The mystery revealed in this post is that potential GDP and labor share reflect each other.
One thing people must realize is that potential GDP describes the center of the business cycle. (See video below for visual explanations.) It seems most people think potential means the top end of the business cycle, but they would be wrong. The data shows it is the center of the business cycle.
Real GDP moves above and below its center, potential GDP, through the business cycle. I will also show in the video that capacity utilization moves along a similar path in relation to labor share. Thus labor share is the center of the capacity utilization cycle.
Equations for the video…
Blue line = Real GDP – potential GDP
Red line = Biz cycle amplitude constant * (capacity utilization – effective labor share)/effective labor share
Business cycle constant is displayed above graph in video. It will be changed to convert the % difference between capacity utilization and effective labor share into GDP billions of 2005 dollars. You will see that real GDP moves in relation to potential GDP as capacity utilization moves in relation to labor share.
Output gap = potential GDP – real GDP
So what is the mystery being revealed?
Potential GDP is a reflection of labor’s share in US national production.
If labor receives a larger share, potential GDP is higher. If labor receives a lower share, potential GDP is lower. After all these years after Keynes, this should not be a mystery.
Economists are just now figuring out that potential GDP is not so high as they thought, and that the output gap is not so big as they thought. They have not understood the effects of labor share falling 7% after the crisis. Now they see that potential GDP has fallen 7% too. It is becoming clear that economists are confused about potential GDP.
While I wait for the 2009-base-year data from FRED for potential GDP, here is the recent data of capacity utilization over effective labor share. Capacity utilization in relation to labor share looks to be peaking again. A contraction always follows this pattern. In spite of labor share moving over the years, the pattern has stayed consistent.