Krugman is honest & Noah Smith is insightful

Paul Krugman is honest in his search to explain secular stagnation, but he is missing a crucial piece to the puzzle. And thus he comes to an incomplete conclusion. But then we see that Noah Smith is bringing the missing piece to the table. (update: Noah Smith cites the work of Michael Elsby, University of Dublin. The Decline of the U.S. Labor Share.)

The missing piece to the puzzle is labor’s share of income. I tend to think that Mr. Krugman still hasn’t come to see the distinction between income inequality and the inequality of labor and capital income. Anyway…

Mr. Krugman points to various factors to explain secular stagnation…

  1. Debt
  2. Baby boomers leaving the work force
  3. Slowdown in productivity
  4. Slowdown in the growth of potential GDP which he says affects demand. He really should say that demand affects the growth of potential GDP. Anyway…
  5. Trade deficit

He begins his conclusion…

“Given the factors I’ve described, it seems hard to avoid the conclusion that the average real rate looking forward will have to be negative. If inflation stays relatively low, e.g. 2 percent, this would mean an economy that often, perhaps usually, finds itself in a liquidity trap.”

This is true… I actually said this in a comment on Mr. Krugman’s blog back in April with a link to a post of mine. Even to this day, people still follow that link to the post. The post is titled, The Progressive Death of the Fed Funds Rate. The post gives a model to show that falling labor share will keep the Fed rate at the zero lower bound until labor share rises again.

Mr. Krugman offers a solution…

“I would say, however, that the most likely way to reduce the deficit would be via a weaker dollar, achieved through low real interest rates, achieved in turn with a higher inflation target.”

This solution is weak. The inflation target is different than actual inflation. If the inflation target was to be raised now, the natural real interest rate would be pushed down further, making it even harder for current real interest rates to stay below them. I say this because the natural real interest rate is based on the Fed rate minus the inflation target. If you make policy to not only push real GDP back to the previous potential trend, but also to keep the Fed rate at the ZLB to do so, then the natural real rate goes down farther with a higher inflation target.  So even with a lower current real rate, the inflationary benefit is lessened.

Noah Smith’s conclusion about labor share is an insightful one…

“So what do we do to bring back labor’s share of income? We wait. The Great Labor Dump can only happen once. When it’s over – when insanely huge amounts of investment in China have saturated that country with capital, for example – labor’s share will bounce back.”

With all my research into labor share and effective demand, Noah Smith goes to the heart of the understanding… China and even Germany for that matter. Mr. Krugman points to the trade deficit, but Noah Smith resolves the bulk of the low labor share issue in one sentence.

We can start though by pushing for a higher minimum wage towards a living wage. Then we wait as Noah Smith says for China to run the course from releasing its inner “capitalist” child.