Relevant and even prescient commentary on news, politics and the economy.

Assuming Full-employment is foolish

Nick Rowe brings up an important issue and sends a warning. He says that New Keynesian economists are assuming full-employment. And it is foolish. Nick Rowe is correct.

Keynes himself talked about how effective demand could stop output before full-employment is reached. The cause is deficient effective demand. And through the research that I do, I have been saying that effective demand is about to cut off output growth from reaching potential output. I show graph after graph of how it happens.

The New Keynesians take the CBO projection of potential GDP as a given and in effect assume we are on our way to full-employment. It’s not going to happen.

Their assumption is foolish and would not be shared by Keynes himself who told what happens when there is deficient effective demand.

Thoma, Krugman, Delong, the Fed, Yellen and others are all assuming a return to full-employment at the CBO potential GDP. Nick Rowe is signalling a warning and others had better pay attention, because this is not a trivial issue.

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Will there be inflation in the next recession?

As I showed over the weekend, the jumps in inflation during the 1970’s were due to real GDP reaching the Long-run aggregate supply curve (LRAS). But underlying the inflation of the 1970’s were dynamics of growth, optimism, speculation, small business development, union bargaining power and a surging labor force from desirous baby-boomers coming of age as pointed out by Steve Randy Waldman. (Desirous is my painting stroke.)

So when real GDP hit the LRAS zones in the 1970’s, inflation resulted. Inflation rose to over 11% in both recessions. The LRAS zone is marked by the paths of real GDP and effective demand. Where the paths cross (see dashed black lines), the LRAS zone begins. Here are the graphs that I made for the 1970’s… (2009 dollars)

1973 reccession

Link to graph #1.

1980 recession 1a

Link to graph#2.

So it is more than obvious that the inflation jumps were created in the LRAS zones as the economy went into recession during the 1970’s. But there were forces to produce inflation. Even though the Fed rate was balanced to bring inflation down to 3% during the 1970’s, inflation moved from 3% before the 1973 recession, rose to 11% during that recession, fell to 6% after that recession and then rose again to 13% during the 1980 recession.

In spite of correct Federal Reserve policy, the financial sector kept feeding the economy and creating money even at higher interest rates. The mood of growth and optimism emanating from the baby-boomers kept the money supply growing in spite of higher interest rates. A higher Fed rate did not matter so much in that atmosphere of growth and decadence in the 1970’s. In essence, society did not respect the intent of the Fed rate to control the economy. They borrowed and the banks lent money. Money was created in spite of a higher Fed rate.

What happened during the 2008 crisis? (This graph puts real GDP in 2005 dollars)

2008 recession 1

Link to graph #3.

We saw no inflation result as real GDP reached the effective demand limit. The factors underlying a strong inflation were not there as they were in the 1970’s. There is more debt overhang now. Net worth took a hit as the bubble popped. The baby-boomers are leaving the labor force to some extent, or are keeping jobs that could make room for younger workers. Also, there isn’t the mood for growth in spite of interest rates.

What about the next recession? (2009 dollars)

2014 recession

Link to graph #4.

We see the same typical pattern before a recession. Real GDP is trending horizontal at a low inflation rate, while effective demand trends toward the meeting place with real GDP. Where they will meet establishes the LRAS zone. What will inflation do as real GDP enters the LRAS zone? Are there dynamics to support a big rise in inflation? I do not see those dynamics. More baby-boomers will leave the labor force. There may even be a bubble popped to bring down net worth. Debt overhang will still be there. Labor has no power to ask for higher wages.

Will we have deflation? Most likely we will see an effort by inflation to rise, but if there is a bubble popping sound, inflation will back off. Pretty much as we saw in 2008. Deflation may be stronger in the next recession.

Will the next recession be dramatic? Oh yes… there will be labor issues, student default issues, government debt issues, deflation issues, derivatives issues, emerging market issues, on-going QE issues and more.

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Has the Fed rate done a good job to balance inflation over the years?

In light of the recent discussions of inflation in the 1970’s (Steve Roth and Steve Randy Waldman), I ask… how well has the Federal Reserve done in setting a Fed rate to balance inflation over the years? Including the 1970’s… Actually very well, except for Volcker in the 1980’s.

First, let me state that there was liquidity from high labor share through the 1970’s. Even though real wages were lower, labor’s share of income did not change much. The baby-boomers grew in economic strength from their labor share liquidity. The Fed rate did not try to control that liquidity in the 70’s. But Volcker put the breaks on the liquidity coming from the Fed rate in the early 80’s. And the babies born from 1960 on graduated from college into a world of tight liquidity due to tight Fed policy. They became disadvantaged. They did not find job openings. As a generation, they fell behind. I was one of those babies that graduated into the heart of the 1982 recession. If the Fed “had gone Volcker in 1975”, as Steve Roth asks in his post, what happened to my generation would have happened to the baby-boomers before me.

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An Effective Demand look at the 1980 recession to envision the next recession

It is good to look back at the 1980 recession and analyze what happened. First, the recession officially started in July of 1980. Be that as it may, the business cycle had already topped off in the 3rd quarter of 1978 when the economy hit the effective demand limit.
Capacity utilization started falling the same time the effective demand limit was hit, 3rd quarter 1978. From there it was falling all the way to July of 1980. Unemployment started rising 2nd quarter 1979, more than a year before the start of the recession. Real GDP rose very slowly from 4th quarter 1978 thru 2nd quarter 1979.
Using a model for Aggregate supply & Effective Demand (AS-ED), instead of the commonly known Aggregate supply & Aggregate demand (AS-AD) model, I will show what happened from 1978 to 1980.
First let’s look at the current situation with the AS-ED model with data from 1st quarter 2012 to 2nd quarter 2013. (2009 real dollars.)
1980 recession 2
The blue dots along the bottom are real GDP on the aggregate supply curves increasing at an inflation rate around 2%. Real GDP will most likely continue this path over the next year, shown by lower dashed black line. The dashed black line above shows the effective demand limit coming steadily downward toward the LRAS zone. (LRAS is long-run aggregate supply). Real GDP and effective demand will meet at the LRAS zone.
What will happen when they meet? Well, let’s now go back to 1980 and see what happened back then. I am not saying that it will happen exactly the same way now, but let’s just see what happened back then.
Here is a graph where the red dots are real GDP on the aggregate supply curves.
1980 recession 1
Look at the dashed black lines in the lower left of graph #2. Real GDP was came in horizontally leading up to the 3rd quarter of 1978. The green dots are the first two quarters of 1978. The first red dot is the 3rd quarter of 1978. Now look at the dashed black line coming down. Before the 3rd quarter of 1978, effective demand had been tracking along that black dashed line since the 3rd quarter of 1975. Effective demand had been tracking steadily downward for 3 years toward the meeting place with real GDP. The same has been happening now since the end of 2010.
In graph #2, the first red dot is on the crossing point of two solid black lines. One solid black line is the aggregate supply curve for 3rd quarter 1978. The other solid black line is the effective demand curve for 3rd quarter 1978. When real GDP sits at the crossing point of effective demand and aggregate supply, the economy reaches the LRAS zone. The LRAS zone is more a zone than a vertical curve in the way the economy moves into it. Theory says that at the LRAS curve, inflation will start to develop and real growth will slow down. We see exactly that happen in the graph above, but in a zone and not directly on a vertical curve. The LRAS zone is marked by crossing lines of the same color before the recession started 2nd quarter 1980.
(note: Leading up to the LRAS zone, the Effective demand curves stay bunched together heading toward the meeting point with real GDP, while the Aggregate supply curve shift right. (see graph #1) Once real GDP enters the LRAS zone, the Aggregate supply curves bunch together and the real GDP starts to move upward on the aggregate supply curve. The Aggregate supply curve stops shifting, and the Effective demand curve starts shifting upward. (see graph #2))
As the red dots of real GDP progress into the red area of the LRAS zone, we see inflation start to develop and real GDP growth slow down. Inflation had been tracking between 6% and 7% since 4th quarter 1975. Real GDP was moving horizontally between 6% and 7% inflation. In the LRAS zone marked by the effective demand limit, inflation rose from 6% to eventually 12% right before the fall in real GDP. Real GDP stagnated through the LRAS zone during 1979.
So there was a cost-push inflation spiral taking place in 1979 within the LRAS zone. What was the solution? The Federal Reserve came to action.
The Fed rate was elevated to 10% during the 3rd quarter of 1978. Then it stayed there for a number of quarters but it was not high enough to suppress the cost-push inflation spiral. As inflation developed after that in 1979 within the LRAS zone, the Federal Reserve raised the Fed rate to over 13% by the start of the recession. Eventually the Fed rate cut the inflation spiral in the LRAS curve. and the dynamics of that spiral had to wind back down… as it wound down the recession started.
In graph #1, we see the same scenario happening again as it was playing out before 1978; Real GDP moving horizontally and effective demand heading downward straight to the point of contact. If real GDP keeps growing at around $100 billion per quarter as it did in 2nd quarter 2013, real GDP will enter the LRAS zone in mid 2014. If the same scenario plays out, inflation will start to develop next year, but with sluggish real growth after.
What is different now? Well, capacity utilization has backed down below 78% which is similar to what happened in 1978. Yet, unemployment is falling, instead of rising. I still think unemployment has a bit to fall before real GDP reaches the effective demand limit next year. But it will be interesting to see the speed with which the economy enters the LRAS zone.

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How to calculate capital income’s consumption rate for recession forecasting

During the posts about the percentage rate of capital income used for consumption, it seemed readers were not sure how I calculated the number. Well, I want to show here how I calculate the percent of capital income used for consumption. The number is currently rising from quarter to quarter. When it begins to fall, a recession is appearing on the horizon. So the method below can be used by anyone for recession forecasting.

1.) I get a blank circular flow sheet ready for inputting data.

how to do CICR 1

Link to graph #1.

2.) I go to the BEA tables for the NIPA data. (National Income and Product Accounts) I get the following information. Table and line number given. (billions of 2009 dollars)

how to do CICR 2

Link to graph #2.

3.) Then I convert the last line for “Government net borrowing or net lending” from 2013 dollars into 2009 dollars by using a converter which uses the GDP deflator. Here is one. The $1185 in graph #2, now becomes $1116 in 2009 dollars.

how to do CICR 3

Link to graph #3.

4.) Next I input that data into the blank circular sheet. You will notice that the GDP at the end does not equal the real GDP in graph #3. There is always a residual from line 27 of table 1.1.6. So, consumption, Govt. spending, Investment and net exports add up to a different number than the real GDP given in line 1 of that table.

how to do CICR 4

Link to graph #4.

5.) Now using the data we can proceed to determine the consumption rate of capital income. It is a process of deduction getting one number, then another, until we get the number we want. In this step, let’s go ahead and complete the bottom section. There are 3 numbers to obtain.

  1. Total Net Taxes = Govt. spending – Govt. borrowing = $1791
  2. Lend(-)/borow = – Govt. borrowing – Exports = -$3077
  3. Gross $$ Saving = Investment – Lend(-)/borrow = $5547

how to do CICR 5

Link to graph #5.

6.) Now I start filling in the top. The first step is to put the real GDP from below into the out-going GDI at the top. Then I input the effective labor share percentage of national income, which in 1st quarter 2013 was 73.9%. The effective capital income share will also be filled in as labor share and capital share add up to 1. The incomes of labor and capital are calculated from their shares. The method of calculating effective labor share is to download the data for the labor share index from this graph at FRED. Then take the index for the quarter in question and multiply it by 0.766. For example, for 1st quarter 2013, the index 96.465 times 0.766 = 73.9%.

how to do CICR 6

Link to graph #6.

7.) The next step is to determine the effective net tax rates for both labor and capital. For capital’s effective tax rate before 2003, I use Jane Gravelle’s data. For data from 2003 to 2011, I use Wikimedia. For data after 2011, I can only estimate. The estimation looks for a balance of movement between the labor’s effective tax rate and the capital’s effective tax rate. In this case for 1st quarter 2013, I set the effective capital tax rate at 15.5%, which gives a capital net tax of $631 billion. I subtract $631 b. from $1791 b. of total net taxes to get labor’s net taxes of $1160 b. Then I can calculate labor’s net tax rate by dividing labor’s taxes, $1160 b., by labor’s income, $11,528 b. The result gives a labor tax rate of 10.1% of labor income. If the capital tax rate had produced a labor tax rate around 5%, I would assume the capital tax rate was too high. and if the capital tax rate had produced a labor tax rate of 20%, I would assume the capital tax rate was too low. Normally the labor tax rate is less than the capital tax rate, so in this case the estimation “seems” balanced.

how to do CICR 7

Link to graph #7.

8.) Now we take the personal savings rate from graph #2, which is 4.1%. I apply this to the labor’s disposable income income of $10,368 b. which is labor income, $11,528 b, minus labor’s net taxes, $1160 b. Thus labor is saving 4.1% of $10,368 b., which is $425 b. You can see the personal saving rate in the yellow box. The 3.7% is savings as a percentage of total income, not just disposable income.

how to do CICR 8

Link to graph #8.

9.) Now I determine labor’s consumption by subtracting savings and net taxes from labor income.Labor consumption = Labor income – labor net taxes – labor savings = $9943 b.

how to do CICR 9

Link to graph #9.

10.) Now that we have labor’s consumption and we know that total consumption is equal to labor’s consumption plus capital’s consumption, we can determine capital’s consumption.

Total consumption = labor’s consumption + capital’s consumption

Capital’s consumption = Total consumption – labor’s consumption = $10,644 – $9943 = $701 billion

Then we can easily determine capital income’s rate of consumption by dividing capital consumption by capital income, $701/$4071 = 17.2%.

how to do CICR 10

Link to graph #10.

There… we don’t need to do any more with the sheet.  I realize that the information for capital income is still not complete in graph #10, but we don’t even need to complete that information. You don’t have to fiddle with imports, exports or even capital savings. We already know the number we want for recession forecasting, which is 17.2% of capital income is being used for consumption. We can use the same calculation method for any quarterly or annual data. For future data, when you see the consumption rate of capital falling, think recession on the horizon.

For those who want or need total accuracy…

It does not matter if the consumption rate of capital is calibrated accurately or not, it will rise calibrated or not… and it will fall calibrated or not, just the same. It’s the relative rising and falling that is used for recession forecasting. (note: the plot of capital’s consumption could be calibrated by reducing the effective labor share by as little as 2%. source)

One person made a comment on a past post that capital gains taxes change wildly and would affect the calculation. However. if you keep a close balanced eye on labor’s net tax rate, you will spot noise in capital’s tax rate. The key is to hold a steady line with informed adjustments about tax revenues. Then what you end up with is a core rate, similar to core inflation that seeks to clean out the noise. The data used for capital income’s effective tax rates do not show noise from capital gains taxes anyway, so the method above is safe to use for recession forecasting.

Everyone needs to have the advantage to protect themselves well before a recession starts, not just those with their fingers on the pulse of capital. Everyone… Now with the above method, labor has its fingers on capital’s fingers. Everyone, including the stock market has a way to know quarters in advance that capitalists as a group are tightening their belts. There is no way to hide it.

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Nick Rowe says it is hard for an economy to get stuck in a Liquidity trap, but it is actually easy.

Nick Rowe from the blog Worthwhile Canadian Initiative asked a very good question on August 30th… “How can you get an economy INTO a liquidity trap?”

He goes through some scenarios that would put an economy in a liquidity trap … and then shows that a reversal in monetary policy could pull the economy out of the liquidity trap. He then presents an idea for inflation inertia that could put an economy into the trap, and it would be hard for monetary policy to pull an economy out.

He finishes his post by saying… “It might be possible to get an economy irreversibly stuck in a liquidity trap. But it’s a lot harder than you might think.”

Well, it is not really that hard to put an economy into a liquidity trap from which it cannot escape. Basically, you lower labor share of income below a certain threshold et Voilá… you are stuck in a long-term liquidity trap, irregardless of monetary policy.

Let me show how this happens… (source)

univ 1a

Link to graph #1.

On the y-axis we see the prescribed central bank interest rate. On the x-axis we see a value called the TFUR, which is simply multiplying the capital utilization rate by the labor utilization rate. The TFUR gives a measure of a total utilization rate for the factors of production, namely labor and capital.

This graph shows the paths of a central bank interest rate based upon the utilization of the factors of production. Each path is determined by the labor share of income. So the blue line uses a higher labor share of income than the yellow line. The orange line below uses the lowest labor share measure. As you move from lower to higher labor share, the prescribed central bank interest rate would rise in response. Thus, as labor share falls, the corresponding central bank interest rate would fall too.

The equation for the prescribed interest rate path is…

Prescribed Fed rate = z * (TFUR2 + els2) – (1 – z) * (TFUR + els) – inflation target

z = the coefficient of the equation which corresponds to the labor share anchor… els = effective labor share which is a measure of labor share that determines the effective demand limit.

To get stuck in a liquidity trap, the path of the prescribed central bank interest rate would have to fall to a level below the zero lower bound. You will notice that all the paths will eventually rise to the right above the 0% lower bound. However, the black line with the green dots is the effective demand limit. The TFUR, according to data since 1967 for the US, will not go much beyond the effective demand limit (black line).

Effective demand limit = 2 * z * TFUR2 – 2 * (1 – z) * TFUR – inflation target

So if a path goes positive to the right of the black line, or better yet, passes below the red dot, the central bank interest rate will get stuck on the red dot, the crossing point between the zero lower bound and the effective demand limit. For example, the yellow line goes positive at a TFUR around 78%. The effective demand limit is at a TFUR of 74%. Thus, the economy will not reach a low enough unemployment rate or high enough capital utilization rate to bring the central bank interest back into positive territory.

How well does this graph match actual data? Here is a graph using actual quarterly data since 1988 for the US Fed rate…

lower bound 2

Link to graph #2.

You can see the Fed rate moving along the zero lower bound all the way to a TFUR of 72%. The TFUR is currently around 72% and the Fed rate is still at 0%. Do you see the point where the zero lower bound and the diagonal line meet? That point is shaping up to be the lockout point, which means the economy is stuck below the zero lower bound. The Fed rate can get stuck at the zero lower bound due to a low labor share of income. The diagonal line is based on labor share.

univ 4a

Link to graph #3.

Graph #3 shows the current situation in the US where the effective labor share is holding steady around 74% after falling 5% since the crisis. So the path of the Fed rate has fallen from above the red dot to below the it, since the crisis. The Fed probably did not see that coming.

The path of the Fed rate goes along the yellow line. We can see that the yellow line passes just below the red dot, but not above it. The result is that the US Fed rate is stuck on the zero lower bound of the liquidity trap no matter what US monetary policy does.

What is the basic mechanism of the effective demand limit? The amount labor is paid determines a limit upon utilization of labor and capital. What business gives to labor sets a limit on production… and the limit says that the product of the utilization rates of labor and capital will not go above the effective rate of sharing income with labor.

Effective demand limit …

Effective labor share – (capital utilization rate * labor utilization rate) > 0

How do you get an economy stuck in a liquidity trap where monetary policy won’t work to get it out. It’s as easy as apple pie. Just lower labor’s share of national income. How do you like them apples?

Welcome to a new economic paradigm.

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The Fed driving too fast down an unknown road

Is the current aggressive monetary policy effective? Do the risks outweigh the benefits?

Mark Thoma wrote on August 31st…

“It’s just that some members of the Fed do not believe the Fed has much influence over the economy beyond stabilizing the financial system. Once that is done, the Fed’s powers are very limited (when at the zero bound) and — in the eyes of some members of the Fed — the risks of further aggressive action, e.g. QE, outweigh the potential benefits. So I think both camps (banking and macroeconomic) have the same goal, stabilizing the macroeconomy, the difference is in the view of how much the Fed can do without risking bubbles, inflation, etc.”

I think the same way and many others do too. Aggressive and loose monetary policy definitely helps the economy bounce back from a recession, but the economy still must function within its own constraints. Monetary policy can try to push the economy beyond a natural GDP level, but the result would most likely be inflation or bubbles as noted in Mark Thoma’s quote.

How one judges the risks and benefits of monetary policy is based on one’s assessment of what the economy is capable of. Many economists like Thoma and Krugman look at the high unemployment rate and spare capacity and say the economy will eventually return to full-employment below 6% unemployment. To me that is a view with rose-colored glasses that disregards Keynes’ concept of an effective demand limit that can cut an economy short of full-employment. The principles of the effective demand limit are really an unknown.

But what I understand in Thoma’s words is there is a view that once monetary policy stabilizes the financial system, the economy then runs its course. Monetary policy can affect the course of the economy within limitations, but is more limited when at the zero lower bound like now.

My view, which is based on seeing an effective demand limit that will stop unemployment around 6.8% to 7%, is that the Fed must be very careful being too aggressive. It’s like driving too fast on an unknown road and not knowing there is a stoplight ahead that is turning red. That stoplight is the effective demand limit based on low labor share of income. In this scenario, the risks outweigh the benefits from aggressive monetary policy. Bubbles are more likely than inflation due to labor income unable to push inflation. Bubbles come from owners of capital, whose income has rebounded extremely well since the crisis.

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Was the cause of the 1960 recession psychological? and now?

What caused the recession of 1960?

Here is an answer given at timerime.com.

“The recession of 1960-1961 was mainly due to the high inflation, high unemployment rates, and a bad gross national product rating. This recession lasted for 10 months and resulted in the second longest economic expansion in U.S. history. During Kennedy’s 1960 presidential campaign he sought to accelerate economic growth by increasing government spending and cutting taxes, and increased funds for education. The GDP of the United States during this period fell 1.6%, and the unemployment rate hit its peak at 7.1%. Kennedy knew that the economy was in big trouble so he sent congress an economic growth and recovery package consisting of twelve measures. They were an increase in the minimum wage from .00 to .25 per hour, an extension of the minimum wage to a greater pool of workers, an increase in unemployment compensation with an increased aid to children of unemployed workers, an increase in social security benefits to a larger pool of people, emergency relief for feed grain farmers, area redevelopment, vocational training for displaced workers, and federal funding for home building and slum eradication. JFK ended the recession by stimulating the economy ten days after taking office.”

Did inflation cause the recession of 1960?

inflation 1960

Link to graph #1.

There does not appear to be much inflation around 1960.

How about the stimulus package from Kennedy? Did it end the recession? How much did government expenditures change?

recession of 1960 1

Link to graph #2. (source BEA NIPA tables)

It does not appear as though the economic growth and recovery package by Kennedy was a big change from previous government spending.

So what caused the 1960 recession?

Investopedia said…

“This recession was also known as the “rolling adjustment” for many major U.S. industries, including the automotive industry. Americans shifted to buying compact and often foreign-made cars and industry drew down inventories. Gross national product (GNP) and product demand declined.”

So did imports increase around 1960 as a % of GDP?

recession of 1960 2

Link to graph #3.

OK… Imports were rising some from 1955 to 1960 and then stabilized after the 1960 recession. Does the stabilization of imports contradict the economic fact that international trade makes everyone better off?

How about inventories?

recession of 1960 4

Link to graph #4.

Inventories were still increasing before the recession.

How about monetary policy? Did the Fed tighten before the 1960 recession?

recession of 1960 3

Link to graph #5.

OK… now we see something. The Fed tightened before the 1958 and 1960 recessions. Why did the Fed tighten before 1960? Well, Christina Romer and David Romer tell us in their 2002 paper, “A Rehabilitation of Monetary Policy in the 1950’s“.

“Like central bankers of the 1990’s, monetary policy makers of the 1950’s had a deep-seated dislike of inflation and acted to control it. Their dislike of inflation was rooted in a model of the economy that emphasized the costs of inflation and the absence of a positive long-run trade-off between output and inflation. These Žfindings provide important insights into the performance of the economy in the 1950’s.”
There you have it. The 1960 recession was caused by the Federal Reserve being too fearful of inflation.
Here is a quote from the Romer and Romer paper…
“In the light of these threats to our economy, I am convinced that the time has come for a decisive signal from the Federal Reserve System’s determination to do its part to check inflationary trends.” (Vice Chairman Hayes, May 26, 1959)
But where was the inflationary trend in 1959? Looking back from 2013, the inflation of 1959 was very low. But to them it was not that low. They had seen high inflation after World War II and were overly preoccupied in letting it to creep back up.
The inflationary boom it seems was in the minds of members of the Federal Reserve. Psychologically, they perceived a threat from inflation that in retrospect was not there. And so we can wonder, is there a psychological worry or expectation in the minds of the current Federal Reserve members, that years from now will be seen as out of proportion? I think yes… The Federal Reserve does not know enough about the business cycle and how to measure the point at which a recession starts. Even Paul Krugman has recently mentioned that we need to know more about this. The end of this business cycle is an unknown to them. Even Bill Mcbride at Calculated Risk is having to wear shades because the future looks so bright. Yet, the shades may keep him from seeing something important.
The end of this business cycle expansion is closer than they all think. They see unemployment still high and lots of spare capacity and think we will simply have slow long-term growth back to potential. It’s not going to happen that way. The economy will hit the effective demand limit due to a lower labor share of income.

“Finally, it is not easy to predict the consequences of a decline in the labor share, and the corresponding increase in the capital share, of a sector of the economy as opposed to the labor share of the overall economy. Nevertheless, a decline in the share from almost 60% to less than 30% is significant and may have important consequences. An increase in the share of profits probably leads to an increase in investment early on. Simultaneously, a decrease in the share of labor over an extended period of time induces a decline in consumption or prevents consumption from increasing, even if the economy is growing. Sooner or later there is a mismatch between supply and demand as the increase in capacity caused by the increase in investment will not be matched by an increase in consumption demand. This is a problem of lack of demand, an under-consumption crisis. Capacity utilization will have to decline and along with it will come a decline in production, employment, investment, and demand.”

Economists do not think this describes the United States… yet. But it is this dynamic of low labor share that will bring about a limit on “production, employment, investment, and demand” before economists expect.  And the Federal Reserve says not one word about labor share. They are going to be blind-sided on this one. Psychologically, economists don’t have a comprehensive contextual perception of the effect of low labor share, as Federal Reserve members did not have a comprehensive contextual perception of inflation back in the 1950’s.

Here is the updated graph of the effective demand limit with the new numbers for real GDP (2009 dollars). We are close…

pot demand 6a

Link to graph #6.

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The limit of labor’s consumption rate

How much of their income do labor and capital use for consumption of finished goods and services? Now, if labor and capital do not spend their money on consumption, they either save it or pay taxes. In the case of labor, whose rate of consumption is very high, they have less and less income available for saving and taxes as the years go by.

On this labor day, we can see the divide between labor and capital.

capital C 5a

Link to graph.

Currently capital income’s consumption rate (blue line) looks to be heading back up to the previous high of 27% seen back in 1965. After 1965, capital income’s consumption rate declined to 0% by 1980. During that time, labor increased its use of income for consumption from 65% to 75%. We might assume that consumption moved from capital income to labor income.

We now see that capital is once again using income for consumption. Eventually, capital will reverse this trend and lower its consumption rate. Will labor income compensate? Will consumption be able to move from capital to labor income?

The problem is that labor income is already pushing its consumption rate to 85% of its income. Could that rate climb even further to above 90% on a sustainable basis? The result would probably be a negative personal savings rate for labor.

Labor income has been pushed to a limit. If labor income is using over 90% of its income for consumption, where is there room to increase taxes on labor, or even expect their savings rate to increase?

The upward trend since 1969 of labor using more and more of its income for consumption will have to be reversed or at least stopped. We have all heard that real wages have stagnated. Labor income has been subdued and pushed to a limit. Its back is up against the liquidity wall. Do we know where the snapping point is? The next recession could push labor income beyond a snapping point.

How is this situation going to be resolved, so that labor income will have breathing room to save money once again? or do we just allow labor to go under the control of capital?

Happy Labor Day!

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