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Business tax cut or Increased Govt. spending?

This is a quick post to a question in the comments section by Jerry Critter on the circular flow model using labor income.

He asks, “To improve the economy, we hear two somewhat conflicting stories.  One, we need to increase government spending, or, two, we need to reduce business taxes.  Can your model compare the relative benefits of these two approaches?”

We start with the current conditions…

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Taking the Circular Flow to the limit of equilibrium

As I said, I was going to post a version of the circular flow model for current conditions of the economy.

Setting up the model

Conditions for national accounts and other numbers are currently… (See these graphs CGINX, XM, Undistprof)

  • Real GDP of $15.650 trillion. (2009 dollars)
  • Effective demand limit of $16.1 trillion. (real 2009 dollars)
  • Effective labor share of 74%. (Effective labor share is a value determined from the relationship between labor share and capital utilization.) The index for Labor share (2005 = 100) as given by the Bureau of Labor Statistics is around 95. The index is translated into an effective labor share of 74%.
  • Gross private consumption $10.700 to $10.750 trillion.
  • Government expenditures $2.900 trillion.
  • Real gross private domestic investment $2.520 trillion.
  • Real net exports ($450 billion) annual basis.
  • Real exports $2.000 trillion.
  • Real imports $2.450 trillion.
  • Gross government borrowing $500 to $600 billion.
  • Undistributed corporate profits $1.0 trillion.

Assumptions  and constraints. These constraints are run in the Solver function of excel.

  • Net taxes (taxes – transfers) are 15% for both labor and capital.
  • All autonomous spending has been made equal to zero. Marginal propensities are for each dollar of disposable income.
  • Imports are roughly the same percentage for both labor and capital consumption. Imports for capital were set at 20% of capital disposable income, (capital income – capital net taxes).
  • Capital saving is equal to undistributed corporate profits of $1.0 trillion.
  • Saving is the money left over from income after taking out net taxes, consumption and imports.

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Extending the preliminary circular flow model with labor share

I want to expand on the last post where a simplified circular flow model was given incorporating labor share of income. That circular flow did not include sectors for a government nor foreign markets. I now will expand that model to include those sectors and more.

Extended circular flow for labor share

Here is the model in equilibrium. The model seeks to simulate the real economy. Dollar values are in billions.

Circular flow ext 1

Link to Graph #1

There is much to unpack here, let’s get started.

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Krugman & Kalecki, “injecting” to escape from a sub-optimal reality

Paul Krugman today wrote that we are in a “Keynesian crisis that calls for Keynesian policies”. Keynesian policies are monetary and fiscal policy to increase demand in the economy.

I wrote a response earlier today about an article from Mark Thoma who called for the same Keynesian policies of monetary and fiscal policies to increase demand. My view is that in normal times, those policies would take us back to a normal real GDP, but since labor share has fallen, the true and natural real GDP now sits at a lower level. If we then use Keynesian policies to push toward a higher real GDP that is above this new lower natural level, we will create an imbalance that could only be maintained by continued “injections” of Keynesian policy. The injections are deficit spending and expansionary monetary policy.

The title of this post implies that the injections are like a drug that lifts us to a “high” in order to escape the dreary, disappointing sub-optimal reality that we live. Economically, we now live in a sub-optimal reality due to a lower labor share of income. (see circular flow model) In order to maintain that “high”, the injections would have to be continued and never stopped. Because if they were to stop, the economy would come down to its true reality. This would cause a recession… like withdrawals from an addiction.

Krugman in his article noted that Michael Kalecki, the famed contemporary of Keynes, “had the answer“. If you mention Kalecki, you know you are going to read something about effective demand. Kalecki worked harder on the idea of effective demand than Keynes in my opinion. My work in economics focuses on effective demand, so I have something to say.

In the Kalecki article that Krugman linked to, we find this written.

“If the government undertakes public investment (e.g. builds schools, hospitals, and highways) or subsidizes mass consumption (by family allowances, reduction of indirect taxation, or subsidies to keep down the prices of necessities), and if, moreover, this expenditure is financed by borrowing and not by taxation (which could affect adversely private investment and consumption), the effective demand for goods and services may be increased up to a point where full employment is achieved.” (source)

This quote  is a basic argument for a Keynesian policy of deficit spending to inject demand into the economy. It is important that the government receive its money by borrowing, because an increase in taxes would be a withdrawal from the economy. The increase in taxes would offset or neutralize the effect of the deficit-spending injection.

Does effective demand actually increase with added injections of deficit spending? Yes, as long as it is within the effective demand limit, where effective labor share is still above the product of labor and capital utilization. Can increased injections push the economy beyond the effective demand limit? Yes… but …

Kalecki writes in the link offered by Krugman …

“It may be objected that government expenditure financed by borrowing will cause inflation.  To this it may be replied that the effective demand created by the government acts like any other increase in demand.  If labour, plants, and foreign raw materials are in ample supply, the increase in demand is met by an increase in production.  But if the point of full employment of resources is reached and effective demand continues to increase, prices will rise so as to equilibrate the demand for and the supply of goods and services.  (In the state of over-employment of resources such as we witness at present in the war economy, an inflationary rise in prices has been avoided only to the extent to which effective demand for consumer goods has been curtailed by rationing and direct taxation.)  It follows that if the government intervention aims at achieving full employment but stops short of increasing effective demand over the full employment mark, there is no need to be afraid of inflation.

The bolded sentences basically say that if the economy finds full-employment at or under the effective demand limit, prices will equilibrate between supply and demand and inflation will not be a problem. The implication is this… If government expenditure pushes production over the effective demand limit, there will be inflation.

I am here to say that the effective demand limit sits at a real GDP of $16.1 trillion (2009 dollars). That level is dependent upon an effective labor share close to 74%. By my calculations, at that level of real GDP, unemployment will come down to between 6.7% and 7.0%, which is not full-employment in the eyes of Krugman, Thoma and many others. They will want to push real GDP beyond $16.1 trillion with more injections… toward the CBO potential real GDP near $17 trillion. The result will be lower unemployment with inflation. Then everyone on the right in economics will accuse them of causing inflation just like “typical” Keynesians. The right will accuse them of taking the economy back to the 1960s. Hippie drugs and all.

Even if there is no inflation from pushing real GDP over the effective demand limit, which is a possibility, the economy would still want to lower real GDP back down to the effective demand limit. There are mechanisms of the profit rate that make that happen. Kalecki and Keynes wrote about that. Thus to maintain the induced “high” of a higher real GDP, the injections would have to be maintained and probably even increased over time. At some point in time, the pressure to stop the injections would mount, the injections would decrease and the economy not being able to maintain the artifical “high” real GDP on its own, would fall into recession.

Kalecki had an advantage over Krugman, Thoma and others. He was keenly focusing his awareness on the effective demand limit, even though he did not have a clear way to predict it. I work on an equation that can predict the effective demand limit. Krugman, Thoma and others need to be aware of the effective demand limit. Without this awareness, their policies will create a drug-induced high that will only lead to a harsher crash back to reality in the future.

They really should be talking about ways to increase the effective demand limit to protect us from inflation and other problems. The only way to do this is to raise labor’s share of income. I don’t see them giving any ideas on this over the past 2 days.

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Mark Thoma, cyclical unemployment & insufficient effective demand

Mark Thoma, professor at the University of Oregon,, posted an article about why labor markets are struggling, “What is driving changes in the job market?” at CBS Money watch.

He basically says that the labor market problems are cyclical, which means a Keynesian demand-deficient unemployment. There isn’t enough demand to allow unemployment to fall more rapidly. The normal Keynesian solution to cyclical unemployment is for the government to provide deficit spending and for the Federal Reserve to provide expansionary monetary policy. The idea behind deficit spending is that the government provides the demand that is lacking in the economy. The idea behind the expansionary monetary policy is that low interest rates will increase non-government spending.

And we see, Mark Thoma ended his piece in true Keynesian style…

“The main takeaway is that contrary to speculation about technological change and part-time work, most of the variation in part-time employment appears to be cyclical rather than structural.
That’s good news: it means policymakers, if they choose to, could use fiscal as well as monetary policy to bolster the recovery of the labor market.”

But there is a problem.

From my work on effective demand, I showed that a low labor share of national income actually lowers the equilibrium level of GDP using a circular flow model. In that model, investment is increased, as is the intention with expansionary monetary policy. Real GDP grows at a certain rate to a certain equilibrium level of GDP. But if we lower labor share of income at the same time, real GDP grows at a slower rate and consequently the equilibrium level of real GDP is lowered. In fact, labor share has fallen a full 5% since the crisis. The effect of this is greater than people realize apparently.

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What Paul Krugman is getting wrong…

Paul Krugman posted an article today… “What Janet Yellen — And Everyone Else — Got Wrong“. But there is something he is getting wrong too, or at least, doesn’t seem to be aware he is getting it wrong.

He talks about the economic recovery having been so sluggish. And he offers this explanation…

“The best explanation, I think, lies in the debt overhang… And I would argue that this debt overhang has held back spending even though financial markets are operating more or less normally again.”

There is a deeper cause that he is not mentioning. What appears to be low demand is actually the symptom of lower labor share muting the money multiplier effect of investment. Paul Krugman knows that the “financial markets are operating more or less normally again”, as he says above. Yet, he seems unaware of how lowering labor share will lower the equilibrium level of real GDP, thus muting the ability of investment to expand through the economy.

I argue that the explanation has to do with labor share falling 5% since the crisis. I provided a simple model yesterday showing the dynamic of how a lower labor share leads to a lower equilibrium level of GDP… “Labor share affects the potential of investment to raise GDP“. The lower equilibrium level of real GDP creates a condition where investment returns to business with a smaller money multiplier. What we see then is sluggishness in the economy even though the financial markets are working fine.

Apart from lower labor share undermining the ability to pay down the overhang of debt, it also causes an “apparently” unexpected dampening effect upon monetary policy. Banks can loan money, but the economic returns on the loans are muted by a low labor share. The dynamics of low labor share are too obvious to overlook. On twitter, Frances Coppola responded to my article yesterday by saying, “that’s a brilliant post. Explains so much that I intuitively knew but hadn’t actually modeled.”

I think, Paul Krugman is simply unaware of the effect that the current lower labor share is having. But once he is aware of it, I have faith he won’t get it wrong.

labor share

Graph of labor share of national income

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EITC refund withheld in student loan default

Jared Bernstein writes about the EITC today (Earned Income Tax Credit), which is a program to help lift people out of poverty when they fall into low-paying jobs.

I just want to add another wrinkle to the story. When a student defaults on their student loans, which is something that will happen more and more in the future, any tax refund they might receive, including an EITC refund, will be kept by the IRS. The money will then be used to pay back the lender of that student loan.

EITC will not work for students running into a poor jobs market. Wages are low. GDP has a lower equilibrium level. Unemployment will stay higher than in the past. And students are now leading the household credit increases with new student loans, along with car buyers.

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Labor share affects the potential of investment to raise GDP

The circular flow is a model used to show how money and products move through an economy. I am going to use a simplified version to show the effect of labor share of income on GDP. Many people think that labor income is not quantitatively different than capital income. I will show that the equilibrium level of GDP is affected by a change in labor share of income. This would have important implications for monetary policy and expectations of GDP potential.

Basic Equilibrium

Let’s start out with a basic model. It will only involve labor, owners of capital, firms and a financial sector. The only injection into the circular flow will be investment. The only leakage from the circular flow will be savings. The model does not include the government sector nor imports/exports.

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Zombie Companies Live!… (cont.)

People see that corporate profits are up, way up. So they wonder, How can there be zombie companies out there if corporate profits are up so much?

The answer is in the “rate” of profit, which had been growing since the crisis. But now we see profit rates slowing down. Robert Lenzner of Forbes wrote in April of this year that “4 of 5 corporations are warning of a negative trend in profits”.

Excerpts from his article…

“That 14% corporate profit rate– you see–is to some extent the unusual result of the Fed maintaining interest rates at near zero. At zero, at 2%, corporations can borrow money to do their business and still report very solid profits, thank you very much. And yes, if interest rates go still lower, profits might temporarily move slightly higher– all the while increasing your downside risk at the certain to happen reversion to the mean of corporate profits.”

 

As the upward trend in profit rates reverses, zombie companies will be brought into the light. These zombie companies fed off of the business expansion, as profit rates were rising after the crisis. They generate a profit which is less than the market average for profit rates. When profit rates revert back to the mean, these zombie companies start losing money. As they struggle, they drag down other companies.

Monetary policy is protecting these less profitable companies from being replaced by more efficient operations. When the eventual recession hits, it will be deeper as more zombie companies will be cleaned out… unless monetary policy and fiscal policy comes to their rescue.

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Zombie Companies Live!… thanks to QE

Let me start by saying that I do not support the loose monetary policy of Quantitative Easing by the Federal Reserve.

Supporters of QE say that it is required because there is so much slack in the economy. They say that we are far below the CBO projection of potential real GDP. Thus, the monetary policy must find a way to lower real interest rates to encourage investment. My problem with this view is that effective demand will put a limit on real GDP below the CBO projection of potential real GDP. (see prior post) In my view, the business cycle will end much sooner than economists think. The benefits they see from pushing loose monetary policy are much more than what I see as possible. The risks of QE are therefore relatively greater.

Supporters of QE also point to high unemployment. The implication is that we need to support business in any way possible to create jobs. I have a problem with this view too. From my calculation, unemployment will be between 6.5% to 7.0% on a quarterly basis when the effective demand limit is reached. Unemployment will stop declining at the effective demand limit. The perceived benefits of QE to lower unemployment below 6.5% are not attainable in my view.

On the other hand, people who do not support QE normally point to the danger of high inflation. I don’t agree with this view either. There simply isn’t enough wage growth to provide demand for higher inflation. Also there isn’t enough upside to capital utilization to support an increasing inflation. Capital utilization will also be limited at the effective demand limit in the 79% to 80% range.

So then what is my problem with QE? What harm can it do? I will refer to William Emmott for an explanation. He is a former editor for the Economist magazine. There is a short video of his view on the problem with QE. (link to video).

His view is this… Accommodative monetary policy “distorts investment decisions”. It “subsidizes certain forms of activity”… “In the long-run you get an inefficient allocation of capital”.

He talks about how low interest rates distorted investment in Japan leading to weak economic growth. He says that the United States has a better chance of escaping this problem than Europe, but the problem is still present.

Mr. Emmott says that “Zombie companies, zombie sectors, are being kept artificially alive by accommodative monetary policy” and that this is “slowing down the process of creative destruction”. I would do more than just point to certain zombie companies, I would say that even healthy companies have become more inefficient from low-interest rate subsidization and from doing business with the zombie companies. Loose monetary policy is a disease that is weakening the interconnected vitality of the economy overall.

These zombie companies are less productive, less marginally profitable, thus less able to raise wages at a time when wages need to be raised. Zombie companies justify lower wages for all companies. Keeping these zombie companies alive is a weight dragging down the demand side of most advanced countries.

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