Effective Demand Research

Say's law fairy... Build it and they will come

Paul Krugman, Dean Baker, Mark Thoma, Ben Bernanke and many others call for fiscal policy to boost employment and production. The idea is that the jobs will create more income, more demand, more production, more jobs, even more production and eventually we return to full employment. In essence, they say to the government, "build it and they will come."

They are calling upon the "Say's law fairy".

In 1803, Jean-Baptiste Say wrote...

"It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. ... Thus the mere circumstance of creation of one product immediately opens a vent for other products."

J-B Say's message was that demand is increased by more production. If you were to tell J-B Say that low demand was the cause of low production and unemployment, he would not have agreed with you. He would have said that too many resources were being employed in some sectors of the economy and not enough in others. His explanation would imply structural unemployment.

The economists above know that currently there is no problem with structural unemployment. They have another way to  justify more output. If you increase employment through fiscal policy toward full employment, labor will increasingly have power to bargain better wages resulting in more demand. The increased purchasing power of labor will resolve some problems with debt overhang too. There would be a snow-balling effect of output, employment and demand back to full employment (implying an unemployment rate of 5% or less).

J-B Say would have also said that prices, wages and interest rates would have to adjust in order to return to full employment. Yet, there is rigidity in wages. As well, the interest rate is blocked by the zero lower bound. So therefore economists conclude that fiscal policy must be used. Even J-B Say acknowledged the usefulness of public fiscal policy to create jobs.

However, there is a problem not being understood. A lower effective demand limit is blocking the economy from reaching full employment. A fiscal stimulus would not be able to overcome this.

Think of effective demand as the rim of a cup. The cup holds production in terms of utilizing labor and capital. As the economy recovers from a recession, the cup is filled with more production, more employment and matching demand. Say's law is in action only up to the rim of the cup, where production encounters the effective demand limit. If more labor and capital is utilized, the cup overflows... the aggregate profit rate declines and the economy responds by contracting.

The problem now is that the rim of the cup is below the full employment that we became accustomed to in decades past. Fiscal policy is fine to raise production and employment below the effective demand limit, but in error when it expects to push them beyond the limit.

Keynes drew the line in Chapter 3. The Principle of Effective Demand.

"Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile."

The effective demand vision of Keynes will become clear this business cycle. The effective demand limit has always been there stopping business cycles, but the cycles were said to stop at accepted levels of natural unemployment, not any demand limit. However, this time will be different. Just since 2009, the effective demand limit has become a significant obstacle to the historic level of full employment. Economists do not realize this... yet.

The effective demand limit is determined by the percentage of national income received by labor, the primary consumers of finished goods and services. The effective demand principle is... The rate of employing labor and capital is limited by the effective rate of labor's share of national income. This principle refutes Say's law and any other view that expects the economy to a reach a full employment beyond the effective demand limit.

Fiscal stimulus would have to raise aggregate labor share to be successful. Yet, any fiscal job creation would have little impact on the national labor share.

Moral of the story... The rim of the cup does not rise, if you keep filling the cup.

... and there's no "Say's law fairy" to raise the rim of the cup either.

A look at 3rd quarter real GDP

The following graph is for Aggregate supply and Effective demand. The pink lines are for 3rd quarter 2013. The blue dots show real GDP. The blue dot to the right is for 3rd quarter 2013. It is obvious that real GDP grew a lot in the 3rd quarter. The blue dot moved far to the right.

The downsloping effective demand lines follow a tight path. The two bottom lines that look yellow and green actually have 5 lines there. There are 3 lines hiding behind them. Strange coincidence.

So I notice that the pink effective demand curve for 3rd quarter 2013 moved up a little. I ask myself why?

Did labor share increase? No... it actually fell a little.

Did the UT index increase? No... it actually fell too.

Then what happened? Well, real GDP is inflated. If real GDP had been less than $15.8 trillion, the pink line would have been in the normal range.

So why is real GDP inflated? Did productivity increase? A little but not much.

It looks as though the real GDP inflation was due to the boost in inventories, which grew $115.7 billion in the third quarter. Inventory grew $56.6 billion in the second and $42.2 billion in the first quarters.

We will see a drag on real GDP either in 4th quarter 2013 or 1st quarter 2014 from declining inventories.

But one thing is for sure, real GDP is getting close to the effective demand limit.

Jared Bernstein's "new normal" potential GDP is similar to effective demand here

Today Jared Bernstein published a graph with a red line representing a new normal for potential GDP.

I was surprised because the line looks very similar to the line I have been publishing for months for effective demand.

Mr. Bernstein does not give an equation for his line, but only a definition...

"The other two lines approximate the potential growth by extracting a smooth trend from the underlying G.D.P. series, controlling for cyclical movements.  The yellow line shows the trend if you stop that trend extraction process in 2007.  The red one shows what happens if you use the full series right through last week’s revision."

The equation I use is "real-time" and not dependent on statistical smoothing. You can derive potential GDP just from the data in one quarter, You do not need a series of data in time.

Potential GDP = real GDP - a * (capacity utilization/effective labor share - 1)

a = business cycle amplitude constant in 2009 $$, currently estimated at $3.4 trillion... effective labor share is determined by a central tendency line (which crosses the origin of a graph) between capacity utilization and the index for labor share: business sector. The slope of that line for 2009 base year is estimated at 0.762.

Mark Thoma linked to my original graph back in April. No impact was noticed after that. So, it will interesting to see if Mr. Bernstein's graph creates a reaction, because economists are less sure now of potential GDP than they were months ago.

Early signs that economy is turning toward a contraction

In this research of effective demand, real GDP is said to be now hitting the limit of effective demand. This means that we should see some signs that the economy is turning toward a recession.

So... do we see any signs?

Starts of recessions are vertical red lines.

Calculated from th NIPA tables, the capital savings rate has hit a historic low level of around 60% and bounced back in 3rd quarter 2013.

Why would a rise in the capital savings rate signal a contraction? At first take, it doesn't make sense. Owners of capital are making more funds available for lending. For example, in 3rd quarter 2013, capital savings roughly rose $300 billion, while government borrowing and private investment rose by roughly the same amount. That doesn't seem like a cause for a recession if investment increases.

When you look at the graph above, a rise in capital savings of off 60% will occur before a recession. Why?

If capital income is saving more, they must by consuming less. We see this in the following graph.

Capital income reached a high in 2nd quarter 2013, and then fell in the 3rd quarter. As you can see, this change has preceded the last two recessions.

When profits run high, capital income consumes. Yet, the aggregate profit rate also reaches a high. Here is the aggregate profit rate.

The aggregate profit rate has been flat for 2 years. A decline in the aggregate profit rate would lead us into the next recession. This needs to be watched over the next 2 quarters.

The aggregate profit rate will decline in response to a rise in capital savings.

This graph shows that when the aggregate profit rate reaches a maximum, the capital savings rate is roughly reaching a minimum. The lines in this graph are roughly showing that the economy will start turning toward a contraction. (red vertical lines are starts of recessions.)

Thought on shifts in labor share

In this graph, we see shifts due to labor share falling.

When the line in the graph above slants downward toward the x-axis, labor share is changing a lot. There are gradual changes. Yet the TFUR (labor and capital utilization) is changing right along with it. It stayed that way for decades. The “interest rate” measure of that relationship was stable. Then after the 2001 recession, the relationship shifted. It shifted again after the crisis.

A core dynamic in the relationship between labor share and TFUR shifted.

First, the TFUR moves up and down within a range.
Second, labor share will maintain a somewhat linear relationship to it as shown by the interest rate measure.
Third, effective demand itself is going through large changes up and down. And effective demand is a function of the same variables, labor share and TFUR.
Fourth, a shift is definitely to the left, not down. The range of the TFUR shifts left to a lower range on the x-axis.
Fifth, labor share is the limiting factor on the TFUR range.
Sixth, thus the shift is due to a core shift in labor share. If the shift was due to TFUR shifting down, the line would simply slide up the existing line. So labor share has to shift to shift the line.

What is a core shift in labor share? If you look at where the shift occurs, you will see it happens during a recession, when businesses are cleaning out labor and capital. At those times, businesses are able to re-construct labor share, as they re-hire on workers. In the last two recessions, businesses made a conscious choice to lower labor share. Most likely in response to price pressures from imports.
Once the business cycle starts to recover, businesses have already set the standard for pay and labor share. Then the business cycle proceeds with that in place, and it becomes difficult to change the standard.
This implies that shifts in labor share must happen during recessions.
The conclusion is that labor share cannot just be raised once a new business cycle gets going. Businesses have already laid the path of it as the recession fades away.
So…. if we were to try to raise labor share in the future, would the best time be during a recession? That is difficult, because labor loses most of its power then.
So then, is it possible to raise labor share in the expansionary phase of the business cycle? Yes, but the effort and the effects on business are great.
So when will labor share rise? Really, the better question is whether it will fall even more during the next recession.

In summary, there is pressure to lower labor share from import prices. Labor share falls during recessions as businesses clean out labor and wages. Yet, labor share can only fall so fast during a recession. There are limitations of time and rigidities. There is probably still some pressure to lower labor share even more, and that adjustment will have to wait for the next recession.

Fed policy is heading into trouble

The future of monetary policy is troubling. I present a video to explain. (Part 4 of a series on the journey of the Fed rate from 1978 to the present.)

Since the 1960's, the Fed rate has consistently reacted to the natural level of real GDP  (in terms of labor and capital utilization). Effective demand sets the natural level. The natural level of real GDP has fallen since the crisis. Monetary policy so far does not recognize this. This graph from the video shows how the natural level of real GDP is determined.

You can see 3 red trend lines. The point where each trend line crosses the x-axis establishes the natural real GDP level (in terms of labor and capital utilization). The trend line on the right is from the 1970's to 2003. The trend line in the center is from 2003 to the crisis. The trend line on the left points to the current natural level of real GDP. The Fed funds rate has recognized and responded to these levels consistently over the years.

The Fed along with other economists, like Paul Krugman and Larry Summers, see a large output gap to bring the economy back to full employment. In effect, they still see the economy returning to the middle trend line above. Yet, they say that there will have to be a negative real interest rate when the output gap is closed at full employment.

The natural real interest rate at full employment is roughly determined by adding productivity growth, population growth and a time preference variable. As people put off consumption into the future, the time preference variable declines. Productivity growth is low, population growth is low and people are preferring to consume less currently.  So it would seem reasonable that the natural real interest rate has fallen from its historic range around 3%.

But has the natural real interest rate gone negative? Well, if it has, productivity growth will be negative in the US at full employment. I don't see it. Productivity growth is simply blocked by effective demand now, as has happened many times since the 1960's. Productivity growth will come back. No, the natural real interest rate will be positive at the natural level of real GDP, but not quite as high as 3%. In the video, I assume a 1.5% natural real interest rate.

So it is not so much that the natural real interest rate has fallen, but rather that the natural level of real GDP in terms of labor and capital utilization has fallen.

Note: In the video, I say there is price stabilization when the natural real interest rate and the current real interest rate cross under the Fed rate. This concept is related to the idea of a neutral real interest rate, which is defined as monetary policy which is neither expansionary nor contractionary. (Bernhardsen 2007, Wu 2005)

Related sources...

Bernhardsen, Tom, Karsten Gerdrup. The Neutral Real Interest Rate. Monetary Policy Department, Norges Bank. 2007.

Escolano, Julio, Anna Shabunina and Jaejoon Woo. The Puzzle of Persistently Negative Interest Rate-Growth Differentials: Financial Repression or Income Catch-up? IMF working paper. November 2011.

Collignon, Stefan. Implications of the Low Interest Rate Environment for the Real Economy. European Parliament. Draft paper. February 2013.

Lambert, Edward. Series of videos on the Journey of the Fed rate. Part 1 (1978 to 1988)... part 2 (1988 to 1997)... part 3 (1997 to 2008). Youtube.com. December 2013

Wu, Tao. Estimating the "Neutral" Real Interest Rate in Real Time. Federal Reserve Bank of San Francisco. October 2005.

The journey of the Fed rate from 1997 and into the future... problems ahead

I posted parts 1 and 2 about the journey of the Fed rate. The first two parts covered the years from 1978 to 1997. Parts 3 and 4 below cover the years from 1997 to 2013 and a look into the future.

The monetary model of effective demand shows that the natural level of real GDP (in terms of labor and capital utilization) shifted twice... once after the 2001 recession and again after the crisis. The shifts were due to declines in labor share according to the equation for effective demand.

The Fed rate respected or at least reacted to the first shift. But the Fed has not recognized the second shift after the crisis. If the Fed was respecting that shift, monetary policy would be tighter at the moment. Instead, we hear Larry Summers saying that the real interest rate would have to go negative now in order for the economy to return to full employment... the full employment we saw before the crisis.

Yet, the effective demand limit has fallen, and full employment will occur at a lower level now. If the Fed was fooled by the first shift, they should not be fooled by the recent shift. But it appears they are being fooled.

Fool me once, shame on you.
Fool me twice, shame on me.

Part 3... The Fed rate journey from 1997 to 2008.

Part 4... The Fed rate journey from 2006 to 2013 and into the future.

The equations for the curves in the graph are...

Path of nominal Fed rate = z*(T² + e²) - (1 - z)*(T + e)

Real GDP anchor = e*(e - T)/(1 + T)

T = TFUR, x-axis in video... e = effective labor share, which is labor share index: business sector * 0.762... z = z coefficient, which establishes position of monetary framework according to effective labor share and TFUR...

Natural real interest rate = nominal Fed rate - inflation target

Current real interest rate = Fed funds rate - inflation

z coefficient = (2e - w + t)/(2e(e-w+1) + w(w-1))

e = effective labor share anchor... t = inflation target, such as 0.02... w = the width of the effective TFUR range that we desire, such as 0.13. The width refers to the difference between the natural real GDP and where the natural real interest rate crosses the x-axis, 0% line.

The Journey of bringing the Fed rate back into balance with inflation

I made a video... in two parts. (sorry that together they are long).  They had to be long.

The videos use the monetary model of effective demand to explain how the Fed was able to bring inflation back under control after the 1970's. The story really is interesting... and then to see how the Fed rate reaches its target after all those years is brilliant.

These videos opened my eyes to new understanding. One thing I realized is that the cause of the bounce in the UT index around 1987 was due to a false natural level of real GDP ( a false effective demand limit) created by the Fed to control output and inflation.

I explain the lines in the videos. Here they are...

Part 1

 Part 2

 The insights gained from these videos will help in understanding monetary policy going forward into 2014 and beyond.

The equations for the curves in the graph are...

Path of nominal Fed rate = z*(T² + e²) - (1 - z)*(T + e)

T = TFUR, x-axis in video... e = effective labor share, which is labor share index: business sector * 0.762... z = z coefficient, which establishes position of monetary framework according to effective labor share and TFUR...

Natural real interest rate = nominal Fed rate - inflation target

Current real interest rate = Fed funds rate - inflation

Natural level of real GDO = when real GDP = effective demand... 3% natural real rate

Fabricated level of real GDP = where 6% natural real rate (Fed seeks to keep current real rate at 6%.)

What do we want... inflation or real GDP growth?

We hear economists calling for higher inflation to lower the burden of debt on borrowers. Yet, we hear them complain about slow real GDP growth too.

Can we have our cake and eat it too? Can we have real GDP growth alongside inflation?

Real GDP rose by 3.6% on an annual basis for 3rdQ-2013. Yet, half of that rise was inventory accumulation. What is going on? Well, we know that China is increasing its capacity to produce by huge amounts every year, and maybe they are dumping competitively priced products on the US market. Maybe Chinese companies are competing even more for market share in the US.

To have such a large increase in inventory could mean there are cheaper prices coming. And with most people complaining of low inflation, one could imagine that the large inventory might lead to lower prices... even lower inflation.

So the 3rdQ increase in real GDP could mean lower inflation.

As the economy grows, real output grows. And the value of output grows. More money is required to incorporate the increased production at stable prices. Thus inflation is controlled as real output grows. This process is considered healthy for the economy.

Normally one can think that inflation stays low as real output is growing. Then as real output reaches its natural level and begins to slow down, further increases in demand tend to show up as price inflation.

But the relationship between the growths of inflation and real GDP are not precisely like this. Here is a chart for the two.

Inflation is the blue line. Real GDP is the red line. You can see many times when they move opposite to each other. But you can see times when they move together. It is interesting to note that in the mid-2000's, real GDP growth was slowing down, but inflation tended to be on the positive growth side.

By the way, even though there was high inflation growth in the 1970's, do we want the volatility that came with it?

Moving forward, we cannot rely on inflation to grow seriously. Will real GDP, gross "domestic" product, increase? Can we produce more here in the US? Not really, the US consumer on balance gets weaker and weaker, as labor's share of real output declines. US consumers have less power to purchase the value of their own production.

It seems to me that we will get neither substantive inflation or real GDP growth.

 

Unemployment trending steady

The November unemployment rate came in at 7.0%. This is trending steady.

This graph combines monthly and quarterly data since January 2012. I track the quarterly data for the effective demand research.

The forecast is for the 4th Q of 2013 to be around 7.1%.

Right now the average of October and November is 7.15%. If December has 6.9% unemployment, the 4Q of 2013 will be 7.07%. If December has 7.2%, 4Q of 2013 will be 7.17%.

That is right on schedule. I forecast the effective demand limit to be reached when unemployment is between 6.5% and 7.1% on a quarterly basis. A couple more quarters still to go. Unemployment is trending with real GDP.