Fall in Capacity Utilization reflects the Effective Demand Limit
The Effective Demand limit upon the economy is not a very visible concept in the econo-blogosphere. Yet, it represents a limit upon the utilization of labor and capital toward the end of a business cycle. When real GDP reaches its effective demand limit, normally we would see capacity utilization peak and start to fall.
Capacity utilization has now fallen for 5 months straight with the new data released today.
So does this continued fall in capacity utilization reflect the effective demand limit? From my own measure using profit-maximization estimations… yes.
Here is a graph which plots employment (1 – unemployment rate) with capacity utilization.
The graph shows the path to increasing profits in the economy. Profits increase as the data approach the effective demand limit and the profit max lines. Employing more capital and labor increases profits. When the limit lines are reached, then profits increase by rising up and to the left on the profit max line where capacity utilization falls while employment rises.
Profit potential is measured by this equation…
Profit potential = (U + C) – a*(U2 * C2)
U = (1 – unemployment rate)
C = Capacity utilization
a = effective demand limit – 2.473 * effective demand limit + 2……. (I have been estimating the current effective demand limit around 75%.)
Back in December 2014 I wrote (link) that the data in the plot above had reached the effective demand limit and that I would be watching to see if capacity utilization started to fall. Well, capacity utilization has fallen every month since. I explain the fall by the graph above.
The graph implies that the economy has reached my estimated effective demand limit and is now reducing capacity utilization to push profits higher. However, pushing profits up by reducing capacity utilization, as looks to be happening, is a delicate situation. The economy develops some instability and creative measures have to be taken to keep the economy out of a recession. It is also a time that bubbles can more easily form.
Nope, it reflects the correction in energy prices. IMO, April was the bottom.
John Cummings wrote: “Nope, it reflects the correction in energy prices. IMO, April was the bottom.”
Do you mean the bottom for energy prices or the bottom for the economy?
I think that John means the bottom of the fall in capacity utilization. He would then expect capacity utilization and employment to rise together now… which they may do for a quarter or two.
It could also be signaling the arrival of the first ripples from China’s belly-flop.
I think you’ve previously shown the effective demand limit being reached at around the current level of gdp , and then flattening out going forward , with only a very slow growth rate. Is this what you project now , absent the labor share rising significantly to give a boost to effective demand ?
The reason I ask is that I’m hearing stories of an expected improvement in residential construction. Since wage gains to date provide no reason to expect such an improvement , I’m wondering if some new financial “innovations” may be in the works to juice the construction sector and gdp.
Since the crisis we’ve been maintaining a relatively stable overall nonfinancial debt/gdp ratio. It would be a shame if we got back on the leverage bandwagon again to goose growth when it could be done more sustainably , not to mention more justly , by raising workers’ wage share.
Real GDP will still rise at the effective demand limit because it is a steady growth state. But the state can be made unstable leading to a recession.
I am doubtful that we will see sufficient wage gain around full employment… the standards are too low for economic health. You have low interest rates to favor business while labor gets weaker and weaker. Capital has so much power…
But I see the zone for a recession opening up toward 2016. The economy is unstable just like Larry Summers has just said… One moderate shock could put the economy into a recession… but the economy can hold out for at least 2 quarters more without going into recession. But a very strong shock could do it soon.
More likely you will have a credit boom rather than a recession. Don’t forget, capitalists have increased their investment into equities in May to counter the oil price decline, imo was not wise. Overreaction to a ‘slump’ that imo, is over.
Capitalists control the credit cycle. This is like saying a recession is coming in 1996, yet capitalists did the same damn thing in 1995 to stem the correction.
You are right that now would be the time to try and generate a credit boom. But how big can the boom be? Could it be nearly as big as the previous booms?