Output is Normally Determined by Effective Demand

An article came out today by Ricardo Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas, called On the global ZLB economy, where they talk about how a liquidity trap scenario can spread globally.They see a high demand for safe assets over their supply.

“The growing global shortage of safe assets imparted a strong downward secular trend to world real (safe) interest rates for more than two decades. Capital flows acted as the propagating mechanism by which the asset-scarce regions dragged asset-rich regions’ interest rates down.”

This is a consequence of growing income inequality in the advanced countries, combined with the extreme inequality of China becoming more influential in global economic flows. High concentrated wealth and income lead to a higher demand of safe assets and less consumption demand.

They do not see any change in this situation coming soon. The correcting mechanisms are being blocked.

I wrote yesterday about why I use labor share as the over-riding factor in determining the limit on output according to Keynes. Labor share is the best approximation of current income for consumption from current output.

They say in their article that global output is determined by demand, once demand for financial assets exceeds their supply.

“Given the nominal rigidities, output is aggregate-demand determined as soon as the global demand for financial assets exceeds their supply, at the ZLB.”

From my research, the limit on output is always demand determined by the effective demand limit.

They recognize that part of the re-balancing of the situation is for incomes to come down.

“In our model, once real interest rates cannot play their equilibrium role any longer, global output becomes the active margin: lower global output – by reducing income and therefore asset demand more than asset supply – rebalances global asset markets. In this world, liquidity traps emerge naturally and countries drag each other into them.”

But the the problem is that inequality is not decreasing, so high incomes are increasing relative to lower incomes which fuels more demand for safe assets, which keeps the interest rates low and keeps them from normalizing and re-balancing.

So in the end, the drop in labor share seen since 2000 was the signal that the global liquidity trap was bound to happen. And especially the precipitous drop in labor share after the crisis was an extremely important indicator to warn of a persistent liquidity trap. Economists are only understanding this now. Yet, I saw this and wrote about it over two years ago as I began my research of effective demand. (link) In that post, I predicted…

“If labor share of income does not rise, the Fed rate will stay dead no matter what they try to do.”

So the article on the global ZLB is revealing what I have been saying for a couple of years. But more will be discovered in time about how effective demand operates.