Krugman is dancing around a root cause… labor share

Edward Lambert | December 26, 2013 1:18 pm

US/Global Economics

Paul Krugman is developing the ideas to understand one of the root causes of the economic problems. His present line of logic leads to understanding the effective demand constraint upon output. He writes…

“Profits took a hit during the financial crisis, but have soared since then, and are now 60 percent above pre-crisis levels; meanwhile compensation has grown hardly at all, and indeed fallen in real per capita terms.

“The point is that we have a depressed economy for workers, but not at all for corporations. How much of this is due to the bargaining-power issue is obviously something we don’t know, but the disconnect between the economy at large and profits is undeniable.”

He is describing the fall in labor’s share of national income since the crisis. It would be nice if he just used the term “labor share”, but he seems to always steer away from that term…

Firms do not care about producing more output. They only care about producing more profits. If producing more output means less profits, firms will not produce more. Keynes described this effect using the term effective demand in Chapter 3 of General Theory. Effective demand is based on labor share. The point at which profits start to decrease with production is the effective demand limit.

Anyway… Mr. Krugman also calls for a model in his post…

“(I’m going to try some formal modeling on all this, but if anyone else wants to jump in, be my guest.)”

OK… I’ll jump in. I have many models on the subject of labor share and effective demand. I’ll use just one.

The following graph shows the shifts in labor share that occurred during the 2001 recession and during the crisis. I stress the word during, because you actually see the shifts occur during the recessions. The equation for the line is given in the graph. (Effective labor share is just multiplying the labor share index: business sector by a constant. In this case, 0.762.)

As you move left on the x-axis for lower utilization of labor and capital, you enter a recession. I have circled the times where the shifts occurred. And the shifts occurred during the past 2 recessions. The green lines show a stable labor share for decades. Then the small blue circle shows a shift to a lower level of labor share during the 2001 recession. The larger oval shows the larger shift during the crisis recession.

Paul Krugman understands why the shift occurs during a recession… (again from same link)

“So a slack economy could in effect serve as a coordinating device for firms; one way to think about it is that it keeps firms from competing too hard for workers, enabling them to exert more monopsony power.” (emphasis mine)

Yes. Firms have an opportunity to “clean out” labor and the wage structures during a recession. Firms are able to establish a new level of labor share. Then this new level of labor share in effect solidifies (rigidifies?) as the business cycle recovers. Thus, it is actually difficult to change labor share outside of the recessionary part of the business cycle.

Labor share can only shift so much during a recession due to wage rigidities and “depth of recession” time. Rigidities can be cleaned out more during a deep recession. We can see that labor share was only able to shift a little during the 2001 recession. That recession was not as deep and long as the recent crisis recession.

Now, how much “coordinating” takes place between the firms is an interesting question. For example, just before the recession in 2007, the two-tier wage contract being negotiated between General Motors and their labor union, UAW-GM, may have been a coordinating message to other firms to lower labor share. The opportunity to do just that presented itself in a big way during the crisis recession.

The thought we need to keep in mind is how much lower labor share will want to shift during the next recession. Maybe labor share was not able to shift as much as it needed to in order to get balance with Chinese imports for instance. But then again labor is fighting back and gaining some victories on the minimum wage front.