Productivity, Recessions & New Levels of Productive Capacity
Noah Smith provoked a conversation here at Angry Bear by wondering what causes recessions. Recessions are not such a mystery when you see the interaction between effective demand and such things as productivity.
The conversation took place in the comments section of a previous post on Productivity’s role as a cause of recession. The issue is whether increasing productivity causes recessions, as opposed to tight money policy or something else.
Truly, a recession is caused by a blend of factors, including monetary policy, effective demand, vulnerable profits and pressures in the economy from an urge to increase productivity. Yet, here I want to show a graph of productivity gains since 1967. I will use a graph previously posted. (link) The graph shows real GDP on y-axis, and utilization of labor and capital on x-axis to represent expansions and contractions of the business cycle.
In this graph, we see how real GDP jumps to a new attractor level after a recession. (Recessions are seen when the plot goes to the left.) Each new attractor level points toward a higher and identifiable productive capacity. Surely, productivity needs to increase in order for the economy to jump to new levels, right? Well, we can visualize when productivity jumps in this process of jumping up to higher and higher levels of productive capacity.
For each data point of real GDP, I change its size to represent the productivity growth over the preceding year.
What do we need to see here? The larger bubbles show larger increases in productivity. You will notice that the larger bubbles primarily appear during those recessionary transition periods. (between the lines & to the left)
So are productivity gains “causing” recessions? Well, they are part of the dynamics that cause recessions.
Many people are concerned about low productivity at the moment. Yet, we can expect productivity to increase through the next economic contraction. Is that saying that pent up productivity will cause the next recession? Well, pent up productivity gains are part of the pressures that cause recessions, in combination with the changes of the effective demand limit. Pent up productivity gains are released through the recession process after effective demand expands. (see article below)
When effective demand (blue line) increases during an economic contraction, productivity (red line) increases with a bit of a lag. The times when productivity growth is low or zero, coincide with a tightening of effective demand. Basically, effective demand can be seen as a leading indicator of productivity changes.
Related Articles
Lambert, Edward. Relax DeLong & Krugman… Productivity advances will appear when there is demand space. Effective Demand blog. December 3, 2013.
Edward,
“When effective demand (blue line) increases during an economic contraction, productivity (red line) increases with a bit of a lag.”
1. Are you saying that consumers demand more products during an economic contraction?
2. Why would effective demand increase during an economic contraction?
JimH,
1. When effective demand expands, it is not that demand expands but the limit of demand rises meaning that there is lots of excess demand waiting to be used in the recovery.
2. Effective demand is a measure of the spare capacity limited to a business cycle. And spare capacity expands during a recession and then gets smaller during a recovery.
Edward,
Two more questions.
“1. When effective demand expands, it is not that demand expands but the limit of demand rises meaning that there is lots of excess demand waiting to be used in the recovery.”
First question, are you using ‘limit of demand’ as shorthand for the Effective Demand Limit as you originally defined it?
“2. Effective demand is a measure of the spare capacity limited to a business cycle. And spare capacity expands during a recession and then gets smaller during a recovery.”
From: http://economics.wikia.com/wiki/Effective_Demand
Demand is the quantity that consumers are able and willing to purchase at each conceivable price. Strictly speaking this definition describes effective demand, as opposed to latent demand when a customer/consumer is unable to satisfy their demand, whether it is due to lack of information about the availability of a product or due to lack of money.Or Effective demand is the “ability” to pay for goods and services.:
From: http://smallbusiness.chron.com/difference-between-demand-effective-demand-17957.html
“Effective demand is a representation of the actual amount of goods or services that buyers are purchasing in a given market. Effective demand is the difference between notional demand and latent demand. Effective demand is a reflection of the extent to which buyers’ income, perceptions and needs combine to result in an actual purchase rather than a mere desire to purchase.”
I have been assuming that effective demand was as the 2 definitions above define it. And they are using ‘latent’ for something like your ‘spare capacity’. Either seems a bit mysterious to me, demand either exists or it doesn’t. Perhaps both are bookkeeping entities.
Second question, are you using some special definition for effective demand? (Some sort of jargon)
This would explain why I am having difficulty understanding.
JimH,
1. I define effective demand as Keynes defined it. It is a limit that can keep the economy from reaching full employment. In essence it is the limit that defines the level of full employent that a business cycle will reach.
2. You have expressed demand. That is what people buy. Then you have latent demand beyond that up to the effective demand limit. So if you subtract expressed demand from the effective demand, you get latent demand….. but I express these demands in relation to spare capacity. Like this…
Expressed demand = labor and capital being utilized
Latent demand = spare capacity
Effective demand limit = full employment of labor and capital
Edward,
So when you say Effective demand, is that the same as Effective demand limit which you have defined with a formula?
JimH,
Yes.
“Surely, productivity needs to increase in order for the economy to jump to new levels, right?”
Perhaps, but your graphs also show that it does not need to jump to get to a new level. Productivity can simply increase as the entire economy grows. Competition can be the reason low productivity activities dissappear.
When I was looking at graphs after the other post, I see that a decreasing number of hours worked is an excellent indicator of a recession. It preceeds the recession and continues after GDP satrts to recover. Whe number of hours worked decreases without consumption decreasing, it is going to calculate out as an increase in productivity, but it is also going to lead to reduced labor share and reduced demand.
“Effective demand is a measure of the spare capacity limited to a business cycle”
I think your calculation of effective demand is interesting, but not what Keynes was talking about. To Keynes effective demand was defined at an equilibrium point. Your calculated values when we are not near equilibrium are something other than Keynes effective demand. That is one of the stumbling blocks – those peak values don’t seem to be particularly useful.
People like Krugman and Baker are proposing solutions which they believe will increase labor share, which will increase aggregate demand, and which will incidently increase your effective demand without a recession. They may not believe we are near the limit as you do, but they don’t need to care if they believe that the limit can be changed.
Arne,
1st comment… However productivity increases through a recession, the point is that those productivity gains are incorporated as the economy recovers by increasing labor hours and capacity utilization.
2nd comment… Keynes saw effective demand as a limit that would make the economy fall short of full employment. Those peak values will settle into a constant effective demand limit fairly soon after a recession. For example, using my equation for effective demand, we could have seen the topside of the business cycle forming back in 2009-2010… I was able to predict the topside of the stock market early last year once I had the equation. My prediction also showed that the economy would fall short of full employment. Keynes described this effect due to insufficient effective demand.
The ED limit can be changed. We saw it happen in the late 90’s. However, Krugman’ and Baker’s solutions are not going to raise effective demand this time. They are counting on dynamics that existed in the past to raise real wages at full employment. Basically they expect full employment to return, but I see the economy will fall short of full employment. So we will not see sufficient rises in real wages.
The problem.is that profit rates have peaked and are vulnerable to declines. It is.hard now to expect sufficient wage gains. In the late 90’s, profits were rising, so there was room to raise wages without collapsing profit rates. That advantage does not exist now.
What most supports my theory of effective demand is the fact that the limit is holding firm in spite of very unusual monetary policy that does not recognize an effective demand limit.
I think monetary policy would have been different if the effective demand was understood and foreseen. Monetary policy would have been more in sync with the true business cycle.