A New Model of the Economy Please

Brad DeLong wrote recently concerning the Uncertainty at the Fed...

"The heart of the trouble consists in the fact that neither financial-market participants nor, it seems, the Fed itself know the true state of the economy or how best to model it – especially in the wake of the 2008 financial crisis" (link)

It is a fact he says. The Fed and others do not know how best to model the state of the economy.

I stand alone with a new model for an Effective Demand limit as Keynes envisioned it.

The basic concept behind the model is that the percentage that labor receives of national income determines a limit upon the utilization of labor and capital in production. The key idea is that capital income based upon utilizing capital resources is optimized at the effective demand limit. Thus capital does not want to go beyond the limit because it begins to consume its power position in the aggregate. Capital seeks to consume labor income while maximizing its relative strength in the economic flow of money.

So why is my model good? While Brad DeLong points out the confusion from the Fed, my model is not confused.

• It knows why capacity utilization is dropping and why unemployment stays low.
• It knows why the output gap has continuously been revised downward, because the output gap was closed years ago in this business cycle.

• It knows why the Fed seems to want to normalize rates. The economy is at the end of the business cycle. Rates are supposed to be close to normalized by now.

So the confusion over where the state of the economy is has led to the uncertainty that Brad DeLong writes about... on both sides, the central banks and the market participants. We see a situation where the market participants see a different economic potential than economists. They have seen limitations in this business cycle. Yet the Fed is still waiting for inflation and demand to pick up, while top line revenue of firms has already topped out in the aggregate.

The Fed still sees that this business cycle will stay alive for another two years.  The disconnect has been severe for many years causing sluggishness in the economy.

The Fed does not want inflation above target because higher inflation causes distortions and slows growth. However, they have entered another situation where there models are misreading the state of the economy and leading to sluggishness anyway.

What is the equation of the effective demand limit?

Effective demand limit upon real GDP = rGDP*e*T/L* (1 - (1 - 1/e)*T/L)

T = capacity utilization * (1 - unemployment rate)
L = an effective demand limit function (Labor share index * 0.76)
e = 3 ... coefficient to set maximum of effective demand at the stable equilibrium with production.

Effective labor share (L) determines the limit upon the % utilization of labor and capital in production. The following graph portrays Keynes' vision of Effective Demand quite well. Let's bear in mind that Keynes never gave an equation for effective demand. He only described how it seemed to work.

This equation works. The economy has followed this model for as long as we have data for capacity utilization... since 1967 to now.

Comments

[JimH]

Edward,
“The Fed does not want inflation above target because higher inflation causes distortions and slows growth. “

This strikes straight at the heart of how we got to the current state of our economy.

The Fed wants what all bankers want. They want a low stable inflation rate because then they have a lower and more stable rate of devaluation of their capital. And they can depend on a more stable return on their capital.

The Fed pays lip service to employment because they have a mandate to factor unemployment into their decisions. But if they over stimulate consumption then workers will have more power to negotiate higher wages. They can quit and go to work for someone who has increasing demand for labor.

But that has not been a problem for the Fed since 1985, because free trade treaties insured that American labor would not be able to get higher wages.

The Fed could reduce interest rates with impunity.

Free trade treaties opened new opportunities for American corporations and American bankers. As more and more American corporations moved more and more of their production to foreign countries, more and more American workers lost the ability to quit a less than satisfactory job. Wages began to stagnate and workers only kept up consumption by borrowing. (After about 1995.) The key was to keep the payments low and that required lower and lower interest rates. In the final stage of consumption funded by debt, the housing bubble helped to create a huge debt bubble. When the housing bubble burst, it was no longer possible to run up large sums of new debt. By then only a miracle could have saved the American economy, the miracle being American corporations paying higher wages than they needed to attract the American employees that they absolutely needed. That did not happen.

Circular flows in the US economy were severely disrupted with free trade treaties. They will continue to be disrupted as long as our trade partners are allowed to export dramatically more than they import.

Creating higher demand by higher immigration into the US or expecting increased investment to create more and more jobs is delusional.

The vast majority of new immigrants will not be bringing millions of dollars, they will spend less than the average American and seek a portion of the existing American labor income pool. As American consumer’s incomes have decreased they concentrate more and more of the spending on the necessities of life. Exactly what new necessity would investors produce? And if some new entrepreneur designed lighted toilets, would they be produced here?

Why hasn’t anyone noticed that more and more young adults are living with their families? Does anyone believe that they are buying their own cutlery, flatware, or bed linen? (They used to do that.) Would they buy more stuff if the prices were lower? Will the cost of living be REDUCED any time soon?

Only your model of the economy offers any insight into the real problem in our current economy.

Wake any of the mainstream economists out of a sound sleep, and they will mutter some response that assumes supply side economics. INVESTMENT or DEREGULATION are just two of their instant cures.

[Edward Lambert]

Jim,
If there is ever a book written about this Effective Demand research, your comment above should be the foreword to the book.

[JimH]

Edward,

You doubt me when I say that we will thrash around in our current economic swamp for another decade or two. But how do you find solutions when you can not even bring yourself to accept the source of your problem? (Or worse yet, distract yourself with trivial arguments.)

The discussion in this article is a little scary.
http://www.bloomberg.com/view/articles/2016-06-02/no-one-is-quite-sure-what-causes-big-recessions

It is a little like saying that it is not the fall that kills you, it is the sudden stop. It trivializes the discussion.

We live on income, but in times of inadequate income, some of us run up debt instead of reducing our expenditures. But the debt must be repaid, so all we have done is to pull purchases forward. (With the blessing of the Federal Reserve.)

Then when it is no longer possible to run up more debt, reality strikes with a vengeance. Inadequate income is worsened by mandatory debt repayment. The Great Depression and the Great Recession stand out for their severity and both were preceded by a massive run up in debt.

Looking back, we should be able to agree that the debt only served to mask a growing problem. Alas, there is no such agreement.

In 2007, Greenspan and Kennedy released a study documenting the amount of Personal Consumption Expenditures which had been made possible by extracting equity from consumers' homes.
See: https://www.federalreserve.gov/pubs/feds/2007/200720/200720pap.pdf

And when that borrowing on homes slowed, the Great Recession was sure to follow. The only variable was the timing.

If the 'powers that be' refuse to recognize that GDP is limited by effective demand then they need to severely limit borrowing or accept semiautomatic depressions. (effective demand in the sense that you document.)