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

Recession Detection using Effective Demand limit

I worked with Dwaine Van Vuuren of Recession Alert a few months ago on using the effective demand limit to detect recessions. He said the effective demand limit gave the best detection of a recession he had ever seen. He said he had seen hundreds. I want to show you one graph he came up with.

This graph is a measure of the gap between real GDP and the effective demand limit. I already showed how this limit will signal a recession in a prior post. This graph from Dwain goes deeper.

The graph shows the “Percent change over one year” of the gap between real GDP and the effective demand limit. The gap was made negative (flipped upside down basically) so that the plot would show a recession down below. (recessions shaded in) (graph up to 1stQ-2013)


Link to Graph

The pink line marks the threshold at 1.6%. In every single case, when the plot broke below the pink line, a recession was currently happening or imminent. The bottom red line was added because of the false positive in 1997. My view is that there was distorted data for 1997.

Apparently from Dwaine, this is a very reliable method to detect a recession. He has since used the effective demand limit to make even better methods to detect a recession, but I will leave it to him to share and publish that work.

The basic explanation of this graph is that the year-over-year gap between real GDP and the effective demand limit narrows above 0% in the graph and gets wider below 0%. An economy recovers from a recession over 0%. (note: When the plot goes back down to 0%, it is concluded that the recovery (within the effective demand constraint) is over.)

A recession is signaled after the gap has narrowed to 0% and then starts widening again. Once the y-o-y “rate” of widening surpasses the threshold, 1.6% in graph, a recession is tumbling in.

As of the 1st quarter 2013, we were not in a recession.

Related reading on business cycles

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Why is inflation so low?… asks Menzie Chinn

Menzie Chinn over at Econbrowser posted on low inflation today. His argument is that there is still lots of slack from real GDP being way below potential real GDP and from high unemployment. The idea is that abundant slack depresses prices.

Inflation is generated as slack capacity is utilized. It’s the normal result of labor market forces in an expanding business cycle. Increased money from business expansion progressively chases fewer goods through marginally declining production.

Normally, slack production is balanced by weak liquidity in the hands of consumers. But there is a deeper problem here than Menzie points to. He is pointing to a present situation of slack capacity, but the problem of slack capacity is so much broader and deeper, because liquidity in the hands of consumers is at a much lower level permanently now. So even if you have spare capacity and slack in the economy, inflation would still trend low.

I will explain using this log graph of inflation, unit labor costs and labor share. (1970 to present) The graph is based on the equation

Inflation = unit labor costs/labor share

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Putting money in the hands of people without creating more debt

People need money. That is the purpose of the Fed’s loose monetary policy. But there is no transmission mechanism that gets money into the hands of people.

Money is predominantly created in the economy through loans and credit from banks. Banks have to make loans or extend credit in order for people to have more money, more liquidity, in their hands. Banks simply have not been making enough loans to sectors of the economy where the money will end up in people’s hands.

People could have more money if their wages were increased in real terms. However, real wages are not increasing. Increasing wages is much better than extended credit for consumption demand, because extended credit is an injection into the circular flow of the economy that must be offset by a leakage. In other words, leveraged consumption will eventually be balanced by de-leveraging. Wages are not a debt, but rather a debt paid to labor for having done work. Labor is then free to consume without compromising future wages. On the other hand, extended credit for consumption eventually leads to a leakage from the circular flow because it is a debt that compromises future consumption by labor.

There are efforts to put money in the hands of people by creating local currencies and mutual credit groups. You can watch two video documentaries about this subject. 1) The Money Fix … 2) 97% owned (from Britain). These two videos contain profound truths about money.

And there is also the Basic Income movement. The idea of a basic income or insured living wage goes back to Beatrice Webb who helped found the London School of Economics. The obvious purpose of a Basic Income is to put money in the hands of people so they can survive, eat, clothe themselves and find shelter. The broader purpose of a basic income is to insure a liquidity foundation in the economy. With a stronger insured foundation for liquidity of people in general, the demand constraints in the economy that I and others write about would not be such a problem.

It is pretty clear that banks can be too big too fail and require liquidity to keep the economy alive. But is it understood that people as a group are too big to fail too? People require liquidity too. The economy is dying because people require more liquidity. I support efforts to increase money in the hands of people that do not depend upon creating debt.


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The People Lie Helpless, by Felix Santana Garcia

This is an article published yesterday by an acquaintance of mine who lives in the Dominican Republic, Felix Santana Garcia. He writes a weekly article for an online newspaper there. (I translated the article from Spanish.)

The People Lie Helpless

* The author is a financial manager and university professor. Living in Santo Domingo.

In recent years the Dominican people have lost their courage and spirit of defense to the extent that the authorities will increase costs, expenses and prices, and they do not flinch or react to protect themselves from measures that are adverse to their limited or low family budget. The people act as if anesthetized or masochistic.

It is surprising to see that every week fuel prices increase steadily. All goods and services in one way or another are impacted by these increases and the Dominican people whether healthy or hard-worker don’t raise their voice in protest.

The reason may have to do with the opposition that today is divided in some cases and in others silenced by corrupting money.

While inflation is reported from January to May 2013 at 1.72% and the annualized (May 2012 to May 2013) 4.99%, the people see in the markets that this is not so as the prices of a basket of necessary household items is estimated at more than RD $ 25,000.00. The situation is made worse because in many households with more than four members one person barely works with a net income of only RD $ 7,000.00.

No surprise to anyone to see how people entering the malls and supermarkets come out with one little pillow or perhaps empty handed, except for employees of public and private administrations who come out with lofty and luxurious emoluments and associated accessories.

So far this year, there are no signs of improvement in the pronounced inactivity of the economy that is on the verge of falling into recession, despite the injection of RD $ 20,000 million easing of reserve requirements and RD $ 9,000 million of assumed budget savings.

Nothing has been able to push the car of the Dominican economy and all because of the abysmal fiscal deficit over RD $ 205,000 million. All the while Mr. Leonel Fernández, the intellectual and material author of such deficit, has not been invited to go through the Dominican courts when for less foul or violations of the laws of the United States and Mainland China, a common citizen or a senior official would be processed to even the extreme of the death penalty.

For this, there are many Dominican families who are now deprived of a crust of bread and a mabí (sugar water, popularly known as tennis water) if not a glass of milk to sustain their lives.

Whole families with sorrow, eat something only once a day, others have to go to bed with a grain of salt under the tongue and a glass of water, in some cases non-potable water, living below the poverty line. This includes families who will never even reach the point of balance (equality between income and expenditure before taxes and interest, that is if they have a loan).

While all this happens, employees and high officials and the people related to the Executive party of the government enjoy high incomes and cushy benefits that allow them to eat and drink like kings and enjoy good resorts and travel abroad.

Poverty increases as an expense of correcting irregularities among other public finances over the past years. What a shame that it is the dispossessed people who are paying the costs of a party to which they were not invited and the party has not ended yet.

Neither was it felt in the shops or on public roads on mothers day or fathers day and many other traditional celebrations, as the purchasing power is at a minimum. So people only spend money when they find a bit on a piece banana only to live poorly.

The Defender of the people is not present, as this problem has no office or budget in the government, but neither is the Pro-consumer present as seen previously. It is forbidden to punish violators of the laws who sell expired products at inflated prices.

Definitely the people are defenseless, and perhaps, due to a poor diet, the people have no strength to raise their voice in protest, so that if the living forces, now dead, are not resuscitated as recently seen in Brazil by corruption and the high cost of living, soon the Dominican people will be a nation of the dead, ghosts or zombies.

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Paul Krugman leads us to Effective Demand

On June 10th, 2009, Paul Krugman gave a lecture at the London School of Economics on how economics should be taught differently after the crisis. (It was actually the third lecture over 3 days. All 3 lectures are available on youtube and I highly recommend them even after 4 years.)

Paul Krugman made 3 references to Keynes’ concept of effective demand in that 3rd lecture. The basic tone is that we need to work on making effective demand useful. It is evident that Paul Krugman has an interest and a respect for the concept of effective demand.

I have developed a new model for effective demand. In future posts at Angry Bear blog, Steve Roth and I are going to be explaining what this new model of effective demand is, how it works and how it can be useful.

For the moment Paul Krugman will lead us to look at effective demand.

Effective demand & an equilibrium limit on employment

In the video on youtube for Krugman’s lecture, at the 20 minute point, Paul Krugman is talking about some criticisms against Keynes. One is that Keynes didn’t have a notion about equilibrium. From the lecture Paul Krugman says…

“You’ll also see people say, well, you know, economists have this notion of equilibrium and Keynes didn’t do that. But, this is Chapter 3 where he lays out the essentials of the general theory. And he says very much, “I am looking for an equilibrium that determines the level of unemployment. I’m looking for, you know… It’s actually in economics style where one curve crosses another curve. And then we’re going to talk about what moves those curves around.””

This is the part from Keynes’ chapter 3 of the General Theory book that Krugman referred to.

“The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand. Since this is the substance of the General Theory of Employment, which it will be our object to expound, the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend.”

Keynes is looking for an equilibrium between demand and supply that determines the limit upon employment. He refers to this equilibrium limit as effective demand.

The principles of effective demand that I put forth state that the SRAS (short-run aggregate supply) curve and the effective demand curve will cross at the LRAS (long-run aggregate supply) curve. The LRAS curve is the notion of the natural real GDP at full-employment where output will not increase, but the price level will. The LRAS also gives us the NAIRU level of unemployment.


Graph #1

The equilibrium that Keynes is looking for is the intersection of the SRAS, LRAS and effective demand curves. Employment will be limited at this intersection which represents potential output. Keynes wanted to tell us that effective demand can establish this intersection even at a level below what economists would consider full-employment.

As Krugman explains Keynes thoughts on effective demand, the key issue is an equilibrium with effective demand that determines the level of unemployment. The graph above shows this with the NAIRU determined at the LRAS curve.

Keynes wrote this in chapter 3…

“Thus the volume of employment is not determined by the marginal disutility of labour measured in terms of real wages, except in so far as the supply of labour available at a given real wage sets a maximum level to employment. The propensity to consume and the rate of new investment determine between them the volume of employment, and the volume of employment is uniquely related to a given level of real wages — not the other way round. If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage, and the equilibrium real wage will be greater than the marginal disutility of the equilibrium level of employment.

“This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.”

Keynes is defining effective demand as a limit upon employment. He first says that employment is not determined by the point at which business is no longer willing to pay a certain real wage, but rather by levels of consumption and new investment. Thus, if consumption and new investment result in deficient demand, employment will be capped at a level below which business would still be willing to hire more workers based on the real wage. In other words, business would hire more workers, but there isn’t enough consumption and new investment to justify it.

Keynes is implying in the quote above that an increase in real wages can increase employment. How does this happen? Demand is the constraint on employment, not real wages. Thus real wages would increase and as you increase demand through higher real wages, the result is increased employment. because you have relaxed the demand constraint.

Effective demand & recessions

Then comes the issue of recessions and business cycles. At the 48 minute point of the video, Paul Krugman says…

“Keynes really put the question of why demand fluctuates on one side. But certainly it’s something we ought to be interested in. Particularly we ought to have some way of thinking about when it is that the bottom is likely to fall out on the economy. But almost nothing done on that.”

I recently posted a series of graphs looking at how effective demand determines the point at which a recession is likely to occur. So we know that the preliminary insights of Keynes into effective demand are within our grasp. Effective demand not only sets the stage for a recession, but it also caps employment and capital utilization before the recession starts.

Effective demand… making it happen

Keynes refuted Say’s law that “Supply creates its own demand”. Keynes stated that demand determines supply. Effective demand speaks to the relative purchasing power of consumers to determine supply. For instance, imagine an economy where labor gets paid 25% of national income. The domestic market for goods would simply provide less to consumers.

At the 53 minute point of the video, Krugman emphasizes Keynes’ focus on demand…

“Where do we go from here? First of all, I think, economists have really got to go back and say that these basic Keynesian type models need to be studied. People need to know that there is this issue about demand. They need to know that sometimes things that can’t be fully justified in terms of maximization are really important… that we need to have a whole different style of teaching. I don’t quite know how we make that happen.”

After all the above, what can I conclude?

Krugman says we need to develop the concept of effective demand better… make it more useful.

Well, 4 years later, we now have a model of effective demand; Steve Roth and I are going to work it out for you in future posts.

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Paul Krugman on verge of an illumination

Today Paul Krugman wrote a piece (and a blog post) about China’s high level of investment in the face of low domestic consumption. It is obvious to me that he is making headway in understanding the importance of low labor share of income.

Remember low labor share means high capital share. Capital income is dedicated to increasing the means of production, whereas labor income is primarily dedicated to purchasing the finished production. Paul Krugman refers to this directly…

“What immediately jumps out at you when you compare China with almost any other economy, aside from its rapid growth, is the lopsided balance between consumption and investment. All successful economies devote part of their current income to investment rather than consumption, so as to expand their future ability to consume. China, however, seems to invest only to expand its future ability to invest even more.”

“Wages are rising; finally, ordinary Chinese are starting to share in the fruits of growth. But it also means that the Chinese economy is suddenly faced with the need for drastic “rebalancing” — the jargon phrase of the moment. Investment is now running into sharply diminishing returns and is going to drop drastically no matter what the government does; consumer spending must rise dramatically to take its place.” (emphasis added)

For me, he is describing the growth model of effective demand, where an economy in its early stages puts more income into capital investment and then over time must shift income to labor to purchase the production of the earlier investment. The result is an increasing standard of living. Yet, he is also describing the problem with the US economy where labor share of income has backtracked to a lower level below previous normal levels. We too have created a lop-sided balance between consumption and investment in the form of labor and capital incomes.

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Real GDP has an appointment to keep with Effective Demand

The subject of potential real GDP is important. As Paul Krugman had a post entitled, “Potential Mistakes”. Today Dean Baker had a post entitled, “GDP Growth Remains Below Potential Growth”.

Paul Krugman said, “It is important to have an idea of how much the economy could and should be producing, and also of how low unemployment could and should go. For one thing, it’s important for fiscal policy; … But it’s also important for monetary policy…”

The key word in this quote is “could”. This post seeks to better define what the economy could produce.

We are living through unusual economic times. The bubble popped and labor share has fallen to levels not seen in a very very long time. Economists don’t quite understand that we are in a different economic reality. Constraints never seen before are now influencing the economy. It appears economists are being frustrated by these invisible constraints, and can’t coherently acknowledge them yet either.
My work in effective demand is revealing constraints not yet formally acknowledged.

It is generally viewed that potential real GDP is output at full-employment of all available labor and capital resources. My view is that potential real GDP is the output limited by potential demand, even if all available labor and capital resources are not employed. Thus, the economy “could” produce up to the potential demand limit.

For example, if you are determining potential production for your CEO, and you tell him that the factory can produce such and such amount at full-employment. Then the CEO asks another employee who did market research into potential demand, if there is sufficient demand for that level of production. And he says, “No, there won’t be demand to support that level of production.” Then the CEO wants to know what level of production “could” satisfy all the demand. It turns out that this level of production is less than you calculated. The CEO then says that the true potential production is the level constrained by demand and that this is the level around which the company will establish its policy and planned utilization of resources.

When economists determine potential real GDP they do not take into account potential demand. In all fairness, they have never had to until now. I will explain this at the end of the post.

First, I will calculate real output with a simplified model where productive capacity is multiplied by the utilization of labor and capital. (The utilization of labor and capital is determined by multiplying the utilization rate of capital, capacity utilization, by the utilization rate of labor, employment rate. I call it the TFUR, total factor utilization rate.)

Real output = productive capacity * TFUR

(Productive capacity is the total possible output using 100% of labor and capital resources.)

For example, with a productive capacity of $19 trillion, capacity utilization of 85% and labor employment of 94%, real GDP would be $15.18 trillion. (19*0.85*0.94)

Second, I calculate potential demand by multiplying real GDP by effective labor share divided by the TFUR. (Effective demand is potential demand.)

Effective demand is potential demand = Real GDP * effective labor share/TFUR

TFUR does not like to be above effective labor share. Thus, real GDP reaches effective demand when TFUR is equal to the effective labor share.

Now we substitute real GDP with the equation for real output… then cancel out TFUR.

Effective demand = productive capacity * TFUR * effective labor share/TFUR

Effective demand = productive capacity * effective labor share

Here is a graph based on a productive capacity of $19 trillion and an effective labor share of 74%. There are trillions of $$ along the y-axis and the TFUR along the x-axis.

pot demand

Graph #1

In this simple model, output rises with more utilization of labor and capital. Then output reaches the effective demand limit and will stop, unless more labor and capital are added and/or productivity increases. According to this graph, potential real GDP would be $14 trillion, because effective demand limits output at that level. Effective demand is based on 74% effective labor share. So we see real output cross effective demand at 74%, where the TFUR equals effective labor share.

In a business cycle, real GDP rises as more labor and capital are utilized. When real GDP reaches the level of effective demand (potential demand), a recession would ensue. The economy will go through various changes between the time real GDP reaches effective demand and the start of the recession.

This is the basic model, but how does it behave in the real world? Well, let’s apply this model to five previous recessions and to the next recession not yet seen.

Leading up to the Recession of 1974

pot demand 1

Graph #2

Graph #2 shows the quarters leading up to the recession of 1974. We see that real GDP rose as the TFUR rose. Then real GDP reached effective demand. Real GDP continued rising for 4 more quarters. The last dot is the start of the recession. Right before this particular recession, the utilization of labor and capital kept rising after the effective demand limit was reached, (TFUR kept rising), which produced some inflation.

Leading up to the Recession of 1980

pot demand 2a

Graph #3

Here again, we see that real GDP (green line) rose with a temporary jump up, until it reached effective demand. In this case, when real GDP exactly equaled effective demand, the utilization of labor and capital started to fall. But there was a false start of a recession. Even though utilization of labor and capital was falling, real GDP kept growing. The recession did not start until the TFUR had fallen from over 81% to below 79%. In some ways the drop in utilization of labor and capital was a recession but technically the recession hadn’t started yet.

How can real GDP keep rising as the utilization of labor and capital fall? Increased productivity, increased stock of capital, or even increased purchases of output in the face of higher unemployment.

Leading up to the Recession of 1991

pot demand 3

Graph #4

Here again, we see real GDP was rising with the increasing TFUR. Then as the lines got close, the utilization of labor and capital fell, even as real GDP kept rising. This is similar to the case leading up to the recession of 1980 in graph #3.

Keep in mind that we are seeing the potential real GDP being reached in each graph. Once that potential is reached, the economy stops increasing the utilization of labor and capital, then goes into a recession. Real GDP might continue increasing, but combined utilization of labor and capital will stop increasing.

The almost Recession of 1994 and the Recession of 2001

pot demand 4

Graph #5

Towards the bottom we see data for 1992. We can see that real GDP (green line) was rising with the TFUR. When real GDP reached effective demand (red line), the TFUR contracted. However, real GDP kept rising. It was a false start of a recession. Then real GDP started rising again with an increase in labor and capital utilization. Then the TFUR contracted again but real GDP kept rising. We can see that effective demand kept rising with real GDP too. Finally the TFUR fell from above 78% to below 70% during the 2001 recession. Yet, real GDP still did not fall.

Realize again that once real GDP reached effective demand at the end of 1994, from that point on for the following years, the combined utilization rate of labor and capital (TFUR) was blocked from rising much further. This is the consistent effect of the effective demand limit.

How can real GDP keep rising when real GDP is supposedly reaching its potential as constrained by potential demand? … Productivity increased tremendously from the first false start of a recession through the recession of 2001. The productivity increase came at the perfect time.

(note: Effective demand rose with real GDP as productivity rose)

Leading up to the 2008 Recession

pot demand 5

Graph #6

Again, we can see real GDP was rising with the TFUR (labor and capital utilization). Then when real GDP reached effective demand, it looks as though real GDP was waiting for productivity to start pushing effective demand upward like in some previous recessions. Real GDP was blocked in a tight range for two years. Productivity did not come to the rescue. Productive capacity did not increase through productivity or increased capital. Effective demand was more solid this time.

For 2 years (8 quarters) we see that real GDP was hitting the effective demand limit. And then when it crossed the polynomial trend line the recession started. Some may ask why the recession started when it did. Well, effective demand was blocking further growth of the bubble and effective demand won. We need to understand why effective demand is becoming more solid.

Leading up to the next Recession… In other words, Real GDP has another appointment to keep with Effective Demand

pot demand 6

Graph #7

This is a graph of the quarters after the 2008 collapse up to the 1st quarter of 2013. As we can see, real GDP is rising nicely with increased utilization of labor and capital (TFUR). Effective demand is coming down to show us where potential real GDP will be. Potential real GDP is somewhere between $14 trillion and $14.5 trillion, at which point a recession would ensue, unless policy can manufacture a rise in the effective demand limit with a bubble, cost-push inflation or a new surge of productivity.

Note too that the recession would take place at a lower level of TFUR (74%) than we have seen for over a half century at least. People say the economy is just depressed and needs more time to get back to trend. Be that as it may, effective demand is going to constrain real GDP at this depressed state. Economists don’t understand this yet.

What does the CBO say about potential real GDP? The CBO says it is now $14.6 trillion and still increasing. Thus, the CBO presents a potential real GDP much higher than the effective demand constraint, which is not increasing into the future. The $14.0+ limit of effective demand is stationary.  In fact, effective demand is already undercutting CBO’s potential real GDP, as we can see in the next graph. Effective demand did not undercut CBO’s potential real GDP in any of the previous recessions. The next recession will be a first time that effective demand will constrain real GDP under CBO’s projection of potential real GDP. Economists have never seen this before and are not aware it is already happening.

pot demand 7

Graph #8

Real GDP will not reach CBO’s projection unless the economy finds a way to push effective demand up. I won’t count on it, because the dotcom-bubble days of manufacturing inflated demand are over.

This is the moment to recall Paul Krugman’s key word “could”. This graph #8 is showing us what the current economy “could” produce within the constraint of effective demand. What the economy “could” produce is lower than what the CBO says.

We need to be aware that effective demand is more solid now because productivity has reached a plateau, investment has been lacking, cost-push inflation would be dangerous, labor share is low from low-wage jobs and unemployment is higher. Productivity tends to increase at lower levels of unemployment.

How will this recession play out? Real GDP will continue to increase on the trend line in graph #7, whether slowly or quickly. Eventually it will reach the effective demand limit. I do not foresee much of a rise in real GDP once the effective demand limit is reached. I foresee a contraction in the utilization of labor and capital. There are scarce policy alternatives now to fabricate a rise in productivity or easy credit.

Like Paul Krugman says, it is important to know what the economy is really capable of producing in order to set appropriate fiscal and monetary policy. And if my analysis above is correct, we should not set a potential real GDP above the effective demand limit. This is just like the CEO who takes into account the limit of potential demand to know the true reachable potential of production.

The potential upside of real GDP is too dangerous to get wrong. The global economy is hanging in the balance. The up-to-now invisible effective demand limit says that economists are getting it wrong.


Written by Edward Lambert

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Productivity & Effective Demand: An Intriguing and Disturbing Story . . .

Edward Lambert at Effective Demand; Effective Demand = Effective Labor Income/(cu*(1-u)) points to the result of an economy left to maximize Profits at the expense of Labor. I have my own version or underlying causes of this issue and Edward gives the economic side of it.

I am going to show a graph of Productivity against Effective demand. It is an intriguing and a disturbing graph. Let me start by giving the equation for the productivity used in the graph.

Productivity = real compensation per hour: business sector/(labor share: business sector * 0.78)

The data for this equation comes from this graph at FRED.

The equation for effective demand is…

Effective Demand = real GDP * (labor share: business sector * 0.78)/TFUR

TFUR (total factor utilization rate) = capacity utilization * (1 – unemployment rate)

Let me just show the graph and then start explaining . . .

Productivity and Effective Demanda

The graph shows quarterly data from 1967 to the 1st quarter of 2013. The red dashed line is a trend line for the data. We can see that from 1967 to 1997, the plot stayed very tight on the trend line. There were deviations from this line during times of shocks and recessions. But it is very interesting how closely the plot followed the trend line before 1997.

Before 1997, the plot going below the trend line was associated with a recession. The explanation of this is that effective demand rises more during a recession because of more available capacity of labor and capital. At the same time. productivity tends to fall behind the trend line due to rising labor share, not falling real compensation.

When the plot goes above the trend line, productivity is ahead of effective demand. Productivity rises due to labor share settling down and real compensation rising. Effective demand tends to stay still during the expansionary phase of a business cycle. The economy grows up to the effective demand limit and then gets set for a contraction.

We used to have a balance between productivity and effective demand. The economy moved directly on top of the trend line for many many quarters. And now the economy has lost that balance. Since the late 90’s it is a fleeting moment when productivity and effective demand come together on the trend line.

Before 1997, there was very little movement away from the trend line. Then something unusual happened between 1997 and 2001, the dotcom bubble years. The plot went progressively below the trend line even though there was no recession. Productivity was rising during these years, but effective demand was rising at such an unusual rate that productivity could not keep up with it. Effective demand was being artificially created and inflated. The recession of 2001 followed the same unusual path as before the recession.

In 2002, the economy had to make an adjustment. Productivity had to rise or effective demand had to fall. During the housing bubble years (from 2002 to the quarter right before the 2008 recession), productivity rose, while effective demand basically stayed steady. The plot went back above the trend line showing that productivity was beyond the capacity of effective demand and that productivity was at a non-sustainable level. The economy sustained this high level of productivity in the face of low effective demand for a few years, but eventually the correction would come in 2008. The correction was a collapse.

Look at where the economy is now. Since the end of 2010, the plot has barely moved from a productivity just below 1.4 and an effective demand around $14.1 trillion. The plot is way above the trend line and has been just sitting in the same spot for over 2 years. Effective demand is too low for the current productivity in the US. This is an economic bomb building energy that will eventually go off when real GDP approaches $14.1 trillion.

A friend of mine had a dream a few nights ago, where a spirit said that the economy is dying. The graph above would lead one to think the same.
Think about it… where can the economy go now from here?
There are 2 options . . .

Option #1 looks at the equation for Productivity: You have to lower productivity by increasing labor share in relation to real compensation.

1. If you lower real compensation, labor share would fall, but it would have to fall slower than real compensation. Keep in mind though that a lower labor share would lower effective demand too, which would work against the objective. However, if labor share actually rose in the face of lowering real compensation, you would see an economic contraction. So lowering real compensation is not a good option.
2. On the other hand, if you raised labor share faster than raising real compensation, productivity would come down as effective demand increased from higher labor share. This is a safe and sensible way to correct the huge imbalance we find ourselves in.

Option #2 looks at the equation for Effective Demand: You have to increase effective demand back up to $16 trillion. There are two options here as well.

1. Utilization of labor and capital would have fall. (TFUR in the equation above would have to fall.) This would mean a rise in unemployment, which would mean another collapse.
2. Labor share would have to rise. This would also have the beneficial effect of lowering productivity, as long as real compensation rose moderately.

As we can see, the only real option to avert another collapse is to raise labor share of income. This is not likely as businesses are even now fighting an increase in just the minimum wage. Businesses are trying to maximize their profits and do not want to raise labor costs. Yet this objective of theirs is going to kill the economy.

The graph above shows that there is a bomb ticking, and it is a bigger bomb than we saw in 2008. Higher productivity in the face of low effective demand is unsustainable. Yet, we have been sustaining it for over 2 years now with an incredible expansionary monetary policy in the face of an incredibly low labor share of income.

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