Saturday, August 30, 2014

Edward Lambert — Blanchard & Krugman are trying to understand Effective Demand

…Effective Demand. This is a term so rarely used in economic discourse. It is not understood. For me, effective demand sets a "definable" limit upon the utilization of labor and capital. So it follows that lower effective demand leads to lower investment, lower output, lower productivity, lower taxes and less ability to pay debts.
Effective demand is based upon labor's share of a national income.…
…sufficient Effective Demand depends upon labor receiving a larger share of national production than they currently receive. No one is going to just give it to them. Labor will have to fight for it.  
Effective Demand
Blanchard & Krugman are trying to understand Effective Demand
Edward Lambert

Domestic private sector over-saving (hoarding), which is due to the ratio of capital share to labor share being excessively high since unspent income increases proportionally with income and wealth, results in insufficient effective demand to sustain output at full employment unless offset by the sum of the government and external balances.

Consolidated domestic private sector balance + government balance + external sector balance = zero (by accounting identity).

Given output of production is less that its aggregate potential using available resources including labor, if the capital to labor share in the consolidated domestic private sector is not reduced by giving labor a greater sharer and capital a lesser, thereby reducing unspent income (saving), then the sum of the government fiscal balance and the external sector balance must increase to offset the shortfall in consumption that would otherwise send a signal to firms to reduce output to less than aggregate potential at full employment in order to prevent an increase in unplanned inventory.

Keynes defined effective demand as the point at which the the aggregate supply curve and aggregate demand curve intersect. Aggregate demand falls when decreasing demand in one industry is not offset by increasing demand in another. As demand spreads across industries, effective demand drops blow the point at which the the aggregate supply curve and aggregate demand curve intersect at full employment.
Let Z be the aggregate supply price of the output from employing N men, the relationship between Z and N being written Z = φ(N), which can be called the Aggregate Supply Function.[5] Similarly, let D be the proceeds which entrepreneurs expect to receive from the employment of N men, the relationship between D and N being written D = f(N), which can be called theAggregate Demand Function. 
Now if for a given value of N the expected proceeds are greater than the aggregate supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to increase employment beyond N and, if necessary, to raise costs by competing with one another for the factors of production, up to the value of N for which Z has become equal to D. Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand. Since this is the substance of the General Theory of Employment, which it will be our object to expound, the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend. — General Theory, 3, I
What this says when worked out is that if consumption demand is insufficient to result in production at potential output using available resources, then for output at full employment to occur, the domestic private sector saving desire must either reduced, or be accommodated by an offsetting combination of the government fiscal balance (by running a deficit) and the external saving desire in the currency (increasing net exports).

One way to reduce private sector saving is by reducing capital share to distributed labor share, since consumption is inversely proportional to income and wealth. If capital and labor share are such that saving is nil so that all output at full is purchased, then the government and external balances can be zero. However, this is unrealistic since some saving is required for future use and also to hedge against uncertainty. So some desire to save must be accommodated in achieving full employment. But excessive saving at the top will result in social, political and economic asymmetries.

From this it follows that either the capital to labor share of income decreases, thereby reducing income that flows to wealth at the top, leading to asymmetrical social status and political power, or that this saving desire be fully or mostly accommodated with the resulting increase of these asymmetries.

From a purely economic perspective, which of the two takes place is more or less irrelevant unless the asymmetries can be shown to introduce inefficiencies owing to income and wealth inequality. Economically, distributional effects are not relevant unless they can be shown to have economic consequences.

However, from the social and political perspective, bringing labor share in line with productivity would result in greater income and wealth equality, hence, greater social and political equality, which are arguably more conducive to democracy than social and political asymmetries based on income and wealth inequality that lead to de facto oligarchy through capture.

It can be argued that simply accommodating consolidated domestic private saving without regard for capital and labor share achieves full employment that the expense of social, political and economic asymmetries that tend toward oligarchy and disrupt democracy and democratic processes. This results in legal and other institutional effects that have economic consequences that create augmenting feedback loops.

Optimal economic policy would balance growth, employment and price stability, and also encourage distributed prosperity. It would also promote social (class), political (power), and economic (income and wealth) symmetry conducive to liberal participatory democracy.

The way to achieving this is by inquiring into how to live a good life in a good society, which has been the basis for ethical, social and political inquiry since the dawn of the Western intellectual tradition. This requires an integrated and balanced approach, which necessitates using a systems approach that draws on all relevant inputs.

Problems arise when economics and economies are abstracted from the societies that they serve as material life-support systems, which is only one aspect of holistic community.


peterc said...

Good post as always, Tom. This one is especially good.

The argument seems consistent with MMT. For example, to take a passage from Tymoigne and Wray's (fairly) recent 'Response to Critics' paper:

"MMT … recognizes the role of a “rightly distributed” demand in addition to the right level of aggregate demand (Keynes 1937), and aims at combating the inherent instability of market mechanisms."

As you indicate, wider inequality can be expected to increase the desire to save. It may also discourage investment due to weakened demand conditions. If government expenditure simply accommodates whatever net-saving desire exists without addressing distribution, the government deficit must be larger as a proportion of income. In the current system, that translates into a larger gift of realized profit to capitalists (budget deficit adds to realized profit) for a given improvement in real output and employment. More equal distribution to begin with means lower net saving desire and a smaller deficit to deliver the same real output and employment.

But, of course, MMT does not call for a blind accommodation of net saving desire. Not only do the MMTers call for "rightly distributed demand" but the JG achieves full employment irrespective of the budget's size.

In the MMT framework, accommodation of the net saving desire will make sense to the extent that distribution is sound and such accommodation does not shrink the JG buffer smaller than the level needed to keep demand-side inflationary pressures in check. Accommodation, in that context, is beneficial in the current system because, as you point out, there are systemic and institutional reasons for households and firms to maintain a financial surplus.

Tom Hickey said...

Thanks, Peter.