Krugman – Are we getting close enough to Full-employment?

Paul Krugman asked today…

“Are we getting close enough to “full employment” that it’s time to let up on the gas? How much slack is there in the economy, really?”

By letting up on the gas, he is referring to tapering by the Federal Reserve. Tapering would signal tightening as he ends his post with this question, “Why not wait for clear evidence that the economy is really approaching capacity before doing anything that could be interpreted as tightening?”

I understand his concern that a low labor force participation rate and “sustained high unemployment” represent scars forming in the economy. Basically Krugman wants the Fed to maintain its aggressive policy for encouraging spending and investment in the economy, since there is evidence of spare capacity in the labor force.

The problem is that Krugman is still assuming that we will approach full-employment. He is being foolish. Why?

  1. Keynes wrote in Chapter 3 that a deficient effective demand can keep an economy from reaching full-employment. Thus it logically follows that we should not simply assume full-employment.
  2. Effective demand is deficient now, since labor share of national output has fallen. Labor has less liquidity to purchase output.
  3. If Krugman would follow his own story of the child care coop where not enough scrips caused a “recession” in the coop, he would see that low labor share shows that labor has less scrips. The result is that the potential output of the economy is lowered to a point constrained by labor’s liquidity. This is Keynes’ thinking behind effective demand.

The question then is… Where is full-employment? … Answer: The employment where effective demand constrains output.

natural rate 2nd

Link to graph #1.

In this scatter plot graph of quarterly data, unemployment is plotted against the percentage difference between capacity utilization and the effective labor share. (Effective labor share is the measure of labor share which determines the effective demand limit upon the utilization of labor and capital.) The data is from 1967 to 2nd quarter, 2013. In the x-axis, capacity utilization increases in relation to effective labor share. We can see that since 1967, capacity utilization does not go much beyond 7% over effective labor share, and not much beyond 6% since the 1980’s. But at the same time, we can see that unemployment on the y-axis falls to a limit itself around 3% to 5%, as capacity utilization reaches its limit.

The pink dots show current data moving to the right. Capacity utilization is about 5% over effective labor share. Normally since 1967, unemployment would have been between 3% and 6%. However, unemployment is now at 7.3%. My assumption is that Krugman would look at this graph and expect unemployment to fall to 6%. But what trend line would unemployment take to reach 6%? The current trend line would imply a 6% unemployment when capacity utilization is 12.5% over effective labor share, or in other words, a capacity utilization rate of 83%.

It is not likely that unemployment will reach 6% on the current trend line. Capacity utilization has been stuck around 78% for over a year and is not about to rise that much.

capac u

Link to graph #2.

One looks at this graph and sees it is crazy to think that capacity utilization will move up to 83%.

So Krugman would then have to assume that unemployment will curve radically downward in graph #1, in spite of unemployment having never done this since 1967. Would it even be possible for unemployment to come down as capacity utilization stays steady? Not likely. More capital would need to be employed as more labor is employed.

Graph #1 shows us that as capital and labor utilization rates approach the effective demand limit, the dots become a bit more tightly bunched, meaning there is less vertical movement. Krugman would have to have vertical movement for unemployment to drop to 6%. Vertical movement is not seen in the historical dynamics when the economy is approaching the effective demand limit..

Thus, I assume that unemployment is actually closer to its full-employment “constraint” then Krugman. I see a full-employment constraint at around 7%. The constraint is based on deficient effective demand as determined by labor’s share of national income, which is primarily used for consumption of finished goods and services. One could use Krugman’s own story of the child care coop to understand how low labor share constrains output, and thus the potential to use spare capacity.

If Krugman looked at graph #1, and saw that unemployment is actually closer to its full-employment “constraint”, would he see evidence that the economy “is really approaching capacity”? Would he change his answer to his question?

He has recently been saying that the economy will eventually improve of its own accord in spite of austerity. And here too, unemployment will reach its full-employment “effective demand” constraint, with or without QE. So why entertain all the risks associated with QE, namely zombie businesses, more inequality, a divided country, bubbles here and abroad…?