Effective Demand Research

Inflation analysis

In the previous post, I wrote about how inflation is a game of cat and mouse between the prowess of consumers' liquidity and firms' prowess to respond with products. I presented the equation for inflation's tendency to rise or fall...

Inflation tendency = liquidity prowess of consumer dollars/production prowess of firms

• If the numerator and denominator are equal, then inflation will be constant. (Inflation tendency = 1)
• If liquidity power of consumers is stronger, then inflation will tend to rise. (Inflation tendency > 1)
• If production prowess of firms is stronger, then inflation will tend to go lower. (Inflation tendency < 1)

I want to ge much deeper into what moves inflation. I will come back to this equation later, but first, a look at inflationary gaps.

Inflationary gaps define the top side of a business cycle, when real GDP is closer to its natural limit determined by the effective demand limit. It is called the inflationary gap because inflation occurs with it, or at least that's the way it was in the past. In the effective demand research, the inflationary gap occurs when capacity utilization is more than effective labor share. The downside of the business cycle is called the recessionary gap, but I might call it the anti-inflationary gap.

Graph #1.

In graph #1, the yellow dots identify the inflationary gaps, when capacity utilization (blue line) is higher than effective labor share (tan line). You can see that inflation (yellow line) increased after the peak of the inflationary gaps in the 1970's. Inflation also fell in the recessionary gaps (anti-inflationary gaps). But inflation rose just a little after the inflationary gaps in the 1980's, and barely at all for the last 20 years.

Why did inflation stop occurring with inflationary gaps?

The answer is related to two factors, among others, but I will focus on two.

Above I presented an equation for the tendency for inflation to rise or fall. Well... How do we know who has more prowess in the market, consumers or firms? The measurement I use comes from what I call the optimal level of the Super macroeconomic potential GDP. (If you want to read about it, here is the link. The explanation is wonkish.)

Here is the equation to use...

The equation gives the optimal level of capacity utilization (cu*) at any moment for the economy. The independent variables in the equation are effective labor share (els), real GDP (Y) and a business cycle amplitude constant (a).

Since capacity utilization rises and falls through the business cycle, the optimum point should be in the center of the business cycle, where capacity utilization is equal to effective labor share. If effective labor share is on balance above the optimal capacity utilization, capacity utilization will be over optimal. Thus, when labor share is too high, the implication is that the prowess of labor's liquidity will be greater than the prowess of firms to respond with products. And inflation will tend to rise.

On the other side, when effective labor share is below the optimal level of capacity utilization, capacity utilization will be lower than optimal on balance and firms will have the greater prowess to pull the inflation tendency negative. The logic is that labor share is too low for an optimal economy. The lower labor share means lower liquidity prowess for consumers.

Let's look at a graph of this...

Graph #2.

The added brown line shows optimal capacity utilization, which has been rising through the years. Optimal capacity utilization is now around 88%. However, labor share has been falling. Effective labor share was above optimal in the 1970's, which gave consumers the prowess edge in the market. The 1970's was a time of inflation. But ever since the 1980's, effective labor share has been below the optimal level giving the edge to firms to control and subdue inflation. Effective labor share has fallen to around 74%.

Comparing effective labor share to the optimal level of capacity utilization allows us to identify a period when inflation tended to rise, and the current era when inflation tends to fall.

The rising of the optimum level of capacity utilization to such a high level indicates that the US economy has matured. The focus since the 1980's should have been on distributing more national income to consumers, and letting the consumers save their money for investment. Lessons to learn...

(note: Milton Friedman's complaints about the power of labor and the minimum wage came at a time when labor had more power than business. But the tables turned during the 1980's and now his complaints would not be correct.)

So far we have looked at two factors that have affected inflation over the years.

1. the inflationary gaps which used to have more effect.
2. the optimal level of effective labor share which shows the shift in prowess from consumers (labor) to firms.

But there is another factor, which is very important and adds more insight into the movement of inflation... The natural rate of interest.

Many economists use the real rate of interest in their models for inflation, as does David Romer. It is easier to determine the real rate instead of the natural rate. Yet, I have a way to determine the natural rate of interest from the effective demand monetary equation. (Here is a link for an explanation. Again wonkish.)

The equation for the natural rate of interest is...

Natural rate of interest = z * ((e_a-u_n)²+e²) - (1-z) * (e_a-u_n+e) - i_t

z = z coefficient to position monetary framework (This shifts as effective labor share anchor shifts.)
e_a = Effective labor share anchor (currently 74%)
u_n = natural rate of unemployment (assumed to be 5% in equation)
e = effective labor share
i_t = inflation target in Fed monetary policy (assumed to be 2% in equation)

The natural rate of interest is very helpful to have, if you can get it. The natural rate of interest that I calculate is for the center of the business cycle. To be clearer, it is for the point in the business cycle between the recessionary gap and the inflationary gap. I could also calculate the natural rate of interest at the LRAS curve where real GDP hits the effective demand limit, but I want to focus on the inflationary and recessionary gaps in this post.

If the economy was in balance at the point between the recessionary and inflationary gaps, then the Fed funds rate would theoretically equal the natural rate of interest. During a recessionary gap, the Fed funds rate would theoretically be below the natural rate of interest in order to support the economy to recover from a recession. During an inflationary gap, the Fed funds rate would theoretically be above the natural rate to control over-heating the economy and to control inflation.

So what do we see when we compare the Fed rate to the natural rate of interest?

Graph #3.

The Fed funds rate is the green line. The natural rate of interest (center of business cycle) is the brown line. Back in the 1970's and 1980's, the Fed rate was always above the natural rate of interest, whether in an inflationary or recessionary gap. Such was the fervor to control inflation. During the 1990's, the Fed rate stayed close to the natural rate, even as it rose to battle the doube inflationary gaps in 1995 and 1997. Since the 2001 recession, the Fed rate is spending much more time below the natural rate, so is the inflation rate too.

You might notice that the natural rate mirrors the effective labor share rate. The mechanism is as labor share rises, there is more liquidity for consumption, which gives consumers a greater prowess to raise inflation. The natural rate will rise to balance that effect and show that the Fed rate should rise a bit more to control that positive inflation tendency.

I want to put all the factors above into one graph and make a few more comments...

Graph #4.

• If labor share was now at the same level it was at in the 1970's, there would be less positive inflation tendency due to a higher level of optimal level of capacity utilization.
• Inflation moved below the natural rate of interest near the end of 1997, the same time that capacity utilization fell for good below its optimal level.
• In 2006 and 2007, the Fed rate was over the natural rate during the inflationary gap, which would have been normal in years past. However, inflation had hardly moved and the Fed looks to have over-reacted. The Fed could have kept the Fed rate lower and allowed a bit more inflation. Some criticize the Fed for being too tight. It depands on how you look at it.
• Currently we are in an inflationary gap, and inflation has been going down. Labor share has fallen first, but now labor share will stay steady. Inflation will most likely stay steady and rise a bit from here. There is not much danger of deflation.
• The Fed rate will stay low near the zero lower bound, as long as the effective labor share stays so far below optimum. The inflation tendency will stay very negative for quite some time it looks like.

Graph #4 has a lot to see.

Note: You might wonder why the natural interest rate rose to almost 5% in the year 2000 when labor share liquidity was below optimal. It's because effective labor share had risen to a high level. But after the 2001 recession, the effective labor share anchor and the z coefficient shifted after being stable since 1975. The consequence of that shift was that the economy moved to a lower new normal. Interestingly enough, that kept the natural rate of interest in the 3% to 4% range. The economy is being pushed farther down with a lower labor share, and the economy will calibrate itself to a natural rate of interest in that range. I find that really interesting.

Inflation is a game of cat and mouse

I have been reading David Romer's class notes called Short-run fluctuations. Part of his paper deals with a model to explain inflation in a liquidity trap. The model is based on real interest rates, output, expected inflation, Keynesian cross and IS-MP model stuff.

He writes... "An economy where the nominal interest rate is zero poses severe challenges for policymakers. If output is less than its natural rate, inflation will tend to fall. With the nominal interest rate stuck at zero, this will raise the real interest rate, and so depress the output further. Policymakers therefore face the risk of the economy spiraling off on a path of continually falling inflation and output, like what we just analyzed."

I don't see output falling like he describes. and How does he determine output's natural rate? Does he use effective demand? His approach seems like the tail wagging the dog.  I mean... I don't think he is seeing the root mechanism of inflation. I don't like his explanation. So what does determine inflation?

Most have heard the standard definition of inflation... Too many dollars chasing too few goods. Let's start here.

This definition comes specifically from demand-pull inflation, but is used for inflation in general.

Now imagine a cat chasing a mouse. If the cat is powerful, nimble and quick, the mouse will be caught. Now imagine dollars that are powerful, nimble and quick. Those dollars will catch the goods. Let's say the dollars are so powerful, nimble and quick that even if you raised the price of the goods, the dollars can still catch them. You now have inflation.

Now imagine goods chasing dollars. That's right, goods now have the power, nimbleness and quickness to chase dollars. Goods are now the cat. But would this scenario lead to inflation? No... This scenario would lead in the opposite direction... to low inflation. The goods have the power to keep their prices low by way of luring and baiting the weak dollars into their trap. Goods have become the predator upon dollars and are optimizing their profits.

Dollars are the money spent by consumers. Goods are the production of firms. The relative prowess between the two determines where inflation will go.

If the liquidity of consumer dollars is more powerful, nimble and quick then the capacity of firms to manage production, you will have inflation. Dollars will compete for the products, which in turn raises prices. On the other hand, if firms are powerful, nimble and quick in managing their suppliers, production and distribution (like wal-mart), then prices will be kept low, along with wages. Goods will have the power to compete with each other for consumer dollars at low prices.

(note: I have not shopped at a wal-mart in over 12 years. One reason for the decline in the US economy is the increased prowess of firms to prey upon the wealth of our middle class, while paying low wages to the poor class.)

Ok back to the subject of inflation... We can create an equation to simulate where inflation will go...

Inflation tendency = liquidity prowess of consumer dollars/production prowess of firms

• If the numerator and denominator are equal, then inflation will be constant and most likely move to exactly where the Fed wants inflation to be. (Inflation tendency = 1)
• If liquidity power of consumers is stronger, then inflation will tend to rise. The Fed will battle inflation, for example Volcker.  (Inflation tendency > 1)
• If production prowess of firms is stronger, then inflation will tend to go lower. The Fed's job in battling inflation is made easier. (Inflation tendency < 1)

But let's look at cases when the liquidity prowess of consumer dollars is stronger.

• Higher wages (higher labor share) relative to production capacity in the 1960's and 1970's led to episodes of inflation.
• At the LRAS curve where we find the natural level of output, firms are constrained to produce more while labor increases its consumption dollars. Inflation tends to spike upward at the LRAS curve.

Let's look at cases when the production prowess of firms is stronger.

• Period from 1990 until the present. Real income has been lagging behind productivity. Labor share has been declining. This has given the edge to firms to be more nimble than consumers. Inflation has been trending lower over that whole time.
• The period following an economic contraction. Firms control production and the utilization of labor. Unemployment is up and wage growth is slow, while firms are re-employing their factors of production. Inflation is low during this time.

It should be no mystery at the present moment why inflation is tracking low. Inflation tendency from the above equation would be less than 1. Firms have high profits, developed infrastructure, and access to capital. Consumers have low labor share of income and higher than normal unemployment. Total labor income is barely back to where it was before the crisis, while capital income has increased beyond that point. Firms are the current predator.

If the Fed truly wants inflation, the Fed will find a transmission mechanism to increase the prowess of labor's liquidity in relation to the firms' prowess to produce. But I don't think that is likely, because the Fed seems to be working for firms and not consumers. The Fed and the firms it represents prefer low inflation, but they have gone too far.

We have had too much supply-side economics. Firms have become cats to all of us consumer mice.

David Romer has the wrong liquidity trap theory for low inflation. Inflation is low not because of the ZLB liquidity trap, but because the weak liquidity of consumers is falling into the trap set by the powerful, nimble and quick firms.

 

Related articles:

Effective demand model for monetary policy. Shows that low labor share is the cause of the persistent ZLB status of the Fed rate that David Romer says is the cause of low inflation.

Post on low inflation. Shows a more detailed approach to explaining low inflation.

Keynes on Effective Demand - Chapter 6

In chapter 6 of Keynes' General Theory, he briefly mentions Effective demand...

"Furthermore, the effective demand is simply the aggregate income (or proceeds) which the entrepreneurs expect to receive, inclusive of the incomes which they will hand on to other factors of production, from the amount of current employment which they decide to give. The aggregate demand function relates various hypothetical quantities of employment to the proceeds which their outputs are expected to yield; and the effective demand is the point on the aggregate demand function which becomes effective because, taken in conjunction with the conditions of supply, it corresponds to the level of employment which maximises the entrepreneur’s expectation of profit."

We see here that employment can be a constraint upon expectations of profit. Firms hire labor when they have expectations of profits. Aggregate demand is a function of the proceeds yielded from labor's work. Keynes is saying that there is a point where firms will not hire more labor because profits from labor will be maximized.

He calls that point effective demand.

OK... But he does not give an equation to determine the effective demand.

I will continue going through the chapters of Keynes' General Theory and making comments where effective demand is mentioned.

William Dudley on the economic outlook... An Effective Demand reflection

William Dudley is the President and CEO of the Federal Reserve Bank of New York. He gave a speech about the economic outlook. The speech is standard talk about economic improvement that is not good enough yet. He states that demand is a constraint on the economy.

"Turning first to consumer spending, such spending has remained fairly subdued outside of interest rate-sensitive consumer durables.  In July, for example, real personal consumption expenditures were flat, and it is unlikely that third quarter consumption growth will be much above a 2 percent annual rate.

"Moreover, the drivers of consumer spending do not look particularly supportive.  In particular, real disposable income growth has grown at less than a 1 percent annual pace since March.  Furthermore, the recent data do not yet clearly indicate a firming in the income growth rate, or the two important components of labor income growth—hours and compensation.

"The conundrum for consumers is a simple one:  if consumer spending growth is to exceed 2 percent annualized on a sustained basis at a time when real disposable income growth is below 2 percent then this would require the household saving rate to decline persistently.  But there is little reason to expect such a decline given that the current saving rate is at a level consistent with current level of household wealth relative to income.

"We have a chicken-egg problem.  If the saving rate remains stable, then stronger consumption growth will require a pickup in income growth. But for income to rise, demand must increase.  This suggests that there may need to be an impetus to growth from other sectors of the economy to generate a boost in consumer spending growth."

Income... Income?... What is income?...  In a black and white view, income can be paid to the rich (1%) or to the poor (99%). If increased demand comes from the rich spending more, the resulting income will go to the rich as wages are not increasing. If increased demand comes from the poor spending more, once again the income produced will go to the rich.

Keynes thought about this too... from chapter 21 of the General Theory...

"...the multiplier will be influenced by the way in which the new income resulting from the increased effective demand is distributed between different classes of consumers." (source)

But we have to ask, if the poor are spending more, where did they get that money? As Mr. Dudley states, disposable income is rising less than 1% currently. Either savings rates go down or consumer debt rises. What does he say about consumer debt?

"Reflecting this improvement, credit standards are beginning to ease, which should support consumer spending on durable goods."

Warning!!! ... While incomes are not firming, credit is beginning to ease. This spells trouble. Do we really want the financial sector to rescue demand with credit?

But the savings rate is not expected to decline any further. Hmmm.... I guess there should be no wonder why inflation is so slow and stable.

Mr. Dudley wake up and just say it... Wages have to rise. The poor (99%) must be the source of the increased demand.

What does Mr. Dudley say about inflation?

"On the inflation side of the ledger, inflation remains below the Federal Reserve’s 2 percent  longer-run objective for the personal consumption expenditure (PCE) deflator.  The year-over-year change in the total PCE deflator was 1.4 percent in July. This has created some concern that inflation is “too low,” raising real interest rates and making monetary policy less accommodative.  I acknowledge this concern, but I believe it will abate as inflation moves gradually back up towards a 2 percent annualized rate over the next few years.

"Putting these factors together along with my forecast of a gradual pickup in real economic activity, my outlook is for inflation to drift back toward our 2 percent objective over the medium term.  However, much like the case of the real growth outlook, there is significant uncertainty around this forecast."

Does he really know what he said here? It will take a few years! for inflation to get back to 2% and even that has uncertainty...

Economics is in a dismal state.

I am fortunate to have an answer. I am from the West, but in my worst New York accent, I say, "Ey, Mr. Dudley, I got two words fors ya." Effective Demand.

Everything he is talking about is explained by Effective Demand, which is lower than previous years and decades due to labor receiving a smaller slice of the national income pie. Low Effective demand explains low savings rates, low inflation, low demand, low income, high unemployment, low wages, mild improvement in the labor market, ineffective monetary policy, and mild but unsatisfactory economic improvement.

And to top it all off, Effective demand points to an economic slowdown in real output within the next two years.

If we had had a knowledge of effective demand in the past, we would have been able to approximate the timing of every recession since the 1960's, except for Volcker's. We would have been able to describe the effects on real output and inflation. And if we were to get some smart economists working in effective demand, we might more clearly see the effects on business investment and more.

Look... Here is the bottom line. Effective demand has moved to a new low normal in the past decade. Whether you think the overall economy has or not, effective demand has. According to the track record of effective demand, the potential of the economy will be cut short below the expectations of economists who are looking at past data. The one piece of data that has never changed until now, and which economists are unaware of... is effective demand.

One last word from Keynes who in my opinion never quite nailed down the dynamics of effective demand, but had insights into how it would work.

"For the schedule of liquidity-preference itself depends on how much of the new money is absorbed into the income and industrial circulations, which depends in turn on how much effective demand increases and how the increase is divided between the rise of prices, the rise of wages, and the volume of output and employment."

The question is... How will the Fed get new money to the right class of consumer in order to increase effective demand?

Answer: In order to not fall prey to the fallacy of composition, wages must be raised across the board, and if possible, across many countries.

Capital has too much money and Labor does not have enough... Full stop.

 

Has hourly self-employment income stayed relatively constant to hourly payroll income?

The Brookings Institute has just come out with a new paper seeking to explain the decline in labor's share of national income. The paper is titled, The Decline of the U.S. Labor Share. It was written by Michael W. L. Elsby, Bart Hobijn, and Ayşegül Şahin. Here is a video of Justin Wolfers explaining the basics of the paper.

The Brookings Institute paper says that the decline in labor share is over-stated because self-employed people are earning less in labor income. And the decline in self-employment income explains part of the decline in labor share.

They say that one third of the decline in labor share can be accounted for by a decrease in self-employment income. The idea is part of understanding what part of self-employment income is labor income and what part is capital income... but I question their basic assumption.

In the paper, they make an assumption.

"Self-employment income in this headline measure is imputed under the assumption that average hourly compensation for the self-employed is the same as for those on payroll. That is, hourly self-employment income = hourly payroll income for all quarters in the postwar period."

They then say that the hours of self-employed people as a share of total labor hours (self-employment hours + payroll hours) have decreased from 14% in 1948 to 8.5% in 2012. When you multiply hours by hourly wage, you must then conclude that self-employed people are earning less as a share of national income over time. Thus they conclude that the labor share of self-employed people has declined over the years and accounts for one third of the total decline in labor share.

It all rests on the assumption that the relative ratio between hourly compensation between self-employed people and those on payroll has not changed over the years.

Can that really be a true assumption when productivity from employee work has grown much faster than their hourly compensation? Hasn't the increased income from increased hourly productivity gone to the "owners" of labor's work? The self-employed still hire employees who are more productive but not receiving compensation equal to their increased productivity. Aren't the self-employed reaping increasing benefits from their more productive employees?

It would seem to follow that employers, even if they are self-employed, are getting more income from increased productivity of their workers.

And if the self-employed are working less hours, wouldn't it might be because they have more leisure time now from increased pay per hour? Are they earning more per hour and now find they can afford more leisure time off?

I think of a cleaning cooperative in Humboldt County, California, called Restif Cleaning Services. The company is 100% employee owned. I talked with them by phone. They tell me that the employee owners receive on average $20 to $24 per hour of work. Now all of their competitors employ workers at a wage rate from $8 to $12 per hour. The self-employed owners at the other companies must be making quite a profit for themselves, especially if we assume those owners are working less hours.

I know a lady who cleans houses. She charges $45 per hour. And then pays workers $10 to $12 per hour to do the work. Needless to say, she does not like doing the work herself because she makes much less per hour. If she does a job of 5 hours by herself, she makes $225 at $45 per hour. If she has a worker do 3 of those hours, and she works 2 hours, she makes $200 ($225 - $25), at a rate of $100 per hour of work. In this case, she is making 8x the hourly wage of her employee. She says it is hard to find good dependable employees. And she is a nice religious person who wants to do missionary work in Africa to help poor children.

What about employers that are not so nice?

Side thought: I think about for a moment how supply-side schools teach that lower wages would shift the LRAS curve to the right. My research into effective demand says that lower labor share would shift the LRAS curve to the left.

We can see that the cleaning lady has an incentive to work less hours, but only because she progressively receives more per hour than the employee on payroll. Thus, the more she can get workers to do the work, the more she makes per hour. Thus, we have an explanation of why self-employed people are working comparatively less hours. It is not because they earn the same or relatively the same over time as those on payroll. It is because they are increasingly earning more per hour than those on payroll. This refutes the apparently casual assumption in the Brookings Institute's paper.

One of the keys to saying that self-employed people are earning relatively much more than employed people is based on employee productivity gains over the decades.

If I then was to assume that self-employed hourly income had risen against payroll hourly income, I would not have reached the same conclusion as the Brookings Institute paper. I would not have said that a third of the decline in labor share is attributed to a relative decrease in self-employment labor income. It would then follow that a decline in labor's share of income is more a result of payroll income declining than the Brookings Institute would have us believe.

However, on page 13 of the paper, it is noted...

"Moreover, rises in compensation at the very top of the distribution of proprietors have been even more extreme than among employees, suggesting that the average hourly compensation of the self-employed has soared in recent decades relative to the payroll employed, violating a key assumption underlying the headline measure."

So they recognize a problem with the assumption. I suggest they not be so sure of saying that a third of the decline is due to lower self-employment income.

Nick Rowe explores interest rates & aggregate demand... What about profit rates, optimism and effective demand?

Nick Rowe at Worthwhile Canadian Initiative asks a question...

"What happened in 2008? Why didn't the cut in interest rates prevent Aggregate Demand from falling? Was it just that the cut in interest rates wasn't big enough? Or is the rate of interest the wrong thing to look at? Because it's only a relative price, and relative prices only matter for relative demand?"

There is a lot to explore here, and I am going to go down the road of profit rates. The issue involves the dynamics at the onset of a recession. But let's start exploring with Keynes and see where it leads. Here is Keynes in Chapter 22 of General Theory...

"Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest!^[5] For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom."

The boom which is destined to end in a slump is caused, therefore, by the combination of a rate of interest, which in a correct state of expectation would be too high for full employment, with a misguided state of expectation which, so long as it lasts, prevents this rate of interest from being in fact deterrent. A boom is a situation in which over-optimism triumphs over a rate of interest which, in a cooler light, would be seen to be excessive." (source)

Keynes says with an exclamation point that a lower rate of interest is the solution to a boom; just keep the boom going by lowering interest rates. Nick Rowe is then asking why a drop in interest rates during 2008 didn't stop aggregate demand from crashing. The Fed rate did almost reach the zero lower bound by the end of 2008.

Graph #1.

Back at the beginning of 2004, inflation started to appear. Soon after the Fed started to raise the Fed interest rate. The Fed rate kept rising until the Fed felt inflation was under control around a 2% target.

We can see that profit rates took a hit when the Fed rate started to rise back in 2004. But they soon got right back on track. Optimism overcame the Fed rate hike. (more on optimism below) The aggregate profit rate leveled out at the beginning of 2006 and then fell by the end of 2006.

Real GDP was growing and eventually hit the effective demand limit in the 3rd quarter of 2007. The recession officially started in December of 2007.

Graph #2. Real GDP stopped increasing after reaching effective demand limit. (note: area shaded red in LRAS zone, but area shaded red in graph #1 is recession.)

Once real GDP hit the effective demand limit, real GDP came to a stop. And we can see in graph #1 that the Fed then started to drop the Fed rate.

So the question is... Was the grinding to a halt of real GDP (and by association aggregate demand) due to high interest rates from 2004 to 2008 and then interest rates not going down fast enough in 2008? or Did real GDP grind to halt primarily because of the effective demand limit upon real GDP? In all recessions prior to 2007, except the Volcker induced recession, real GDP slowed down and stopped once reaching the effective demand limit.

What does Keynes say about the effective demand limit in Chapter 3 of General Theory?

"Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. 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." (source)

We can see in graph #1 that aggregate profit rates started falling a year before real GDP reached the effective demand limit and kept falling for at least a year after. I would generally say that profit rates had been maximized before and after the effective demand limit. 

If interest rates had dropped faster and farther in 2008 as the recession was starting, would the profit rate have started heading up? Would the expectation of more profit by entrepreneurs been resuscitated? 

Or was the true problem having the Fed rate too high in 2006 and 2007?

As Keynes said in the first quote above from chapter 22, optimism can overcome a high interest rate. And when real GDP had room to grow in 2005 before hitting the effective demand limit, there was reason for optimism. Profit rates continued to increase. And in a certain light, the Fed rate was inconsequential to the growth of real GDP through 2005. But as profit rates began to maximize in 2006 approaching the "constraining dynamics" of the effective demand limit, the Fed rate became a problem. And when real GDP started grinding to a halt from the effective demand limit, the Fed quickly tried to bring down their interest rate.

Getting back to Nick Rowe's question... "Why didn't the cut in interest rates prevent Aggregate Demand from falling?"

In light of Keynes' quote from chapter 22, the Fed rate should have dropped in mid-2006, when profit rates were declining and as real GDP was approaching the effective demand limit. The party of the boom would have been extended by optimism. The demotivating dynamic of the effective demand limit upon optimism would have been overcome. Unemployment and capital utilization would have stayed steady as real GDP kept growing from increasing productive capacity through optmistic investment. Profit rates would not have risen, but the sense of optimism to continue enjoying those profit rates would have continued.

The Fed kept the rate too high if one had wanted to avoid the crisis. But personally, I am glad the bubble burst. Eventually we will get back to a normal sustainable economy once economists realize that we need to fix where we are, and not try to return to the bubble years before the crisis.

 

Capacity utilization low and steady as she goes...

Here is the latest reading on capacity utilization. Data for August 2013 released yesterday.

Link to graph.

It has been flat-lining for over a year and a half. Look familiar? Similar thing was happening before the crisis.

Note: To really appreciate capacity utilization, here is a table giving the sectors of industrial output involved and their value-added weights. Capacity utilization covers 3 stages of processing goods; Crude, Semi-finished and finished.

Industrial sectors include food, oil & gas extraction, chemicals, petroleum & coal products, transportation equipment, computer & electronic products, pharmaceuticals & medicines, plastics & rubber products and electric power generation.

I have heard it said that industrial production only accounts for around 16% of the economy and thus does not carry much weight.  Remember that imports are also around 16% compared to real GDP. But beyond that, there are a lot of industries adding value onto industrial production, which include advertising, sales, marketing, distribution, packaging, healthcare, infrastructure projects and even construction. The demand that these industries encounter for their products and services determines capacity utilization in industrial production.

Capacity utilization is a powerful indicator for the utilization of resources for the whole supply chain from raw materials through processing to the final consumer.

"In essence, supply chain management integrates supply and demand management within and across companies. Supply Chain Management is an integrating function with primary responsibility for linking major business functions and business processes within and across companies into a cohesive and high-performing business model. It includes all of the logistics management activities noted above, as well as manufacturing operations, and it drives coordination of processes and activities with and across marketing, sales, product design, finance and information technology."

A typical supply chain begins with the ecological, biological, and political regulation of natural resources, followed by the human extraction of raw material, and includes several production links (e.g., component construction, assembly, and merging) before moving on to several layers of storage facilities of ever-decreasing size and increasingly remote geographical locations, and finally reaching the consumer." (source)

So anyone who discards capacity utilization is not seeing its importance as an indicator of resource utilization throughout the supply chain.

Inflation low and steady as she goes...

In another post, capacity utilization is low and steady, and inflation is too. Here is inflation (all items less food and energy on a quarterly basis).

Is this a problem? Well... One way to look at inflation is to see it as money growth that was not used for increasing real output. In other words, money is being used to increase employment and production. Money then needs to be distributed among more workers and more production. The result is a suppression in price increases.

So would we rather have increased employment and production or inflation? Increased employment is better. However, the problem is that money growth is not leading the economy. A little inflation would show that money growth is maximizing increases in employment and production. But when we see inflation falling, employment and production could be better with a little more money around.

Where is the money? The real problem is that the money in the hands of labor is not growing. Labor are the primary consumers for finished goods and services.  Inflation depends upon money growing faster in the hands of consumers than growth in production.

If there is $100 of disposable income, and 10 items to buy, there is $10 available per item. If disposable income rises by 10% and items increase by 5%, there will be $110 of disposable income and 10.5 items to buy. There will be $10.47 available per item. This leads to inflation.

But if disposable income rises by 5% and items increase by 10%, there will be $105 in disposable income and 11 items to buy. There will be $9.55 available to spend per item, instead of the original $10. This is disinflation.

We have an economy where labor's liquidity for spending is much weaker than capital's liquidity for increasing production. Thus, we get this low and steady inflation rate, where production is maximizing its control over the liquidity of consumers. Production is controlled in such a way as to keep the liquidity of consumers from getting stronger. Business methods use such powerful analytical tools that they are able to maximize control over consumer spending to increase their own profits and liquidity.

Another problem is that business is also minimizing the cost of labor by keeping wages low. Business, in general, is too focused on increasing profits at the expense of society. The only solution is for labor to increase in power and demand higher wages. Business will simply increase its production and employ more people. That is a good thing, right? Not for business... They are enjoying high profit rates, mostly due to labor share of income falling 5% since the crisis.

Tracking profit rates since 1967

This is a follow-up post to the previous post on the aggregate profit rate. Here is a graph of an aggregate profit rate based on the data from "Current-cost net stock of Fixed Assets", which have been converted into 2009 dollars. Table 1.1 of the BEA's Fixed Asset Accounts tables.

The aggregate profit rate is hitting a high. But we will watch it as it eventually will come back down.

Looking at profits rates on capital

The effective demand equation can be used to evaluate profit rates on capital. This measure is a useful indicator of the business cycle. When profit rates fall, the economy is heading toward a recession.

The basic equation to determine the profit rate on capital is...

Profit rate, r = (1 - effective labor share) * real GDP/value of capital goods

This equation simply comes from this equation for capital share of income...

Capital share = profit rate * capital goods/real GDP

Capital income = profit rate * capital goods

We already have effective labor share and real GDP. All we need is a value for capital goods. I go to table 9.1 at the BEA's Fixed Assets Accounts Tables. Then I use line #2 for Private & Government Fixed Assets. (The table currently has the numbers in 2005 dollars, so I convert to 2009 dollars by multiplying by 1.09.) Here is a graph of the value of capital in the US since 1996 in 2009 dollars. (quarterly data)

Graph #1

The growth trend in capital formation was faster before the crisis. The blue line shows actual data, which the BEA gives up until 2011. The orange dots are projected data for capital that I use to calculate the profits rates up until the 2nd quarter of 2013.

Here then is the graph for profit rates since 1996.

graph #2.

We can see that profit rates peaked in 3rd quarter 1997, which agrees with a graph from Samuel Bowles' book, Understanding Capitalism. We can see that profits rates dropped until the end of the 2001 recession... and then started rising fast through the bubble years.

The dashed red line shows the 1 year moving average for profit rates. We can see that profit rates were stuck for 2 years before the 2008 crisis. One could have seen here that a recession was likely. When profit rates are seen along side the consumption rate of capital income, the picture gets clearer to forecast a recession.

graph #3.

Some economists thought the economy was on the verge of a recession in 2011. There was a brief downturn in profit rates and capital income's consumption rate. But the economy pulled up from there. The economy will only go into a recession after reaching the effective demand limit.

Something to keep our eyes on is that the profit rate tends to flatten out before capital income's consumption rate starts to fall. And it looks as though profit rates are currently flattening out.