Dean Baker understands Effective Demand
In a piece yesterday called High Asset Prices, the Savings Glut, Secular Stagnation, and Unemployment, Dean Baker wrote…
“The idea that the economy could be subject to an ongoing problem of inadequate demand used to be grounds for eviction from the realm of serious economists. But anyone who is willing to look at the evidence with a straight face really can’t escape this conclusion.”
This idea of inadequate demand is not crazy. Keynes said that weak effective demand could keep the economy from reaching full employment.
“This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.” (source, General Theory, Chapter 3)
So Dean Baker shows us that he understands the nature of effective demand to limit economic output and the utilization of labor.
Baker has been writing this for a long time. He also writes that the way to increase demand is for the US government to spend more money, and that since the economy is well below potential GDP (in his view), there wouldn’t be the negative effects (like inflation) that large deficits otherwise could cause. I think he would agree with the desirability of increasing labor share, but I haven’t ever seen him suggest that this is necessary for government spending to increase GDP. So I have assumed that you disagree with Baker on these matters.
Unfortunately for us, there are many schools of economic thought. So any politician who wants to continue with old tried and true economic tools will have plenty of support. (Well, ‘tried’ anyway.)
We have only been at this since December 2007. The wealthiest Americans are not ready to admit defeat yet! Perhaps after another decade or two, there will be some real change. (Or perhaps after a decade and a few riotous demonstrations.)
Dean Baker spends 2 paragraphs exploring government spending and 2 paragraphs on reducing the trade deficit. Government spending on the necessary scale would be temporary at best and it has already been tried. And the workable method of controlling trade deficits by using tariffs has become passé.
As a side note, only a fool could believe that the US can devalue the dollar faster than China or other south east Asian countries can devalue their currencies. We are the reserve currency because the rest of the world wants it that way.
We could do something to help our current lack of demand problems. The key is wiping out un-payable debt, we should make debt slavery go away.
In 2005, the bankruptcy laws were changed to favor debt holders. We should reverse all those changes but we should also liberalize bankruptcy even further. This would force lenders to be very selective about borrowers.
WE DON’T NEED MORE CREDIT TO FINANCE PERSONAL CONSUMPTION EXPENDITURES, WE NEED LESS! Consuming future income is completely out of control. How many people are flushing 10 to 20% of their disposable income down the drain? (With compounded interest it is probably higher than that.)
After the initial crisis, everyone would be better off except the financials.
This won’t be a magic cure, but it would help and it would not increase the national debt. Better to light one candle than to curse the darkness.
Mike B,
I have some disagreements with Dean Baker.
His view is that we only need to spend money to get out of recessions. his view is to just raise aggregate demand. But Keynes said that there is an effective demand limit to aggregate demand. Dean does not understand this point yet. He seems close though.
I had a twitter exchange with Dean last year, and he said the way to get out of recessions is to spend money… and he said that the prior recessions were brought on by the Fed raising interest rates to slow inflation or to burst bubbles. He thought neither would be likely this next time.
Yet, I see the likelihood of bubbles forming increasing this year as the effective demand limit is reached. The effective demand limit was reached in 2006, 2 years before the recession. There were 2 years of allowing bubbles to get out of control. I disagree with Dean on this one. I do see the Fed stopping bubbles earlier this time.
Yet, Dean says that spending is the answer. Yet, that just hurries you along toward the effective demand limit.
Dean would agree that labor share needs to rise, but he doesn’t make the connection to effective demand. Even though he understands the nature of effective demand, he doesn’t make the connection to labor share, but rather to spending.
Labor share is a more abstract way to understand effective demand. So far the economy is following the labor share view of effective demand quite well.
JimH,
Clearing out debt is needed. And you are right on about devaluing the dollar.
Your points on govt spending and controlling trade deficits are spot on.
I did not want to criticize the solutions that Dean gave to insufficient demand, but rather show that he understands the concept of demand limiting the economy. and that other economists have not accepted that view.
I am not an economist although I studied it a long time ago, but isn’t the problem income inequality and the 1% reaping all the benefits of international trade and productivity increases? It is not like we are suddenly a poor country. We are a very rich country which would be even richer if we fully utilized our resources–capital and human–and Edward’s lack of effective demand is holding us back because too many people remain unemployed and too many people who are employed are not making enough money to support themselves and would not raising the minimum wage go a long way towards solving all those problems?
When is the last time that labor share consistently increased over say a 10 year period?
10 years is almost certain to be an eliminating limit, let’s say 3 years, if that’s ever happenened.
“effective demand is holding us back because too many people remain unemployed and too many people who are employed are not making enough money to support themselves”
Not what Edward is saying.
Actually, too many people who are employed are not making anough money to buy thier share of what is produced.
I am sure it would horrify Republican economists, but a direct result of Edward’s model is that (you can be in a position where) you can tax away profits, use it to increase demand, and it will cause the economy to grow. I observe that by the concept of deadweight loss we will all be worse off because we will be consuming “too much” compared to the amount that “efficient markets” would have produced.
I think that the reason that Edward cannot get Baker or Krugman on board is that Edward has not described a mechanism whereby policies cause effective demand to depend on a constant (0.78*labor share).
Arne: “I think that the reason that Edward cannot get Baker or Krugman on board is that Edward has not described a mechanism whereby policies cause effective demand to depend on a constant (0.78*labor share).”
That is a very good point.
I believe that the underlying mechanism of Effective Demand Limit is a side effect of labor share. As labor share is decreased, the velocity of M2 also decreases and visa versa. That happens because labor share, as opposed to capital, is much more likely to be spent immediately into the consumer economy where part of it goes to labor share and gets spent immediately again etc, etc, etc.
And not so coincidently we are now seeing record low velocity levels:
http://research.stlouisfed.org/fred2/series/M2V
Arne,
Excellent clarification.
We are watching the mechanisms in real time. We see compression of certain data. Profit rates have been compressed. Productivity has been compressed. Utilization of labor and capital have been compressed. Yet why do these compressions occur at the constant 0.76*labor share index?
Like you say, others want to see how that could happen.
JimH,
Velocity is definitely a part of the picture. Yet does velocity itself have a lower limit? What constrains that limit?
Velocity = GDP / M2
I assume there is no theoretical limit on the high end for Velocity. There probably is some practical limit but I don’t know what that would be. Probably something to do with high velocity not leaving enough in capital for investment.
Assuming that GDP can not go lower then M2 then the lower limit on Velocity is 1.
Can you think of anything beyond that?
Definitions:
M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.
M2 consists of M1 plus: (1) savings deposits (which include money market deposit accounts, or MMDAs); (2) small-denomination time deposits (time deposits in amounts of less than $100,000); and (3) balances in retail money market mutual funds (MMMFs).
Gross domestic product (GDP), the featured measure of U.S. output, is the market value of the goods and services produced by labor and property located in the United States.
I was concerned about that constant x labor share from the beginning but I thought I saw some explanation on your website. It has been a while since I checked that.
I came to the conclusion that this was a constant to get to 2005 or 2009 dollars.
Does this still apply:
http://effectivedemand.typepad.com/ed/2013/03/what-is-effective-labor-share.html
Especially see item number 8.
In item number 2 you were using Effective Labor Share = .78 x labor share. Which would imply that it is not a constant since you are now using .76?
Also see this:
http://effectivedemand.typepad.com/ed/2013/03/why-078.html
Also see this:
http://effectivedemand.typepad.com/ed/2013/05/the-price-spaces-of-the-effective-demand-model.html
“The 0.78 is just a conversion from 2005=100 to effective values in relation to capacity utilization.”
Also see this:
http://effectivedemand.typepad.com/ed/2013/06/proof-of-effective-demand-incorporating-unemployment-and-nairu.html
“By multiplying labor share by 0.78 we obtain the central tendency line. (See previous post.)”
Also see this (7/02/2013):
http://effectivedemand.typepad.com/ed/2013/07/3-ways-to-calculate-productivity-effectively.html
“Why do I multiply labor share by 0.78 to get effective labor share? It is the central tendency line in the plot of capacity utilization with the Business sector labor share index with a y-intercept of 0. But let’s apply effective labor share to the graphs for productivity and see what we get.”
Also see this (8/20/2013):
http://effectivedemand.typepad.com/ed/2013/08/circular-flow-comparisons-for-labor-and-capital-incomes-past-and-present.html
“The rest of the numbers have benchmarks in the data, but they need to be able to adjust to the “effective” adjustment. For example, labor saving will be a little different, but close to, the official number for household saving, as opposed to domestic business saving. (The effective adjustment is now based on 2009 as the base year. The coefficient for “effective” adjustment is now 0.7657. When 2005 was the base year, 0.78 was the coefficient.)”
Also see this (10/19/2013):
http://effectivedemand.typepad.com/ed/2013/10/the-natural-rate-of-unemployment-in-the-cobra-equation.html
“Effective demand limit = (els)/x
x = capital utilization
els = effective labor share (This is determined by multiplying Labor Share index for the business sector by 0.766… 2009 as base year.)”
Jim:
Sorry, for some reason you needed approval to post this lengthy reply.
JimH,
In response to your thought on velocity, I posted another view…
http://effectivedemand.typepad.com/ed/2014/07/explaining-effective-demand-with-productive-capacity.html
Hi JimH,
I am just now seeing your lengthy comment.
The switch to 0.76 happened when FRED switched from 2005 base year to 2009. That changed the labor share index reference point. I went through some data and changed the coefficient until finally settled on 0.762. I have been using that number for quite a while.
The 0.762 is a conversion of the labor share index to a value that gives the central tendency of capacity utilization over time.
So effective labor share is really “central tendency of capacity utilization” as a function of labor share.
run75441,
It may have had something to do with the number of links too. I was trying to be complete enough to reduce the possibility of more comments.
Sorry for the length, and thanks.
Edward Lambert,
“So effective labor share is really “central tendency of capacity utilization” as a function of labor share.”
Wow, it will take some time to wrap my mind around that!
And now on to you new view.