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

Correcting the Cartoon in Noah’s Post

Noah Smith posted a cartoon about how the minimum wage works. The cartoon came from Mark J. Perry at the American Enterprise Institute.

hackonomics

Noah said that it is Econ 101ism and I totally agree. Now the cartoon is obviously a wrong way to look at minimum wage. (I use the word “obviously” to play upon the word “actually” that irked Noah in his post. ¯\_(ツ)_/¯ )

The cartoon by Mark Perry is stupid economics. Let me show you a much better cartoon of how the minimum wage works.

Now, the cartoon above does not take into account externalities and the social costs surrounding the minimum wage. For example, when the minimum wage is low, we find more people using government programs.  That is because social costs of labor must be covered, either by wages or by public or private services.

Also, every economist seems to forget the prime directive of economics… I rarely ever read about economists using the term “Net Social Benefits”. It would have been a perfect moment for Noah to use this concept. The prime directive of economics is to maximize “Net Social Benefits” and not “Net Private Benefits”.

The global economy is floundering because economists and politicians have focused on “Net Private Benefits” of the rich guided by a trickle-down 101ism thing. Mark Perry is only concerned about maximizing private benefits.

So here is the obviously better cartoon… An artist, I am not.

beach min

The coastline is an ecosystem just as society is an ecosystem. People depend upon the marine life for food. Then the marine life depends upon a healthy coral reef. Then the coral reef depends upon the sea level.

The level of water in the sea describes how well the ecosystem of the coastline functions.

      • If the level of the water drops below the coral reef, it will die and the marine life with it. The people suffer.
      • If the level of the water rises above the land, the coral reef goes too far below the surface and does not function well until it can grow higher over a couple of generations.

But when the level of water is just right, there is abundant marine life and people are much happier.

The level of sea water corresponds to the level of the minimum wage. When the minimum wage is too low, the ecosystem does not function well and the social costs accumulate. When the minimum wage is just right, life is better for society overall.

The cartoon by Mark Perry is a childish way to view the ecosystem of a coastline. All he cares about are the houses on the beach. His cartoon cares nothing for the ecosystem of the sea upon which people ultimately depend. His type of thinking  disregards the ecosystems of nature and society’s relationship to nature. It is his type of thinking that is causing so many problems for the earth and society.

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Tracking Labor Share & Unemployment

In May of 2015, I wrote about the relationship between Labor Share and Unemployment. The post basically said that lower labor share translated into a higher limit upon unemployment.

Here is the original graph from that post…

ls unrate

In the post, I wrote…

“The graph implies that as labor share falls, labor is less inclined to supply their labor… and the natural rate of unemployment rises.

“Since 1947, the unemployment rate falls to a level consistent with implied supply & demand limits set by labor share of national income. The US is now hitting the implied supply limit.

    • Will the unemployment rate only fall as long as labor share keeps trending up?
    • Will the plot line end up respecting the implied supply limit of labor?”

So what has happened since this graph was posted? Has the plot line broken through the limit that I estimated? or Has the plot line respected the limit?

Here is the updated graph… (quarterly data)

ls unrate2

The plot line has respected the estimated limit. (Currently labor share at 100 and 4th quarter 2015 unemployment at 5%.)

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Projecting a Recession from 2013

I woke up today to see oil below $27 a barrel, the US 10-year at 1.6% and the Dow down to 15,600. How quickly the economy is faltering. It is a crazy moment.

Oil below $29 a barrel creates Geo-political tensions that can create attacks of aggression. Other countries have already tried to negotiate with the Saudis to raise oil prices… and now oil is slipping to even new lows. A tense situation for oil producers.

The US 10-year hitting 1.6% so fast over the past month seems to be building downward momentum. The yield curve is trying hard to flatten even with short-term rates near zero.

Recession seems imminent. Will it happen?

I called a recession this year based on my assessment of effective demand. Others like Tim Duy and Janet Yellen do not see a recession this year. But they lack an understanding of effective demand.

I have seen this coming for a couple of years.

Back in September of 2013, using my Aggregate Supply- Effective Demand model, I saw that an effective demand limit was forming at a Real GDP around $16 trillion (2009 $$). The AS-ED model was only developed in April, 2013.

Here is an image from a post back then.

ased3

I saw that the effective demand lines were bunching together setting up a Long-run Aggregate Supply zone around $16.1 trillion, where the aggregate supply and effective demand lines would meet.

I wrote in September, 2013…

“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? … 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.
.
The recession of 1980 followed the same pattern. The effective demand lines had been pointing toward an effective demand limit for 3 years since 1975. Then Real GDP hit the ED limit in 3rd quarter, 1978. A recession began to form and was official 2 years later. (link) (Note: The red dots in this graph show Real GDP moving with core inflation.)
ased4

Eventually in a post in August of 2014, I projected…

“The projection now is for real GDP to enter the zone of the effective demand limit between $16.000 trillion and $16.160 trillion. This will happen before 2014 ends assuming the calibration of 0.762 for effective labor share is within a close margin of error.”

So what happened?

aded2

Update Note: The red dots in this graph show the crossing points between aggregate supply and effective demand. These red dots are different from the red dots in the previous graph. These red dots show the equilibrium so to speak between aggregate supply and effective demand. In both graphs, the crossing points expanded upward as Real GDP hit the effective demand zone (LRAS).

The equilibrium points began to rise when Real GDP hit $16.1 trillion. That is a sign of hitting the effective demand limit. This happened before the end of 2014, just as I had predicted. When effective demand rises in the LRAS zone, the dynamics of the economy are on the downside of the business cycle, just starting downward.

Ever since the end of 2014, the economy has been faltering. I predicted that the Dow would orbit 17,300 through 2015. And it did.  I gave a 70% chance of recession this year back in January. (link, see comments.)

If this cycle is like the cycle before the 1980 recession, we would see a recession about 2 years after hitting the effective demand limit… That would put a recession this year, 2016, in the summer or fall.

So I got glimpses of the effective demand limit upon Real GDP as early as September, 2013.  We have seen this coming for years.

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FOMC Projections of Fed Funds rate

Here is the graph from FRED for FOMC Summary of Economic Projections for the Fed Funds Rate, Central Tendency, Midpoint. (link)

fomc ffr

1.15% for 2016.

2.45% for 2017.

3.20% for 2018.

LOL… lots of luck.

“The projections for the federal funds rate are the value of the midpoint of the projected appropriate target range for the federal funds rate or the projected appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. Each participant’s projections are based on his or her assessment of appropriate monetary policy. The range for each variable in a given year includes all participants’ projections, from lowest to highest, for that variable in the given year; the central tendencies exclude the three highest and three lowest projections for each year. This series represents the midpoint of the central tendency forecast’s high and low values established by the Federal Open Market Committee.”

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The Fed messed up

This post will build upon my previous post with the Cobra equation. In that post, I gave a model showing that the Fed is completely behind the curve of the business cycle. The Fed should not be raising rates at this point in the business cycle.

When to Normalize in Theory

In the model, aggregate profit rates have a somewhat circular movement through a business cycle. I say somewhat because in other business cycles, the circular movement looks more like a bouncing ball off of the effective demand limit.

healthy cycle

In the green portion of the cycle, aggregate profit rates are increasing. There is broad momentum to expand utilization of labor and capital. It is the best time for interest rates to get on a path to normalization. The economy can withstand the good medicine of normalizing interest rates because of the momentum of increasing profit rates.

If US interest rates are too low or too high in the green area, global imbalances will grow to some extent.  In the present business cycle, inflation and the labor market looked weak, interest rates were kept low. Even though the economy seems weak and fragile in the green area, the underlying profit momentum drives economic developments and possibly imbalances. Normalizing interest rates are meant to moderate those imbalances.

So the Fed decided not to normalize interest rates because the economy seemed weak and partly because economists like Paul Krugman said the Fed needed to wait for inflation. But global debt accumulated, even emerging market debt, because interest rates were not normalizing in the US.

The accumulated debt is a problem that hinders growth. Apart from there just being more debt, much of the debt in emerging markets is in US dollars. So if interest rates are normalizing in the US, there is a control over too much US dollar debt developing in emerging markets. That is a good thing, because now we see greater problems as the cycle begins to tighten with monetary policy and peaked profit rates.

Also in hindsight, the increased use of US dollars in emerging markets is a problem now that commodity prices are falling. As well, the devaluation of the Chinese Renmibi may have occurred earlier in a more balanced way, if the US had been normalizing interest rates earlier.

So what has the Fed done?

healthy area

This graph seeks to show that the Fed should have been normalizing interest rates in the green area when there was the momentum of increasing aggregate profits rates. The “global” economy would have had better discipline, better balance in order to not create cyclical debt imbalances in US dollars. (Cyclical means that at a certain point in the business cycle, the imbalance becomes a problem.)

Moreover, the efficiency of the US economy would have been greater. Higher interest rates imply more productive companies and consequently better net social benefits, as long as the interest rates are normalizing with the profit rate cycle and with a correct estimate of the real natural rate.

The generally accepted normalized rate for the Fed rate is between 3% and 4%. We are far from there.

The Fed should have been normalizing rates in the green area, and certainly not in the red circle… as they have done. They are completely behind the curve.

With aggregate profit rates peaked for over a year now, it is clear that the business cycle has peaked. So from what I see, the Fed has really messed up, even Paul Krugman. They seem to think that the economy is still within or arriving at the green area of the business cycle.

Now is absolutely the wrong point in the profit rate cycle to be normalizing rates. In a normal cycle, this would be the time that interest rates peak or even fall, but not rise. The Fed can tip the economy into recession.

As I have said before, the Fed will go through some deep soul-searching… as things will not turn out well for them.

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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.

update change in cobra profit rate

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.

update 3d monthly

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.

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Will more economists say that Fed waited too long?

I have been saying for more than two years that the Fed should have raised the Fed rate earlier. Now it is too late because the economy is over the top of the business cycle… or as I would say, against the effective demand limit. They should have raised the Fed rate when effective demand was open and available to give momentum. (my recent post on this.)

So I give you this video from Boom Bust. I direct you to the end of the show in the segment called, Big Deal (21:30 minutes [point). You will see across the bottom of the screen, Federal Reserve Tightening Too Late. They talk about why the Fed should have raised the Fed rate earlier. Will more economists end up realizing this? … I think so…

You might also watch the segment of the show with DiMartino Booth. She has said the Fed waited too long too.

Update: Why did the Fed wait too long? This to me is an interesting question. Paul Krugman is kind of upset that the Fed is raising rates now and is unclear why. But ironically, the Fed may actually have been listening to Krugman and DeLong and others causing them to hold off. But eventually the Fed had to get on the normalization path. Yet, waiting until the top of the business cycle is kind of not smart. But they did not know that the business cycle was reaching its top fast… but I did with my effective demand calculation…

They over-estimated the output gap. While I saw less actual potential because I re-calibrated potential lower with a drop in labor share.

So what are you going do?

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Now Noah Smith raises the Zombies to put them down

Noah Smith posted an article about Zombie companies in Japan. He recognizes that creative destruction must take place. Zombies must die. So bail outs of inefficient businesses must stop.

“Japan’s cycle of bailouts must end.” Noah Smith, January 20, 2016

I agree and have written in the past about the Zombie companies weighing down advanced economies. They hold down wages, productivity and growth.

“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.” Edward Lambert, August 5, 2013

“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.” Edward Lambert, August 6, 2013

“So there must be pressure within the banking system to keep the central bank rates low for a “considerable” time in order for society and banks to avoid suffering the hardships of killing zombies off.  Yet we will eventually have to kill them off in order to improve productivity and real wages. Sooner but for sure later the world will have to take its medicine by central banks tightening their rates…” Edward Lambert, September 19, 2014

Will the Fed loosen monetary policy back up with another QE? Will they try to save the zombies again and again as Japan has done?

It is great to see Noah Smith bringing this issue up, because the downturn we are seeing is related to vulnerable zombie companies out there in the economy. If the Fed and other policy makers would just let the market open up for entrepreneurs to creatively destroy the zombies, eventually the world economy would move forward with vigor.

But, as Noah points out, when Sharp has 50,000 employees on the line, and small start-ups much less, jobs must be saved. But the cost is lower wages which eventually drag down the demand side of the economy. General Motors in the US was bailed out and their wages dropped.

So I give a big cheer for Noah’s article… YEAH!

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Recession or Resetion?

Reset button on white background

I wrote last summer that the Dow would not rise much above 17,300 and then eventually drop from that level into a recession. We see markets dropping now, but are they dropping into a recession or a resetion?

What is a resetion? That is when the markets “reset”. Stock values have been high so at some point they need to come back to reality. Many companies have been overvalued. Now is the time to reset stock values.

The difference between a recession and a resetion is that a recession hits the whole economy and a resetion hits certain markets and business values.

In a recession and a resetion, many companies are challenged to survive and some end up fading away. Ultra-low interest rates have kept inefficient companies alive which have kept down wages and productivity. The survivors come out stronger.  Productivity rises after.

We will see at least a resetion of the stock markets. But will we see a recession in the whole economy? Well, there is a need for a resetion of the whole economy too. Rent prices are pressuring the budgets of many people.  Inefficient companies need to be weeded out. Asset prices beyond stocks need to reset too. So a resetion (resetting) of the whole economy could result in some healthy changes.

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Forecasting the Markets thru Effective Demand

Most economists do not put stock in the stock market. That is to say that they do not include the stock markets in their analyses. Yet, economists should have a sense of what the markets will do if they are actually good economists.

Economists seem to think that the stock markets are ruled by psychology and irrationality. Maybe so, but they can still be understood. Economists do not seem to understand stock markets. However, Larry Summers says that economists and policy-makers should not ignore the stock markets. (link)

Tim Duy who is a respected economist stands by his prediction that there will not be a recession this year. (link) Yet he also predicted that the stock markets would rise modestly this year. (link) Who really thinks the Dow could make it back up to 18,000 this year? There would have to be massive easy monetary policy globally. Yet that would just make the markets that much more top heavy.

What economists really need is a way to measure the limits of the business cycle. I have the advantage of being able to measure an effective demand limit on the business cycle.

In 2014, I said that the Dow would orbit around 17,300 for the rest of the business cycle. Then I said last summer that the Dow would not go much above 17,300 and would eventually come down from that point into recession. After this past week, I can more easily repeat my prediction. It would take a lot of psychological healing from China to other parts of the world to bring back faith in stock markets to get the Dow over 18,000 before the next recession.

What did I do to make these correct predictions?

It is just an understanding of effective demand, which signals the natural top of the business cycle. My models are developing in order to foresee this top years in advance. I seem to be the only economist using a measure of effective demand to make correct predictions ahead of the markets. Other economists make correct predictions without using a measure of effective demand. But my point is that effective demand can be used to much easier.

If other economists are able to understand what I understand about effective demand, we might see better predictions and policies. Of course, the proof in the pudding will come if there really is a recession this year. Then my measure of effective demand hit spot on the natural top of the business cycle near the end of 2014.

Am I a great economist? No… but the great ones would be better if they understood effective demand.

Keynes emphasized effective demand in his great book, but does anyone but me put a number to it? Not that I see… and my numbers are hitting spot on… so far.

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