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.
- 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.
- When real output reaches the point of effective demand, it will slow down and normally signal an economic contraction. (see graph below)
- 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.
- So normally inflation develops at the LRAS curve, as money increases in aggregate demand are diverted into higher prices and higher wages.
- Normally labor share will rise at the LRAS curve.
- 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.
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.
Ed:
See if you agree with my comments on your “chopped liver” post. This comment:
“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.”
corresponds with what happen to automotive in 2005 and was exacerbated in 2008 when Wall Street stole the economy from Main Street. In retrospect, automotive was a microcosm of the economy. Too much capacity in auto manufacturing with demand saturated with inventory (automotive model is to build and then sell regardless of demand). Automotive was reducing capacity in 2005 and going forward reducing Throughput and Labor while cutting back on Material Cost. It was in its own recessionary period as it had reached its effective demand long before with its capacity. Recessions happen regardless of capacity, throughput, or material cost.
Lambert
notwithstanding Run’s comment above, I find
“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.”
unconvincing. You offer no reason for this except your graph, but that is begging the question.
why would profit (rates?) level off if labor share rises? because as a percent of total income it decreases as labor share increases as a percent of total income? perhaps. but if labor share rises and production and consumption increase, profits would increase absolutely, if not as a percent.
what determines the “natural level” of output? seems to me with more people working, output would rise unless limited by natural resources, or be the failure of capital to be applied to making work “efficient.”
you seem to be saying that an increase in effective demand will cause recession. that sounds backwards to me from what i thought you were saying in earlier posts.
Coberly,
You are hitting the critical points to understand.
First, you say “you seem to be saying that an increase in effective demand will cause recession.” Here is the process from past recessions. Real GDP reaches the effective demand limit. Then real GDP slows down and sets up a recession. As the recession is forming, effective demand is increasing. It is a response to falling employment and capital utilization before the recession starts officially.
Second, you ask “what determines the “natural level” of output?” If you disregard the effective demand constraint on output, the natural level would be determined by the natural rate of unemployment, capital resources, and other available factors of production. However, if you take into consideration the effective demand constraint, then the natural level of output is a function of supply constraints and demand constraints. The demand constraint is currently stronger than in the past. The problem is that the AS-AD model does not recognize demand constraints well. Demand simply follows output. But effective demand constraint stays steady and waits for output to reach it. The “equilibrium” dynamic between supply and effective demand establishes the natural rate of output at the LRAS curve.
Third, you say, “but if labor share rises and production and consumption increase, profits would increase absolutely, if not as a percent.” A rise in labor share is matched by a decline in capital share, which comes from profits of owning capital. In order for the profit rate to continue to rise as capital share falls, productivity has to be increasing.
Let’s look at this equation…
profit rate = (capital share * productivity * labor hours)/value of capital
Holding value of capital constant, if capital share falls, then productivity and/or labor hours would have to rise faster than the fall in capital share, in order for the profit rate to rise. Seems simple enough. You employ more workers with the capital you have and the profit rate increases. However, the value of capital increases as the business cycle moves, So productivity and labor hours have to overcome that too. What we see is as a recession starts to form, the profit rate falls mostly from weekly labor hours falling, value of capital rising, and capital share falling as wages and prices rise.
So the profit rate is not able to overcome the constraint that effective demand puts on labor and capital utilization as the business cycle comes to an end.
What is the cause of the recession though? Is it natural business cycle, or is it the availability of investment opportunities outside the system?
If we measure the US economy, capital flees to other economies once the profit expectation drops below a certain point. Then it “flees back” once the economy has collapsed enough for interest rates to drop and rates of return to be in line with expectations.
This happens both with real companies doing actual business and with “investors” in the “markets.”
Could you soften this with some way of making it expensive to move capital out of the economy, but cheap to move it into the economy (at least in the short term before everyone started that)?
If there wasn’t an external economy, capital would instead be redirected to other profit making opportunities inside the system, so the cycle should be less magnified at least in regard to the perspective of labor income.
However, historically our business cycle has been less severe nationally in modern times than in the period before 1900.
Maybe I’m missing something here, just kind of typing without much time to think about it.
J.Goodwin,
Cause of recession? It is a function of both things you mention. Natural cycle and investment optimism. Keynes talked about this. and at the end of the 90’s, profit rates were falling, but there was plenty of investment optimism to overcome the falling profit rates. We saw this again from 2005 to 2006.
About capital movement, It sounds to me like you are talking about some sort of tax on capital outflows. Is that what you have in mind?
Many are worried about bubbles in the external economy. Not all bubbles pop at the same time, which may be due to capital escaping one bubble popping and moving to inflate an external bubble, then when another bubble pops, some of its capital escapes into another bubble in another country… and so on.
We may be living in a world where there will always be a bubble somewhere to give refuge to capital interests. It may be sustainable too.
Edward
thanks for the reply. when you write your book i hope to be able to read it all as a continuous story.
you left me this time with that recession coming “because” labor was increasing its share. now i think you are saying that the recession was always coming, just not official yet.
i am still not convinced that labor and capital are eating out of a fixed pie. increase wages and employment, even government employment, and maybe especially government wages (to compete with private business for labor) and the pie grows.
Coberly,
The pie grows with more employment and higher wages. And it will be nice for labor to get a boost, It’s that the pie grows right into a constraint. Maybe you understand the constraint as setting a fixed pie.
Mr Lambert, excellent read…A little difficult for me to understand, however, I think you are correct and way ahead of the conventional crowd..
Edward
I admire your project and wish you well. But like Hans above, I do not understand much of what you say, and some of it is counterintuitive… against my pre conceived notions… you would have to take more time than you have to explain it to me. But it’s just possible you may need to take more time than you have to explain it to you. I would strongly advise NOT explaining it in terms of the model itself, but go back to what you know about what actual people and businesses do… and remember that they usually do many things which counteract each other.
Hans and Coberly,
Your comments are well taken.
Let me make one analogy about employment and profit rates.
Let’s say that profit rates start to decline before full-employment at the LRAS curve. That is what I see in the graph above.
Think of it this way, the coldest day of the year is not on the winter solstice, Dec 21st. It is January 9th, some 3 weeks later. So on the coldest day, the sun is already gaining strength in the sky. Likewise, the hottest day is not June 21st, but July 10th, some 3 weeks later and the sun is already losing strength in the sky.
Employment increases like the temperature increases in summer, but the underlying movement of profits like the position of the sun in the sky has already started heading in a cooling direction.
So when employment really starts to look good, profit rates are already signalling the cycle will be moving in the other direction.
Is that a good analogy?
Coberly, you are wiser than you think…
Mr Lambert, that is a salient analogy…Hats off, everyone!
I am still struggling with four and five, but are you suggesting that when employment peaks so does the business cycle?
You are one of the few to see, the “sub-optimal business cycle” unlike the many euphorians preachers…
Coberly, you are wiser than you think…
Mr Lambert, that is a salient analogy…Hats off, everyone!
I am still struggling with four and five, but are you suggesting that when employment peaks so does the business cycle?
You are one of the few to see, the “sub-optimal business cycle” unlike the many euphorians preachers…
Edward ,
New in RWER that you may find of interest:
Leon Podkaminer – ” Global output growth: wage-led rather than profit-led? ”
http://www.paecon.net/PAEReview/issue65/Podkaminer65.pdf
“….For this Note the starting point is the theory linking investment dynamics to the functional distribution of output: that is the proportion in which national output (or income) is divided between wages and profits……..
The theory…..assumes that in the longer run private investment is an immutable function of two ‘variables’: (1) the profit share; (2) the level of production capacity utilization. Each of these two variables, taken separately, is assumed to exert a positive impact on investment. However, the level of capacity utilization is higher when the wage share is higher (as the consumption propensity out of wage income is ‘naturally’ higher than the propensity to consume out of profits). Hence the profit share and the level of capacity utilization are not independent of each other – actually these two variables are ‘antagonistic’. Depending on some (fairly simple) analytical considerations, it is possible – at least in theory – to identify one of the two variables in question as eventually dominant in so far as investment impacts are concerned. If a certain arithmetical inequality is satisfied then the profit share is dominant, otherwise it is the capacity utilization. In the former case investment (and overall output) growth responds positively to redistribution of income from wages to profits. In the latter case investment (and overall output) growth responds positively to redistribution of income from profits to wages. Not surprisingly, the former case is called an instance of ‘profit-led growth’, and the latter a ‘wage-led growth’…….”