Improvement in employment will signal the end of the business cycle

An issue arose in the comments at a previous post, Labor share is chopped liver to Mr. Krugman.

The issue is whether increasing employment in order to increase wages and labor share is a good strategy for fiscal and monetary policy. Dean Baker, Paul Krugman and others put forth this strategy. It seems common understanding that if the government could increase employment, that wages would rise and labor share would rise. But we have to broaden our scope of this strategy to see its eventual outcome.

  1. Keynes talked about output rising and employment rising until a point which he called effective demand. At effective demand, firms will experience maximum profits and they will not have expectations of higher profits.
  2. When real output reaches the point of effective demand, it will slow down and normally signal an economic contraction. (see graph below)
  3. The effective demand limit establishes the LRAS curve for the economy. As real output reaches the LRAS curve, money increases in aggregate demand switch from increasing output to increasing prices.
  4. So normally inflation develops at the LRAS curve, as money increases in aggregate demand are diverted into higher prices and higher wages.
  5. Normally labor share will rise at the LRAS curve.
  6. Effective demand will increase with increasing labor share and a falling profit rate, but as effective demand increases a recession will eventually form.

The business cycle does its thing. There are natural limits to output, employment and demand.

Now, let’s look at a graph.

profit rate 4

Link to graph: Aggregate profit rate and effective labor share.

The blue line is the aggregate profit rate which is determined by the equation…

Aggregate profit rate = (1 – effective labor share) * real GDP/Value of capital goods

effective labor share = labor share index (business sector) multiplied by 0.766.

It should come as no surprise that these lines mirror each other, because labor share of income is the flip-side of profits for capital share of income; normally in the form of retained earnings.

But then we ask… is it a good thing to raise labor share through increasing employment? Well yes, because effective demand will increase, but you will see profit rates leveling off and then falling. and if you look at the red dashed lines in the graph which show the starts of recessions, whenever profit rates decline over time, you are heading toward a recession.

So it is not smart to just let the free market increase labor share at the LRAS curve and expect the economy to keep growing into a wonderful future. By the time labor share starts to rise in the free market, profit rates will have leveled off, output will be nearing its natural level and effective demand as described by Keynes will be signalling an eventual recession. To say that a recession won’t happen because there will still be too much spare capacity to reach potential is to be naive with Keynes’ concept of effective demand.

To be clear, the real problem I have with Dean Baker, Mr. Krugman and others is that they expect output to reach potential as projected by the CBO. They have rose colored glasses on and their optimism is just sure that employment will progressively snowball toward 6% unemployment, higher real wages and $17 trillion in real GDP (2009 dollars). But yet, effective demand will bite on profits way before that.

In the long term, labor share will have to rise by 5% to get back to a normal healthy economy, but it will take a continuous effort through booms and recessions to get there.

Let’s face it… we have fallen into a sub-optimal business cycle and a recession will come quicker than some expect.

Note: 1987 was a recession for those like me who graduated into its job market. There were also global financial problems at the time.