Effective Demand Research

New Real GDP number - 1stQ, 2014

Real GDP came out today at $15.946 trillion. Here is the projected 1st quarter 2014 update.

Real GDP was lower than trend. It still has not reached the effective demand limit. But it is close.

Potential real GDP is trending squarely on its new normal.

The small Propensity to Consume by Capital Income... and the Fall in Labor Share

James Kwak at Baseline Scenario writes about wealth inequality and supports systematic redistribution. And Steve Roth wrote on this too at Angry Bear.

What is the propensity to consume by capital income? Well, for every dollar of capital income, roughly 18% is being spent on consumption. (15% effective tax rate, 67% savings rate)

What is the propensity to consume of labor income? Well, for every dollar of labor income, roughly 85% is being spent on consumption. (10% effective tax rate, 5% savings rate)

So, what does it mean in an economy with a real GDP around $16 trillion that labor share of income has fallen by 6.8% since 2007? Well, 6.8% of %16 trillion is $1.088 trillion. If that money was in the hands of labor income, $925 billion of it would be spent on consumption. However, that money is in the hands of capital income, so only $196 billion of it is spent on consumption.

The difference is $729 billion less being spent on consumption.

Brendan Greeley and Matthew Phillips at Bloomberg Businessweek tell us what the current shortfall in potential GDP is according to the 2007 CBO projections ...

"The CBO’s own data show this as a current output gap of $754 billion."

The fall in labor share looks to have accounted for almost all of the fall in potential output.

Update note: Real GDP is made up of consumption, net government spending, investment and net exports. Yet, total real GDP is split into labor share and capital share. Thus consumption, net government spending, investment and net exports are all contained within the split between labor and capital shares. An increase in capital share lowers consumption and is hopefully made up for in increased investment. Investment was $2.639 trillion in 1st quarter 2007 (real 2009 dollars). It was $2.656 trillion in 4th quarter 2013. An increase of $17 billion in real terms. So increased capital share did not lead to a significant increase in investment. The rich are richer, but real GDP has fallen.

Yes, potential output is lower... That is old news.

Yes, potential output is lower than people thought, much lower.

I have been saying for almost a year that potential output is lower. (link 1, link 2) Commentators on Mark Thoma’s blog thought I was nuts. Mark Thoma himself did not agree with me. Mark Thoma now offers one explanation to his class that the cause could be hysteresis, where long periods of unemployment make the economy more sluggish. But Eric Morath contradicts that view…

“The finding backs an emerging view that the relatively weak recovery is due to more than just the deep recession. Economists appear to have not accurately projected the impact of a number of trends, including demographic shifts and changes in the number hours worked per week, that were taking shape even before the recession took hold.”

Even David Beckworth recently (January 17th) wrote about natural interest rates and concluded using the Finance-neutral method that the output gap was still large.

“We cannot directly observe the natural interest rate, but there is evidence of ongoing slack in the economy. And since slack–or a negative output gap–is a key determinant of the short-run natural interest rate, it is reasonable to believe the natural interest rate has been depressed over the past five years.”

Even Paul Krugman believed potential output was little changed from before the crisis…

“…potential output is defined as the highest level of output consistent with stable low inflation. If you want to claim that an economy has grown unsustainably above potential, you need to show me the accelerating inflation.” (link)

“potential GDP is a measure of how much the economy can produce, not of how much people want to spend.” (link)

Yet, he makes a mistake. True potential does depend on how much money people have to spend. If not, then why doesn’t Chinese firms sell more to their domestic population? Well, it’s because people in the US have more purchasing potential.

As for inflation, if production is healthier than how much people have to spend, inflation will be muted. We live in a world of under consumption from fallen labor share in advanced countries. Europe and the US are concerned about weakening inflation.

Krugman needs to acknowledge the weakness in his potential output concept. He would have been able to foresee the reality of a small output gap.

So we see top economists making a crucial mistake in determining the output gap. Now the risks of easy monetary policy will become quite apparent. As Mark Thoma offers a warning to his class from the 30:00 to  31:30 minute points in this video…

“If that is true (very small output gap), then they (the Fed) should back off the stimulus starting now.”

I based my calculations on labor share over a year ago and got it right. So this news about potential output being lower is not news to me.

Comparing methods to determine Output Gaps

David Beckworth made a determination of nominal interest rates using the Output Gap from this paper...Measuring potential output: Eye on the financial cycle, by Claudio Borio, Piti Disyatat, Mikael Juselius. 

In the paper they present this graph of output gaps determined by various methods, real-time and ex-post.

The red lines are what was given in real-time. The blue lines show what was determined later by looking backward.

In the paper, they say...

"The HP filter gap and the full-fledged approaches of the OECD and IMF – a representative sample of current approaches – did not detect that output was above sustainable levels during the boom that preceded the financial crisis. In fact, the corresponding real-time estimates indicated that the economy was running below, or at most close to, potential. Only after the crisis did they recognise, albeit to varying degrees, that output had been above its potential, sustainable level. By contrast, the finance-neutral measure sees this all along (bottom right-hand panel). And it hardly gets revised as time unfolds."

David Beckworth uses the Finance-neutral calculation for his post.

But now I want to show my calculation which would have been real-time without being revised later. (quarterly data)

Update: Left axis changed to match first graph above.

The paper criticizes the approaches of the IMF, OECD and HP filter for not seeing the economy was over potential before the crisis, but my real-time calculation would have seen that.

Yet the Finance-neutral method did not see that the economy was running below potential after the 2001 recession. My method, along with the IMF and HP filter, did see that. Even their revisions showed the economy was below potential in 2003.

My method is set up to see in real-time a fundamental shift in demand if one has occurred. My method is showing a shift downward in potential since the crisis.

My method, along with all others, recognized the fall from potential in the crisis.

My method and the HP filter show GDP returning to potential by 2011. The HP filter gives results that most resemble mine. HP stands for Hodrick-Prescott (HP) filter. A neighbor of mine works in the same office as Edward Prescott. Little coincidence.

My method to determine potential GDP is...

Potential GDP = real GDP - a * (c/f - 1)

a = business cycle amplitude constant in real 2009 $$, $3.4 trillion... f = effective labor share... c = capacity utilization...