In this effective demand research, I calculate the output gap by comparing capacity utilization to the effective labor share.
You will see a graph to the right on this blog where that value is update. The graph is called, ED Output Gap.
In the past, the output gap reaches a peak between +$100B to +$200B before heading into a recession. The current calculation is doing the same. Yet the recent steep decline in the output gap would normally signal an economic contraction is near.
New Labor Share data came out today for 1st quarter 2016. It is 100.1. As I expected, it is still climbing.
Why did I expect this? Because unemployment was dropping against an estimated limit that I have been watching. So labor share needed to rise.
There are some graphs that imply a higher risk of recession. When the red dots in the AS-ED model start rising along close AS lines, this has been a signal of imposing recession in the past.
The output gap is falling to a level after rising that has signaled an impending recession in the past. (look at green line)
This graphs implies that unemployment would start rising soon according to patterns in the past. (look at red line curving away from y-intercept.)
The economy looks to be 1 to 4 quarters away from a recession. However the recession alert graph is still not showing a recession, even though it is hovering towards the red line. Conceivably the line could be in a zone where a recession could be triggered. (between the yellow and red horizontal lines.)
Obviously not a good time for the Fed to raise rates next month. The economy is weakened.
My models see a recession likely to form before the end of 2016.
One has to be crazy to disagree with Brad DeLong. Then, I must be crazy. He said...
"After being wrong for eight straight years, critics of expansionary macro policies in a high-slack low-inflation economy--" Link
It is true that if we look across America, we will see lots of slack and underemployment. Labor force participation is low. Labor hours are at the same level as 15 years ago. (link) Part-time work is higher than in the past.
So why do I disagree with Brad?
Monetary policy is coordinated with the hope that the high-slack will eventually be utilized. In the words of my daughter, "Not gonna happen". Much of the labor force is simply not going to be needed for the equilibrium economy. Much of labor has been cut out (marginalized) from the equilibrium economy.
The reason is growing inequality...
more concentrated wealth and income = more concentrated consumption demand = more concentrated production
We need fewer labor hours to serve those with the concentrated wealth. The equilibrium level of labor is lower. So we will now always see slack and more underemployment, because the labor force is being concentrated due to income inequality.
The hope of low interest rates is for lower-level businesses to hire the marginalized labor and tighten the labor market so that inflation will return. But the larger marginalized labor force sitting outside the equilibrium economy helps keep wages down. So inflation will stay weak. The low Fed rate is in a delusional attempt. The Fed rate will stay low for a long time until it recognizes that a significant portion of the high-slack is simply gone causing inflation to remain weak.
The Two Groups within Slack
When you look at the high-slack, a relatively smaller portion of it currently will be utilized to bring the economy into an "equilibrium" state of full-employment. The slack that we see is comprised of two groups.
Those who will be utilized.
Those who will not be utilized... the marginalized.
The "true slack" only corresponds to the first group. It is an error to put both groups into the potential slack to be utilized, because as the second group grows relative to the first, you drive down the Fed rate unwisely... unless you see institutions and policies reversing inequality. But inequality in the US is not reversing.
It is like expecting 100 people to come to a party, so you make enough food for 100 people. But then, really only 50 people have any chance of getting to the party. It was an inefficient error expecting 100 people. Too much food will be prepared. Too many people will be hired to prepare the food. Yet, businesses are smart. They know to hire enough labor to prepare food for only 50 people. That is what the "true demand" is.
Brad DeLong should know that inequality marginalizes portions of the labor force. He works in an organization that deals with inequality. And he sponsored a forum on inequality with Oscar Landerretche (economist from Chile who speaks against inequality) Youtube video link. In the video link Oscar Landerretche seeks to articulate his direct experience and deep insights of inequality.
Inequality produces higher levels of underemployment within the effective demand limits. I wonder if Brad DeLong has any measure of an effective demand limit upon an economy as Keynes tried to describe it. (link)
As the Fed rate rises, the marginalized workers will become more visible as to what they really are... marginalized. The marginalized workers really are unusable, unprofitable and unneeded slack. "True" slack in the economy is actually low. The unemployment rate would most likely rise as the Fed rate normalizes trimming out the weakly-incorporated marginalized. At some point though, the Fed rate will have to let go of these marginalized workers as dead weight on the equilibrium economy so that it can normalize... Otherwise a way has to be found to reverse the trend of inequality.
Menzie Chinn wrote about various ways to estimate potential GDP. It becomes perplexing when an estimation shows that the output gap could be zero. Why? Because there are such weak inflation pressures...
“That seems implausible to me, but then, so too does a nearly zero gap, given the lagging inflation rate.” – Menzie Chinn
The gap can be closed with weak inflation pressures.
Just hold down labor power, spread underemployment among more people, reduce labor share by 5%, mute investment and increase inequality. You weaken consumer power for more people. Now the real problem in understanding low inflation at a zero gap is thinking there is still much more spare capacity with so much underemployment. That is not good thinking. Underemployment does not necessarily imply spare capacity. It could also imply economically marginalized people working in underemployed jobs, which holds down wage inflation.
The economy has a balance for the number of labor hours needed for the concentrations of consumer wealth in an economy. The higher concentrations of wealth that we see now imply fewer labor hours in balance. We have seen labor hours peak at the same level for two decades now. The result is that many people will be cut out (marginalized) from the economy because they are not needed in the balance.
So what appears as spare capacity is really unneeded capacity that will never be utilized.
How many people have been cut out of the economy by rising inequality? We will eventually know as the Fed rate seeks normalization.
What is the primary error in macroeconomics? Potential output... and this error is huge. The measure of potential output is the foundation for many calculations.
Natural real interest rate
Natural level of unemployment
If you get these wrong, there will be problems. Paul Krugman wrote an article for the IMF, Increasing Demand. He writes…
“First, we don’t really know how far below capacity we are operating… Nobody knows—"
How wrong has macroeconomics been? Well, I am going to compare the CBO projection of potential real GDP with my own calculation of potential from my Effective Demand research.
As real GDP declined back in 2008, the CBO was not adjusting their projection of potential (pink line). Whereas my calculation (dark red line) moved horizontal for 3 years. My calculation showed that potential real GDP dropped to a lower trend line... a lower "New Normal".
The red arrowed lines show the discrepancy between my view of potential and the view of all major economists since the crisis. The discrepancy is huge and started early. The macroeconomic discourse has been based on this major error since the beginning... and the CBO downward revisions of potential have not cleared the error.
Assume for a second that my calculation of potential is correct. Then you realize that
monetary policy has been misguided.
imbalances have been building from erroneous policy for 5 years.
Larry Summers' projection of a negative natural real interest rate is misguided.
secular stagnation is just dropping to a new trend line.
I will make two more comparisons of the CBO potential real GDP and the effective demand potential.
During the Volcker recession, real GDP dropped quite a bit. However, the potential real GDP from the effective demand research did not drop to a new lower normal. It followed parallel to the CBO projection... and then moved with real GDP after the recession. The economy had a normal recovery from the recession.
In 2000, real GDP (yellow) started to flatten and fall. While the CBO was raising their projection of potential (pink), my effective demand potential (dark red) was beginning to flatten as well. Eventually all lines come back together in 2004.
But the important point is that potential real GDP gives a measure of slack in the economy (unused utilization of labor and capital). This measure of slack is critical for monetary policy. In 2000, the effective demand potential was showing that slack was increasing into a recessionary gap (real GDP less than potential). However, the CBO was still showing a high inflationary gap (real GDP more than potential). Greenspan saw the inflationary gap, saw inflation rising in 2000, expected more inflation and raised the Fed rate. The recessionary gap started to form months later. The effective demand potential said that he should not have raised the Fed rate like he did.
"As the economy grew rapidly during the second half of the decade (1990's), economists were uncertain whether real output was rising above potential, in which case interest rate hikes would be called for, or whether both actual and potential output were growing more rapidly, leaving the output gap stable."
The ED potential GDP showed the latter; potential was rising leaving the output gap stable.
In my view, Volcker was not misled by the CBO's projection of potential. Yet Greenspan in 2000 was misled... Now, the Fed and major economists have been hugely misled for 5 years by a CBO projection of potential that is much too high... Years from now, macroeconomics will look back and recognize this great error.
Note: The equation for Effective Demand potential real GDP...
ED Potential real GDP = real GDP - $3.2 trillion * (capacity utilization/(index of non-farm business labor share * 0.765) - 1)
With today's revisions of real GDP, I want to post two graphs.
Trending Real GDP according to Effective Demand
So after the rise late last year, and the dip in the 1st quarter and the rise in the 2nd quarter... The potential GDP of Effective Demand is simply back on its exponential trend line. Yet, real GDP is closer to its projected effective demand limit roughly around $16.1 to $16.2 trillion.
The Output Gap
The output gap as determined by Effective Demand is based on the % difference between capacity utilization and effective labor share. The output gap is currently in range for a normal top to the business cycle. The implication is that there is little spare capacity left in the business cycle.
The Economist online magazine has an article called, Jobs are not Enough, where they show a poor understanding of effective demand.
"Economic growth over the business cycle is driven mostly by swings in demand, and in recent years demand has been held back: households have been repaying their debts; the government has restrained its spending and raised taxes; and interest rates, having reached zero, are unable to fall further"
OK, demand drives the business cycle.
"Over the long run, however, a country’s potential growth depends on supply: how many workers it has and how productive they are. The recent divergence between America’s employment and output suggests the country faces not just deficient demand but also enfeebled supply, as more people working without more output means lower productivity. That is bad news for all Americans since their standard of living depends on productivity."
Then they drop demand from the equation and say that potential growth depends on supply. What happened to demand which was driving the business cycle? For me, they simply do not understand the concept of effective demand, which is the demand measurement for determining the limits of potential output.
They take this error in understanding to the next level... by saying that supply is the problem for high unemployment and low output. They specifically point to productivity, which is actually constrained by effective demand. And assuming a standard of living is based on productivity, a poorer standard of living is caused not by supply problems, but by demand problems... namely, low labor share. They are not making the proper connections between effective demand, productivity, output and unemployment.
Like Keynes said, until people understand effective demand, "all discussions concerning the volume of aggregate employment are futile." (link)
As a small economist, my views are not seriously taken seriously. But still, if I turn out to be right, I will have bragging rights. So Paul Krugman wrote today about how the IMF way over-estimated the potential growth path of GDP. His post is titled, The Damage Done...
"That’s a huge shortfall. Yet the IMF believes that the output gap is only a couple of percentage points. If so, either there was a huge coincidence — a sudden, unanticipated drop off in potential growth that just happened to coincide with the financial crisis — or the crisis, and the poor macroeconomic management that followed, have done incredible damage."
OK... so what happened? Was there an unanticipated drop off in potential growth or was there poor macroeconomic management?
I have never been confused over potential GDP. Mr. Krugman wants us to think that there was poor macroeconomic management. But there really was an unanticipated drop off.
Over a year ago, I saw potential GDP had started trending lower right away during the recession. Here is a graph of the CBO potential and my calculation of potential GDP (green line). (link to graph)
While the CBO and Federal Reserve continue to adjust downward their estimate of potential GDP, my line for potential GDP started trending lower right away. It flat-lined until 2010 and then settled into a stable lower growth path. I have never had to adjust my calculations of potential GDP. Real GDP keeps moving right along my potential GDP. The confusion by economists and central banks over potential GDP will end up being expensive. Hard to say that humbly as a small economist, but from what I see, the great economists still have something to learn.
Now was there mismanagement of the macroeconomy? This is the real question? Was the economy hurt somehow by some policy? Would real GDP have trended faster upward if we had done something "correctly"?
From what I see, economic growth has been on a normal path in this business cycle. So no, I do not see any real damage, Mr. Krugman. The economy is growing normally. Let me explain with the model for effective demand.
I only want to focus on the blue line, which shows how real GDP grows as more labor and capital is utilized. The blue line has a y-intercept of zero. (see post for explanation of model) Now ask yourself, as the business cycle goes through its expansion phase, would real GDP really tend to rise up that blue line on a straight trajectory? or would it take lots of different angles?
If real GDP tends to rise up that blue line on a regular basis, we could conclude that when real GDP moves up that blue line, the economy is expanding normally... and that there are no real shocks to normal growth.
Here are a series of graphs using real data for the model above. The blue lines that you see below have y-intercepts of zero. You will see that real GDP (the green lines) has always risen along this blue line during the expansion stage of previous business cycles. Then look at the last graph to see that real GDP in the current business cycle is once again rising normally.
And finally, the current data. You will see real GDP settle into its new trend by the middle of 2010 and began following the standard rise of the blue line. ... And has been very close to the blue line ever since.
So when all the economists pull their hair out over how real GDP rises or falls from quarter to quarter, they look pretty silly. Real GDP is rising according to its standard path.
Real GDP has been growing on a very stable path in spite of policy mistakes that people may try to point out. However, the mistake of keeping interest rates low in hopes of growing the economy back to where it was before, has not hindered nor really helped growth. Low interest rates will be a problem when the business cycle starts ending earlier than economists think.
Sidenote: Look closely at the above graphs. The real instability at the end of a business cycle comes when real GDP begins to deviate to the upside of the blue line. Real GDP is currently staying on the blue line and rising normally. So relax everyone. The economy is behaving normally... and there is no apparent disaster from macro mismanagement. The economy simply adjusted to a new level very early on in the crisis and has been following that new level.
The real disaster is how great economists, like Mr. Krugman and many others, have gotten potential growth wrong from the beginning and continue to do so...
Data as of 2ndQ-2018
Effective Demand = $18.332 trillion
Real GDP = $18.514 trillion
Productive Capacity = $24.711 trillion
UT index is at effective demand limit = -0.72%
demand limit = 74.2%
TFUR = 74.9%
ED Fed rate rule = 4.3%
Estimated Natural Real Interest rate = 2.4%
Short-term real interest rate = 2.7%
There is no recession for 2ndQ-2018. Chance of recession is growing as economy heads toward 2nd effective demand limit in this business cycle. I am forecasting that economic conditions will begin to contract in the second half of 2018.
Click on Graphs below to see updated data at FRED.
UT Index (measure of slack):
z derivatives in terms of labor & capital:
Effective Demand, real GDP & Potential GDP:
ED Output Gap:
Corporate profit rate over real cost of money:
Exponential decay of Inflation:
Measures of Inflation:
YoY Employment change:
Speed of consuming slack: yoy monthly:
Speed of consuming slack: quarterly:
Real consumption per Employee:
Will real wages ever rise faster than productivity?:
Productivity against Effective Demand limit:
Bottom of Initial Claims?:
Tracking inflation expectations:
M2 velocity still falling:
All in one:
Double checking labor share with unit labor costs & inflation: