How much spare capacity remains in the economy in terms of labor and capital? This question is an incredibly important one… and economists such as Krugman, Bernstein and Baker are deluded by past grandeur…
You will hear Paul Krugman say that the Fed rate must stay at the zero lower bound in spite of the financial risks, because there is still so much spare capacity… such that the benefits of pushing the economy towards that spare capacity outweighs the costs of QE and the ZLB Fed rate. Yet, spare capacity is not so great…
I measure spare capacity by a variable that I call the TFUR, total factor utilization rate. The employment rate is multiplied by the capital utilization rate… like this…
TFUR = labor utilization x capital utilization
Labor utilization is just (1 – unemployment rate). Using current data we get…
TFUR = 92.7% x 78.1% = 72.4%
How does this value compare to historical data since 1967?
We would still be considered in a recession according to past data, but we should not live in the past. We need to understand the present.
The top limit of the TFUR held fairly constant from the late 70’s to the late 90’s. Then it dropped before the crisis. And if you look at the most recent data, the line is trending to even a lower limit. The implication is that there is actually little spare capacity left.
There must be an explanation of why the line looks to be capping off below 74%.
My work points to the fall in labor share which has weakened relative demand for production. The top limits in the graph follow the fall of labor share. The following graph super-imposes the effective labor share (the labor share index * 0.762) onto the TFUR.
The pattern becomes visible. The mechanism though is escaping top economists like Paul Krugman. They continue to say that there is a lot of spare capacity out there. Even Jared Bernstein and Dean Baker just came out saying that unemployment can go down to 4%.
“Our work suggests that 4 percent — the average unemployment rate for 2000, the last time we were at full employment — is a reasonable target, one worth shooting for.”
A 4% unemployment rate was accompanied by a roughly 82% capacity utilization back in 2000… which put the TFUR around 78%. By the pattern in the graph above that number is not going to happen. The utilization of labor and capital is slowing down to a lower limit… and there isn’t any past precedent that says it will speed back up.
Mr. Bernstein and Mr. Baker are looking at the past, and not current dynamics. They look to be deluded by a former grandeur. They do not see the new reality forming in front of their eyes. Mr. Krugman and many others are in the same boat.
These are dark days when the supposedly enlightened economists don’t see critical mechanisms. and Why is this critical? Because lots of spare capacity is the justification for QE and aggressive monetary policy.
Just imagine what will happen when the spare capacity caps off at a lower level, and the Fed is sitting there with QE and the zero lower bound… Can you say… How fast can we taper? … 3 times fast