I am of the opinion that the economy is overshooting its natural sustainable level at the moment. There are problems that can occur from that. Below I give a warning from the field of Population Ecology.
Stocks are rising to records partly on the back of a lower labor share in 3rd quarter 2014, which today was adjusted down from 97.3 to 96.2 (non-farm business sector). That is a big adjustment. The profits seen in the stock market are partly based on a big hit to labor share.
Along with the hit to labor share, firms are stepping up hiring in an effort to support profit rates.
You see some talk that maybe the Fed will start to raise its base rate earlier in 2015. From Tim Duy…
“They (the Fed) may be less pleased that stocks keeps hitting record highs as it suggests that financial conditions are easing somewhat, thus perhaps necessitating a faster pace of rate hikes. Over the longer run, I remain wary of the flattening yield curve.”
So the economy is gaining great momentum with nominal rates still at the zero lower bound. Are we overshooting?
The Principle of Overshoot
In the field of Population Ecology, there is a principle for overshooting the carrying capacity of an environment. Population can be sustained at the carrying capacity of an environment. The idea of overshoot is that if the carrying capacity is exceeded too much, the environment will be damaged and carrying capacity will collapse. What does overshooting look like? (source 1, source 2)
The carrying capacity would be like the natural level of output for an economy. If the economy is pushed too far beyond it, we could actually do damage to the economy, such that potential output would drop even further afterwards. The next recession would be that much more grueling.
I know Krugman and others push for overshooting saying that the risks of tightening monetary policy too soon outweigh the benefits. But overshooting has a great risk too. And Krugman acknowledges that we do not know where the natural level of potential output is.
Is secular stagnation the result of overshooting sustainability with years of bubbles before the crisis? Maybe, but I think the drop in labor share is more to blame. However, we still need to be careful that policies are not causing a tremendous overshoot.