” which have been lacking since the mid-90’s is interesting as well.
Goes against the grain a bit and narrows down the governmental “deficits” to tax cuts and 9-11 warmongering.
They don’t provide the growth outright investment and purchases do. The ARRA had very little of this.
Convincing the American people of how this “spending” is necessary is a bigger problem.
Marko,
I see what you are saying. Fiscal policy has to bring down employment in order for the labor market to raise wages. You are right, but I try not to say anything related to a political process because the government is completely dysfunctional.
The economy is going to have to find another way to raise wages, and the hope of that is slim.
Ed
In your reply to Marko, just above, are you describing a multi-factorial process or are you describing the result of that process? And did you mean to say employment? Or did you mean unemployment?
Why take a circuitous route to the desired goal?
Oh! And who is Marko in this topic thread?
I think the comments as well as the post get it mainly right, but I am not sure that it is fair to say Krugman got it wrong .He is commenting on the sluggishness of the recovery and everyone agrees that it is due to a lack of effective demand, but why wasn’t the stimulus in 2009 more effective? And why can’t the economy spiral up as it spiraled down? I agree with Krugman that it was the debt overhang. Now the reason for the debt overhang is that labor’s share declined steadily per the chart from 2000 to 2008 and people borrowed to maintain a standard of living including using their homes as ATM machines. When the music stopped those who had chairs deleveraged and/saved more. Dumbya’s tax cuts did little to boost labor’s share and the 2009 tax cuts were spent on deleveraging/saving and by definition were mostly received by people with jobs. The amount of direct government spending was vastly too small as Krugman argued at the time and since. If there was no debt overhang, it might have been adequate, but do not forget that capital likes to keep shrinking labor’s share and business has done everything possible to keep unemployment high because it boosts the bottom line. Hence the large salaries of the CEOs who “saved” their companies by slashing and burning the labor force.
I think Ed means Matt instead of Marko. 😉
Terry, the stimulus was effective in the near term. Just was/is not enough, and not sustained at that level long enough to help longer term. On that latter point, Krugman was calling for a way bigger stimulus.
Matt,
Sorry, I said Marko, when I meant to write to you above.
Jack,
I meant unemployment. And bringing down unemployment is a multi-factoral process, but I am wondering now if unemployment will come down relatively faster than capital utilization will go up over the next year.
And if a circuitous route gets the job done, why not?
Terry,
Yes, there is debt overhang, But labor share is more revealing as a cause of the sluggishness. First, low labor share reduces the ability of consumers to pay down debt. Second, low labor share creates a dynamic that slows down the economy, and slows down the money multiplier leading to a lower real GDP equilibrium. A slower growing real GDP is the direct result of a lower labor share.
So if you want to explain the sluggishness with debt overhang, fine, but realize that low labor share directly produces sluggishness. And when and if debt is paid down and labor share is still low, you will still see real GDP growing at a sluggish pace. It’s because the money multiplier from injections into the economy is reduced as labor share declines.
Paul Krugman is not even mentioning labor share. I don’t think he is even aware of this dynamic. I could not even see it published anywhere on the internet.
An anonymous commenter on another blog told me that he had seen a similar theory back in the 60’s from Michio Moroshima, Kaldor and Kalecki. That tells me there is a hole in economic theory.
I did a long search last night for models using labor income or labor share, like the one I posted yesterday. I found absolutely nothing on the internet. I searched for 2 hours through images, publications and links. Nothing.
And even Frances Coppola hadn’t seen it before. This model is new, simple and apparently unknown.
I always thought the relevance of the labor share of income was fairly well understood and I was under the impression that it played an important role in the ideas of Marx and Kalecki.
Maybe you’ve seen this already, but this is a good empirical study of the issue: http://www.ilo.org/wcmsp5/groups/public/—ed_protect/—protrav/—travail/documents/publication/wcms_192121.pdf
This is probably the first time I have read a “what Krugman fails to understand” piece that seemed correct. Krugman has taken note of the discussion of the effect of income distribution on growth, admitting along the way that he has not given it enough thought to make a contribution.
I would point out that, to some extent, the discussion over the effect of income distribution on growth reflects progressives accepting the terms of debate that grows out of trickle-down thinking. Trickle-down assumes the “right” goal is GDP growth, and whatever fosters GDP growth ought to be assumed to help everybody in fair measure.
This is a good tactical step for progressives (setting aside the contribution to our understanding of how the economy works), but may prove to be a strategic error. Tactically, demonstrating than a more equitable distribution of income boosts growth shows how weak the argument for trickle-down really is. Strategically, progressives have now predicated one of their own arguments on the “virtue” of GDP growth.
KH;
This is an old comment of yours. Stumbled a cross it.
Nick above might be right. Kalecki is a good place to start.
Kharris,,
Remember to keep separate (labor and capital incomes) from (inequality within labor incomes). Labor income in whatever form, rich or poor, is still used primarily for consumption or labor saving.
Matt, (got the name right)
See post today on Krugman & Kalecki.
Krugman’s explanation of the economic recovery having been so sluggish… “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.”
So consumer debt overhang retards growth, but government debt to GDP (ala Reinhart & Rogoff) has little or no impact on growth according to Krugman and other unabashed Keynesians. Problem solved – just transfer all consumer debt to the government via government bailouts and giveaways! Am I the only one that sees the inconsistency of Krugman’s position?
I would not get too excited about Krugman. He is just another bought and paid for corporate shill, this time guarding Obama’s left flank.
Krugman is for race-to-the-bottom ‘free’ trade agreements. By his silence, he is for cheap-labor open-borders immigration agreements. He was for forcing Americans to buy crummy overpriced health insurance from private companies. Etc.
Krugman talks pretty, but he would not have a place of honor in the New York Times if he was saying anything at all that might discomfit the rich and powerful in any serious way.
It’s Kabuki economics.
It’s difficult for me to take any talk of “debt overhang” seriously while the markets continue to price long term (government and other) debt so low. THAT’S immediate tangible information. It’s inconsistent, to my mind, to insist upon the logical ramifications of large long term government debt and costs in this sector, and ignore such logic and ramifications in others, say, such as the long term costs of climate change. People regularly do ignore the latter, and are. So, why should long term government debt be any different? And why should it matter at all. (“What? Me worry?” “Don’t worry. Be happy.”)