Estimating Effective Demand toward a Recession
The new update to 3Q labor share came out today. The last two quarters were revised firmly upward. Investors may be concerned about profits after these revisions.
I have my own estimation of an effective demand limit upon a business cycle which is based on labor share, capacity utilization and unemployment. Labor share represents effective demand. The graph basically measures spare capacity as the difference between labor share and a composite of utilizing capital and labor. The more labor share, the more spare capacity can be utilized.
(link to graph and equation)
The current business cycle has followed perfectly so far my projection that the plot line would be limited by the zero lower bound, as has been the case for decades. Many well-known economists doubted my projection. So we may end up opening a paradigm shift in economic insight…
The question remains whether the plot line will bounce off of the zero bound again as it did before the last two recessions or start heading upward toward another recession.
The movement of the plot line above can be used in another graph to signal the probability of a recession. As spare capacity starts to rise after hitting the effective demand limit, the economy rides the edge of a recession.
When the plot drops below the yellow line, a yellow flag goes up for a recession. If the plot drops below the red line, we are in recession. The plot line dropped below the yellow line in 4Q 2012, but the economy hadn’t reached the effective demand limit yet.
Currently, the plot in the first graph has reached its effective-demand zero lower bound… and is near, but not below, the yellow line in the 2nd graph. So fingers on the yellow flag, but not raising it yet.
Gosh, Edward, given that the Fed apparently totally disagrees with you and appears to be on the verge of raising target interest rates because they thinks are going so swimmingly, maybe that will push the dollar up even higher along with crashing the housing construction industry and the stock market and who knows what all else so as to push us over not only your yellow line but your red one, and we shall have a recession and Donald Trump as president, something clearly we deserve.
Of course, It’s great that the Fed would disagree with me. They have been changing their forecasts constantly, right? My equation would have had the same forecast since 2011, but I only found it in 2012.
But the Fed still sees lots of spare capacity, but much of previous capacity is marginalized due to inequality and other reasons. So the effective demand limit is lower. They do not see it.
Realize, the Fed has no way to determine an effective demand limit years in advance… Just maybe, I can. Think of the possibilities.
Peterson’s Posen and Blanchard might be getting a clue , as they’re now pushing Japan to institute broad-based 10% wage increases for Japanese workers :
If they’d extend the argument globally , and suggest taking that 10% out of the hides of the top 1% , we might actually get somewhere. Don’t hold your breath.
Oops. I just noticed that you beat me to the punch with this , Edward , in your most recent post.
This graph posted by Sober Look seems to show a long-term deterioration in the U.S. business sector , as evidenced by the growing proportion of money-losing firms ( gray line – note higher highs and lows over time ) :
Does the recent rise in money-losers without any increase in default rates mean that we’re keeping zombies alive via forbearance , repeated refinancings at lower rates , etc. ?
I sense the approach of an end-game , but have no idea when it will arrive , or what it will look like. ( In other words , I’m perfectly suited to be the next Fed chair. )
Excellent work… I thought the same as you when I saw that graph. Zombies are alive.
The firms losing money rises before a recession. The lack of default alongside more firms losing money would indicate living Zombies. These are firms that should be defaulting in a “normal” cycle, assuming past cycles were normal and proper.
That graph would be good to follow as the Fed tries to raise rates. I would expect the default rate to rise.
Per the losing money without defaulting-
What is the distribution? How many small businesses are always on the edge? Is the reduced demand stemming from lower labor share enough to push them below zero? I would think that optimism about continued improvement would be the thing that would prevent them from taking the step of defaulting. Only the loss of confidence associated with a full fledged recession will make them give up hope.
yes, your insights are true, but they are general for any business cycle. The graph shows that this business cycle is different. The defaults are staying low while the losing money firms are rising. That didn’t happen in previous cycles.
I think/suggest that recession is an artifact of positive feedback on the rate of change of demand. As long as everyone expects the economy to be in slow motion, it tends to stay in slow motion. The underlying growth associated with population allows variation in firm performance without the feedback effect becoming very strong.
I agree with you. Expectations are critical. The slow motion fed upon itself, positive feedback loop. I remember a conversation I had after the crisis where a developer said that going forward, the key was to make money more slowly instead of quickly.
The other way to interpret the graph showing the growing share of money-losing businesses is by using a business analogy of “labor share”. When we speak of labor share , we’re really using a proxy for the bottom 90-95% of income earners – those whose consumption is almost entirely dependent on their earnings from labor , and who have been losing share of aggregate income over time , mainly to the top 1%.
A similar situation exists for businesses , as large MNCs have captured a bigger slice of the aggregate income pie. We’ve abandoned antitrust enforcement , resulting in control of more and more of the economy by oligopolies , putting the squeeze on small- and medium-sized enterprises ( SMEs ).
I suspect Edward’s labor share formula would yield similar results if it was constructed using ” SME share” instead.
Do you have some data to look at for the SMEs?
No , unfortunately , I don’t know of an easy way to compile such data. It must be available in some form though , since I’ve seen several articles that have discussed the trend of big business capturing larger shares of revenues , e.g. :
Graph of small business share :
On the other hand , this article suggests that SMEs are capturing a larger share of exports over the last decade or so :
You might be able to derive a useful measure of gdp share capture from the industry concentration data at Census , here :
The negative spread between unit labor cost and nonfarm business prices rose to 2.2% as compared to its’ originally reported 1.2% value.
Unit labor cost is up 3% and prices are up only 0.8%. this is a major driver of corporate profits and the news is getting worse.
Interestingly, S&P reports that 2015 operating earnings are expected to fall 5.6%, but excluding energy they are expected to rise 6.1%. Looking at this many think that all we need is for oil prices to stabilize and 2016 EPS could see double digit gains.
Does not look like that to me as I’m seeing numerous examples of weak pricing and margin pressures.