Effective Demand Research

Attractor State of Productive Capacity is Shifting

This post will update the Attractor Productive Capacity graph. (link to original post)

What is an attractor state?

It is a state around which a dynamic system organizes itself.

"Self-organization is the spontaneous often seemingly purposeful formation of spatial, temporal, spatiotemporal structures or functions in systems composed of few or many components. In physics, chemistry and biology self-organization occurs in open systems driven away from thermal equilibrium. The process of self-organization can be found in many other fields also, such as economy, sociology, medicine, technology.

"Stable internal representations of the external world indicate the presence of attractors. Here, an attractor means one of the states of the system where the system settles after starting from a given initial condition. Self-organization needs these attractors to have a sufficient instability to be able to alter in order to adapt to the environment."  (Self-organization at scholarpedia.org)

The plot below will show how the economy settles into an attractor state for Productive Capacity. Then it breaks away from the attractor state to adapt to a new environment of economic growth for the next business cycle. The economy shows both stability and instability in the graph. That is the key to an attractor state of self-organization, adaptation and growth.

Here is the graph which plots Real GDP against the TFUR... (capacity utilization * (1 - unemployment rate). (TFUR is what I call Total Factor Utilization Rate.)

Productive capacity is found where the attractor lines cross a TFUR of 100%.

The pattern is normally for the plot to follow a line originating at the crossing of the x and y axes during the growth phase of a business cycle. This line represents an attractor state for the growth in a business cycle. Then the plot rises above the line and falls to the left into recession setting up the next business cycle at a higher attractor level of Real GDP.

The 1990s were an exception because the plot kept rising without the TFUR falling into a recession.

This updated graph shows that the economy has lifted off from the current attractor state and is heading toward the future projected attractor state.

How will we get there?

There are two possibilities...

1. A recession
2. The TFUR stays stable while Real GDP keeps rising. But the key is to have increasing productivity. This happened in the 1990s.

We do not see increasing productivity growth, so the most likely path will be through a recession.

Krugman is talking abount labor share... Have hope middle class

I sense that we are witnessing a special moment in economics with Paul Krugman’s article today, Notes on Piketty. He is exploring the new work by Thomas Piketty, Capital in the 21st century. He focuses on the difference between r, the rate of return on assets, and g, the overall rate of economic growth. When r is greater than g, wealth will accumulate in the hands of capitalists. When r is less than g, capital wealth falls and labor’s wealth rises through increased return to labor.

He then says that the economy (global) will converge overtime to a steady-state growth rate of n, which is the sum of labor force growth and technological progress. Piketty points to a period from 1913 to 2012, when n grew fast. And r was less than g. We saw the great rise of the middle class labor sector during that time. Now Piketty says that n is falling, that the global labor force and technological progress is slowing down. There are many reasons to think this. I might point to a series of videos from a lecture by Dr. Philip Lawn (video #1).

Krugman points to an extremely critical idea…

“a decline in n will lead to a rise in the capital-output ratio and a fall in both r and g. Which falls more? Well, it depends on what happens to the capital share in output”

Exactly… He is finally starting to talk about capital and labor share.

When n declines, the rich capitalists protect their wealth by raising their share of output. They are able to push r up relative to g as both fall. Thus their accumulated wealth will not deteriorate and may even grow more. The middle class will lose wealth in the process.

Then Mr. Krugman asks the greatest question of all. We are witnessing a special moment.

“How much of the decline in r relative to g in the 20th century reflected fast growth, and how much reflected policies that either taxed or in effect confiscated inherited wealth?”

Can you smell the flowers blossoming? Yes, the New Deal helped build a strong middle class. Yes, higher tax rates on capital and high incomes helped build the middle class. Yes, social insurance policies helped build the middle class. But what about monetary policy?

This is where Mr. Krugman may see the light. Loose monetary policy has been complementing not only the recent rise in capital share, but also the unraveling of policies that spread wealth from capital to labor. I refer specifically to policies of deregulation of the financial sector, of lower taxes on capital income and of wages falling behind a living wage standard. These policies increase the debt burden on labor by the way.

Loose monetary policy is also a policy that pushes up r relative to g. The rate of return on assets is increased when the cost of capital is lowered. Thus loose monetary policy is adding to the wealth inequality that is bringing down the US and other advanced economies. The US must protect its middle class. The solution is to raise the cost of capital through a combination of tightening monetary policy, raising taxes on capital & higher incomes and strengthening once again the transmission mechanisms of wealth to labor, namely unions, living wages and investing in locally owned businesses.

Mr. Krugman is realizing that the cost of capital must rise in order to change the tide for wealth to flow back to the middle class. The effective rate of return on “global” assets, r, must be pushed down by policy, which includes monetary policy. Look, transmission mechanisms of wealth to labor are extremely weak. So, loose monetary policy has been causing a lot of damage by establishing greater long-term wealth inequality. Piketty is warning us about this.

Mr. Krugman’s post ends unfinished. I sense that he needs time to think some things through. I can hardly wait for his follow-up.

One note: Let’s give credit where credit is due. The period from 1913 to 2012 when the middle class surged was forged in large respect by Beatrice Webb. Her work supported Keynes and the Institutional Economics later forwarded by John Commons. Students of John Commons later developed the New Deal under FDR. She even supported the role of cooperatives to strengthen local ownership of business and assets.

“In 1913, she co-founded with her husband the New Statesman, a political weekly edited by Clifford Sharp with contributions from many philosophers, economists and politicians of the time including George Bernard Shaw and John Maynard Keynes.” (Wikipedia on Beatrice Webb)

Mr. Krugman is realizing something that was understood by Beatrice Webb long ago. I reference this paper by Bruce Kaufman… Sidney and Beatrice Webb’s Institutional Theory of Labor Markets and Wage Determination

Relax DeLong & Krugman... productivity advances will appear when there is demand-space

Brad DeLong wrote a praised piece about growth... The Honest Broker: Is Growth Getting Harder? If so, Why, and What Can We Do About It?

Yes, it was an interesting piece, but I have a bit of a critique of one point concerning productivity. I see productivity as blocked by demand. But he doesn't make that critical connection in his piece. First he quotes Brink Lindsley...

"Both Tyler Cowen and Robert Gordon argue that the productivity slowdown… reflects… exhaustion of the… great technological breakthroughs of the late 19th and early 20th centuries…" ... "Was the IT revolution that has transformed our lives in so many ways really only good for a decade of strong productivity growth? Or is the current TFP slump merely a breathing spell in a long-term resurgence?"

DeLong does not quibble with the assumptions here. He accepts the explanation and then writes many passages about technology and innovation. Remember now... the issue here is the productivity slowdown and its effect on growth.

Let's move along to another part of his piece...

"for the near-term, worries about “secular stagnation” are overwhelmingly either wrong or worries about how to solve the technocratic problem of mobilizing societal risk-bearing capacity and properly distributing our productive capacity among sectors and our output to individuals. We may fail to accomplish these tasks. But they are our most urgent ones. We should not let the intellectual interest of wondering about the long run shape of technological progress do too much to distract us from the urgent current public-policy problems of restoring full employment, reversing the pointless and destructive rise in inequality of income and wealth..."

He is saying that we should deal with distribution before we worry about technological progress. But not connecting the two...

"The point is this: things that make the production of things we buy more efficient – that make them cheaper – raise real GDP. And the larger is the expenditure share of a commodity in what we buy, the more does an improvement in the efficiency of its production boost real GDP per worker."

Still no connection between productivity and demand.

"Thus I suspect that not innovation exhaustion but rather institution design will be our big problem in keeping the pace of true economic growth going into the long-run future."

Here he links economic growth to institutional changes, not demand. Then he ends by giving the floor to Paul Krugman and his "Techno-optimism"...

"what Larry Summers and I have been suggesting is that we may face a persistent shortfall on the demand side. ... But what do I think about Gordon’s notion that the good times of progress are behind us? One honest answer would be that I don’t know, and can’t even make a good guess.

"What I can say, however, is that my gut feeling remains that while Gordon may be right about the next decade or two, he’s likely to be very wrong beyond that. Or maybe it’s a bit more than my gut. I know it doesn’t show in the productivity numbers yet, but anyone who tracks technology has a strong sense that something big has been happening the past few years, that seemingly intractable problems — like speech recognition, adequate translation, self-driving cars, etc. — are suddenly becoming tractable."

So in the end, we see their faith in innovation as the answer to the shortfall on the demand side. If we make better things better and cheaper, real GDP can grow.

Now my view... Demand is a big obstacle standing in their way.  Demand can stop productivity growth and has many times over the decades. This graph shows how productivity stops when real GDP nears the effective demand limit.

Productivity will sit motionless against the effective demand limit for years. Then start to move as effective demand increases in an economic contraction. This next graph shows productivity growth in relation to changes in effective demand. (YoY growth at a moving average of 1.5 years, based on quarterly data from the first graph above.)

When effective demand (blue line) increases during an economic contraction, productivity (red line) increases too with a bit of a lag. The peak of productivity growth is fairly constant over the years, 2% to 4%. The times when productivity growth is low or zero, match with decreases in effective demand.

The big concern over productivity now has DeLong and Krugman second guessing technology. But the real block on productivity is simply demand. Productivity is held at 0% growth because of weak effective demand.

The implication is that current gains in productivity are matched by the disappearance of other production in a zero sum game. Thus increases in productivity lead to zero productivity growth against the effective demand limit. If one company increases productivity, other companies must lower their production. Profits between firms are crowded out at the effective demand limit. That is the economic constraint on productivity.

During an economic contraction (seen by effective demand going positive in the graph above), space is created for productivity to stop being a zero sum game. Firms can increase productivity and profits without the profits of other firms being crowded out. You will see, as soon as the blue line above goes positive, you will see a jump in productivity. Look how many times that has happened in the past.

DeLong and Krugman do not see this. Productivity growth is simple economic dynamics of demand and production.

They may not see this because labor share does not appear much in their writings. Effective demand is determined by the relationship of labor share to the utilization of labor and capital. Once you realize how far labor share fell just since the crisis, then you realize how serious the constraint on productivity is. Instead they are left searching for grand philosophical explanations, when the dynamic is actually simple.

So my words to DeLong and Krugman... Relax... the advances already made in productivity will appear during the next contraction... and the capacity for long-term economic growth will depend on labor's share of production. Greater levels of labor share give greater "demand-space" for productivity.

Cited article...

DeLong, Brad. The Honest Broker: Is Growth Getting Harder? If so, Why, and What Can We Do About It? Washington Center for Equitable Growth. December 3, 2013.

The decline of the g variable

In a previous post, I found an equation for the center of the business cycle, potential real GDP. In that equation was the variable g.

Center of business cycle as % of productive capacity =

T * (1 + g * (1 – c/e)) ….. or ….. T * (1 + g – g * c/e)

T = capital utilization x labor utilization... c = capital utilization... e = effective labor share... g is a variable between 0 and 1.

I wrote that the variable had declined over the years. Here is a graph showing its precise decline.

The decline has been consistent and polynomial. The g variable is a result of the business cycle amplitude being constant over the years at roughly around $200 billion (2009 $$).

Yet, it is interesting to see that a low g variable infers a dynamic preference for the utilization of capital over paying labor more. However, the utilization of capital is pushed downward by lower and lower rates of labor share due to demand constraints.

Businesses will say that it is better to utilize capital and that lowering labor share helps lower costs. Thus growth in real GDP is being driven by lower labor share, lower costs and the utilization of capital. But the % of productive capacity being used by the economy goes lower and lower through the years.

Lower costs of production and lower demand are moving the center of the real GDP cycle lower as a % of productive capacity.

The US is finding it more profitable to use less productive capacity. Labor loses out, but corporations are people too, right?

Here is the difference between 1967 (g = 0.79) and 2013 (g = 0.21)...

The lines have reversed roles since 1967. In 2013, changes in capital have more momentum to raise the center of the business cycle. (blue line is steeper) We can see again an explanation why employment is slow to recover after recessions now and why capital utilization bounces back so quick. However, the overall business cycle center is lower. Labor share is much lower. Demand is more of a constraint on real GDP growth. Yet, businesses still seek more profit in holding wages down.

Equation for potential GDP (center of business cycle)

I was up late last night figuring out an equation to calculate the center of the business cycle. The new equation is opening up my eyes to many new insights.

There is a brute way to calculate the center of the business cycle. First we find the productive capacity of the economy. There are two equations for this.

Productive capacity = Real GDP/T

Productive capacity = Effective demand/effective labor share

T = TFUR, multiply labor utilization by capital utilization

Then to figure the center of the business cycle, there is this equation.

Center of business cycle = Real GDP - Biz cycle amplitude constant * (c/e - 1)

c = capicity utilization... e = effective labor share

Then to find the % of productive capacity for the center of the business cycle...

% of productive capacity = center of business cycle/productive capacity

But I wanted to find a more elegant equation that opened a deeper understanding of the center of the business cycle, which is important because it is a foundation of how the economy grows.

Here is the equation that I found...

Center of business cycle as % of productive capacity =

T * (1 + g * (1 - c/e)) ..... or ..... T * (1 + g - g * c/e)

g is a variable between 0 and 1 that changes over time. I will explore g in the rest of the post because it is the mystery of the equation.

The variable g has declined over the years, showing that capital utilization is now a preferred way to raise real GDP. The video explains that. (link to video if not seen well.)

 But you can see in the video that the center of the business cycle has been declining over the years as a % of productive capacity. The cause of that is a drop in labor share (effective demand). However, business generates growth through capital utilization now, even though capital utilization is suppressed by low demand.

Here is a graph for current data...

Anyway, these are some preliminary insights to work on.

Potential GDP & Real GDP are "in phase"... another economic mystery revealed

Many economists talk about a huge output gap and that we will return to the potential GDP trend from before the crisis. It is not a wise thought. A mystery needs to be revealed.

Potential GDP and real GDP were "out of phase" during the 1970's, then by 1990's they were "in phase". What does this mean?

This graph shows annual % growth for real GDP and potential GDP (center of business cycle). The red and blue lines are 2-year moving averages. Each point on a line represents the annual growth rate for the previous 2 years. The red and blue lines moved "out of phase" before the 1990's, and "in phase" since 1990. (quarterly data has been faded to show moving averages.)

Potential GDP represents the center of the business cycle. Real GDP rises and falls in relation to this center through business cycles. As everyone watches real GDP, it is also important to watch the center of the business cycle (red line). Why? Because real GDP oscillates around that center. If the center rises, real GDP will oscillate at a higher level of output. Likewise, if the center falls, real GDP oscillates at a lower level of output.

Before the 1980's, when real GDP growth (blue line) slowed down during a contraction, the average productive potential of the economy (red line) would grow faster. Thus contractions were a time when fundamental economic growth would increase. This allowed the economy to bounce back from recessions better. Since 1990, when real GDP slows down, average productive potential also slows down. Now the economy tends to recover slower.

The other side... Before the 1980's, when real GDP rose fast, the average potential of the economy would slow down. The effect would be a counter-balancing that maintained a more "stable" trajectory of economic growth.  Since the 1990's, when real GDP grows faster, the average productive potential grows faster too. It's a pro-cyclical process. Now the effect leads to bubbles because there is no counter-balancing.

The idea is that real GDP growth feeds upon itself into increasing productive capacity of the economy. An atmosphere of bubbles appears. People think that growth creates growth and the cycle will continue up and up and up. So there is more pro-cyclical behavior at all levels. The tendency to fall into a bubble economy is much more likely.

In the graph above, you can see that in the 1990's, the economy maintained a higher high than had previously been "experienced". (subtle reference to Jimi Hendrix)  But now we can see the economy hitting a lower low than has ever been seen for many decades. There is no mystery about this effect. There is a pro-cyclical bias to growth with the mentality of feeding off of the fury of increasing asset prices.

This graph shows the overall movement between real GDP and potential GDP. Real GDP (yellow line) and potential GDP (red line) twisted in a braided pattern before the 1980's. Then when the two went "in phase" after the 1991 recession, both lines "bubbled" up to a new height. They started to come down after the 2001 recession, but the housing bubble allowed the two lines to rise again "in phase". The crash came in 2008 when the real GDP and its average productive potential both fell "in phase". The higher high became a lower low.

When I hear economists talking about returning to the previous trend line of potential GDP saying that we still have a huge output gap, I have to roll my eyes. They don't realize that the trend line during the bubble years was due to real GDP increasing "in phase" with center potential. It is a false effect and one that can only be sustained by periodic crises for counter-balance. When two waves are in phase, the resultant amplitude is increased... in both directions, up and down. By wanting to return to the previous high, they insure another low like the one we have now.

The basic idea is that when they move in phase, the economy will experience higher highs and lower lows. The business cycle will have wider swings. This is not healthy. Personally, the economy works better in a democracy when the two are "out of phase".

Anyway, questions to ponder... How did this change take place? Will these two lines go back "out of phase" in the future?

A study in the dynamics of international flows... #4

Yesterday I criticized Mr. Krugman for saying that savings were in excess. I said that personal savings is down, and domestic savings are not enough to cover investment such that the US has to borrow from abroad. This post will explore the relationship between domestic savings, domestic demand and the Current Account balance.

I start with a story yesterday from Spiegel Online International that pointed to Germany's very large trade surplus, which is higher than China's.

"The Treasury's semiannual currency report criticized Germany's over-reliance on exports, a high current-account surplus and weak domestic demand. These factors "have hampered rebalancing at a time when many other euro-area countries have been under severe pressure," the report concluded, citing budget tightening in the euro periphery. "The net result has been a deflationary bias for the euro area, as well as for the world economy."

Why is Germany's high Current Account surplus a problem? and What is the connection to weak domestic demand?

To answer these questions, I refer to an article written by Michael Pettis back on May 21st, 2013. The title of the article was, "Excess German Savings, not Thrift, Caused the Euro-Crisis". Mr. Pettis is a professor in Beijing. He is an expert on the Chinese economy. He also has relatives in Spain, so he is very familiar with the situation in Europe. It is also a joy to write commentaries on his web site. His responses are respectful, timely and informative. He sets the standard for a true educator online. Ok... enough of my praise for him.

National Savings vs. Personal Savings

Here is a statement from his article, which is long, and should be read. I will quote many points in his article throughout this post.

"One of the reasons that it is been so hard for a lot of analysts, even trained economists, to understand the imbalances that were at the root of the current crisis is that we too easily confuse national savings with household savings."

So I criticized Mr. Krugman when he said that savings were awash in excess. I said that he must not be talking about personal savings. OK, so he must be talking about national savings. So what is the difference between personal and national savings?

"The national savings rate, on the other hand, includes not just household savings but also the savings of governments and businesses. It is defined simply as a country’s GDP less its total consumption."

 One can also use the % of total consumption to GDP to assess national savings.

"In an open economy, if a country saves more than it invests it must export the excess savings. It must also export the excess production."

"What is more, by exporting excess savings, the country is providing the funding to foreigners to purchase its excess production. This is why the current account and the capital account for any country must always add up to zero."

The implication is that since the US is importing savings and importing production on balance, the US must be saving less than it invests. Consumption must be rising. However, when Mr. Krugman says that there is excess savings, it is logical to assume that consumption as a share of GDP must be falling. OK... so what is it? Is consumption in the US rising or falling? If we look at consumption in the US as a share of GDP we not only see that total consumption is rising, but so is consumption of domestic production.

So if consumption as a share of GDP is rising in the US, national savings must be falling as a share of GDP. (National savings = GDP - total consumption) So again, Mr. Krugman must be mistaken about savings. Where is the excess national savings that he is talking about? They aren't there. The US has less national savings, which is why it still has to import savings from other countries.

Labor Share affects National Savings

My research into effective demand centers upon labor share. And as Michael Pettis explains, labor share is at the heart of the imbalances in international flows...

"China’s extraordinarily high national savings rate, in short, is a function primarily of the extraordinarily low household share of GDP."

Many people get confused by this. They think that lower income should translate into lower savings. Actually, lower income translates into lower consumption, which translates into higher national savings.

One thing the US has to be very, very careful about is that low comparative labor share in China is being exported into the US and other countries. Labor share is falling in the US. Yet, our consumption as a share of GDP is rising because China is importing their larger comparative share of national savings. The US must lower domestic savings to absorb the savings from China. The problem is that the US has never been challenged by such a large increasingly productive economy with such a low labor share.

I don't think the US is aware of this dynamic yet. The US national savings as a share of GDP is falling as consumption rises. A falling labor share since 2000 is a dynamic to balance our comparative dis-advantage in labor share.

But let's keep moving.

Connecting National Savings to International Flows

"It is China’s national savings rate which is “monumental” and which drives China’s current and capital account imbalances, and the national savings rate is monumentally high because the national consumption rate (which consists mostly of the household consumption rate) is extraordinarily low."

Thus, the high national savings of China translates into a Current Account surplus. China then needs to export that savings surplus. China is capable of production far beyond its domestic demand. So it exports that excess production as well.

Michael Pettis says that Germany lowered its share of GDP to labor, which raised national savings to such an extent that Germany then exported their excess savings to Southern Europe. The result was the Euro-crisis. I should also say that Heiner Flassbeck from Germany also points to low wage share in Germany as a primary cause of the Euro-crisis.

I let Michael Pettis tell the story here... (source)

"In the 1990s Germany could be described as saving too little. It often ran current account deficits during the decade, which means that the country imported capital to fund domestic investment. A country’s current account deficit is simply the difference between how much it invests and how much it saves, and Germans in the 1990s did not always save enough to fund local investment."

"But this changed in the first years of the last decade. An agreement among labor unions, businesses and the government to restrain wage growth in Germany (which dropped from 3.2 percent in the decade before 2000 to 1.1 percent in the decade after) caused the household income share of GDP to drop and, with it, the household consumption share. Because the relative decline in German household consumption powered a relative decline in overall German consumption, German saving rates automatically rose."

"As national saving soared, the German economy shifted from not having enough savings to cover domestic investment needs to having, after 2001, such high savings that not only could it finance all of its domestic investment needs but it had to invest abroad by exporting large and growing amounts of savings. As it did so its current account surplus soared, to 7.5 percent of GDP in 2007."

"As German savings rose, eventually exceeding German investment by a wide margin, Germany had to export the difference, which its banks did largely by making loans into the rest of Europe, and especially those countries that were financially “shallower”. Declining consumption left Germany producing more goods and services than it could absorb domestically, and it exported excess production as the automatic corollary to its export of savings."

"Of course the rest of the world had to absorb excess German savings and run the current account deficits that corresponded to Germany’s surpluses."

"Spain and the other peripheral European countries all saw their trade deficits expand dramatically or their surpluses (many were running large surpluses in the 1990s) turn into large deficits shortly after the creation of the single currency as their savings rates shifted to accommodate German exports of its excess savings."

"The way in which the German exports of savings were absorbed by Spain is at the heart of the subsequent crisis. As long as Spain could not use interest rates, trade intervention, or currency depreciation to block German exports, it had no choice but to balance the excess of German savings over investment. This meant that either its investment would have to rise or its savings would have to fall (or both)."

"Both occurred. Spain increased investment in infrastructure and in real estate, but it seems to have done both to excess, perhaps because of the sheer amount of capital inflows. After nearly a decade of inflows larger than any it had ever absorbed before, Spain, like nearly every country in history under similar circumstances, ended up with massive amounts of misallocated investment."

"The imbalance created within Europe by German policies to constrain (domestic) consumption forced Spain into increasing consumption and boosting investment, much of the latter in wasted real estate projects (as happened in every one of the deficit countries that faced massive capital inflows)."

"Germany had to export its excess savings, Spain had no choice except to increase investment or to allow its savings to collapse, with the latter either in the form of a consumption boom or a surge in unemployment. No other option was possible."

"For this reason the European crisis cannot be resolved except by forcing down the German savings rate. And not only must German savings rates drop, they must drop substantially, enough to give Germany a large current account deficit. This is the only way the rest of Europe can unwind the imbalances forced upon the region in a way that is least damaging to Europe as a whole. Only in this way can countries like Spain stay within the euro while bringing down unemployment."

"As long as it is part of the euro, Spain has no choice but to respond to changes in German savings rates. There is nothing mysterious about this process. It is simply the way the balance of payments works, and thrift has nothing to do with it. If Germany does not take steps to force down its savings rate by increasing the household share of GDP, then either all of Europe becomes like Germany, in which case growth slows to a crawl and some other country – maybe the US? – will be forced to resolve Europe’s demand deficiency either through higher unemployment or through higher debt, or Europe must break apart to free Spain and the other peripheral countries from German savings imbalances."

So now we can see why the US Treasury is upset with Germany for still running such high trade surpluses, and why it points to Germany's high savings rate and weak domestic demand as proof of internal polices that are detrimental to Europe as a whole. As it is, Europe is already moving at a crawl.

This story should sound familiar too. China is acting like Germany toward the US. We can also see why China pegging its currency to the US dollar can be a problem. It is easier for China to export its excess national savings to the US. The US cannot really block Chinese exports with trade intervention and currency depreciation. And now the US is limited in its ability to use interest rates due to the lower bound.

So... Where are those excess savings awash?

"If Spain were to make its workers more competitive by reducing wage growth relative to GDP growth, it would implicitly be forcing up its savings rate to generate employment. To whom would Spain export those savings? The world is awash in excess savings..."

There you have it. The World.... the world is awash in excess savings because of falling labor share in emerging countries, like China and India. Moreover, in comparative terms, the US is not awash in savings. Mr. Krugman does not seem to see this yet. The rest of the world has a comparative advantage in national savings by grace of much lower labor share rates.

We can see what happened to Europe when Germany decided to raise their employment by lowering labor's share. Now we can understand what China is doing to the US by being able to produce so much output while paying very low labor share. The situation would be different if China was still a backward country with production limits. But China has increased its productive capacity incredibly since the 1980's. The problem is that Chinese production using such low labor share is overwhelming the US economic balance. Another "victim" is Japan who also has a comparative dis-advantage to Chinese national savings in terms of labor share.

When Japan came along with such great production decades ago, the US found balance with the Japanese, because our labor share rates are comparable. Yet, China's labor share rate is so ridiculously low forcing up their national savings, that our economy is facing a real challenge.

Ultimately China must raise its domestic demand by raising labor share of its population. China is investing 50% of its GDP, which is not sustainable. At some point, someone is going to have to "sustainably" consume the increased productive capacity. It will have to come from increased domestic demand from a higher labor share. The natural flow in international trade is for labor shares among other factors to balance over time. So as labor share drops in the US, there is a dynamic for labor share to rise in China. But labor share in China has a long way to rise and there are political and economic challenges associated with that.

And Unemployment in the US?

Michael Pettis also mentions exporting unemployment in his article and I want to include some of what he said.

"If the savings that Germany exported into Spain could not be fully absorbed by the increase in Spanish investment, the only other way to balance was with a sharp fall in Spanish savings. There are two ways Spanish savings could have fallen. First, as the Spanish tradable goods sector lost out to German competition, Spanish unemployment could rise and so force down the Spanish savings rate (unemployed workers still must consume). Second, Spain could have reduced household savings voluntarily by increasing consumption relative to income."

Think of the US and China. China is exporting their comparatively high national savings to the US (due to comparatively very low labor share rates). According to Michael Pettis, the US must absorb those savings from China. The two currencies are effectively pegged. We either have to raise our investment or lower our national savings rates. Investment has been moderately health in the US. Also, we can see in the graph above that the US has lowered its savings rate by increasing the rate of consumption. Real GDP has had to fall to a new lower trend line so that consumption as a share of GDP would rise. The US economy has been shifted to a sub-optimal state.

The US has also lowered its national savings rate with more unemployment, a lower labor force participation rate and a lower personal savings rate. As well, the natural rate of unemployment has risen. The personal savings rate is back down around 4%. Truly, the US has a serious problem.

Next in the series is what the US could do with its Current Account deficit...

Do low wages really increase the natural level of output?

One thing that is seen sometimes is a strange teaching in economics and business. The teaching says that lower costs of production will increase the natural level of real GDP output.

Now the natural level of real GDP output is considered the limit at which the economy can produce. It is seen as the total productive capacity of the economy. The full-employment of the natural rate of unemployment is found there too. It is traditionally determined by looking at available factors of production at full-employment. Once real GDP reaches its natural level, output slows down and increased demand results in higher prices instead of more output.

However, some schools teach and therefore many businessmen have it in their heads that lower wages, which are a cost of production, will increase the total productive capacity of the economy.

Here are some links to examples...

• University of North Carolina's Euro Challenge competition for high school students...

"The long-run supply curve can shift when the costs of production change. Examples of changes to the long-run aggregate supply curve:

• A restriction on immigration reduces the number of workers available, and thus increases the cost of production (wages will be higher).
• The reduction in the required minimum wage allows firms to hire more workers at less cost.

• Economics online from the UK...

"The effects of an increase in capital investment

"The initial impact of investment is on the AD (aggregate demand) curve, which shifts to the right as investment (I) is a component of AD,

"In the long run, the investment will increase the economy's capacity to produce, which shifts the LRAS curve to the right. Finally, it is likely that production costs will fall as new technology increases efficiency and reduces average costs. This means that the SRAS curve shifts to the right. The combined effects are that the economy grows, both in terms of potential output and actual output, without inflationary pressure.

Here is a source that does a good job at explaining why lower wages would increase the potential output at the natural level... They show how higher wages and lower wages can increase the natural level of output. But this example still makes a critical error.

• Macroeconomics Principles, authors Libby Rittenberg and Tim Tregarthen.

"In Panel (a), an increase in the labor supply shifts the supply curve to S₂. The increase in the supply of labor does not change the stock of capital or natural resources, nor does it change technology—it therefore does not shift the aggregate production function. Because there is no change in the production function, there is no shift in the demand for labor. The real wage falls from ω₁ to ω₂ in Panel (a), and the natural level of employment rises from L₁ to L₂. To see the impact on potential output, Panel (b) shows that employment of L₂ can produce real GDP of Y₂. The long-run aggregate supply curve in Panel (c) thus shifts to LRAS₂. Notice, however, that this shift in the long-run aggregate supply curve to the right is associated with a reduction in the real wage to ω₂."

Behind these examples is a belief that the presence of a minimum wage will reduce the demand for labor, thus cutting people out of the labor force, thus reducing the numbers of people that will work, thus reducing long-run potential output.

If we look closely in the above examples, we will see an error in understanding. They view the supply and demand for factors of production affecting long-run output, but they do not view the supply and demand for money used for consumption affecting long-run output. The examples above do not include the fact that if real wages are lower, ultimate demand for production will be lower. Thus, they see more long-run production, but they don't see the reduction in potential consumer demand.

All across the advanced countries we have been seeing a decline in labor's share of national output. With this, we see a stagnation of real wages and an increase in corporate profits. Thus, the portion of output income that is given to labor to buy production is less. Do companies really think that lower real wages will keep long-run natural output from falling? Ultimately, at some point, weak consumer demand will be the limiting factor upon the long-run natural level of output.

The effective limit of demand upon the long-run natural level of output is called the effective demand limit.

It is time to include the effective demand limit in the models for the long-run natural level of output.

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.

Paul Krugman on verge of an Illumination

Today Paul Krugman wrote a piece about China's high level of investment in the face of low domestic consumption. It is obvious to me that he is making headway in understanding the importance of low labor share of income.

Remember low labor share means high capital share. Capital income is dedicated to increasing the means of production, whereas labor income is primarily dedicated to purchasing the finished production. Paul Krugman refers to this directly...

"Chinese businesses were investing furiously, not to build capacity to serve consumers, who weren’t buying much, but to serve buyers of investment goods — in effect, investing to take advantage of future investment, adding even more capacity. Would there ever be final buyers for what all this capacity could produce?"

He is describing the dynamics of Effective Demand. He is also describing the dynamics of the growth model of effective demand. Yet, he is also describing the problem with the US economy where labor share of income has fallen below normal past levels.

Paul Krugman is on the verge of an illumination about the dynamics between labor and capital income. This blog of effective demand is full of the new models needed to describe the problems from an imbalance between labor and capital income.