The Effective Demand Rule without the Anchor

I have been writing about the Effective Demand rule for monetary policy lately. The version that I have been showing uses a labor share anchor, which is a projection of where labor share will be at the natural limit of the business cycle. Labor share has always tended toward its labor share anchor at the end of a business cycle. So the labor share anchor is a measure of the eventual potential in the economy.

Some people may not feel comfortable with the anchor as it is estimated from a trend line of effective labor share. I have another version of the Effective Demand Rule that uses the labor share data that is released by the US Department of Labor: BLS... without converting it to an anchor.

I will show graphs for each version.

First is the graph using the anchor representing the eventual natural potential. Second is the graph using the trending effective labor share. (Effective labor share = Non-farm labor share: Business sector * 0.762) The second graph is a more straight-forward way to measure the base nominal rate underlying the economy.

Since the crisis there is little difference between the two graphs. Yet you will notice some differences. For example, between 1998 and 2004, monetary policy is seen as tighter before and after the 2001 recession. The economy was building slack after 1998 and a lower Fed rate would have been proper. The version above using trending labor share shows that better. Labor share ultimately fell (after 2001 and especially after the crisis) and ate up some of that accumulating slack.

What some call secular stagnation is just the process of labor share falling to eat up excess slack caused by competitively lower labor shares overseas and new productive technology. Should the fall in labor share have been temporary? Did it become an undesired global downward spiral? I think so... If advanced countries could now coordinate a reversal of falling labor share, the aura of secular stagnation would dissipate like a morning fog.

Note: An important thing to realize in the Effective Demand Rule equation is that the only value of labor share that works... is the basic "effective" labor share value used to determine Effective Demand. Thus the accuracy of the Effective Demand Rule (when compared to the actual Fed rate) supports the calculation of the effective labor share, and thus the projection of the Effective Demand limit.

The labor share used in the following graph is based on weighted averages of past quarters. Weighting in this manner gave less overall error than the hp filter.

Here is the equation to weight labor share...

weighted labor share = (7.2*LS of last quarter + 2.5*LS of 2 quarters past)/9.7

Here is a graph just to show the effect of the equation to weight labor share. The orange line is what is used in the 2nd graph above.

You can see that labor share lags behind itself, but the highs and lows are softend a bit. Labor share has to obtained by looking at past quarters where data is available. Data is only available after each quarter ends.

Comments

[Fred]

Hi Edward - I have two questions, if you have time: 1) Just what would be needed for the advanced countries to "coordinate a reversal of falling labor share" and, 2) since this coordination (or even individual action) is unlikely, what happens next? Thanks.

[Edward Lambert]

Fred,
Agreed... the coordination is not likely. What happens next?
Economic potential is stunted. But now the million dollar question...
Does that mean there is more slack?... Well, no.
There is pretty much the same amount of slack as before in terms of what the economy will use by the end of the business cycle.
Therefore, there is slack out there that the Fed has no power to fix. The Fed's low rate shows that they think they can fix it. But they can't. The Fed rate should rise in relation to the slack left before the end of the business cycle. Yet, it won't rise enough by then.
There is a dramatic situation taking shape...

[Fred]

Heck, based on the Fed minutes from the July meeting, I don't think the rate is going to rise at all if the economic recovery, such as it is, slows down or stops making progress. So we likely face the end of the business cycle and a zero fed funds rate. What is this "dramatic situation" of which you speak?

[Edward Lambert]

The dramatic situation is just that... reaching the end of the business cycle with the Fed rate still stuck on the ZLB. There will either be a great deal of soul-searching by many economists, or blame on unforeseen things. Some economists will accept their failing to see it coming, others will not accept that they missed it.

[JimH]

Edward,

I agree with you on the "dramatic situation".

Before this is finished, I believe that some economic theories are going to be exposed as based on certain assumptions which are not always true.

Japan seems to be the "canary in the mine". Japan's economy is export based, they import raw materials, manufacture products, and export a large percentage of that production to the developed world including the US. More accurately, to the worker/consumers in those countries. Their fundamental problem has been that after 1985 they faced increasing competition for the developed world's import market.

Their primary response to that problem was a monetary one and later Keynesian stimulus. But none of their policies have brought their economy back to health. At best, their policies provided some temporary relief from time to time. And over time left their government massively in debt. Japan can not force the developed world to buy from them, so logically, they will have to change their economic paradigm. The essential question is how do they purchase the raw materials to meet at least their domestic needs?

American economists were critical of the Japanese response to their problem but in the end we have done just about what they did.

Our fundamental problem is that we have outsourced production to countries with cheaper labor costs and in the process left American worker/consumers unemployed, or underemployed, or just underpaid. For about 25 years, our problem was masked by consumers borrowing more and more equity out of their homes or finding other ways to run up more debt. When that was no longer possible, reality came to the front.

Lowering interest rates as policy, assumes that there is a ready supply of credit worthy and willing borrowers.That is not true when debt becomes excessive. Stimulus as policy, assumes that you can continue that policy forever because it seems in most cases that when the stimulus ends so does the benefit.

In our case the essential point is that either government policies improve the economic health of most American worker/consumers or the effects of those policies will be temporary.

Obviously the limits of monetary policy and the limits of Keynesian stimulus have not been understood. Excessive debt seems to trump both.

[Edward Lambert]

JimH,
The news says that there are some papers being presented at Jackson Hole which say that monetary policy is unable to fix the labor trends...
That is good to hear.

[JimH]

Well, sooner or later they will have to face reality. The sooner the better, so it is good to hear.

It has been over 6.5 years since the beginning of the Great Recession.

I began complaining about the potential severity of the downturn at the very beginning, and began using the phrase "Consumers can not spend what they do not have."

The Greenspan and Kennedy study about home equity withdrawal had gotten my attention. It should have caused everyone to take notice of the consumer debt levels and their significance.