Climate Change

The fact of near term, catastrophic climate change is both illustration and proof of the dysfunction of orthodox Neoclassical economics, but also any other economics which does not have an institutional component.

Environmental Protection Agency

For forecasting, nothing is easier to read than the chart of the rise in CO2 emissions over the past quarter century. The loss of Arctic Sea ice, the growth of the average temperature, the increasing frequency of violent weather, all are charts as easy to read as they are alarming.

Wikipedia

The science behind climate change predictions is long established and solid. All major scientific organizations have asserted its validity. Its predictions have proven out over time.

Yet climate change has earned nary a whisper in the economic discussion. It is the health of the banking system, the recovery of housing, the size of the federal deficit that are presumed to be the drivers of economic well-being. This is not withstanding the enormous toll of violent weather, drought, flood we have seen so for and the potential for the effects to become hundreds of times worse. The loss of resources and natural systems are invisible to the economics as practiced in 2013. Repairing and rebuilding from damage is a positive thing in GDP, the measure used for health.

This is partly because the orthodoxy is entirely distracted with readings on the dials and how they relate to their hypothetical or replica of the economy. Federal deficits are a monetary phenomenon that has history. They can be seen in this replica. The certain collapse of the ecosystem cannot. There is no monetary trend line for it.

The other major part is not the invisibility of climate change in measurement or model, but the active denial of the science by major sectors of the existing corporate economy, and the active promotion of climate-damaging technologies by these and others. This is the institutional side: The failure to put a price on carbon, the manipulation of the political system to avoid addressing needed changes, and the simple distortion of the science for public consumption.

The challenge for the forecaster is not so much to anticipate the gradually worsening effects of climate change, but to capture these effects in numerical terms that can be tracked over time and used for policy purposes. An additional challenge is to make these numbers comparable to those of other forecasters so as to provide a base for evaluation.

These are impossible with the current tools. Efforts to create indexes which calculate the depletion of resources and the destruction of natural systems are in their infancy. Some of them are general equilibrium models. These did not work well in the Great Financial Crisis, nor do we expect them to work well in the case of unrecoverable changes to natural systems. The Stern Report made some assertions which we take seriously as the best case scenario. Noting we have already done nothing for the nearly ten of the 10-20 years mentioned.

Using the results from formal economic models, the Review estimates that if we don’t act, the overall costs and risks of climate change will be equivalent to losing at least 5% of global GDP each year, now and forever. If a wider range of risks and impacts is taken into account, the estimates of damage could rise to 20% of GDP or more.

In contrast, the costs of action – reducing greenhouse gas emissions to avoid the worst impacts of climate change – can be limited to around 1% of global GDP each year.

The investment that takes place in the next 10-20 years will have a profound effect on the climate in the second half of this century and in the next. Our actions now and over the coming decades could create risks of major disruption to economic and social activity, on a scale similar to those associated with the great wars and the economic depression of the first half of the 20th Century.

The economic modeling of climate change through Integrated Assessment Models (IAMs) is treated here in that report.


GDP, as noted, the main metric of economic health that is used to compare forecasts, actually improves with some catastrophes as rebuilding is measured well while destruction of property and wealth and productive capacity is not, at least initially. Employment and incomes may rise or fall similarly, so an economic forecast focused on the short term may miss the obvious trend entirely.

Over time we will be developing a metric for output which simply adjusts GDP for health care outcomes, public investment, and depreciation and destruction of resources and natural systems as if they were privately held capital. That project has not yet begun.

The general outline of the future, our baseline for climate change, is not a mystery. Increasing incidence of flood,wildfire, drought, violent storms, pest infestations, and the rest of the litany of outcomes are not in doubt.

Note:

Adapting to climate change can be the World War II that brings the economy back to full employment and paves the way for prosperity beyond. Investments that prolong the habitable life of the planet plainly create value that can be tapped to repay investors. If this needs to be -- as much of it certainly does -- a public investment, so much the better.

World War II entailed spending on arms and munitions and operations that created great destruction. Immense progress was made in spite of this. The technologies of aviation, communication, transportation and others were greatly enhanced by wartime research and development and deployment. After the War the U.S. grew and prospered as never before, partly because of the absence of industrial competition from Europe and Japan, and partly because of the economics of the New Deal and Keynes that put jobs first and did not fear big government.

Climate change is a looming disaster larger than World II. It is replete with tragic possibilities, determined adversaries, and those who would pacify the enemy and compromise away a livable future. It does not have to be that way.

Productivity

We will forgo the formal prediction of productivity for this post, because the long-term relationship with unemployment is disturbed by the distortions in unemployment we pointed out a couple of weeks ago. That is, the unemployment rate is unnaturally low because the participation rate is unnaturally high.

Below is our paper on the relationship between productivity and unemployment which will appear in the upcoming edition (March?) of the Real World Economic Review. You will notice chart in our paper shows the data graphed to 2008, because the Great Recession kicked in and the data became unreliable. Here is a chart from the David Ruccio at the Real World Economic Review blog which shows the shape of productivity growth through the most recent time point available.

What you see here is a steepening of productivity growth at the time of the huge layoffs and spike in unemployment. We submit this is not a ratification of the orthodox view, but rather the consequence of the fruit of labor being counted after that labor has been fired. That is, the product that was sold in 2009 resulted not only from the work of those employed at that time, but also the many who had been let go. The plant and systems they may have developed did not leave with them. The more recent flattening is what we would expect from the Rule of 8.



Productivity, Unemployment and the Rule of Eight

Alan Taylor Harvey

Abstract

Productivity is a central issue in the economy, but its causes are very poorly understood. The term "multi-factor productivity," for example, is attached to the greatest part of productivity gains year after year, but its definition remains amorphous. In this paper, we display the clear correlation between the unemployment rate and changes in productivity in the medium and longer term. We distill this relationship to the "Rule of Eight" — Eight minus the unemployment rate equals the change in productivity. We then contend that the causation runs from unemployment to productivity and discuss why this must be so, particularly focusing on two considerations: (1) In the real world, as a factor becomes more scarce, its use is husbanded, so when labor is scarce, its use is optimized, and (2) the rising marginal cost curve (which is the idea underlying the orthodox belief in declining productivity as labor is increased) does not correctly describe the real world of most firms. Finally, we look at how the inverse relationship between the unemployment rate and productivity changes affects how we think about inflation, and in particular, the use of orthodox analytical tools of NAIRU and the Phillips Curve. That is, because productivity growth is higher during periods of low unemployment , and goods and services are being produced with fewer hours of labor, the price of goods ( all other things equal) should tend to fall. This should reduce inflationary pressure, rather than exacerbate it as the two conceptual tools predict.

The Rule of Eight:

Eight minus the unemployment rate equals the change in productivity over the medium and long terms.

Graphing the civilian unemployment rate against the annual change in productivity, then applying the most complex polynomial function available on Excel creates the following display for the period 1948-2008.

We are using here the most commonly cited data for each of these variables. For unemployment, the unemployment rate of all civilian workers, and for productivity, the changes in output per hour of all persons in the business sector, as reported in the Economic Report of the President. (Tables B-38 or B-42 for unemployment and Tables B-44 or B-50 for productivity, depending on the years.) We see the two functions are virtual mirror images of each other around a central trend of 4. At any point in time, the change in productivity will equal approximately eight minus the unemployment rate and vice versa. As productivity rises, unemployment falls. As unemployment falls, productivity rises. The correlation between the two smoothed lines is virtually complete.

This relationship is likely more intuitive to real world economic actors than to academics or theorists. When labor is tight, managers manage, workers are shifted to more productive tasks, tools improve, capital is used more efficiently, processes are streamlined. Exploring the many ways this is done is beyond the scope of the present work, but this is in essence no different than the first law of economics, restated simply: When something is more scarce, less of it used.

It is important to acknowledge here that contemporaneous and short-term data often belie the medium- and long-term trend described by our polynomial functions. That is, for any particular quarter, when unemployment spikes higher, productivity may rise as well. A close look at the individual years in the graph above, for example, will show many examples where there is a short-term contradiction to the long-term relationship. Popular commentary often runs to the idea that workers work harder for fear of losing their jobs, or the least productive workers are fired; but so far as we are aware, there is no formal validation of this relationship.

We offer here two potential alternative explanations for these contemporaneous contradictions to the long-term relationship:

(1) When workers are laid off (i.e., unemployment rises), their contribution to subsequent production does not immediately leave with them. For example, an accountant may have developed procedures or methods which are used after he or she leaves the company, but the output of the company attributable to those methods does not immediately decline with his or her leaving. Thus – since the productivity statistic considers only currently employed individuals – the output per hour of a business unit may be calculated using fewer workers than are actually responsible for that output. The corollary is that, as businesses ramp up production, they hire and train workers, which may for a period of time depress the productivity statistic.

(2) Managers may not react to changes in labor availability immediately, either by reason of incompetence or oversight, or because adaptation is more complex, and changes in equipment or processes or work rules may not easily or quickly be accomplished.

In any event, the point remains that the stable correlation in the data is that suggested by the Rule of Eight, and the unemployment rate and the change in productivity are inversely proportional.


Causation

Three logical possibilities present themselves: (1) a change in productivity influences unemployment, (2) productivity and unemployment are both determined by a separate factor, or (3) productivity gains follow and are caused by drops in unemployment. We will accept by assertion the third of these alternatives, so as to focus on the most likely dynamics.

The theory is straightforward, but bears repeating: In the real world, as a factor becomes more scarce, its use is husbanded, so when labor is scarce, its use is optimized. The incentives are in place to motivate optimizing labor. But why, if it is so obvious, has this not been observed to this point? We suggest that it is because economic education, Neoclassical theory, has obscured the connection. A rising marginal cost curve is assumed, which by assumption mandates declining productivity as labor is added. That is, if costs per unit are going up, productivity per unit of the factors of production must be going down. The assumption of a rising marginal cost curve is the assumption that additional labor added results in lower output per unit of labor.

Although this is institutionalized in the "Big X" supply and demand curve taught to virtually every undergraduate, this construct of the Neoclassical theory does not generally hold in the real world. Rather, a more classical view applies: Prices are set by the cost of production and output is determined by demand. Empirically, it has been demonstrated that the marginal cost curve does not really rise as assumed in the view of decreasing marginal productivity. Surveys of actual businesses have shown, rather, a flat or falling marginal cost curve. *

NAIRU and the Phillips Curve

Finally, it is interesting to address the implications of the clear correlation described by the Rule of Eight on the Phillips Curve and NAIRU, two commonly used devices that relate unemployment and inflation. Neither of these conceptual devices produces the clarity of the Rule of Eight. The Phillips Curve produces a sequence of corkscrews when graphed. NAIRU — the Non-Accelerating Inflation Rate of Unemployment — fails to show any sturdy relationship. Both rely on the fervor of well-placed advocates rather than empirical validations.

The weakness NAIRU and the Phillips Curve have in describing and predicting the real world lies in part in the relationship to productivity we have been exploring here. That is, because lower unemployment leads to increases in productivity, it actually mitigates price rises, rather than encourages them, all other things equal. A second weakness is that both NAIRU and the Phillips Curve, in fact, have as the implicit causal factor not unemployment itself, but the incomes and related demand pressure associated with more or less full employment. That is, incomes are assumed to be bid up as unemployment falls, and it is these incomes which then lead to prices being bid up. Both also assume that demand pressure is not mitigated by expanding supply. Neither the demand (income) nor the supply (commodities) assumptions is particularly robust, and both depend on other factors.

A simple mathematical description of these relationships might be:

Δ Prices (Inflation) = Δ Incomes / Δ Output – Δ Productivity

Of course, this representation simplifies away some valid considerations. It assumes all incomes are spent on the commodities in question and all output is in the form of these commodities. In fact, when incomes rise, some will be saved; and when incomes fall, some savings will be used. But this consideration, again, act in a manner counter to that assumed by the Phillips Curve and NAIRU. That is, following from Keynes' work on the marginal propensity to consume, as incomes rise, proportionally less of the those incomes go to purchasing commodities, since some is saved. Additionally, if output expands in response to increasing prices, as it would in the real world, the denominator here would mitigate against inflation. But the assumption that all output comes in the form of commodities is fundamentally not right, since it ignores investment goods and government services. Inflation in commodities may well rise when investment increases, or as during wartime when more government services are produced, and this may not be a bad thing. There is fruitful inquiry to be had in this direction (informed by the work of Michal Kalecki and Hyman Minsky, among others), but it is beyond the scope of this discussion.

NAIRU goes beyond bad in this arena, because it assumes that drops in unemployment do not only lead to price increases, but that there is a point where inflation actually accelerates. That is, NAIRU predicts an impulse in the opposite direction (with the image "wage-price spiral") that it ascribes directly to employment pressure. The Phillips Curve merely indicates we will observe a direct relationship between unemployment and inflation. Again, neither of these theories is empirically robust, yet both are favorites of orthodox policymakers.

A speculative example for the use of the Rule of Eight
Our current economic times are characterized by no significant investment by households, businesses, or government and no strength in incomes.

If workers decided to limit hours of availability unilaterally, and thus shrink the number of unemployed, as some have suggested (notably Dean Baker's work sharing concept), the unemployment rate would drop and the Rule of Eight would indicate we would expect productivity increases. Both NAIRU and the Phillips Curve would suggest higher inflation, but no additional incomes would (necessarily) be produced and thus we suggest there would be no impact on inflation.


Conclusion

There is a direct, clear correlation between unemployment and changes in productivity in the medium and long terms. There is theoretical consistency and empirical ratification of this relationship. Implications of this relationship illuminate the manifest weaknesses in orthodox assumptions and in analytical concepts such as the Phillips Curve and NAIRU.

Unemployment, Employment

Employment growth and the real rate of unemployment are not only key economic indicators. They are the measure of the economy. All the other numbers, including GDP growth and the other indices, are secondary. Labor is the primary capacity that must be used to its maximum. A full employment economy is the only healthy economy.

Earned incomes, the basis of healthy demand, deteriorate in periods of high unemployment.  It is not simply that the number of idle workers enables employers to demand lower wages, it is the fact that high unemployment can exist only in conjunction with low rates of investment.  Investment goods production typically pays more than consumer goods production, and investment produces -- or can produce, if targeted coherently -- the value that grows the economy and incomes.

Idleness is bad.  It is bad for the skills and well-being of the idle person, and idle capacity means unmade goods and services, an absence of products we could use to build on.  On the other side, the incomes that come with jobs are the demand that is the primary driver of market capitalism.  The stagnation in the employment numbers is further exposed as a disease by the fact of these falling real incomes for most workers.  People who lose jobs and find another typically lose up to one-third of their take-home in the exchange.  This is a recipe for further decline.

Any one of a number of measures shows that the labor economy has been deteriorating for decades. A major impetus for consumer debt was to make up for this deterioration. This debt bubble, the financialization of the economy, and the inevitable crash are the proximate reasons for the current long-term stagnation, but they are also symptomatic of the longer term trend.  The fundamental point remains that a full employment economy is the only healthy economy.  Fore forecast purposes, this means that gauging the strength and direction of employment will go a long way to predicting outcomes, and policies that address employment will be the only effective policies to recovery.

There are a lot of problems.

The problem in theory and in policy is the conventional wisdom that unemployment, underemployment and mal-employment are necessary or natural conditions, that the economy can be healthy when its workforce is sick.  [There are, in fact, major tools of policy-makers whose presumption is exactly this.  NAIRU, for example, the "non-accelerating inflation rate of unemployment," or as it is sometimes called, the "natural rate," assumes a trade-off of employment and inflation. Likewise the Phillips Curve, treats output and unemployment as balancing.  Both view inflation as a volatile and dangerous thing, a plague unto itself, rather than as a temperature reading that could as easily mean health as disease.]

A second problem is finding a metric that correctly indicates the health of the labor market.  The headline unemployment rate, for example, measures the number of unemployed, as limited by several characteristics, divided by the number of available workers, as limited by several characteristics.  The limitations have been added over the years, always tending to reduce the headline number, so that it now bears little resemblance to the number of fifty years ago.

The reduction of the rate from its peak in 2009 is largely a function not of the increase in employment, the numerator (of unemployed/workforce), but of the denominator. The workforce has been deteriorating under the economic pressures. Job growth rarely peeks above 200,000 in a month, and we need 600,000 to get to recovery, but the unemployment rate goes down because fewer people are actively seeking employment.  Thus the slow drop in the unemployment rate is not a sign of health, but  a symptom of stagnation, a function of the decline in job-seekers.  The employment-to-population rate ought to be around 63%.  It is stuck below 59% and is not moving.

Click on chart for larger image

And the third problem for our forecast is, of course, we need to be comparable to other forecasts so as not to be accused of fixing the game. So what we need is a metric that defines idle and under-used labor that can be translated to the headline unemployment rate that others focus on while still telling the tale of the true condition of the workforce.

We've chosen the U6 "All-In" rate published by the Bureau of Labor Statistics as Table A-15. To translate to the headline rate, we are going to use the statistical relationship from the past, which is relatively stable but drifting higher (now at 1.85).  The chart at the top displays the historic rate and our projection for the next two and a half years, for both U6 and the headline rate of unemployment. 

Our chart has some colors in it to display the relationship of unemployment to the economy at large.  A number above 10 is in the red zone.  Incomes, demand, budget deficits, a whole range of socioeconomic indicators is deteriorating.  These effects are not short-term, and damage both the condition and trajectory of the economy.  In the 8-10 range, things are stabilizing.  Below 8, things are constructive, as indicated by the green bands.

It is important to remember, again, that any step downward in these rates is likely due to the weakness in the available workforce, as people become discouraged or move to second-best options. When we show a flat line, it is actually a worsening condition in absolute terms.  It is also important to remember that the longer the number is in the red, the more suffering in the immediate term, but also the more long-term irremediable damage.

We do not expect to do dramatically better than others in this metric. The forecast is easier for everybody in stagnation, particularly those whose primary technique is to extend the trend line. 

Forecast:

Stagnation continues.

There is no reason for anything to change fundamentally.  Further federal austerity will cause unemployment to drift higher.

The direct employment programs, construction of infrastructure, or federal support to states and localities which are the only too obvious beginnings of a labor market recovery are not in the political pipeline.  The agenda has been captured by austerity advocates.  Cutting back in a period of stagnation is a course certain to replicate the experience of the 1930s.  The difference between the 1930s and today is that we have the New Deal programs of Social Security and unemployment insurance, and we have other social safety net programs that provide a floor of demand higher than that of that era.


What it means

Literacy, mobility, public order, rescue of the environment, protection of the young, old and infirm -- these are essential features of a civilized society, and there is no gizmo, no technology, no carbon technology, that can provide these things. These are labor intensive. Look at the complexity and interdependence we experience in any single day. And consider this: Everything in the world is composed of energy and labor. If we need to use less energy, we will need more labor, particularly in Agriculture.  Is that the direction we are headed?

The sad part for us is that we need these people.  We cannot afford to be idle.  Climate change is on the march, an army on our borders, and our defenses have not yet begun to be built. Every person on this planet needs to be in this struggle, but because the generals of the assault on the environment have co-opted the political leadership, we are locked out of the armories that contain our weapons: infrastructure spending, pricing energy at rational rates, full-scale research and development, immediate conversion and retrofitting. The workforce needs to be trained, employed, housed, educated, fed, and so on.  When it is returned to health, the economy will return to health.

Demand, Incomes, the Financial Cycle

Market capitalism is constrained from the demand side.  Output is determined by demand, the strength of effective demand.  The demand side is the macro side. The supply side is the micro side.  When corporations convince us that their well-being is primary, or at least preliminary, to the well-being of the society, they are selling us a bill of goods.  It is the demand side that is primary and preliminary.

There are several components to effective demand.  Begin with incomes, and you quickly find the interface between demand and supply arguments:  Jobs.

Jobs are -- for the individual worker and from the macro perspective as well -- a source of incomes and hence demand.  Jobs are for the corporation a cost, a factor of production.  A company does not produce jobs, it produces products with jobs, with labor. What produces jobs and profits is demand for those products.

Other elements of demand derive, like jobs, from income.  Profits, interest payments, rents, social insurance and pension benefits are types of income.  All of these are important. Stable incomes mean stable economies.  But the most significant source of demand by far for forecasting purposes, second only in importance to wages and salary income, is the change in debt -- the increase or decrease in credit outstanding.  The change in effective demand can be usefully understood as the change in incomes plus the change in debt.

The change in debt has been studied by economist Steve keen, following from Hyman Minsky and John Maynard Keynes. Keen has developed the "credit accelerator," the change in the change in debt, and shown its direct effect on metrics like employment.  Minsky explored extensively the debt cycle, its progression through different financing structures -- hedge, speculative and Ponzi. (What we might call "investment financing," "rollover financing," and well, "Ponzi financing.")

A recent paper from Claudio Borio of the Bank for International Settlements (BIS) entitled, "The Financial Cycle and Macroeconomics: What Have We Learnt?" goes into the credit creation and destruction cycle in depth, and promises to bring Minsky's thought into the mainstream. (Although it may come without attribution; the paper owes a great deal to Minsky and Keen, but they were never cited in it." Below our predictions in this post is a sequence of observations from Borio's paper.

[Others, of course, have seen the financial cycle, the boom and bust. Notable among these is George Soros and his "super-bubble" analysis.]

In this mix is the central bank. In the U.S. it is the Federal Reserve.  The Fed's activities to control inflation, its imperfect understanding of how money is created, and its capture by narrow banking interests, have combined with its power to support and affect financial markets and institutions.  This combination has resulted in policies that arguably lengthen and exacerbate the contraction phase of the current financial cycle, Borio intimates. In Europe, the European Central Bank has done worse, demanding austerity as well from the nation-states it serves.

Effective demand, including incomes and credit growth, has another major player:  Government.  The government hires people, borrows money and produces goods and services. The public goods it produces have particular attributes that make them essential to the private economy as well as to its citizens.

Different types of income and spending affect the economy differently at different times.  For example, the tax cuts of 2008 and 2009 had a very small net effect on demand, since they were used by households largely to pay down debt or they were saved.  In more certain times they might have been spent.  A contrasting example, the direct spending on infrastructure under the 2009 Recovery and Redevelopment Act had a very large effect, as the jobs created there supported households and a full spectrum of consumer activity.  This is an area best informed by multiplier analysis, which we take up in a subsequent forecast.

With this brief background, our forecast is informed by the following predictions:

The financial cycle will continue in its contractionary phase for several years, at least.  We are not near an inflection point.

The Fed and other central banks will continue to forestall debt writedown, lengthening the contraction and delaying the recovery.

Incomes from wages and salaries, rents and investments, will stagnate and trend lower.

Government hiring and investment will be in austerity mode, as its borrowing will be devoted entirely to pass-throughs to private citizens via social insurance or tax cuts.  This pass-through of federal borrowing to the private consumer sector is the equivalent of the Fed's life-support programs for the banks. It enables the term "recovery" without producing one.

Sectors which can devise credit for their customers (e.g., Autos in the U.S.) will experience sales and growth. Those which cannot (e.g., certain parts of  residential housing) will not.

Household balance sheets will improve only slowly, and renewed use of credit will be dampened.

Relief in the form of government hiring and investment in needed public goods is not likely in the near future.

Excerpts from
BIS Working Paper No. 395
"The financial cycle and macroeconomics: What have we learnt?"
 Claudio Borio
December 2012

"The financial cycle has a much lower frequency than the traditional business cycle." p.3.

"Combining credit and property prices appears to be the most parsimonious way to capture the core features of the link between the financial cycle, the business cycle and the financial crisis.  Analytically, this is the smallest set of variables needed to replicate adequately the mutually reinforcing interaction between financing constraints (credit) and perceptions of value and risks (property prices)." p.3.

"Peaks in the financial cycle are closely associated with systemic banking crises." p.4.

"The close association of the financial cycle with financial crises helps explain another empirical regularity: recessions that coincide with the contraction phase of the financial cycle are especially severe." p.4.

"The most promising leading indicators of financial crises are based on simultaneous positive deviations (or "gaps") of the ratio of (private sector) credit-to-GDP and asset prices, especially property prices, from historic norms." p.5.

"Financial liberalization weakens financing constraints, supporting the full self-reinforcing interplay between perceptions of value and risk, risk attitudes and funding conditions.  A monetary policy regime narrowly focused on controlling near-term inflation removes the need to tighten policy when financial booms take hold against the backdrop of low and stable inflation. And major positive supply side developments, such as those associated with the globalization of the real side of the economy, provide plenty of fuel for financial booms:  They raise growth potential and hence the scope for credit and asset price booms, while at the same time putting downward pressure on inflation, thereby constraining the room for monetary policy tightening." p.6.

"Arguably, since shocks can be regarded as a measure of our ignorance, rather than of our understanding, this approach [real business cycle analysis] leaves much of the behavior of the economy unexplained." p.8.

During the financial boom, credit plays a facilitating role, as the weakening of financing constraints allows expenditures to take place and assets to be purchased.  This in turn leads to misallocation of resources, notably capital but also labor, typically masked by the veneer of a seemingly robust economy." p.8.

to be completed

2013 Forecast Overview, with GDP and Net Real GDP

The United States is bouncing along the bottom with downside risks, a bottom that is sloped downward. This has been the forecast for the past three-plus years at Demand Side Economics. Levels of employment and investment dropped dramatically during the Great Financial Crisis and have stagnated since that time. The Obama stimulus of 2009 provided only $250 billion of high multiplier public investment, an impulse that has long since died out. State and local government has become a permanent drag. Monetary policy has actually squeezed real disposable incomes both by depressing interest income and by inflating commodity prices. The fiscal policy debate is now mired in whether to have more or less austerity.

[For a discussion of the problems of economic forecasting see our Principles discussion.]

We see no change to public policy that would lead to a substantive recovery. No direct employment programs are on the horizon. The federal government has abandoned states and municipalities to fend for themselves. There will be no meaningful infrastructure spending. (A recent trial balloon for $50 billion in infrastructure would cover about one-fifth of what is needed for simple maintenance.) The climate cliff has happened without arousing any particular interest, and we await the moments of impact -- violent weather, lost resource capacity and permanently damaged natural systems. There will be no meaningful reparations to the middle class, nor a restoration of the egalitarian society which worked so well in decades before the 1980s.

Absent positive contribution from government and caught in its own negative feedback loops, the private sector is destined to drift lower. Investment will be lower. Asset prices will be lower, except as markets are juiced by bubble financing from the Fed. Consumer prices will be lower, again to the extent they escape the Fed's liquidity injections. Personal incomes will be lower. This is the bottom sloped downward.

The combination of easy money for financial players, the tremendous debt overhang in the private sector, and declining real incomes will expose fragile financing structures and lead to further threats of financial crises. Those threats will be met by straightforward debt adjustments or by prolonging the debt squeeze and shifting the pain from the financial sector to taxpayers. Debt adjustments would clear the economy for growth, but are the definition of systemic crisis. Shifting the pain in a way that preserves the current financial architecture exacerbates the inequality, injustice and potential for social disruption. These are the downside risks.

The labor market will deteriorate along with public and private investment. Huge private debt burdens will continue to take their toll. The failure to meet climate change with action will multiply the cost in human, environmental and economic terms. Capture of the political process by entrenched corporate elites ensures that change is not coming from pragmatism or reason, and must first come from power.

An unprecedented public involvement and a disruption of the current power structure is required, but prospects for change are not completely absent. The recent elections revealed a rising opposition to free market fundamentalism. Election financing reform seems to be a priority at the grass roots. The movement to address climate change is mobilizing millions in a direct challenge to corporate power, specifically that of the Energy Complex, and this movement is largely outside the traditional political machinery. Evidence that forward motion is possible may come soon, if the new Congress is able to break through obstructionism. Most importantly, the evidence of failure of current practices will continue to grow. Financial markets must sooner or later acknowledge the real economy. Crises are not behind us. And in the context of a stagnant economy and failure to deliver on past promises, there will likely be little interest in more corporate bailouts. At a minimum, confrontation will draw key issues and players into the light of more general public understanding.

On the other hand, the entrenched interests now in control are extremely powerful and have effective control of the political and judicial branches of government. Historical examples of economic stagnation combined with popular disenfranchisement have resulted more often to chaos and destruction than to positive transformation.

One last positive, however. The old people. In times prior to the Modern Era and even up through the late part of the last century, elders were leaders who were respected. For good reason. They had seen enough to know and survived enough to have demonstrated intelligence or values. In this early part of the 21st Century, with the retirement of baby boomers, we have an immense number of people with experience, and people with a stake in a working government. It once was said that you were liberal in your twenties and conservative in your fifties, but that was more a description of being co-opted than of aging. Now the boomers find the promises of seven percent gains in stocks year after year as ephemeral as their 401(k)s. Older people will have the time (if not energy) to get involved. And they have at least the opportunity of perspective. To the degree they support the broader interest with their time and talent, and do not become strictly an interest group for social insurance and health care, the power base for reform is set.

What is the forecast?

In terms of common metrics:

GDP to sub-zero

Employment in its current stagnant, deteriorating pattern

Investment lower, both private and public

Prices lower in real terms

Easy money creating instability in financial markets

GDP and Net GDP

To engage with traditional forecasts, we need to translate our outlook into common economic parlance, which begin with the measurement of GDP.

GDP is an object lesson in Keynes' dictum, "Better to be approximately right than precisely wrong."

Briefly, most forecasters are bad at predicting GDP more than a quarter or two away, and this includes "blue chip" forecasters, forecasters at the Fed, and for the most part all those who use the Neoclassical paradigm. In addition, the data itself often bounces around from advance to preliminary to final to baseline revision. In combination with the very short-term focus of most forecasters, this means the score often changes some months after the game is over but nobody notices. Even were the forecasts accurate, the metric itself is flawed. GDP has an importance in conventional thinking far greater than its value. GDP excludes much of what is important, includes bads at the same price as goods, and fails to use comparable accounting for comparable activity -- in particular, private v. public investment.

That said, real GDP growth is the score by which forecasters are measured. To it we add our exclusive measurement "Net Real GDP." This is a particularly Demand Side concept, as it seeks to expose the proportion of growth that is due directly to federal deficits, and we include in "deficit" borrowing (or paying back) to social insurance trust funds. Trust funds are completely analogous to private insurance, the spending from benefits is spending into the private economy, and there is no reason to characterize them in the same was as defense spending, education, roads or other activities of government, which deal primarily in public goods.

Our forecast is condensed to the chart below:

Our view is that we scored an eight in the 2008 forecast, as opposed to the orthodox consensus scoring below one. We get credit for not missing the devastating drop, nor overestimating the subsequent rebound. [We, in fact, do not see the recovery at all in terms of the business cycle. The improvement in numbers is not a real economy event, but a statistical event conjured by big federal deficits, easy monetary policy and failure to make the structural adjustments necessary.]

The 2013 Forecasts predicts things on a shorter term, which is the reason for its variability. A flat line extension of both GDP and Net GDP from the 2008 Forecast would be an acceptable alternative. Net Real GDP is lower in our prediction than actual numbers because we anticipated greater interest in infrastructure spending.

But again, remember, even the flat line overstates the health of the economy going forward. Much of the nominal growth is coming in health care, where bad accounting confuses inputs with outputs. And a great deal of economic deterioration is masked by resource depletion, environmental degradation and workforce decay.