The subject of potential real GDP is important. As Paul Krugman said yesterday in a post entitled, "Potential Mistakes"...
"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 will describe what the economy could produce.
It is generally viewed that potential real GDP is output fully employing all available labor and capital resources. My view is that potential real GDP is the potential 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.
First, I will calculate real output by multiplying productive capacity 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, potential demand = Real GDP * effective labor share/TFUR
TFUR does not like to be above effective labor share. Thus, real GDP reaches potential demand when TFUR is equal to effective labor share.
Now we substitute in the equation for real output...
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.
Graph #1
Output rises with more utilization of labor and capital. Then output reaches the potential 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 potential demand limits output at that level. Potential demand is based on 74% effective labor share. So we see real output cross potential 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 different changes between the time real GDP reaches effective demand and the start of the recession. We will look at those changes.
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
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. Before this particular recession, the utilization of labor and capital kept rising, (TFUR kept rising), which produced some inflation.
Leading up to the Recession of 1980
Graph #3
Here again, we see that real GDP (green line) rose 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 were 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
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 a similar case 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 increases the utilization of labor and capital, then goes into a recession.
The almost Recession of 1994 and the Recession of 2001
Graph #5
At the bottom 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 potential demand kept rising with real GDP too. Finally the TFUR fell from above 78% to below 70% during the 2001 recession. Yet, real GDP did not fall.
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)
Hidden in graph #5 is a story of how the economy fractured creating an environment of bubbles that exists to this day. I won't go into that story here.
Leading up to the 2008 Recession
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. But 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. We need to understand why effective demand is becoming more solid.
Leading up to the next Recession
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 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 real GDP can push effective demand higher 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. 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.
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 higher unemployment. Productivity tends to increase at lower levels of unemployment.
How will this recession play out? 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. It will be a crazy time. Let me just mention a couple of factors.
- First, economists are not going to expect the numbers to start revealing a recession. They will find some way to justify bad numbers later, but we can see when the bad numbers will start to come.
- High bank reserves and low interest rates may trigger inflation. The Fed could not even fathom tightening much now after seeing the reaction of bond markets around the world. Cutting back on loose monetary policy may trigger falls in global housing bubbles.
- Unemployment is already high at 7.6%. As unemployment comes down, the TFUR will increase and real GDP will increase bringing us closer to the effective demand limit on potential real GDP.
- Productivity has been stagnant for 3 years due to a number of factors, such as low demand from low labor income, lack of new innovations and deteriorating capital (public and private).
The global economy has been made unstable by low interest rates. I have my doubts that the economy can push against the effective demand limit like it did from 2006 through 2007. The Fed raised rates during that time to control a bit of inflation. Yet, this time around, if the Fed tries to regulate the economy in any way, the global reaction will be tremendous.
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, monetary policy is based on a false notion of potential real GDP. This is too dangerous to get wrong. The global economy is hanging in the balance.
(note: In other posts, I refer to potential real GDP as the center of the business cycle. In this post, I refer to it as the top limit of real GDP. In other words, as the theoretical top limit of the business cycle.)
Ok important new wording here: effective demand = potential demand. Tricky semantic waters. And those waters matter. See for instance:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/01/if-6-was-9-and-if-s-werent-i.html?cid=6a00d83451688169e2016761e39a82970b#comment-6a00d83451688169e2016761e39a82970b
And Nick's reply.
"unless real GDP can push effective demand higher"
I think this is problematic and confusing wording. Real GDP doesn't "push." It's a measure, not a force. ??
This is better I think:
"unless the economy finds a way to push effective demand up"
Posted by: Steve Roth | 07/10/2013 at 08:45 AM
Which brings us back to recent debt discussions. This seems crux-ial to me (though I feel like it's missing something):
http://debunkingeconomics.com/wp-content/uploads/2012/10/TowardsUnificationMonetaryMacroeconomicsMathArgument.pdf
And this?:
http://dnwssx4l7gl7s.cloudfront.net/nefoundation/default/page/-/publications/Model_paper_web.pdf
The dynamics of debt seem pretty straightforward in those long, fairly steady TFUR/RGDP growth periods. It when we hit those ziggy-zaggies (like the crazy long one '95-'00) that things get dicey, and real-economy debt levels/changes/accelerations might give insights into the dynamics.
But maybe those periods are just too chaotic to understand coherently?
Nevertheless debt measures might give predictive insight on when those chaotic periods are imminent?
Posted by: Steve Roth | 07/10/2013 at 08:52 AM
The semantics are important. Effective demand sets a potential for real GDP. As effective demand changes, so does the potential. But it is good to distinguish the two like Nick Rowe does with other words.
And you are right, the economy finds a way to push effective demand up.
Posted by: Edward Lambert | 07/10/2013 at 10:11 AM
The dynamics of debt and credit need to distinguished in the model. For example, why did productivity rise so fast after '95 with neutral change in labor and capital utilization? Was it credit opening up or the internet? We also know that labor share ticked during time. What would have happened if labor share hadn't risen?
There are lots of mechanisms affecting each other like gears in a watch. How do they articulate between each other?
I saw your email where there is a need to start laying a foundation of the model of effective demand that shows the articulations of the economy within the model.
Posted by: Edward Lambert | 07/10/2013 at 10:23 AM
The graph labeled 'Leading up to the 2008 Recession' seems to end at the 1st quarter of 2008 which makes sense.
The graph labeled 'Leading up to the next Recession' has 16 quarters ending at the 1st quarter of 2013.
So these graphs don't overlap.
But still it does not seem correct for 'Effective Demand' to have jumped from less than $13.5Trillion in the 1st quarter of 2008 to $16.2Trillion in the 1st quarter of 2009. Is this correct? Am I misreading something?
One of my most repeated lines over the last 5 years is that 'Consumers can not spend what they do not have.' And the second most repeated line is that 'Producers will not produce what they can not sell'.
Your work puts this into a model. Great work!
Posted by: Jim Hornsby | 07/20/2013 at 05:07 AM
Jim,
Effective demand jumped from $13.5 tr to over $16 tr because capacity utilization dropped 16.5%. Both employment and real GDP dropped by 4.7%. But capacity utilization fell much more. Eventually capacity utilization came back in line by the end of 2010 and effective demand leveled out below $14.5 tr.
So the big rise in effective demand was simply due to the huge fall in utilization capital.
Can you explain to me further how your repeated lines are explained by the effective demand model? I would like to see how you connect the dots. It helps me see what you are seeing.
Posted by: Edward Lambert | 07/20/2013 at 10:57 AM
By late 2007 it was obvious that a lot of home loans were in trouble and I wondered why homeowners were so willing to take on loans with such onerous terms. (Adjustable rates after 2 years which could go up 3% at a time.) I found two sets of statistics which seemed to say that consumers had slowly stopped saving and slowly descended into debt from 1984 to 2005.
From the Bureau of Economic Analysis Department of Commerce – Personal Income and Disposition:
1984 Personal savings as a percentage of disposable income was 10.8%
2005 Personal savings as a percentage of disposable income was less than -.5%
Note: The 2005 savings number was corrected to .5% some time afterward when the entire table was shifted positively.
My original link is now broken but the last page of this document seems to give the shifted historical data:
http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0513_hist.pdf
From a March 2007 study co-authored by Alan Greenspan (Line 3 + line 4 + line 33):
1991 $56 billion was taken out of the equity of homes in a year.
2005 $577 billion was taken out of the equity of homes in a year.
From: http://www.federalreserve.gov/pubs/feds/2007/200720/200720pap.pdf
From the Federal Reserve website:
1984 Fed Funds Rate was 10.23%
2009 Fed Funds Rate was .16%
From: http://www.federalreserve.gov/releases/h15/data.htm
Note: When you see this statistic on a chart it is a stair step down at each recession and it never returns to it's pre-recession high, for each recession after 1984.
First consumers reduced their savings, then they borrowed the equity out of their homes. Finally consumers were so deeply in debt that borrowing was no longer generally possible. And the interest payments made things worse than before the debt was made. Demand for goods had to slow down or at least grow more slowly.
My conclusion was that global free unbalanced trade had kept consumer's income down between 1984 and 2005. And the Federal Reserve was masking the damage with lower and lower interest rates, all along the way.
Mainstream economists seemed to believe that 'demand' is ever present, that only supply side stimulus is ever needed. That worked until it didn't. Then they tried 'stimulus' in various forms, which was at best a temporary patch since it did create a sustainable demand.
As they said about the Great Depression, it was not so bad as long as you had a job. That is true today. And if we didn't have Unemployment Insurance, Social Security Insurance, and Medicare and Medicaid, we would recognize this as an ongoing Great Depression 2. And if the CPI and unemployment statistics were less misleading, we would realize that it is worse than we think now. How many part time workers are on the Supplemental Nutrition Assistance Program (SNAP) because they can not find full time work?
Mainstream economists seem to be lost. They don't understand the cause of this Great Recession, because they assume demand is ever present, and they can not admit that global free unbalanced trade is NOT a rising tide that lifts all boats. They talk about financial depressions and panics and vaguely describe the associated recoveries as slow, but they ignore their effects on the consumers of those earlier times and thus on demand and thus on the economy. Irving Fisher (1867-1947), the economist, wrote that debt caused the Great Depression, and to that you can add the bank failures which wiped out personal savings and severely diminished the ability to get credit. Taken together, these severely diminished demand.
Lastly mainstream economists believe that the Great Depression was ended by war material production during World War II. They ignore what would have happened once war material production was ended and 8 million men and their future wives were left jobless. The miracle of recovery was due to rationing and the resultant personal savings. And 8 million men were also saving money because they were in war zones with no place to spend their pay. (The personal savings rate reached 25% for 2 years and was only a little less in 2 other years.) At the end of WWII young men came home, married young working women, and used their savings to buy the things needed to set up a new household. And in 1946 they could buy a new personal automobile, for the first time since 1941. That spending created new demand which manufacturers were happy to satisfy and thus they converted from war material production to consumer goods production. That caused a regenerative cycle to be created and it was sustained. (The federal government redeemed war bonds with very high income taxes on Americans especially the wealthiest.)
So whether we want to admit it or not, we live in a demand driven economy.
I believe that your 'Effective Demand' equations state that there is a 'limit' on Real GDP which is imposed when labor's (consumer's) share drops too low.
That seems to be consistent with what happened during the Great Depression and consistent with what is happening now.
Posted by: Jim Hornsby | 07/20/2013 at 05:13 PM
Perhaps the actual limit on GDP is enforced by the 'Velocity of Money'(VOM).
I can't find a FRED graph of VOM for the Great Depression but I did find a graph of "Gross Domestic Product / St. Louis Adjusted Monetary Base" which is a formula for velocity. It runs from 1929 to 2013.
See that graph for velocity here:
http://research.stlouisfed.org/fred2/graph/?g=9wK
Notice the minimums at 1935, 1940, and 1946 during the Great Depression. It would seem that velocity is a lagging indicator.
Notice that velocity was increasing from 1946 until after 1981 when it began to decrease. Also notice the minimum in 2013 which seems to be lower than the minimums during the Great Depression.
One possible interpretation would be that investment dollars are not recirculated in the economy as often as consumer spent dollars.
It would be interesting to see one of your charts done with data from 1928 to 1946. (1948?)
Posted by: Jim Hornsby | 07/21/2013 at 07:14 AM
Demand... the capacity of people to spend money and still save. We are beating a drum to raise people's incomes. The beat is growing.
One day we will have charts for effective demand going back to 1928.
One thing about WWII that people rarely mention is that labor share of income rose a lot. I have to find that information again and post it.
Posted by: Edward Lambert | 07/21/2013 at 08:32 PM
I am intrigued by your comment that during WWII the labor share of income rose.
The only data that I could find seems to indicate that it fell, see figure 6 on page 9.
http://clevelandfed.org/research/policydis/no7nov04.pdf
Rationing was put in place starting in May 1942:
http://www.ameshistoricalsociety.org/exhibits/ration_items.htm
"The Emergency Stabilization Act was passed in October 1942, which placed wages and agricultural prices under control":
http://www.u-s-history.com/pages/h1689.html
After October 1942, employers started to use fringe benefits to attract labor.
The highest personal savings rates were in 1942, 1943, and 1944.
The high personal saving rates seem to have been due to rationing.
I don't believe we can duplicate the rationing. But it is helpful to understand the reason that the Great Depression was actually ended instead of some vague reference to WWII or WWII war production.
Posted by: Jim Hornsby | 07/23/2013 at 06:47 AM
I started to wonder if personal incomes had risen a lot during WWII.
I looked at Personal Income Table 2.1 at this website:
http://www.bea.gov/
I set the 'Options' for Annual and All which got me the years 1929 to 2012.
It appears that Personal Income rose at very high rates from 1940 to 1944.
Year -----1940-----1941-----1942-----1943-----1944-----1945-----1946
Income---78.4 ------96-------123.4----152.1----166------171.6-----178.6
Increase--0.075----0.224------0.285----0.233----0.091----0.034-----0.041
Note: Increase is my calculation.
This explains why inflation became a problem and price controls were put in place in October 1942.
So incomes rose while labor share fell. Companies must have been making huge profits.
Nonetheless, it was rationing which forced personal savings rates to levels which could support a changeover from war production to consumer production.
Posted by: Jim Hornsby | 07/24/2013 at 07:51 AM
It truly is fascinating how much income for labor rose during WWII.
Labor share looks to have risen from 1943 till after the war.
Posted by: Edward Lambert | 07/24/2013 at 10:30 PM
Here is inflation from the Bureau of Labor Statistics
From:ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
Year -----1940-----1941-----1942-----1943-----1944-----1945-----1946
CPI-------14.0-----14.7------16.3-----17.3------17.6-----18.0------19.5
% Increase--0.7------ 9.9-------9.0------3.0------2.3-------2.2------18.1
Note: % Increase is Dec-Dec from the table.
You see the high increases in the CPI during 1941 and 1942. This chipped away at the income increases for those 2 years.
Price controls were implement in October 1942, then there low increases in the CPI for 1944 and 1945.
Most rationing appears to have been lifted by the end of 1945, and in 1946 there was an increase in the CPI of 18.1% . This was the beginning of personal savings being spent and it caused inflation.
Posted by: Jim Hornsby | 07/25/2013 at 05:01 AM
The income increases were balanced by high inflation.
There is an equation for labor share.
labor share = unit labor cost/price level
When price level goes high, labor share goes down.
Do you have the data for unit labor cost during WWII?
Posted by: Edward Lambert | 07/26/2013 at 07:42 AM
I believe that the data for the 'unit labor cost' during WWII would be at BEA's website:
http://www.bea.gov/
Unfortunately I can not give you a direct link to the Table 1.15 Price, Costs, and Profit Per Unit of Real Gross Value Added of Nonfinancial Domestic Corporate Business (A) (Q)"
Instructions:
1. Click on the bea.gov link above.
2. In mid screen (horizontal) in the "National" category, click on "Corporate Profits"
3. On 5th line, click on "Interactive Tables: National Income and Product Accounts Tables"
4. In mid screen (vertical), click on "Begin using the data"
5. In mid screen (vertical), click on "Domestic Product and Income"
6. Scroll down and select "1.15. Price, Costs, and Profit Per Unit of Real Gross Value Added of Nonfinancial Domestic Corporate Business (A) (Q)"
7. In mid screen (vertical) and right side, select "OPTIONS"
8. Select the A for Series (for annual)
9. Check "Select All Years"
10. You will now see data beginning at 1929 and ending 2012.
11. Read the Legend while you are here and it is downloaded.
12. In mid screen (vertical) and right side, select "DOWNLOAD"
13. Click on button for "Download XLS File"
This is a royal pain, but I don't know of any other way to get to the appropriate data. The bonus is that you can download the data for a local spreadsheet. Things can go quickly, once you get used to this scheme.
Please let me know if this works and the data is appropriate.
Posted by: Jim Hornsby | 07/27/2013 at 10:10 AM
This table 1.15 as described in my last message seems to need some explanation.
Look here on page 13-38 (Last page):
http://www.bea.gov/national/pdf/ch13%20profits%20for%20posting.pdf
Posted by: Jim Hornsby | 07/27/2013 at 11:01 AM