Labor Share adjusts up as Profit Rates adjust down
Oh, the low tide.
When an update to Labor share of national income is released by the Bureau of Labor Statistics, it does not make headlines. Yet, it gives insight. The BLS released today their revised Productivity and Costs report for 1st quarter 2014.
In the 1st quarter of 2014, the non-farm Business Sector Labor share index was revised up from 97.2 to 97.5. When labor share rises, the implication is that profit rates decline. Here is how I see profit rates. The most recent data shows that profit rates fell, but they have been holding fairly steady near the peak since 4Q-2011.
Even though the BLS report does not mention labor share directly, there are other data given… (% is for change since 1st quarter 2013)
- Productivity… rose 1.0% over the past year.
- Output… rose 2.8%.
- Labor hours… rose 1.7%.
- Real hourly compensation… rose 0.9%.
- Unit labor costs… rose 1.2%.
Unit labor costs = Real hourly compensation/productivity
Change in Labor share = change in unit labor costs – change in inflation
Since unit labor costs rose less than inflation over the past year (1.2% to 1.5% respectively), labor share actually fell over the past year.
- Labor share… fell 0.23% from 1Q-2013 to 1Q-2014.
Profits have been good for business with a 2.8% rise in yearly output and a 1.2% rise in unit labor costs.
What do I expect going forward?
Productivity will not rise much because it is against the effective demand per labor hour limit. Real hourly compensation is rising very slowly (only 0.4% annual rate from 4Q-2013 to 1Q-2014). So unit labor costs may tick up slightly. I foresee inflation staying steady or even ticking down a bit toward 1.3% on a quarterly basis. Thus labor share will continue to rise mildly.
So what will happen to the profit rates?
Profit rates have hit their maximum for the past 2+ years. But will they go down? Well, looking at labor costs, higher profit rates will hold steady. But let’s break this out.
Profit rate = (1 – labor share)*GDP Output/Capital
Profit rate = (1 – unit labor costs/inflation)*productivity * labor hours/Capital
- As unemployment comes down, labor hours should go up. That increases the profit rate holding all else equal.
- As unit labor costs rise slowly and inflation falls slowly, profit rates decrease.
- Since productivity is constrained by the effective demand per labor hour limit, it will not give much of a boost to profit rates.
- If capital can be contained, profit rates would tend to rise. So there is an incentive to control expansion of capital, unless capital can lower unit labor costs and increase productivity.
Considering 4 things…
- Profit rates have peaked
- Labor share has bottomed out
- Productivity has stalled
- Capacity utilization is low
… increases in capital will not be made profitable by lower labor share as they have in the past. So, the key to profit rates now is to raise labor hours holding all else fairly constant. Thus firms have an incentive to hire in an atmosphere of controlled unit labor costs, stable inflation and constrained productivity. Unemployment is coming down but unit labor costs are being strictly controlled and productive capital investment is moderate.
The important thing here is… How long can firms keep unit labor costs controlled? The protests for higher wages are growing.
What is the problem that can bring down profit rates?
Firms do not want to see their profit rates fall… even though their aggregate profit rates are very high already. If profit rates start to fall, asset prices will fall. This will have a cascading effect to investment and consumption. The problem is that asset prices are dependent upon very high profit rates which are based on a historically very low labor share. This situation is unsustainable. People are demanding higher wages because they are struggling terribly. Moreover, government assistance increases to make up for low wages. There are calls for higher taxes on capital.
Even if labor share rose and profit rates were to back down from 9% to a more sustainable 8% (which is still high historically), asset prices would fall and there would be a negative cascading effect upon the economy.
Profit rates just simply went too high and labor share went too low. Bringing these back into a sustainable balance will trigger an unstable financial situation, which would likely produce a recession.
Just why would decreasing asset prices produce a negative cascading effect in the economy if that decrease was generated by an increase in the labor share with its increase in demand? The holders of those assets have shown for the last four years that they have no plans to do anything with them and many of those assets sit outside the US anyway. Unless the asset holders were demonstrating a real interest in bringing much of the cash they hold back to the domestic economy for investment, the assets are a nullity in effecting flows in the economy. About the only asset class which might be affected is residential housing and the change in labor share would improve housing affordability and therefore provide some buoyancy to that sector.
PrahaP,
You ask a great question. You are right that demand is needed to keep the business cycle alive. However, high profits and high asset prices have led to a lot of consumption by capital income. Once profit rates decline due to higher labor share, you will see that demand will not actually increase. When you are at the end of a business cycle, there is a zero sum game. What labor gains, is capital’s loss.
You would see some buoyancy in the housing sector. Yet, at the cost of lower profit rates. The stock market is already high without substance. Stocks rise on low volume. There is less substance in the data to warrant higher stock prices.
Basically, capital income has been so strong, that it has been driving the business cycle with its own strong consumption. Even when labor begins to start their own business expansion so to speak, capital income will be ending theirs. And capital income has been so strong that it won’t take much decline in capital income and profit rates to slow down the economy.
And once firms see that labor share and unit labor costs are rising, just watch the reaction from capital. They will protect their own wealth as they back out of the economy.
Edward Lambert,
From your comment above to PrahaP:
“Basically, capital income has been so strong, that it has been driving the business cycle with its own strong consumption. Even when labor begins to start their own business expansion so to speak, capital income will be ending theirs. And capital income has been so strong that it won’t take much decline in capital income and profit rates to slow down the economy.”
You seem to be underrating the impact of the probable increasing M2 velocity as labor share increases.
M2 velocity is currently at historic lows:
http://research.stlouisfed.org/fred2/series/M2V
Consumers can not spend what they do not have, and producers will not produce what they can not sell.
So we will have a recession whether profit rates fall or not.
Hi JimH,
If velocity increases, will you see a rise in inflation or a rise in output?
Producers are selling to the rich who are consuming quite a bit with their income. The rich are capable of suddenly protecting their money and closing the spigot of their consumption, even as labor consumes more. We cannot assume that as labor share rises, and capital share falls, and stock prices stop rising, that capital income will continue their consumption spree.
And can we have a recession if profit rates don’t fall? Keynes implied through his description of effective demand that the maximization of profit rates marked the end of the business cycle.
So it seems that a recession just about requires that profit rates peak and fall back some. There are other indicators of recession like the change of total hours worked from quarter to quarter.
Check out this graph where recessions are quite recognizable.
http://research.stlouisfed.org/fred2/graph/?g=CBp
reply to link from Naked Capitalism
I watched the video of Dean and Bob… and I heard them say one thing… That it is not understood why unemployment has come down so fast.
The answer is in the equation above…
Profit rate = (1 – unit labor costs/inflation)*productivity * labor hours/Capital
Increasing labor hours when unit labor costs are controlled and productivity is constrained will increase profit rates. So there is currently an incentive to increase hiring.
Also, once labor share stopped falling, profit rates had to look for another variable in that equation in order to rise or at least not fall. They found increasing labor hours as the answer.
Yet, if labor starts to become more costly, growth in labor hours will slow down to preserve profit rates.
New Deal Democrat has a response to this post…
http://bonddad.blogspot.com/2014/06/of-corporate-profits-progressives-and.html
Edward Lambert,
Velocity = GDP / M2
Therefore: GDP = M2 x Velocity
So I expect GDP to increase with an increase in velocity.
I believe that consumption by the bottom 90% far exceeds that done by the top 10% who choose instead to invest or save. Remove some of the money from the capital investment pool and give it to the bottom 90% and most of it will be spent over and over again in the economy. That is velocity!
Surely you have not come to believe that the wealthiest Americans all need 10,000 pillows or automobiles or homes.
If your theory about the spending of the rich were true then velocity should be at normal levels. INSTEAD VELOCITY IS AT RECORD LOW LEVELS.
As to your graph, it certainly does not surprise me that hours of work fall just before or just after a recognized recession occurs. Profit rates might peak but that is not required to cause negative growth of GDP.
And lastly, you and I both know that we are headed for a recession.
JimH,
Yes, a recession is looming out there. We are not close yet. Another 6 months of data will help forecast when.
Yet, I want to reply to your equation about GDP = M2 x V
If you have a small group like the 1% spending a lot, you will have lower velocity, because the money does not have to pass through as many hands. So you say that moving that money to more hands will increase the velocity. And GDP will rise.
Now my reply is that GDP has a constraint from effective demand. At the constraint, if you increase velocity, you will see an increase in prices instead of output. An increase in prices will increase profit rates as long as unit labor costs rise less.
So there can be a chase by firms to keep prices rising faster than unit labor costs. But if there are constraints on inflation due to strongly anchored inflation expectations as we now have… firms have to fight just to keep unit labor costs from moving up, because they know inflation will not bail them out.
So what we have now is a situation where velocity is stuck. Inflation will not increase it. GDP will not increase due to an effective demand constraint.
So we come back to raising the effective demand constraint, which relies on a higher labor share. A higher labor share would put more money into more hands and raise velocity, but it also affects profit rates. And if inflation is out of the question, firms are stuck with rising labor costs. It is at that point in time that productivity must rise. If it doesn’t, effective demand continues growing and we have described the precursor of a recession.
Well anchored inflation expectations is actually a constraint on getting some relief from this mess.
You seem to be saying that at best an increase in labor share will only offset the falling demand brought on by a decrease in capital profits. How is such an exchange a bad thing? Your concerns regarding a possible recession resulting from falling asset values (if I understand you correctly) is not an observation, but a supposition. Beware the economist who supposes what the future holds in store.
I was assuming that the money removed from the capital investment pool would be paid to labor which would raise labor share and thus raise the Effective Demand Limit.
If businesses insist on raising prices so as to maintain their profit rate then nothing has been accomplished except to start inflationary cycles such as occurred when oil prices were continually increasing in the 1970s.
Capital will have to except a lesser share or production will have to be moved back to the USA or our economy will continue to spiral downward.
Our circular flows have not been large enough to support our economy after production was moved overseas. This is our most fundamental problem. This problem has been masked by consumers taking on huge amounts of debt. Consumers can not take on much more debt and total household debt is slowly stabilizing. (In the aggregate) Now the amount of money in the circular flows have to be increased or we spiral downward.
We have been here before.
Beginning in about 1920 our capability to produce new types of durable goods exceeded the American consumer’s capability to pay for them. (Mostly farmers) They resorted to the newly invented installment credit, until they exceeded their ability to take on more debt. Sales of some durable goods slowed even before the October 1929 stock market crash. (Credit Expansion, 1920 to 1929, and its Lessons – Charles E Persons – Quarterly Journal of Economics – November 1930 Pages 94 to 130)
Professor Charles E Persons’ article was very difficult to get but it should be available from any university library. It is a very interesting read.
The end of his last paragraph is especially telling:
“Once the newly developed credit resources reach maturity, new debt created is balanced by installments due on previously assumed obligations. The nation can buy only such volume of goods as is covered by its current income. The check to expansion is sharp and is intensified by the excesses inevitably associated with periods of over-rapid expansion. Such a course of events is clearly proven by the evidence as to credit expansion in the period 1920 to 1929. The depression into which the nation fell in the latter years was undoubtedly due in part at least to these developments in our complicated economic structure. Manifestly these events are too recent and our records too incomplete to attempt to measure their relative importance as compared with other factors of great weight. But there can be no doubt that their influence was large.”
The economist Irving Fisher agreed with Professor Persons assessment.
The fundamental problem in the 1920s was that consumers did not have the funds to afford the newly invented durable goods being produced and marketed. But they wanted them. Electric refrigerator sales were 11,000 in 1922 and rose to 630,000 in 1929. (An increase of about 56 times in 7 years) Automobiles produced were 2,646,229 in 1922 and rose to 6,456,000 in 1929. Now add the increase in sales of vacuum cleaners, electric irons, ironing machines, washing machines, and sewing machines. The demand was there but the funds were not, thus the new fangled installment credit. This credit fostered a build up of factories until consumers credit limit was reached. Then came the Great Depression.
Hi Jack,
Normally increasing labor share toward the end of a business cycle is not a bad thing. Firms can raise prices to offset rises in unit labor costs. Then firms can keep hiring to support the profit rate. Yet, inflation is now constrained. So, there must be an extra effort to contain unit labor costs.
There is a strong movement to raise wages. Still wages will be scheduled to rise slowly if they rise.
Today the Dow and the S&P closed on highs.
These highs represent high profit rates. Do you expect profit rates to rise? If they fall, stocks will fall with them. How do you think the Chinese housing market would react to that? How about lending in Europe? How about Brazil and India? How about investment in the US? Will the push back against higher wages intensify? Do firms consider a 9% aggregate profit rate as the new normal? And anything below that as poor performance?
We have an economy that is more top heavy than we have ever seen since the depression. And there are constraints that make the situation more fragile, like low and stable inflation, like an unemployment rate higher than normal.
Capital income is becoming dependent on profit rates, while in 2013 they relied on rising asset prices. Well, asset prices are not rising the same in 2014. So profit rates become even more important to capital income cash flow. thus, you have to watch profit rates even more closely.
A supposition is a guess, an uncertain belief.
Yet, it is not a supposition when you describe the dynamics of your supposition. Then it becomes a model to guide how you forecast the future. I am saying that if labor share rises, and profit rates fall, there are dynamics that would most likely lead to a contraction in business relations.
JimH,
Yes… that is it.
Now your words… “spiral downward” echo in my head.
I am wondering if the next recession would be a spiral downward, or a fierce battle over national income between labor and capital.
I am thinking the fierce battle scenario. Are you seeing an uncontrollable downward spiral?
I see nothing as dramatic as fierce battles or an uncontrollable downward spiral. Just a slow descent, now that consumer debt loads have about reached their maximum. After all, it has taken us almost 30 years to reach our current predicament.
It seems to me that most predictions fail because they assume that corrective action will not be taken. But sooner or later there will be a correction of some sort.
Recessions have been getting deeper and lasting longer if judged by unemployment. The problem with the next recession is that the traditional Fed fixes will not be available and the national debt will limit other responses. But the federal government will have to do something.
JimH,
I hear you.
i will add that unemployment was slow to come down while labor share was dropping. That is because profit rates were rising “nicely”. Then when labor share bottomed out, we see unemployment falling faster.
But then that gives insight into the next recovery after recession. Can profits once again depend on a falling labor share? We would hope not right?
If labor share does not fall after the next recession, how will firms increase profit rates? Productivity will have to rise, or capital will have to fall, or labor hours will have to rise, or inflation will have to rise faster than unit labor costs.
The two most likely candidates are a faster rise in labor hours, rising inflation and a drop in total capital value.