STOCK MARKET WATCH -- Monday, 19 August 2013

[Demeter]

22. What Paul Krugman is getting wrong… Edward Lambert MUST READ!

http://angrybearblog.com/2013/08/what-paul-krugman-is-getting-wrong.html

Paul Krugman posted an article today… “What Janet Yellen — And Everyone Else — Got Wrong“. But there is something he is getting wrong too, or at least, doesn’t seem to be aware he is getting it wrong.

He talks about the economic recovery having been so sluggish. And he offers this explanation…

“The best explanation, I think, lies in the debt overhang… And I would argue that this debt overhang has held back spending even though financial markets are operating more or less normally again.”

There is a deeper cause that he is not mentioning. What appears to be low demand is actually the symptom of lower labor share muting the money multiplier effect of investment. Paul Krugman knows that the “financial markets are operating more or less normally again”, as he says above. Yet, he seems unaware of how lowering labor share will lower the equilibrium level of real GDP, thus muting the ability of investment to expand through the economy.

I argue that the explanation has to do with labor share falling 5% since the crisis. I provided a simple model yesterday showing the dynamic of how a lower labor share leads to a lower equilibrium level of GDP… “Labor share affects the potential of investment to raise GDP“. The lower equilibrium level of real GDP creates a condition where investment returns to business with a smaller money multiplier. What we see then is sluggishness in the economy even though the financial markets are working fine.

Apart from lower labor share undermining the ability to pay down the overhang of debt, it also causes an “apparently” unexpected dampening effect upon monetary policy. Banks can loan money, but the economic returns on the loans are muted by a low labor share. The dynamics of low labor share are too obvious to overlook. On twitter, Frances Coppola responded to my article yesterday by saying, “that’s a brilliant post. Explains so much that I intuitively knew but hadn’t actually modeled.”

I think, Paul Krugman is simply unaware of the effect that the current lower labor share is having. But once he is aware of it, I have faith he won’t get it wrong.




Labor share affects the potential of investment to raise GDP Edward Lambert

The circular flow is a model used to show how money and products move through an economy. I am going to use a simplified version to show the effect of labor share of income on GDP. Many people think that labor income is not quantitatively different than capital income. I will show that the equilibrium level of GDP is affected by a change in labor share of income. This would have important implications for monetary policy and expectations of GDP potential.

Basic Equilibrium

Let’s start out with a basic model. It will only involve labor, owners of capital, firms and a financial sector. The only injection into the circular flow will be investment. The only leakage from the circular flow will be savings. The model does not include the government sector nor imports/exports.

http://effectivedemand.typepad.com/.a/6a017d42232dda970c01901ea90bc5970b-800wi

LENGTHY TUTORIAL CONTINUES AT LINK

http://angrybearblog.com/2013/08/labor-share-affects-the-potential-of-investment-to-raise-gdp.html

AND FOR COMPLETENESS, HERE'S KRUGMAN:

What Janet Yellen — And Everyone Else — Got Wrong

http://krugman.blogs.nytimes.com/2013/08/08/what-janet-yellen-and-everyone-else-got-wrong/?_r=0#postComment

Don’t worry, this isn’t another entry in the Larry/Janet debate, where I’ve said my piece. Instead, it’s prompted by a nice but I think incomplete analysis by Matt O’Brien of the reasons Janet Yellen underestimated the damage a bursting housing bubble would do; analyzing that issue, it seems to me, is a good way to get at the broader question of why recovery has been so sluggish. The starting point is that we had a monstrous housing bubble, and Janet Yellen recognized it in real time. Here’s housing prices deflated by consumer prices:



It’s important to notice that just being willing to see the obvious here puts Janet Yellen way ahead of a lot of people who still presume to give us advice on the economy. But Yellen initially thought the damage from a bursting bubble could be contained, although she was starting to worry by 2007. Why was she wrong? Matt emphasizes the financial crisis — the way the bursting bubble created a run on the shadow banking system. And that’s clearly key to understanding the severity of the 2007-9 slump. However, financial stress peaked in early 2009, then fell sharply:



Unfortunately, the economy didn’t come roaring back. Why? The best explanation, I think, lies in the debt overhang. For the most part, even those who correctly diagnosed a housing bubble failed to notice or at least to acknowledge the importance of the sharp rise in household debt that accompanied the bubble:



And I would argue that this debt overhang has held back spending even though financial markets are operating more or less normally again. Finally, nobody really anticipated the disastrous response of policy, above all the squeeze on public spending at a time when we needed more government spending to sustain the economy until private balance sheets were repaired. Here’s total (all levels) government spending deflated by the implicit GDP deflator (an overall price index), comparing the last recession and aftermath with the Bush years; if spending had grown this time the way it did in the past, unemployment would probably be close to 6 percent:



In short, getting the bubble right, while no small thing, wasn’t enough; Yellen (and many other people, myself included) underestimated the fragility of the financial system, but also the importance of household debt, and, above all, the foolishness of policymakers.