Effective Demand Research

Update of Natural Unemployment rate... 5.9% to 6.2%

Here is a graph of the Effective Demand dtermination of the NAIRU, the natural unemployment rate.

The red dots plot the recent movement of the Unemployment rate in relation to the UT index which measures spare capacity to the effective demand limit. (quarterly data)

I used to use a linear trend line to determine the natural unemployment rate, where the plot crosses the 0% point on the x-axis. Yet the recent plot is moving like a polynomial line. The equation of the trend line shows a 6.2% for the natural unemployment rate. Yet the plot could go a bit lower, so I estimate a natural unemployment rate of 5.9% to 6.2%.

We currently have 6.2% unemployment for the 2nd quarter of 2014. And tomorrow the forecast is for a 6.1% unemployment which keeps the graph above showing that the economy is very close to the effective demand limit. The critical variable to confirm the effective demand limit is a drop in capacity utilization, which may be coming after the big drop in the Chicago PMI.

Related article...

Zumbrun, Josh. Wall Street vs. Brookings on the Decline in Unemployment, Round 1. Wall Street Journal: Real Time Economics. July 31, 2014.

Drop in Chicago PMI signals Effective Demand limit

The Business barometer in Chicago, the Chicago PMI, dropped significantly in July. The expectation was for 63.o and it fell to 52.6. That is a huge drop.

I will be very interested to see if capacity utilization is dropping now in the US. That would be a strong sign that the US has hit the effective demand limit.

Shortage of labor due to rejecting wage offers?

This posts refers to an article written by Gary Burtless, Unemployment and the “Skills Mismatch” Story: Overblown and Unpersuasive.

Mr. Burtless says that businesses are complaining about a skills shortage in an environment of lots of job openings. What kind of model might describe this situation? I have one... (link to model)

Labor share represents the strength of real wages to entice workers. The employment rate represents the percentage of workers that will be employed at that labor share. If labor share/real wages fall, less workers are willing to supply their efforts at that wage level. Yet firms will demand more workers... or better said, firms will expect workers to be just as likely to accept lower wages.

Now Mr. Burtless sees this situation and suggests to firms...

"It is cheap for employers to claim qualified workers are in short supply. It is a bit more expensive for them to do something to boost supply. Unless managers have forgotten everything they learned in Econ 101, they should recognize that one way to fill a vacancy is to offer qualified job seekers a compelling reason to take the job. Higher pay, better benefits, and more accommodating work hours are usually good reasons for job applicants to prefer one employment offer over another. When employers are unwilling to offer better compensation to fill their skill needs, it is reasonable to ask how urgently those skills are really needed."

I agree with Mr. Burtless. Employers expect there to be enough workers who will take whatever wage is offered them. The solution is to offer better wages and benefits. And the aggregate data is showing that firms are not raising wages much.

Yes, there is trouble in Japan

Just yesterday I posted about how weak real wages in Japan spells trouble for Abenomics. Today we see by way of Stanley White and Leika Kihara at Reuters that output in Japan might be showing recession.

"Output is clearly weakening, enough to make you even wonder if the economy is OK," said Yoshiki Shinke, chief economist at Dai-ichi Life Research Institute."

I keep something in mind… From my view, Japan is already up against the effective demand limit. How do I know? Capacity utilization has been falling all year while unemployment ticks down. So GDP growth will not keep rising as much as in the 1stQ 2014.
http://www.tradingeconomics.com/japan/capacity-utilization

Disposable personal income is weak…
http://www.tradingeconomics.com/japan/disposable-personal-income
household spending got weaker too… You see a jump before the taxes in this graph.
http://www.tradingeconomics.com/japan/household-spending
If household spending simply returns to zero% growth, it will be trending on a lower path now after a few months of decline. We would need to see household consumption rise more than that.

 

Update on Real GDP and the Output Gap

With today's revisions of real GDP, I want to post two graphs.

Trending Real GDP according to Effective Demand

So after the rise late last year, and the dip in the 1st quarter and the rise in the 2nd quarter... The potential GDP of Effective Demand is simply back on its exponential trend line. Yet, real GDP is closer to its projected effective demand limit roughly around $16.1 to $16.2 trillion.

The Output Gap

The output gap as determined by Effective Demand is based on the % difference between capacity utilization and effective labor share. The output gap is currently in range for a normal top to the business cycle. The implication is that there is little spare capacity left in the business cycle.

Update on Consumption by Capital income

One economic variable that I track is the percentage of capital income used for consumption. It is not an exact number but an estimate in order to see trends over time. With the new revisions to GDP out today, I will update this variable.

I have previously said that consumption by capital income would drop this year as the stock market hits a plateau. In April, I said that the Dow Jones would rise to around 16,800 and move around that level. Some 3 months later, I look at the Dow right now and see it is at 16,851... Still within range.

A drop in consumption by capital income would offset increases in consumption by labor income.

So what is happening to the use of capital income for consumption?

The most recent data, which will be subjected to further revisions later,  is showing a drop in consumption by capital income. How much money would this represent?

This graph estimates a drop from $1.108 trillion to $882 billion from 1stQ to 2ndQ. This is a drop of $226 billion. The estimated consumption by labor income rose by $292 billion. So there was a net rise in consumption of $66 billion from 1stQ to 2ndQ.

Now I compare the rates at which labor and capital incomes consume.

We see the drop in capital income consumption below. The rate of consumption by labor income is trending just a bit upward, but holding quite steady. Since the 1980s, the rate of consumption by labor income tends to bloom upward after a recession, then begin a soft rise before the next recession.

Just one more graph to show that the savings rate of capital income rose in 2nd quarter.

Past trends have shown that once capital income starts preserving itself through increased saving, a path to a recession forms. There has been a floor of 58% since the 1980s. The plot hit that floor twice recently and now looks to be possibly rising. The implication would be that the end of the business cycle is upon us and we have turned a corner toward an eventual recession.

Of course, the above graphs will be revised in the following months, but at least we get a preliminary look at an important trend. I am expecting the trends to continue developing a path to the next recession.

It is important to read the movements of capital income as they tend to have more insight into the trends of the economy.

Real Wages weak in Japan... trouble for Abenomics

I have written that the success of Abenomics in Japan would depend on raising labor's share of income faster than inflation. Basically real wages need to rise. I would now add that real wages need to rise faster than productivity. The key is to raise effective demand with healthier consumption demand.

So we see an article in the WSJ today that the Virtuous Cycle of Abenomics is Spinning more slowly. Why? What is happening?

"... a string of recent data — from soft consumer spending, tepid wage growth, and a newly muddled jobs picture — offer a sobering reminder of the challenges that remain before Prime Minister Shinzo Abe..."

The article points out that labor demand looks to be peaking. Unemployment has recently risen. There is a decline in permanent work with a rise in non-permanent work. The prospects for a significantly higher labor share are low.

The article did mention that profits in Japan are good.

"The signs aren’t all bad. Companies are expected to report robust profits over the next couple of weeks, suggesting more potential for hiring and higher wages. In anticipation of such results, the Nikkei Stock Average has rallied in recent days, trading at a six-month high."

More potential for hiring and higher wages??? Firms are competing on the international market. It is not likely that those profits will find their way into the hands of labor in Japan in any significant way. That should have already happened. And there is little sign it is happening now.

In all, I measured the success of Abenomics upon raising labor share. So far, wages have not risen enough for Abenomics to eventually succeed in its goals.

Profits Maximizing at the Effective Demand Limit

When Keynes wrote about Effective Demand in Chapter 3 of General Theory... he tied the limit of effective demand to the maximization of profits. Currently I see the economy reaching the effective demand limit by the end of 2014. Is there a sign that profits are maximizing?

Here is Gina Martin Adams of Wells Fargo & Co. from an article at Bloomberg Businessweek.

"The decline in non-financial EBITDA margins is “sending something of an ominous signal” that may be followed by a peak in net-income margins, she wrote in today’s report. “Peak margins were a good indicator of impending recession in each of the last cycles,” she wrote. Sales growth will have to pick up considerably in order to ease concern about margins, she said."

Time is running out on the bull market.

Example of not understanding Effective Demand

The Economist online magazine has an article called, Jobs are not Enough, where they show a poor understanding of effective demand.

"Economic growth over the business cycle is driven mostly by swings in demand, and in recent years demand has been held back: households have been repaying their debts; the government has restrained its spending and raised taxes; and interest rates, having reached zero, are unable to fall further"

OK, demand drives the business cycle.

"Over the long run, however, a country’s potential growth depends on supply: how many workers it has and how productive they are. The recent divergence between America’s employment and output suggests the country faces not just deficient demand but also enfeebled supply, as more people working without more output means lower productivity. That is bad news for all Americans since their standard of living depends on productivity."

Then they drop demand from the equation and say that potential growth depends on supply. What happened to demand which was driving the business cycle? For me, they simply do not understand the concept of effective demand, which is the demand measurement for determining the limits of potential output.

They take this error in understanding to the next level... by saying that supply is the problem for high unemployment and low output. They specifically point to productivity, which is actually constrained by effective demand. And assuming a standard of living is based on productivity, a poorer standard of living is caused not by supply problems, but by demand problems... namely, low labor share. They are not making the proper connections between effective demand, productivity, output and unemployment.

Like Keynes said, until people understand effective demand, "all discussions concerning the volume of aggregate employment are futile." (link)

IMF suggests improving skills of youth & lower pay?... Keynes rolls over

Here is a video from the IMF...

At the 4 minute point, the representative talks about youth unemployment in Europe and recommends two things...

1. training to appropriate skills which would make someone more valuable.
2. bringing down costs of employment.

Oh, how wonderful!... Make your skills more valuable only to meet wage suppression. They just do not understand that people need to be paid more.

Keynes wrote...

"The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment."

In other words... It is pointless to increase the marginal product of labor when you are faced with insufficient effective demand.

Every country has a self-interest to compete by lowering labor costs. In effect, the advanced world is continually sinking into a secular stagnation. The key is for an organization like the IMF to step in and recommend a coordinated effort among countries to raise labor income, not decrease it, and thus increase effective demand for production. That will create investment.

Just pay labor more!