In the preceding posts, I talked about the potential real GDP based on Effective Demand. I want to show the equation for it and some graphs too. First the equation...
ED potential real GDP = real GDP - $3000 billion * (cu - els)/els
els = effective labor share ... cu = capacity utilization ... $3000 billion is a constant for the amplitude of the business cycle around potential GDP in terms of real $billions of dollars (2005).
The equation simply says that the business cycle is determined by the rise and fall of capacity utilization around effective labor share. The center of the business cycle is when capacity utilization is equal to effective labor share. There we see (cu - els) = zero, and ED potential real GDP = real GDP. When capacity utilization is above effective labor share, ED potential real GDP will be below real GDP. When capacity utilization is below effective labor share, ED potential real GDP will be above real GDP.
Here is the graph of data since 1967.
In the graph we compare Effective Demand (ED) potential real GDP to actual real GDP and to the official potential real GDP released by the Congressional Budget Office (since 1967). For most of the years, there is really no surprise. The blue line and the pink line of the different potential real GDPs follow each other fairly closely. But then we get to the crisis of 2008 and the lines make a big divergence. Here is a graph focusing on that divergence...
The yellow line of real GDP falls and begins to follow a parrelel path to the official potential real GDP from the CBO. We are familiar with that scenario. But the potential real GDP calculated upon effective labor share fell with real GDP and then moved straight right for 2 to 3 years before settling into a new parellel path to the official real GDP line. Real GDP has moved from below the ED potential real GDP line to above it as capacity utilization rose above effective labor share. (note: During that period of time, effective labor share fell a few percentage points.)
Now, if the ED potential real GDP line stays steady, it is only reasonable to assume that the eventual contraction of the economy will cause capacity utilization to fall below effective labor share again. The consequence is shown by the additional brown line where real GDP will turn to cross the center of the business cycle.
It's interesting to note that the ED potential real GDP started to diverge from the official potential real GDP in 1Q-2008 before it fell hard in the 4Q-2008. The economy was falling apart months before the crisis became public knowledge.
What does it mean that potential real GDP could fall so harshly? Many economists can't fathom a fall in potential real GDP. They think that it represents the natural potential of the economy using its full resources of labor and capital. They think that the economy will simply return to that level as labor and capital are re-utilized. But this is where the principles of Effective Demand come in and explain the situation. A lower effective labor share has locked the utilization rates of labor and capital into lower levels. The economy won't be able to utilize labor and capital to the extent that it needs to in order to return to the historic potential trend.
Real GDP moves within a range governed by the dynamics of the business cycle. Potential real GDP is meant to describe the center point of that range. Effective demand has the ability to put constraints on real GDP. The basic mechanism for doing that is the effect that effective labor share has on the utilization rates of labor and capital. The dynamics of Effective demand can box the economy into new levels.
Let's look at the equation for Effective Demand...
ED = real GDP * els/(cu*(1-u))
The principle of Effective Demand says that real GDP will not want to rise above Effective Demand. Therefore, as effective labor share (els) goes down, the constraint on real GDP goes down too. Before the crisis, effective labor share was roughly 78% and the combined utilization rates of labor and capital, (cu*(1-u)), were roughly 76.5%, just a little below effective labor share. Since then, effective labor share has fallen to 4 % points to 74%. The combined rate for labor and capital has fallen 5 points to 71.5% as of 4Q-2012. In essence, they have both fallen close to the same amount, meaning that the economy is almost back to the pre-crisis ratio between els and cu*(1-u).
Before the crisis, the combined utilization rates of labor and capital stayed just below effective labor share for 3 years! Even during the bubble, the principle of Effective Demand limited the utilization of labor and capital. The implication is that the combined utilization rates of labor and capital will not now return to 76.5%, because it must stay below the current effective labor share of 74%. The low level of the ED potential real GDP reflects the constraint.