Christina Romer & Not fearing an economic correction of mistakes
A talk given by Christina Romer was very good. (Posted by Mark Thoma) She said many practical things about economic downturns. She loved to refer back to the Great Depression. The basic message was not to fear downturns, and to be careful of doing anything to prolong them. Economies will recover normally and fairly quickly with supportive policy.
She points to shocks that prolong recoveries, such as cutting back on government spending and raising interest rates too fast. But I must say that a certain shock has been left out of her presentation. That is the shock of a falling labor share which was not normal after a recession and which explains stubbornly high unemployment through weak demand. Yes, deleveraging will cut into consumer spending. Yet, a drop in labor share will also cut into consumption due to the compounded constraint on labor’s liquidity.
Christina Romer wants us to learn from the Great Depression… So let’s remember that the minimum wage was made law in 1938. Unemployment fell after that.
As far as the current crisis… Yes, the Fed should have acted with aggressive monetary policy… Yes, the government should have responded with aggressive fiscal stimulus. Yet, there is a serious social problem getting worse, which is inequality. Society will pay heavily into the future for the current policies exacerbating inequality. Political influence is more unbalanced. Ownership of capital is more unbalanced.
I would love to support continued aggressive policy to bring the economy back to full employment, but the social cost of inequality is sickening. And if stopping this disease means putting the economy back into a recession, then so be it. As it is, Christina Romer is telling us not to fear an economic correction as long as its recovery is done correctly. It is like re-breaking a bone to set it straight. If the re-breaking of a bone is not done, the bone won’t work correctly in the future. It is proper medicine. You will be better off going through the moment of extra pain. (This is a link if you want to understand the medical wisdom behind re-breaking bones.)
In hindsight, along with aggressive fiscal and monetary policy after the crisis, we should have had aggressive policy for directing liquidity to middle and lower income groups. Mrs. Romer said this too in her talk referring to helping middle income groups with their debt overhang.
My prescription is to re-break the economic bone which has not set correctly, and this time let’s be aggressive in setting straight better wages and labor share from the start.
The idea of re-breaking the economy may sound crazy to you, but the methods of medicine have a greater wisdom than what I see currently among economists. The Volcker recession was good medicine. It had a wisdom to re-break the economy to correct inflation. Current day economists seem squeamish about an economic correction, even if it was to correct mistakes.
Who has any faith that the next downturn will be handled properly?
Seems to me the next downturn will be handled exactly as the last two have been; the Fed puffing up asset bubbles and the Federal Government doing almost nothing.
There is no question that David S is right and the harm done by downturns to all but a small fraction of the populace is staggering. The one benefit of the Great Depression was that it was so massive and all encompassing that we got real social programs–social security- and real regulation of financial markets-Glass Steagall, the SEC-and that has not been the result of the Great Recession. To put tens if not hundreds of millions of Americans through the agony of another downturn, without any realistic probability of better results unless it is at least as bad as the Great Depression is to me a very bad idea. This is particularly true when what is needed is political will to stand up to capitalists and there is no reason why that can not be done without a downturn or would be occasioned by anything short of economic collapse in a downturn. To use the medical analogy you could straighten the bone without rebreaking it and rebreaking it offers only a slight improvement in the odds that it will get straightened.I am also old enough to remember the Volcker Recession and that was a cruel and heartless way to protect the asset values of the wealthy on the backs of working people. Its only redeeming feature was that it was short, but then Reagan had to run for reelection in 1984.
If I understand what Ed is suggesting, the down turn leading to a proper recovery will not happen unless there are the proper people with the correct understanding of what needs to be fixed and how to fix it to make the down turn happen.
That is, the bone does not re-break on it’s own. It required people thinking correctly as to the means by which healing takes place to understand the need and then implementing the apparent contradictory solution of re-breaking the bone.
The down turn Ed is suggesting is one that will be intentionally caused do to the proper corrections being implemented vs one do to a bubble and thus just part of this sick cycle.
Besides the minimum wage, the government also purchased the mortgages and re-wrote them for the citizens such that they kept their homes. This was another direct means of putting money in the hands of the many vs the few.
This time we relied on the free market to be that altruistic. Stupid move.
Interesting ideas here. Reading along this idea of breaking the economy to fix it I wondered if there isn’t a recent historical reference, i.e. the reunification of Germany.
In the immediate aftermath of Germany “fixing inequality” between workers in the east and west the economy was horrible, iirc unemployment surged towards 20% in Berlin etc. But the german taxpayers stepped up recognizing the benefit of putting the country on one economic (primarily western capitalistic ) platform. And eventually it worked out, of course things have changed since then but they at least fixed the problem of aggregate domestic unemployment.
I can’t help wondering if this isn’t also one of the showstoppers in a US reconciliation of inequality. Unlike Germans who were welcoming people back (sometimes from their own families) we have a lot of people in the US who are trying to argue the have nots don’t belong here. And don’t deserve to make a living wage.
The more I thought about this idea the more I liked it – The reunification of the US. An unfortunate association with Senator Edward’s presidential campaign perhaps but maybe another more credible national democrat could take it up. (I am referring to his Two Americas speeches which I actually found rather compelling)
Reunify the US!
Terry
I agree with you. My reading of the “Reagan recession” is that it was really the Volker recession. Reagan’s people were trying to stimulate the economy with defense spending while Volker was still fighting an inflation that was already over. He didn’t quit until the banks themselves started to fail.
I don’t think the economy has to be “re-broken” to set properly. A little government stimulus, whether on money borrowed or taxed from the rich doesn’t matter, as long as it is used to fund real jobs or underwrite real businesses.
Maybe in the long run there are other factors I don’t know about, but it sure looked like the Fed in the Great Recession did what it knew how to do to save the banks, and maybe therefore the economy, but didn’t understand the need to save ordinary people’s jobs or homes, and that giving money to the banks did not mean that money would be “invested” in an economy without demand.
I cannot help myself… in this spirit of revolution, I give a link to the song that says…
There ain’t nothing fair in this world,
Look for something left in this world,
start again…
As far as the Volcker recession, inflation was on a rampage and it took the Fed 15 years to get in under control.
Did they go too far? Did they beat it down too far? Maybe they did… but they had to do something and that was their prime mission.
As you read now around Europe and the US and even Japan, there are strong doubts that wages and labor income will rise. Inflation is low now due to weak wage demands. The Fed was able to beat down inflation against the workers as some say here, but they are weak to raise inflation now because they have no power to raise wages. They are powerless to even recommend it in their communications. Low inflation is out of their hands. They wait and hope that as the labor market gets tight, inflation will re-appear… but it won’t likely happen. There is still pressure to lower wages for global competitiveness. Still too many have the narrow view that lower wages will lower unemployment.
Thanks Coberly. I think if you look back at Bernanke’s testimony to Congress he made repeated calls for action on the fiscal side which after the first bill of $900 billion or so was all toward austerity because of the deficits which only matter when a Democrat is in office. Krugman said at least in retrospect that the $900 billion was too small. I think it was flawed because too much was in tax cuts which those of us who were still working thought was great–we paid down our debt because we saw how fragile the whole system was–but did absolutely nothing for those who were out of work or who paid so little in taxes that the tax break amounted to the pittance they would have to pay in under your Northwest Plan concerning social security. The Fed did what it could and in my view helped, but I do not think anyone since Friedman would think you could solve a financial crisis and the accompanying deleveraging solely through monetary policy. That was what the Great Depression proved which got better with more fiscal stimulus, then got worse again when the deficit hawks reared their ugly heads in 1936 and finally was ended and then some by the massive deficit spending on World War II which was Keynes on steroids. And which included some check on the wealthy capitalists with price controls and war profiteering laws etc. My point is that economic downturns do not automatically provide the political will to make structural changes in an economic/social system unless they are cataclysmic and maybe involve a world war. I do not want that and it should not be necessary to have that much pain in a democracy.
Edward, Just so we are clear. I think you are spot on with your analysis of effective demand and labor’s share. In the long run growing inequality is game, set, match on EVERY economic and social issue. That being said, economic downturns hurt everyone in varying degrees except the very wealthy–arguably it hurts them too, but they do not notice and there simply is no reason to suppose that we will do any better with the next one then we have done with the last several. In the long run everyone is dead and I for one do not welcome short term pain for speculative benefits down the road when I am dead.
Terry
thanks, i did not know that about Bernanke. actually read a book about B and the bank bailout. never mentioned it.
Lambert
also thanks. i don’t know much. still, don’t like to hear about new recession on accounta who gets hurt. and it’s like Terrry says..
Terry,
In the art of negotiation, one starts with a position that contains viable threats to the other side. If you say that you will never be in favor of producing an economic downturn as Volcker did, you lose power to gain what you want.
Obama was weak early on in his presidency. He let the republicans get too many compromises. Obama would never let the government shut down. That fact allowed the republicans to control him. He later stiffened against their silly demands of shutting down the government and said, “ok, go ahead and shut down the government. The people will know that you did it, not me.” The result is that they will never do that again.
If you say that you would never allow an economic downturn, you weaken the extent of your power in negotiation. You are then willing to allow the status quo of growing inequality to continue, because you do not want to hurt innocent people. Well, the rich are hurting innocent people. And fighting for the innocent requires not only putting forth economic models that explain effective demand, but the kind of bravery that can reset a bleeding broken bone with your bare hands while listening to screams of pain. But you know that you are fixing the broken bone correctly.
Do you want the other side to respect your power? The key is to make them confused about your power, so that they are unsure of what you are capable of. That strengthens your position in the negotiation. If they know what your limitations are, they can control you in the negotiations, like the republicans did with Obama.
So let me ask you… Would you welcome an economic downturn if it put into question years of failed monetary policy and thus gave the possibility to incorporate into policy the importance of labor share and more direct help to middle and lower incomes?
“…Yes, deleveraging will cut into consumer spending. Yet, a drop in labor share will also cut into consumption due to the compounded constraint on labor’s liquidity.”
Maybe everybody here knows what that means but me. I know we have weak demand for goods because too many people are unemployed or not earning enough to buy a lot of things, but I would not have used the above-quoted words to say that, so probably there is some extra meaning that I am not getting.
I have not had any courses in Economics so probably it’s my problem, but I read other economics blog posts with a higher level of comprehension than I got from the above.
Break that Rich Man’s leg bone, TAX HIM.
91% would most certainly release a scream of PURE healing.
Here is my response that I wrote on the money illusion blog…
The idea behind breaking bones is that sometimes a broken bone does not heal correctly. Then from then on, for example, the person cannot walk well. So the Doctor will re-break the bone and set it correctly.
After the crisis, labor share fell. Profits increased. Inequality is increasing. Financial stability is becoming more of a concern to the Federal Reserve. Inflation is staying low, as well as in Europe. There is weak demand from low labor share to support demand and efficiently stabilize credit. The transmission mechanisms of liquidity to middle and low income households was not good enough. Christian Romer acknowledged this in her talk.
The economy healed incorrectly after the crisis. The economy is proceeding with a permanent limp related to policies that increase inequality, including monetary policy, which does not have a direct mechanism to transfer liquidity to middle and lower incomes.
Weak demand is limiting supply, as Larry Summers said in referring to Inverse Say’s Law. Potential GDP is lower than people thought or think. Weak demand is related to low labor share. The economic environment is not conducive to raising wages. There is concern that inflation will stay below target for years, in the US and Europe.
So what do you do? Do you just keep moving forward with the same policy thinking that a far off full employment will solve the situation, while inequality gets more and more entrenched everyday? Maybe you, but not me. I do not want to see the US become like a Latin American country with undemocratic and unstable politics and many marginalized workers. You know this is happening.
Let’s say you are a brick layer and you are building a wall. Your foreman comes and sees that your wall is not straight.
Will he say, “just keep building. We have to finish this house”? No, a good foreman will say, “Tear it down and start over”.
So break the bone again, let the person scream as you set it correctly. They will be grateful later on. Would you be too squeamish to do such a thing? If so, you would not be a good doctor. And the principle applies to being a good economist too.
Remember Volcker? He broke the economy to set inflation correctly. It eventually took some 15 years to control inflation and stabilize monetary policy around it, but it had to be done. Volcker was a great economic doctor.
I posted another comment to Scott Sumner’s post… Here is what I wrote.
You link above to a post by Marcus Nunes where he says the recession was unintended. Yet, read the first two interviews at this link… They knew a recession would occur.
http://www.pbs.org/wgbh/commandingheights/shared/minitext/ufd_reaganomics_full.html
” many people warned President Reagan that if he did this, there’s likely to be a recession. And obviously who wants a recession? But I can remember President Reagan using those famous words, “If not now, when? If not us, who?” So he did the right thing, and we did have recession. But also, inflation dropped like a stone.” George Shultz
Reagan and Volcker had the backbone (speaking of bones) to go through the recession risking political backlash. Some members of the Federal Reserve in the late 1970’s and early 1980’s did not have the backbone and started voting against raising the Fed rate.
Would you have had the backbone?
I don’t think you would have from what you sarcastically wrote above, “… a left wing blog that advocates intentionally driving the economy into a recession as a way to reduce inequality… Voters will love it…”
Well, voters didn’t like inflation back then and they certainly don’t like inequality now. In the end, Reagan’s approval rating went back up. You do what you have to do.
A commenter on the money illusion blog asked me a question…
so what’s your recommendation, Edward? Reverse QE and raise the overnight rate? What would that achieve.
Here was my response…
Phillipe,
There is a growing problem of inequality that is getting more entrenched everyday. Monetary policy is feeding the inequality. We can see who is benefiting and who is not. Just as inflation adversely affected economic decision-making back in the 1970’s, inequality is distorting decisions now to the point that financial stability is once again a primary concern. Asset prices are once again becoming distorted. The central bankers talk about it.
Yet, the Fed is in a trap now. If they tighten to stop this, they really do risk a recession. Profit rates have peaked. So what do they do? They choose to push on keeping a hopeful face that a far off full employment will rectify the problems, including inequality and low inflation. That is the only way out of this trap. Basically they didn’t realize the strength of weak demand to foil their plans. They expected the economy would have recovered by now.
My view is that a recession will happen anyway before their full employment level is reached due to weak effective demand, which monetary policy could not resolve. And the recession will easily be blamed on a monetary policy that benefited the rich at the expense of everyone else. Then as the economy recovers, there will be pressure to not have the same policy response again. The new response will have to incorporate policies directing liquidity at middle and low incomes.
Larry Summers has already pointed to weak demand causing low production. He has said that policy in the future must be directed at demand. That means labor income in my book. The words of Larry Summers have influence. So the stage is already set. When the next recession happens, the foundation is already laid for a policy switch toward directly helping middle and lower incomes.
The next recession will open the door to more progressive policies. People all over the world are talking about the problems of inequality. So now I am hopeful for the changes in the next recession.
Anyway, I differ from economists like David Beckworth on potential GDP. I see it as much lower than they do. The result is that the Fed rate should be higher. Keeping it low increases the financial instability. But the Fed is in a trap. They want out of QE. Like I said they expected the economy would have already recovered by now. So they are uncertain about what is foiling their plans. But they have to move slowly being careful not to alarm anyone considering the instability of international markets. They may say they will support the economy if data is weak, but irregardless, they will not turn back from persistent tapering and eventually raising the Fed rate.
The Japanese have laid out the excuse for the Fed to use if they want to pull back. As expected , Abenomics is proving to be an exercise in string-pushing , and now that they’ve realized this , they simply announced victory – Japan is now operating at potential ! We’re done ! We fixed it !
I’m guessing the Fed will start to move in this direction , revising their estimates of potential gdp lower and lower , faster and faster , so as to replicate Japan’s “success” as unconventional policy winds down.
I don’t think the Fed pullback will cause a gdp crash , though it might inflict some well-desrved damage to asset prices. We’ll muddle along at slow growth and low inflation/low deflation , similar to Japan’s post-1990 experience. This will not be an altogether bad thing , because it might provide the impetus to make needed changes to income shares , distribution , and fiscal policies in general , as you suggest. At least we’ll finally get to see , up-close and personal , what kind of economy you’re left with after three-plus decades of trickle-down. It won’t be pretty.
Lambert
i cannot dispute your economics or your theory of negotiation. yet my experience has been that tough guy negotiators are always negotiating with someone else’s pain, and the lead to prolonged, bloody, stupid wars.
there are other ways to increase labor share with the (counterintuitive) ‘nother recession.
in any case i think the “rich” would be just fine with another recession. from their point of view it “disciplines” the work force.
and my reading about the volker-reagan recession is different from schultz’s…. another tough negotiator… at least William Grieder talks about conflict between Reagan’s men and Volker on that subject. And inflation “dropped like a stone”? is not my memory of the eighties.
you wanna be careful about this.
I was thinking about this discussion last night walking my dog and it really does come back to the lack of effort on the fiscal side because of the liquidity trap. I never understood the liquidity trap many years ago in college, but plainly we had one in 2008-2009 because people with money would rather bury their money than put it to productive use because of the risk they perceived in all asset classes. The Fed responded by flooding the world with liquidity essentially trying to fill the trap and let it overflow into the economy. Certainly the Fed’s action have pumped up equities to the point where some talk about that as the next bubble. The problem now is lack of demand. If I had some extra bucks I do not know where to put it–businesses do not need the money to expand operations because no one would buy the additional goods or services offered. Interest rates may be low, but the only ones who could borrow are governments and consumers. Governments do not want to grow their debt because of politics and consumers who need to borrow have difficulty qualifying under more stringent lending guidelines. Essentially, we are still in the liquidity trap because monetary policy can only do so much. Indeed to the extent interest rates rise as QE 2 is phased out I think there is a continuing risk of deflation–which is excellent for the 1% and terrible for everybody else. Edward I agree with you that in retrospect Obama was much to timid in dealing with the GOP. For me the moment of truth was when he cut the deal with McConnell following the 2010 mid terms and I di not vote for him in 2012. nevertheless, I fail to see how a downturn is any threat to the rich particularly if accompanied by deflation which makes the rich’s wealth worth more, keeps down wages and the cost of luxury goods and makes all the debt that most people and the government that much harder to pay. Rather than involving the courage to rebreak the bone, it seems more like cutting off your nose to spite your face. In any event, it is not like anyone can call up a downturn on a whim. I assume what Roemer was talking about was the Fed’s efforts to keep the economy going and to lessen the impact of downturns when they occur. I still think those are good ideas and that we should address the inequality issues through progressive taxation, inheritance taxes, corporate tax reform, minimum wage legislation, greater federal government involvement in social welfare programs which used to be implemented by labor unions and some step back from wide open international trade. obviously, recent SCOTUS decisions make the political mountain a bit higher but there seems to be at least some evidence that right wing billions are being wasted.
Terry
don’t want to sound “me too” but I do want to let you know you are not alone. your analysis of the situation is much closer to mine than Lamberts… with all due respect to his sophistication, and being right to point at “labor share” when everyone else was pretending not to see the problem.
I would say to Lambert… be careful of metaphors.
I would also point out that Larry Summers was calling for a “bubble economy” not so long ago. Another example of what a Harvard education can do to a person’s intelligence (He is still “bright” but completely out of touch with reality. Except, of course, that he knows how to make money in a bubble economy, and those who get hurt… ? who are they?
These people… high end economists… have never considered “the masses” as more than ancillary persons who get better than they deserve by eating the scraps that fall under their table.
If you listen to Christina Romer’s speech (Edward has a fondness for posting videos rather than papers, precisely because I believe he hopes no one will take the time to view them) she says in her list of strategies:
“Avoid crises if possible.”
“End crises quickly if they do happen.”
“Use monetary and fiscal policy aggressively.”
and
“Avoid self-inflicted wounds.”
This is exactly counter to Edward Lambert’s perscription of re-breaking the economy.
Some keys to understanding Edward Lambert’s economic views:
1) His model of “Effective Demand” misappropriates its name chiefly from Keynes, but also from Michal Kalecki. In Lambert’s model, labor share of income acts as a constraint on employment and capacity utilization which he terms the “effective demand limit”. But if you actually read Keynes’ General Theory (Chapter 3) you’ll find that “effective demand” is simply the intersection point between the aggregate demand and aggregate supply curves. Keynes argues that effective demand can be increased through monetary stimulus and public works projects. Similarly, Kalecki argues that effective demand can be increased through aggregate demand stimulus. This of course runs completely counter to Lambert’s claim that effective demand is a limit to employment and capacity utilization against which aggregate demand stimulus is totally ineffective.
2) Edward Lamberts’ model of “Effective Demand” is originally derived from the work of Boddy and Crotty (1975), Boddy (2007) and Goldstein (1986, 1996). Rather than link all three I’ll simply link the most recent paper:
http://www.peri.umass.edu/fileadmin/pdf/conference_papers/crotty/Boddy_Crotty.pdf
Boddy shows through careful examination of the research evidence that labor share of income can be described as a function of employment and industrial capacity utilization. Once again Lambert perverts this, this time by inverting cause and effect. In his model, employment and capacity utilization are functions of the labor share of income. The fact that this runs counter to his own sources and a large body of research evidence seems to be of no concern to him, since he is not interested in the truth, only in advancing his own model of “Effective Demand”.
3) If you examine his blog posts, you’ll find that Edward Lambert’s main public policy perscription is the reduction of aggregate demand stimulus, specifically by ending QE and raising interest rates. Given what we know from the research evidence, this is exactly the opposite of what should be done if one’s goal were to raise labor share of income, as Lambert repeatedly claims.
I have a hard time reconciling all of this with the idea that Lambert’s intentions are good and that it is his thinking that is simply muddled. How can one so blatantly misapprehend Keynes and Kalecki, or Boddy, Crotty and Goldstein? There is something seriously amiss here.
Mark:
What is Effective Demand/aggregate demand in relation to Labor and Capacity? Apply some definitions if you would please.
Terry and Coberly,
You bring up good points that must be included in fixing the economy.
Yet Terry you say one thing…
“I fail to see how a downturn is any threat to the rich particularly if accompanied by deflation…”
I posted a new post today that shows how this will happen… Romer and Summers have laid the foundation for implementing more progressive policies during the next recession.The next recession will easily be blamed on policies that benefited the rich. Policy will become more progressive to reverse inequality.
So… the next downturn is more of a threat to the rich than continued policy trying to avoid a recession, in spite of deflation and other complications.
Sadowski
i think and hope you are wrong about Edward. There is enough room for misunderstanding, or taking different emphasis, from other workers’ ideas to justify trying to work out more carefully the “what do I mean by that”‘s before we start calling it misrepresentation.
from my point of view… and i could be misrepresenting, or misreading, Edward, he is the first around these parts, these time, to point seriously at “labor share” as a factor limiting “growth.” he may also be right about the need to raise interest rates…. us old people can’t buy much if our interest income has disappeared…
whether this amounts to breaking the economy i can’t say. but it it seems to be a reasonable thing to do in spite of those who say it “will break the economy,” i’d say Edward has a point in saying, “that’s a risk we are willing to take,”
My guess is that the standard models… all of them… are too limited in the universe of variables they are willing or able to consider, to be taken as god’s law when it comes to trying to make things better for the least of us.
In other words, i am not qualified to speak about “economics,” but until the economists start doing a better job..for me… i am not too ashamed of that.
Coberly,
“There is enough room for misunderstanding, or taking different emphasis, from other workers’ ideas to justify trying to work out more carefully the “what do I mean by that”‘s before we start calling it misrepresentation. from my point of view…”
It’s not like Keynes and Kalecki, or Boddy, Crotty and Goldstein are that hard to find and/or understand. Lambert clearly misuses the term “effective demand” and has inverted the direction of causality between labor share and employment/industrial capacity utilization.This isn’t even subject to interpretation.
“us old people can’t buy much if our interest income has disappeared…”
You are truly fortunate if you are a retired person for whom an interest rate increase would be purely beneficial. This is definitely not true of most American senior citizens.
“whether this amounts to breaking the economy i can’t say. but it it seems to be a reasonable thing to do in spite of those who say it “will break the economy,””
Edward Lambert himself says we should break the economy.
Edward Lambert:
“My prescription is to re-break the economic bone which has not set correctly, and this time let’s be aggressive in setting straight better wages and labor share from the start. The idea of re-breaking the economy may sound crazy to you, but the methods of medicine have a greater wisdom than what I see currently among economists.”
Do you think we should re-break the economy? Romer clearly doesn’t. Nor would FDR.
Keynes defines Effective Demand in Chapter 3 of The General Theory:
https://www.marxists.org/reference/subject/economics/keynes/general-theory/ch03.htm
“Let Z be the aggregate supply price of the output from employing N men, the relationship between Z and N being written Z = (N), which can be called the aggregate supply function. Similarly, let D be the proceeds which entrepreneurs expect to receive from the employment of N men, the relationship between D and N being written D = f(N), which can be called the aggregate demand function. Now if for a given value of N the expected proceeds are greater than the aggregate supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to increase employment beyond N and, if necessary, to raise costs by competing with one another for the factors of production, up to the value of N for which Z has become equal to D. Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.”
In other words Effective Demand is simply the point where AD and AS intersect. To be excruciatingly clear, Effective Demand is the price level and real output level that correspond to the point where AD and AS intersect.
Keynes went on to argue that policymakers always have the ability to shift AD to the right through expansionary monetary policy and public works so that effective demand can be increased until full employment is achieved. As he says in Chapter 10:
”If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”
http://www.marxists.org/reference/subject/economics/keynes/general-theory/ch10.htm
And here’s what Raford Boddy has to say (I already posted the link in my first comment) about the research literature on labor share. Keep in mind, Boddy is *Edward Lambert’s own source*, not mine (Page 3):
“I begin with three well-known explanations of labor share or its inverse. The overhead labor-wages lag hypothesis long identified with Sherman (1972, 1997) makes labor share a function of capacity utilization. The depletion of the reserve army theory hypothesis closely identified with Boddy and Crotty (1975) makes labor share a function of unemployment. The markup theories of Goldstein (1986, 1996) make the inverse of labor share a function of unemployment and capacity utilization. Since Goldstein’s views on the impact of unemployment are along the lines of Boddy and Crotty, it is his theory on the impact of capacity utilization that is of concern here. I begin with Boddy and Crotty on the role of unemployment and then turn to the contributions of Goldstein and Sherman on the role of capacity utilization.
Unemployment and the Strength of Labor
Boddy and Crotty focused on the increase in labor share in the second part of the expansion as the outcome of the rising strength of labor. Declining rates of unemployment increase labor share by increasing product real wages for given levels of labor productivity. According to Boddy and Crotty the depletion of the reserve army can also directly affect labor productivity.
Although Boddy and Crotty (1975) carried out the analysis in the Burns Mitchell NBER cyclical stages framework and not with econometrics, we argued—presciently for my purposes in the present paper– that the confidence of labor would depend both on the level of unemployment and on the change of unemployment. Most workers are not directly affected by bouts of unemployment. Their confidence should be high when the rate of unemployment is low but confidence should also be affected positively if the rate of unemployment is decreasing. Based on the above arguments, I assume that the change in labor share depends on both the rate of change of unemployment and its level. It is crucial to understand the implications of the inclusion of the level of unemployment as a determinant of the change in labor share. Suppose that the rate of unemployment is extremely low but unchanging. In the absence of the level of unemployment the prediction would be that labor share would remain constant. With the inclusion of the level of unemployment the prediction becomes that labor share would continue to rise.”
So there’s no doubt that labor share is the effect, not the cause, of employment and capacity utilization.
run75441,
“What is Effective Demand/aggregate demand in relation to Labor and Capacity? Apply some definitions if you would please.”
Aggregate Demand (AD) is the total demand for final goods and services in the economy at a given price level. Aggregate Supply (AS) is the total amount of goods and services that firms are willing to sell at a given price level. Without going into excessive detail, AD slopes upward and AS slopes downward:
http://upload.wikimedia.org/wikipedia/commons/2/25/AS_%2B_AD_graph.svg
Note that the horizontal axis represents total real output and the vertical axis represents the aggregate price level. The point at which AD and AS intersect is known as “Effective Demand”. Effective Demand is the amount of total real output and the aggregate price level for a given level of AD and AS.
Labor employment is proportional to total real output. Capacity utilization is the relationship between the level of real output that is produced with existing plant and equipment, and the level of output which could be produced with existing plant and equipment if capacity was fully used.
AD is mainly affected by monetary and fiscal policy, with expansionary policy moving AD to the right and contractionary policy moving AD to the left. AS is affected by anything that affects the costs of production. Practically speaking, policy makers have little control over AS, and when AS does shift, this is usually in response to an increase or a decrease in commodity prices, such as oil.
A situation that might correspond to our current one is one where effective demand is such that employment and capacity utilization are lower than what might be deemed most desirable. An appropriate public policy response would be to shift AD to the right through more expansionary monetary and fiscal policy, thus increasing both the level of real output and the aggregate price level, and resulting in higher employment and capacity utilization.
Based on the empirical research, a higher employment level and a higher capacity utilization level would also correspond to a higher labor share of income.
Mark:
I will answer you; but, I do not believe I need to cite Keynes, Boddy, Crotty, Sherman, etc. I am going to talk to you on how to schedule a plant which is not so much theoretical as it is practical. A plant is more than likely a microcosm of an economy, would you agree? Thank you for the definitions and the explanation Mark.
“…AD slopes upward and AS slopes downward…”
should read
“…AD slopes downward and AS slopes upward…”
Assuming “The Bone” has healed incorrectly when it hasn’t “healed” at all. Its already “broken” and flopping around, break it ALL ya like. QE wasn’t a “splint or a cast” it is a crutch propping up a soon to be amputee.
True- the best way to avoid inequality is to just make everyone poor…
run75441,
“I am going to talk to you on how to schedule a plant which is not so much theoretical as it is practical. A plant is more than likely a microcosm of an economy, would you agree?”
Personally I have a preference for the empirical over the theoretical (although one cannot exist without the other). But I’m not the one who is misusing the term “effective demand”. In my opinion, the AD-AS Model is the single most useful model in macroeconomics, so to have someone so blatantly abuse it really bothers me.
Secondly, I think it is a grave mistake to assume the macroeconomy is simply a scaled up version of the microeconomy. That belief is subject to the Fallacy of Composition. In fact, that was one of the main points that Keynes repeatedly hammered on in the General Theory.
So no, a plant is extremely unlikely to be a microcosm of the entire economy.
Mark:
A manufacturing engineer stopped at Economist’s View one time while I was there reading (typical for me as I read just about anyone. I have even read you at times.). He lives in the world of practical very much as I do. I had to explain to him, no one at Economist View understood his complaint. He was micro-based and everyone else (besides me) there was macro-based. I would think somewhere in the history of economics, someone started out with something smaller in scale and grew it into a much larger model. True there are different types of plants with different types of capital equipment and different types of Labor and impacted differently by each country the plant is occupying. I do not believe I have stepped in Nizkor territory.
It appears all of what you say in your explanation can be found in a plant in some manner. For example; there is Labor, Capacity, Demand, and Cost within a plant. To improve Capacity to meet Demand, you can add Labor, add capital equipment, or change the process to improve throughput. If you add capital equipment you may increase labor or if you change capital equipment you may decrease labor. If you change your manner of throughput; you can decrease the amount of time to manufacture, lower inventory inputs, and work in process. Taking such actions shifts the capacity to the right of your graph to meet Aggregate Demand.
Another scenario is what I have seen in China multiple times now. I had a chance to visit a bearing manufacturer. This particular manufacturer casted its own bearings, forged them, and machined them to specification in two $1 billion(each- over emphasis) facilities near Shanghai. The facilities were mostly idle. They will be supplying forgings to every other bearing manufacturer in China. While visiting other manufacturing facilities, it was not uncommon to go by acres of new housing (apartments, etc.) and store buildings. In Shenzhen, we drove by one mall which must have been a mile long. Here is an example of using Labor with no near term demand. If Demand does develop, China will make one huge economic leap. China’s infrastructure and capability will surpass the US.
Back to my earlier points, you can even do the what ifs in a plant. If demand increases and the plant does nothing to improve throughput and remains the same with Labor and equipment, it can still run for a period of time utilizing the slack time used to maintain capital equipment and the weekends of Labor. It would be similar to what took place pre-2001 recession when the economy overheated and Participation Rate increased to 67+%. Those were heady times. I understand if this is beyond what you may consider as within your scope. I often times just read, absorb, and digest.
I guess I am not sure why you are taking it as personally as you detailed here; “so to have someone so blatantly abuse it really bothers me” Edwards comments? Not a right or wrong declaration; but, people often times start with an Assumption to arrive at a Conclusion. It should not bother you that he is willing to discuss it. He also may not change his belief or his thoughts.
Regarding Keynes make work concept:
The treasury’s notes would have to be based on something. Basically it is the value of the nation. As money is created when the banks loan, someone/thing requesting a loan is doing so figuring on wealth creation, not simply a profit from the difference of D minus Z. That profit in time morphs into wealth.
Simply printing and burying treasuries to be dug up by employees of an entity that has paid a lease has created or added to wealth in what way? The value of the labor of the digging? Or was Keynes suggesting the treasuries have inalienable wealth divinely endowed? And if it was houses built instead, how many houses get sold if we wait for the ability of those to buy them for when the capacity of the building workers to be utilized such that they receive a greater share of the treasuries that are funding the the purchasing of the houses?
At what point in this treasuries fueled process of creating wealth does unemployment start to decline if we have to wait for labor shares increase (which would be the means that would allow more purchasing of houses) to happen after unemployment begins dropping? And how does this work with declining labor pool effects on the resultant lower unemployment?
And then we get that confidence thing. A total intangible that in economics is treated as tangible. I’m not saying confidence is not a human emotion that does not get expressed via economic activity. I’m saying it has a basis and it’s expression does not stop at the boundaries economists define for their theories and models.
Basically, Kenyes model sounds like that which we call a bubble.
The problem with Keynes’ digging treasuries and Boddy, Crotty, and the rest is they all come from the starting point of money (ignoring Jazz’s desire to define money). Mind the money and assure it’s efficiency and all will be good with society. This would be true if the understanding of efficiency were founded in something more than increasing the total aggregate of money in it’s various forms.
I don’t know if economics just doesn’t get that society has a purpose for having an economy and thus does not know to go beyond simply modeling the economy on how money flows or if the real lack of backbone is in a fear that it will be found out to not be the profession they think they are if they included an all inclusive goal beyond simply understanding money. Just like banking thinks and has maneuvered to place it’s self outside and separate from the producing aspects of the economy, economics seems to think an economy exists outside of society.
Thus, labor share depends on lowing unemployment, increasing utilization, some entities expectations of profit and that all governing “confidence”? And it will all happen before the worker sees more money in their hands? Anyone remember my post noting that killing trust in this nation is what is killing our economy?
run75441,
China is a very large economy that is growing very rapidly. I’m certain there is a lot of seemingly odd things one can observe there but nevertheless this is still only of an anecdotal nature.
“I guess I am not sure why you are taking it as personally as you detailed here; “so to have someone so blatantly abuse it really bothers me” Edwards comments? Not a right or wrong declaration; but, people often times start with an Assumption to arrive at a Conclusion. It should not bother you that he is willing to discuss it. He also may not change his belief or his thoughts.”
I see no problem with calling for higher labor share of income. But I have a problem with people saying just about anything and everything if they think it will achieve it.
Edward Lambert:
1) Routinely cites people as evidence for his views, when on closer inspection their views are almost always the opposite of his own.
2) Has misappropriated terminology implying his views are the same as the people from whom he took the terms.
3) Cited empirical research and yet constructed a model with assumptions that totally contradict that research.
Lambert’s latest call for “re-breaking” the economy is, quite frankly, way over the top. I’m a little shocked at how people seem so willing to defend Lambert no matter what he does.
Mark:
This statement “so to have someone so blatantly abuse it really bothers me” was your comment in an earlier post of yours.
As far as China fleshing out infrastructure by keeping Labor busy, show me where I am wrong? I am not the only one to claim this. Others have also claimed China is keeping Labor active building infrastructure. I have provided an eyewitness account of the miles of unoccupied infrastructure being built to keep the Chinese people working in and around Shanghai and also Shenzhen. Google it if you choose not to believe this China/Asia traveler who does this in business. It is the proverbial burying of glass bottles of Yuan-Renmin and having Labor dig it up, which I believe someone else brought up in the blogs frequented or perhaps it was you. I am kind of wondering about your knowledge base now.
Sadowski
I don’t think we should re-break the economy. Due to a typo “it it” should have been “if it…” you may have thought that’s what I was saying. I was saying that ignoring those who SAY it will break the economy may be both sound negotiation and sound economics.
I think Lambert is on the wrong track here, and certainly wrong on the politics. But between us I’d rather see a little clearer understanding of what he is getting at than simply having a fight about it.
run75441,
“As far as China fleshing out infrastructure by keeping Labor busy, show me where I am wrong?”
Who said you were wrong? I said it was anecdotal. It’s trivially true but of absolutely no intellectual significance.
Incidentally China’s nominal GDP (not real) doubled from 2007 to 2013 and doubled before that between 2002 and 2007. So not only is capacity increasing at a very rapid speed, aggregate demand is as well.Anything you saw unused, say a year ago, is probably being used by now.
Mark:
This is from December 2013 and February 2014. It is true and you are making assumptions you can not support. There is much going on there that is not any where near capacity. Those same two plants I saw in December were the same in February . . . barely used.
From where do we gain the confidence that we have the knowledge, political will, or capability of doing a better job of “setting the bone” the next time around? Capital was easily able to assert its primacy over labor the last time. What makes anyone think they wouldn’t be able to emerge in an even better position if another crisis ensued?