Economists look foolish by not seeing what Central Bankers see… small output gap

Antonio Fatas writes that the central bankers are estimating smaller output gaps in Europe, the UK and the US. I have been saying for a year that potential GDP is far less than the CBO estimate. But other economists have been sticking to the claim that the output gap is still quite large.  Economists do not understand effective demand yet. We see this reflected in what Mr. Fatas writes…

“Measuring potential output or the slack in the economy has always been challenging. One can rely on models that capture the factors that drive potential output (such as the capital stock or productivity or demographics) or one can look at more specific indicators of idle capacity, such as capacity utilization or unemployment rate.”

Do you  see any demand factors for determining potential output in his quote? No. So if productive capacity stays the same, so should potential output, right? Well, wrong… if demand is undermined, for example by a 6% fall in labor share of national income/output, the economy will not be able to sell its potential output. There is a demand constraint.

Keynes wrote about effective demand, which when weak, can keep the economy from reaching potential output. We are seeing this now. Well, at least, I am seeing this happen. Other economists have not caught on… yet… But it is inevitable that they will.

Here is a model that plots aggregate supply and effective demand (US economy). It is similar to the model of aggregate supply and aggregate demand, but effective demand is used to show the effective demand limit upon output.

as ed 4Q13 2

The blue dots show real GDP increasing to the right over the past 8 quarters.The up-sloping lines are aggregate supply for real GDP for the given inflation rate. The down-sloping lines are effective demand. The down-sloping lines of the effective demand limit have stayed within a fairly tight band. Effective demand has fallen into this band 6 of the past 8 quarters.

There are two lines that fell out of that band. One was the labor income surge at the end of 2012 before the payroll tax changes of 2013. The other was the capital income surge at the end of 2013. Apparently businesses are competing to show better profits or simply protecting themselves as the minimum wage movement grows in strength. The effective demand limit corrected back to the band after the labor income surge of 2012. I expect the effective demand limit to correct back to the band in 2014.

The effective demand band is pointing to a meeting place with the increasing real GDP, as shown by the red zone. Real GDP in the US will reach the red zone of the effective demand limit between $16.0 and $16.1 trillion. The red zone is the actual potential GDP as constrained by effective demand. This model of effective demand is showing what the central bankers are seeing… potential output is much less than the CBO estimate above $16.7 trillion.

The tightness of the band is an important character-defining aspect of effective demand. After recessions, effective demand falls into a band that eventually points to the end of a business cycle expansion (red zone). Because of this consistency of effective demand, we are able to foresee the end of an expansion a couple of years in advance. Let that sink in for a moment.

What the central bankers are now seeing could have been seen 2 years ago, if they had this model. As it is, economists have no model for effective demand. They will blame the stunted potential GDP on the recession itself, and not on weak demand. As Mr. Fatas writes…

“business cycles can leave permanent (or at least very persistent) scars on output through the effects they have on the capital stock or the labor force. But it is important to understand that the permanent effects are the consequence of the recession itself. If we could manage to reduce the length and depth of the recessions we would be minimizing those permanent effects. And in that sense, accepting these changes as structural and unavoidable is too pessimistic, leads to inaction and just makes matters worse. If you read the evidence properly, you want to do the opposite, you want to be even more aggressive to avoid what it looks at a much bigger cost of recessions.

There is no word about raising wages and labor share in his prescription to overcome a lower potential output. By not understanding properly how demand constrains output, economists are looking foolish in the eyes of businesses and central bankers. The bankers see the numbers from actual businesses. Economists look at past data for production without incorporating a measure of demand. Economists are disconnected from reality.

What does it mean that the economy is closer to potential than even the Federal reserve projects in their forward guidance? For investors, it means that profit potential going forward is much less than they think on average. For the general population, the error in judgement creates more economic instability and thus more risk of a harsher contraction. For economists, it means that they have an opportunity to learn a lesson about effective demand. Yes, Keynes wrote about it back in the 1930’s, but economists have come to equate it with aggregate demand. A mistake that can be corrected.