Re: Tim Duy… Brains need not explode
Tim Duy, who is a cool economist, points out a difference between the labor market and output GDP… Labor market improving while GDP is slowing. He describes this difference for the Fed.
“Now they have slow GDP growth and fast employment growth. That will make brains explode on Constitution Ave.”
Yet, Brains need not explode. I have had a model of this difference for a couple of years, which predicted perfectly this situation. Yet, my model ultimately shows that the business cycle has ended, which is something economists like Duy and others at the Fed may not accept.
The Cobra Equation
The driving force behind an effective demand limit is the aggregate profit rate. When companies have increasing profit rates, it is more difficult to have a recession. We have seen in the past year that the aggregate profit rate is falling. This is not a good time to be raising interest rates. It would have been better a few years ago. Anyway…
I gauge aggregate profit rates in 3-dimensional space with what I call the Cobra equation, because it resembles a cobra in 3-D space…
Profit rate = (U + C) – a*(U2 * C2)
U = (1 – unemployment rate)
C = Capacity utilization
a = effective labor share2 – 2.475 * effective labor share + 2
When I take the derivative of the equation, I can gauge the potential change of the aggregate profit rates. I can take the derivative with respect to C and U.
d profit rate/dC = (1 – 2aCU2)
d profit rate/dU = (1 – 2aUC2)
They look the same but in reality they take different paths. Here are the derivatives up to December 2015.
Basically the graph shows that the utilization of capital reached its max profitability towards the end of 2014, when the red line reached zero %. Businesses have squeezed all they can from capital in the aggregate. For capital, the business cycle is over. But hiring labor is still profitable, so as the business cycle hangs on, we will see improvements in the labor market.
This model predicted perfectly the path of utilizing labor and capital. Here is a graph plotting the Cobra equation. The utilizations of labor and capital reached profit maximization, slid along the max limit, and have since backed off which is setting the stage for a recession type scenario.
The Greater Meaning
The greater meaning behind this model is that the economy has already reached the top of the business cycle and the Fed is completely behind the curve for raising the Fed rate now. They should have been normalizing the rate before the plot in the above graph reached the effective demand limit. The economy had momentum at that point to withstand interest rate rises… but not now.
The Fed should stop trying to raise the Fed rate and just let the business cycle collapse on its own. The Fed is just hastening the recession process by projecting rate increases beyond the effective demand limit.
The Fed is really messed up because they do not have a “real-time self-calibrating” measure of an aggregate effective demand limit. But we have one here… so brains need not explode. However, brains may explode once the Fed realizes they are completely behind the curve.
Update: A bit to add about slowing GDP…
This goes back to the equation for profit rate…
Profit rate = (Productivity – Real compensation) * Total labor hours/Capital stock
Increasing labor hours increases the profit rate. Whereas increasing the capital stock would tend to decrease profit rates. So when capital is maxing its use in the aggregate, we will see an aggregate drop in capital investment, which is the current driver of slowing GDP.
It does not appear there is enough slack for inefficient companies to survive as the profit margins decrease.
My equations tell me that in the aggregate there is not enough slack. I have come to trust my equations because they are predicting really well the aggregate stuff. Except for inflation… I do not have a model that connects inflation into my model. I am studying some papers now to get some ideas. I knew that once labor share started to rise, inflation would perk up… but I need a model for it.
I am suggesting inefficient companies will start to hurt now that interest rates start upwards. You think differently?
No… I agree. That is a normal consequence of raising interest rates. It is also a healthy consequence in the long run. Having interest rates too low for too long has increased the incidence of inefficient and marginal companies. These companies are even more at risk at the effective demand limit. There is no profit momentum in the aggregate that they can be pulled up by.
Great post, I stumbled on the site from a comment you made on Interfluidity. This is great stuff, really interesting.
welcome to Angry Bear
I am still trying to get a handle on your equations. I reread posted going back to October 2013.
I don’t understand why the subtraction should be of the form a*(U2 * C2). I can imagine many other possible factors. Your statement about diminishing returns seems offhand.
What I think I see is that you have found that it works until there is a recession. You assert that the point where it stops working indicates a cause of the recession, but why is it not simply a result of the recession?
The last two recession, IMHO, occurred because we built stuff we could not use because we incorrectly thought the demand for the stuff would just keep going up. We built more Internet businesses (and more bandwidth) than could survive. It was not so deep a recession because although many of the businesses could not come back, Netflix and Youtube snapped up the bandwidth for entirely new sustainable businesses. Then we built more houses than we could use. The recovery was slow because it needed population growth to fill the supply. How does either of these come out of reducing capacity utilization to increase profits?
It seems to me that if you have employed more people and given them more money, then businesses will start to find more innovative ways to go after that money with new products. If we had gotten real products instead of financial vaporware, what then?
Here is where I come from. It is different than other economists.
I see a business cycle. You have a recovery phase after a recession. Then you have a phase where you have reached the top of the business cycle.
The dynamics of the recovery phase and the top phase are different. So that what you describe in your comment manifests differently in each phase. So it is important to know which phase of the business cycle you are in.
The Fed thinks that we are still in the recovery phase. That is why their actions are destabilizing the markets.
Before the 2008 crisis, the economy had hit the top phase. So the economy was vulnerable to a recession. It was holding on to the business cycle through bubble dynamics which were to eventually collapse. I think the economy could have held on without going into a recession, but once the shenanigans became public, the markets were coming down.
Before the 2001 recession, capacity utilization was dropping perfectly along the profit max line as it has done lately. Some business cycles get this far to see the economy slide along the max profit line. Some business cycles just go into a recession once the profit max line is reached.
Do you see us slipping back into a recession as a result of the Fed’s misreading of the situation? It looks like 4th quarter GDP would indicate as much. Plus, income gains are down from the previous quarter and savings have increased over the previous quarter. http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm