In the previous post where I presented the basic growth model based on Effective Demand, I showed that as the real GDP of an economy grows, capacity utilization and effective labor share need to rise too in order for the economy to remain in optimum balance.
In the early stages of growth, there are economic, cultural and political institutions that give more share of national income to capital in order for the economy of the country to grow. But then as the economy grows, and there is a need to maintain balance in the economy, effective labor share needs to increase. However, the institutions that give profits to capital are simply hard to change. The people who control capital resist lowering their share of national income. It is human nature, but it is not wise. This is a rather common occurrence in the world.
So what happens in the growth of an economy, if labor share is not increased?
Let's start by looking at the model from the previous post...
The economy revolves around the green line and won't go higher than the red line. The economy is in balance when it is near the crossing points of the blue and green lines. Ok, if you need an explanation of that, go to the previous post.
So now let's put a dot on the graph for an economy that is growing. The yellow dot will show that the economy is in balance.
The yellow dot is near the green line, it is below the red line and it is near the crossing point of the blue and green lines. The economy is doing well. But it is growing... so now let's advance the economy into the future and raise real GDP...
Ok, real GDP has risen, now what happens? Well, the economy has two choices.
- It can move up the green line and increase both capacity utilization and labor share of income.
- It can resist increasing labor share and simply raise capacity utilization to reach this new level of real GDP.
If the economy chooses option #2, capacity utilization can only rise to the red line and it must stop because of the limit imposed by Effective Demand. Here is the graph...
So we can see that the economy by resisting to increase labor share of income keeps its utilization rate of capital at a low level. This is inefficient as less capital is utilized than could be. However, it is very profitable for those who control capital. Real GDP is greater and labor share has not increased.
We can now measure the inefficiency. The distance from the yellow dot to the blue line, optimal capacity utilization, is the loss in optimal capacity utilization at that rate of effective labor share. This loss is a dead-weight loss to society. It represents the lost opportunity to utilize more capital. The society remains as under-developed, but with a rich capital class.
I show that the path to maturity is to follow the green line.
The scenario of not raising labor share of income during growth is all too common in the world, and it is actually happening in the United States. Let's look at the most recent data for the US...
So how can we graphically visualize this dead-weight loss? Well, we go back to the basic model of Effective demand and look...
Where the two dashed green lines cross is the present state of the economy (real GDP = $13.665 trillion, capacity utilization = 78.5%). Do you see where the pink line and the up-sloping line cross? They cross at 88% capacity utilization. This is the optimal rate of utilizing capital at the present real GDP. We can confirm this 88%, by going up two graphs to where the US data was plotted. There you will see the blue line at 88% when effective labor share is at 74.5%. Optimal capacity utilization is 88%, but we are only utilizing 78.5%.
Why don't we use 88%? We can't because Effective demand will impose a limit between 80% and 81%. We cannot get to 88%. We have fallen into an inefficient economy.
The US economy during the 1980's revolved around the crossing point of optimal utilization of capital. Some say it was a golden era for business. Well, of course, the economy was in balance in terms of utilization of capital and labor. Since 2000, the US economy has moved well to the left of optimal utilization of capital.
The best way to describe this dead-weight loss is to make an analogy to a monopoly, where production is cut, in order to make more profits. Basically, the US economy is under-developed and has become one of rent-seeking.
China would like to avoid what the US and many other countries have done... and that is not mature properly. China is a country that honors its mature citizens. It would like to have an economy that is mature and honorable. The US economy at this moment is not mature and it is not honorable.
(note: I did a quick back of the envelope calculation of how much effective labor share would have to rise per year if China's real GDP is growing at 8% per year. Labor share of income would have to rise 2.3% per year in order for China to grow in balance. Thus, if in a year, effective labor share was 64%, the next year it would have to be 65.5%. Is China increasing its effective labor share at that rate? I don't know. I don't have the data. It also depends on how close China is to the equilibrium green line.)
