A New Model of the Economy Please
Brad DeLong wrote recently concerning the Uncertainty at the Fed…
“The heart of the trouble consists in the fact that neither financial-market participants nor, it seems, the Fed itself know the true state of the economy or how best to model it – especially in the wake of the 2008 financial crisis” (link)
It is a fact he says. The Fed and others do not know how best to model the state of the economy.
I stand alone with a new model for an Effective Demand limit as Keynes envisioned it.
The basic concept behind the model is that the percentage that labor receives of national income determines a limit upon the utilization of labor and capital in production. The key idea is that capital income based upon utilizing capital resources is optimized at the effective demand limit. Thus capital does not want to go beyond the limit because it begins to consume its power position in the aggregate. Capital seeks to consume labor income while maximizing its relative strength in the economic flow of money.
So why is my model good? While Brad DeLong points out the confusion from the Fed, my model is not confused.
- It knows why capacity utilization is dropping and why unemployment stays low.
- It knows why the output gap has continuously been revised downward, because the output gap was closed years ago in this business cycle.
- It knows why the Fed seems to want to normalize rates. The economy is at the end of the business cycle. Rates are supposed to be close to normalized by now.
So the confusion over where the state of the economy is has led to the uncertainty that Brad DeLong writes about… on both sides, the central banks and the market participants. We see a situation where the market participants see a different economic potential than economists. They have seen limitations in this business cycle. Yet the Fed is still waiting for inflation and demand to pick up, while top line revenue of firms has already topped out in the aggregate.
The Fed still sees that this business cycle will stay alive for another two years. The disconnect has been severe for many years causing sluggishness in the economy.
The Fed does not want inflation above target because higher inflation causes distortions and slows growth. However, they have entered another situation where there models are misreading the state of the economy and leading to sluggishness anyway.
What is the equation of the effective demand limit?
Effective demand limit upon real GDP = rGDP*e*T/L* (1 – (1 – 1/e)*T/L)
T = capacity utilization * (1 – unemployment rate)
L = an effective demand limit function (Labor share index * 0.76)
e = 3 … coefficient to set maximum of effective demand at the stable equilibrium with production.
Effective labor share (L) determines the limit upon the % utilization of labor and capital in production. The following graph portrays Keynes’ vision of Effective Demand quite well. Let’s bear in mind that Keynes never gave an equation for effective demand. He only described how it seemed to work.
This equation works. The economy has followed this model for as long as we have data for capacity utilization… since 1967 to now.
what happens when you offer your model to the “real” economics journals?
I never have submitted it. It only exists here at Angry Bear and my own blog.
I think you have a nice observation about a factor that constrains the economy, but it is an overstatement to call it a model.
I have a mental model (also is not really a model) which says there are three main contributors to economic growth.
1) Population grows, increasing demand and growing GDP by about .5 percent each year.
2) Technology advances and we make more stuff or provide more service for the same labor and capital, increasing GDP by 1 or 2 percent per year.
3) Firms plan to grow and contribution to GDP growth is erratic but generally positive.
If firm’s plans are aggressive, positive feedback can generate a bubble and modeling the impact on GDP is as much speculation as the firm’s plans are. If firm’s plans are modest, 1) and 2) will provide a buffer to the chaotic impact of the speculation.
There are (at least) two other critical factors.
4) Fiscal policy. This is currently paralyzed, so has no effect on GDP, but a real model would include the possibility of change.
5) Monetary policy. This actually acts by changing firm’s plans. Historically, the current low rates would be encouraging speculation, but rates are only part of the model.
I accept that your description of how labor share constrains demand is an important aspect of a model. Your description of profit maximizing behavior appears to be important in understanding how firm’s plan.
What I do not see in your understanding is that the Effective Demand Limit in terms of raw GDP must continue to increase because of 1) and 2), and provides a moving goal post for 3), 4), and 5).
Recession comes from slamming into the limit and having to make huge changes in firm’s plans. In the current highly damped economy, firms can hit the limit and simply adjust until the limit catches up. If the Fed pursued a policy that was good for labor share, it would also make the economy more reactive which would reward speculation and increase the likelihood of recession.
We want policies to improve the economy by increasing labor share, but Washington is not just paralyzed, it is too stupid to get a good model.
Effective Demand does not grow unless labor share grows. Capital income will make utilization decisions within the limits of labor share. When labor share is lower, optimum capital utilization becomes lower.
Effective demand is represented by % utilization, not value or quantity. There is an optimum level of labor share. We are currently below it.
A recession does not occur when the economy reaches the effective demand limit.
If the Fed pursued a policy to raise labor share, there would have to be more power to labor unions for bargaining. The Fed does not do labor policy.
“Effective Demand does not grow unless labor share grows”
This is clearly wrong, but perhaps that is because my problem statement was not the same as yours. The workforce can grow without changing labor share since labor share is a percentage. A growing workforce will lead to an increase in demand and an increase in GDP. Your Effective Demand may be defined with percentages, but the economy is dynamic. Failure to account for the dynamics is failure to have a model.
I understand that you are not saying that reaching ED triggers an economy. I AM saying that the rate at which you reach ED will impact recession dynamics. In the current overdamped economy, recession is unlikely, but identifying an ED limit is still valuable.
The Fed has an unemployment mandate. Its actions impact labor policy. If it were to allow inflation to increase employment to the point that labor had more power to bargain (regardless of unions) it would have caused labor share to increase because there are people whose attachment to the labor market is dependent on wages. The Fed may not do “labor policy”, but its actions need to be part of how labor effects the economy.
It is correct… Effective Demand does not grow unless labor share grows, because effective demand is calculated with labor share. It is not calculated by a growing work force or increasing fiscal stimulus. Why? Because any money that you inject into the economy circulates with the same labor share. You can inject 5% more money, or loans, or helicopter money, but all that money circulates in such a way that the water level of capital income relative to labor income does not change. Thus, effective demand does not change because capital will still control the utilization of labor and capital within the effective labor share influence.
“it would have caused labor share to increase ”
I overstated my case. Causing workforce participation to increase is not the same as causing labor share to increase, but I intuit that they would go together somewhat.
I suggest you look at the ISM ( purchasing managers) deliveries index.
It just jumped from 49.1 to 54.1. It measures the share of firms experiencing slower deliveries. It is a great leading-concurrent indicator of capacity utilization, commodity prices,– including oil –interest rates and the S&P 500 PE. It strongly implies that we are in a late cycle environment. Moreover, it suggest we should be looking for signs of demand pull inflation rather than the cost push inflation the Fed and others are concerned about.
In addition, the ISM price index is also rising strongly.