Circular Flow of Labor & Capital
In the study of economics, one learns the circular flow of the economy between firms and households. This post however presents another circular flow model based on capital and labor. (It is a closed economy with no government for simplification.) There are 4 pools within this circular flow related to the income and utilization of labor and capital.
In the center of the model is the percentage of national income from production that goes to owners of capital. We do have a capitalistic economy. The control of capital is at the center of the economy. Capital income is central to determining the pools around it… the percentage of national income going to labor and the percentage utilizations of labor and capital.
This circular model is different because we do not see money going back and forth between entities. Instead we see dynamics of utilization and distribution between one pool and another.
Share of Income between Capital & Labor
At the top of the circular flow is the relationship between how much of national income goes to capital and labor. For the most part, this is determined by owners of capital because they control the equipment, investment funds and other capital used for production. Then they hire labor to work with the capital.
There is a historical power struggle between capital and labor for sharing the income from production. Strikes, walk-outs and killings define the history. When labor loses bargaining power, labor share of income tends to fall. What effect then do changes in labor share affect the utilization of labor and capital?
Relationship between Labor Share & % Utilization of Labor (Green line in model)
In production, labor needs to be hired. The amount of available labor supplied depends on labor’s share of income from production. Here are some graphs to show this relationship. (update: The following graph presents the Unemployment rate as the percentage employed, instead of unemployed.)
As the labor index rose to over 112 in the 1950’s and 1960’s, unemployment increased. The utilization rate of labor looked to be limited by the demand of capital owners. Since then, labor share has fallen. Now it looks as though labor is limiting its own supply. The implication is that labor is less willing to supply its labor when its share of income is low.
We see this relationship also in the Labor Force participation rate.
When labor share was higher, the percentage of labor participating in production was higher. The steep decline in labor share since 2003 was accompanied by less labor participating in production. Granted there are other demographic influences. Still there looks to be some effect of lower labor share on the LF participation rate.
Relationship between Labor Share & % Utilization of Capital (Red line in model)
This relationship triggered by personal economic research in Effective Demand back in 2012.
As labor share of income falls, so does the upper limit of the utilization of capital (lower red line in the following graph.)
Since the 1960’s, the maximum of capacity utilization in business cycles has fallen to lower levels with lower labor share. The effect of lower labor share upon capacity utilization is how I define Keynes’ concept of Effective Demand.
Relationship between Labor Share & both the % Utilization of Capital and Labor
This relationship involves the 3 circles around capital share in the circular flow model above.
Upon seeing how labor share limits the utilization of capital, I noticed an effect from the utilization rate of labor. So I developed a simple equation…
Labor share index * 0.76 >= capacity utilization * (1 – unemployment rate)
The equation basically says that a labor share conversion (* 0.76) would set an upper limit to the value of multiplying together capacity utilization and (1 – the unemployment rate). (0.76 was the slope of the midline tendency above in the plot between labor share and capacity utilization that zeros in on the limit.) So, in effect, the unemployment rate established the limits of capacity utilization in relation to labor share.
We see this in the following graph. (link to Fred data)
The plot tends to stay above the zero line showing that the equation holds from business cycle to business cycle, including the current strange one. The converted labor share rate is seen to set a limit upon the multiplied utilization rates of labor and capital.
The Relationship between the % Utilization of Labor and Capital (Violet line in model)
As the business cycle recovers after a contraction, both the utilization rates of labor and capital increase. But there comes a point where the utilization of capital will stop increasing or fall. This point reflects an optimum use of capital as I show below. The utilization of labor may keep increasing or fall at that point.
How can this dynamic be put into an equation?
The following 3-dimensional equation gives a value for a z-vertical. As the z-vertical rises, capital and labor is used more optimally and the business cycle keeps progressing. The goal is to keep increasing the z-vertical as long as possible through a business cycle. A rising z-vertical shows optimum utilization of labor and capital.
z-vertical = m + k – am2k2
m = (1 – unemployment rate)
k = capacity utilization rate
a = 1.46 – 0.76 * labor share index
The maximum of this equation is…
Max of z-vertical = √1/2ak … (square root of 1/2ak)
Here is a graph.
In the last year, capacity utilization has been falling while the utilization of labor has been increasing (unemployment falling). The equation predicted this. Yet has the z-vertical continued to rise? (link to following FRED graph)
Yes, the z-vertical has continued to rise in this business cycle. However, the z-vertical is at lower levels in relation to the past which reflects the poor economic environment currently. A low z-vertical ultimately reflects under-utilization of both capital and labor which is a result of the lower than optimum labor share.
Now, I look at the derivatives of the above equation in terms of both capital and labor. A higher derivative means lower than optimum utilization.
First, the derivative in terms of capital. (FRED link)
Capital utilization is always brought to its optimum during a business cycle. That is the priority of capital income at the center of the circular model. Capital has the advantage over labor.
Now, the derivative in terms of labor. (FRED link)
Unlike capital, labor never reaches its optimum utilization since it never reaches zero in the graph. Capital comes first in capitalism. And since the 1990’s, the utilization of labor has been getting worse as seen by the plot steadily trending upward. The increasingly unmet potential of labor utilization coupled with lower labor share is a problem.
Capital has not lost its advantages while labor has.
The utilization of labor has also been decaying since the end of 2014. So when economists say that the labor market is looking hopeful, I have seen the labor market getting progressively worse and heading toward an economic contraction.
The rise in power of the monopolies that Joseph Stiglitz writes about is giving more power to capital income. The above dynamics between labor and capital show the adverse impact upon labor. The result has been lower labor force participation, higher unemployment, lower capacity utilization, a weakening utilization of labor and an ever more sluggish economy.
Something needs to be done to give power back to labor.
You might want to label that “Employment Rate” instead of “Unemployment Rate”.
In that graph, I put an update to say that unemployment was presented as % employed instead of unemployed. Does that fix your concern?
I’m not sure. Right after that graph, you have this: “As the labor index rose to over 112 in the 1950′s and 1960′s, unemployment increased.”
Is that correct?
Yes, that is correct. As labor share rose to that high level, the unemployment cycle increased to higher levels.
OK — and you’re saying that relationship no longer holds?
When labor share went really high, it pushed the limits of firms to demand labor. In other words, firms did not like paying out so much in labor share. That situation does not hold anymore. In the 1960’s Milton Friedman pushed against the minimum wage and unions. Rightly so, labor share was getting too high. But now due to Friedman and others, labor has lost its power. Now we have the other problem. Labor share is so low that now labor is not motivated to supply its labor. Before it was a demand problem, now it’s a supply problem.
“Labor share is so low that now labor is not motivated to supply its labor.”
When the government pays enough so that you don’t have to work, and takes away so much of that assistance when you do work, it makes some sense for unskilled laborers to not work.
In places that do not have such safety nets, people will work for whatever they can get, so the employers hire them. Even here, we see employers hiring illegal immigrants for less than Minimum Wage. Why would they work for such wages? Because it’s that or nothing — and it’s still more than they would make in Guatemala or El Salvador.
So the question is, how do we get power back to OUR laborers?
I am in favor of some protectionist policies. They would do us good, and be good for China. China grew too fast in an unsustainable way. That is partly our fault. China bought $93 billion of our residential property in a year. The Chinese government itself is trying to curb that because it reflects capital flight. But China is disrupting economic balance in the US.
The immigrants that work in the US still spend money in the US. They are better than workers in China for the US economy at this point.
To protect our workers, the workers in our country, wages need to rise, protectionist measures need to be taken against China from dumping its excess inefficient production on the us.
Also, interest rates need to rise to improve efficiency in the world economy.
And illegal immigrants need to have the ability to get work visas more easily because they do add to our economy. They need protection. They need power to fight for their wages too because they do want better wages. They really do. And if they can get better wages, than everybody can.
I worry about the 0.76 constant. What is it really? Is it genuinely constant, something variable that has a strong tendency towards that figure, or is it potentially massively variable in some as yet unseen way?
Also, what was different about 1995? The upward march of that labor utilization could have been similar plotted from 1970 to 1990, but then it became dramatically lower. NAFTA and other things happening at the time don’t seem like they would be favorable to labor gaining power. Inflation wasn’t particularly high or low.
The march upward in the late 90s was due to labor share increasing. We are seeing labor share increase now too, but there are no bubbles like in the 90s.
And the 0.76 constant? I hear your thoughts. Is it variable? Why does it seem constant? The 0.76 is really just a calibration of the 2009 index which is based on 100 for 2009. Obviously labor share was not 100% in 2009, so the index number has to be converted to a lower number. The graph of capacity utilization against labor share gives a slope of 0.76 as a mid-trendline. But will that relationship curve if the dynamics of the US economy change greatly? As long as the data is gathered in the same way it should hold steady at 0.76.
You will hear of other numbers for labor share, but the conversion to an “effective” labor share that I do pulls out a value of labor share associated with the limit upon capacity utilization. So it is in a sense a more real view of what labor share actually is in the US.
Will the lines between capital income and labor income become more blurred distorting that value? We have not seen that yet in the data.
If you just look at the straight chart of labor’s share it is very obvious that it is highly cyclical. Interestingly, labor’s share is a very good leading indicator of recessions, as every post WW II recession has been preceded by a rise in labor’s share. But the lead times vary sharply. Maybe it is because the rise in labor’s share is driven by weak productivity that occurs late in the cycle. On the other hand the rise in labor’s share tends to be accompanied by rising rates. Why? It could be that it is when inflation rises and fed policy shifts to fighting inflation. Alternatively, maybe the fed wants to keep capital’s share high and creates a recession to reverse the rise in labor’s share.
Pick your poison or conspiracy theory.
It also makes an interesting theory about the stagflation of the 1970s.
Real growth in the 1970s was almost identical to real growth in the 1980s. So why are the 1970s look at as a poor economy and the 1980s as a good economy. Maybe it is because the inflation of the 1970s shifted income to labor and the disinflation of the 1980s shifted income back to capital. So from the point of view of capital, or wall street, income stagnated or actually contracted in the 1970s and rose sharply in the 1980s.
You make good points about labor share. It has an influence on the business cycle. I would say that its relationship to how labor and capital are utilized drives the end of the business cycle. Even now, I see a contraction forming in spite of the Fed keeping rates super low. The business cycle is decaying from the point of view of my model.
The Fed does not try to control labor’s share. They try to keep the economy in a stable state around full-employment. So they have to keep their foot near the brakes as they are doing now. But they are so far behind the curve and they really do not know it. When the contraction comes, there will be quite a bit of soul-searching at the Fed.
When the oligarchs control everything including the government why do you think that they will do anything to help the middle class? For more on this go see todays Wallstreetonparade.com and become more informed and enlightened. Also looking into the rear view mirror all the time will never get us where we all need to go or become…
My model allows us to predict the future better than other models… Can you see that? These models predicted how this biz cycle would end before it happened.
We are not looking into a rear view mirror here.