How to Explain Recession, Price Inflation and Full Employment at the Same Time
… or Are You Working More Now and Enjoying It Less?
The economy has contracted two quarters in a row, what most people think of as a recession. However, it will take a few months more before the NBER officially tells us whether we have “officially” crossed into the recession column.
Regardless of when and what the NBER says about the state of current economic conditions, we can be sure of one thing as the economic data continues to roll in, any economic model that cannot explain the concurrence of full employment, recession and rising prices, our current state of affairs, cannot provide a useful template for thinking about how to fix the economy.
At a conceptual level, here’s the issue. In the Keynesian model, the mainstay of the economics profession, full employment and a declining economy are fundamentally inconsistent with one another. Nevertheless, that’s what the data shows is taking place. The unemployment rate continues to hover at post- war lows of approximately 3.6% while the economy has now contracted two quarters in a row, at -1.6% and -.9% respectively.
In other words, the data appears to show an economy in two places at the same time – at least according to the Keynesian model. Recall, in that model, supply chain disruptions and the curtailment of energy production are seen as left shifts of aggregate supply from AS1 to AS2 along AD1. (Figure 1a) In Keynes-world, this is expected to drive up the price level while output and employment decline. Therein lies the rub. Unless unemployment increases, the model falls apart since a declining economy and full employment are innately inconsistent. (Figure 1b)
What good is economic theory if cannot explain reality in real time? Fortunately, there is a way out of the Keynesian trilemma that can help us to understand where we are and may be heading. In a Supply-side type framework, which connects tax rates and regulations to economic activity and in turn to the value of the dollar, the simultaneous occurrences of recession and full employment are perfectly consistent.
Here is the set up. Start with a 2-good Production Possibilities Curve (PPC) that every freshman learns about in Econ 1a. (Figure 2) The PPC shows all of the possible output combinations of good A and good B and is bowed out meaning that increasing specialization leads to increasing opportunity costs. For example if good A represents health care procedures, then if the economy were to increasingly specialize in the production of A, firms in that industry would have to employ increasingly less suitable inputs. Since not everyone is cut out to be a doctor, plowing resources into good A means that incremental production of that good will cost the economy increasing amounts of good B that could have been produced in the same time frame.
Now let’s add a third dimension, time (labor hours), to our PPC. Time is the ultimate scarce resource and the universal standard of measure in the system. That’s why we say that time is money. Absent a magic wand, getting more output requires an investment of time and skills which when combined with land, capital and energy gives us a PPC in 3-D time-output space. In Figure 3 below, additional hours worked either by the same people or more people lead to the production of additional market baskets or GDP, denoted as circles.
The limit to labor’s productiveness is the amount of capital available with which to work and personal endurance. Just as doubling work hours will not necessarily double output owing to fatigue, doubling the number of workers will not double output if there is not enough capital infrastructure to support an increased need for tools. Think of the adage: too many cooks in the kitchen will spoil the broth. In econ-speak this is known as the law of “diminishing marginal returns”, meaning real wages will be falling if there is not enough capital per worker in the production mix.
For example in Figure 3 above, a one-market basket economy (the little circle next to PPC1) can be achieved in 40 hours given the capital stock but it takes, say, 90 hours to double output. Fatigue alone guarantees that doubling hours will not double output, and of course if the energy to fuel capital (designated above as a cart on wheels) is substantially reduced, then the economy will contract.
This leads to a denouement. Since January 2021 we’ve been knee-capping the energy sector by putting the kibosh on new drilling and by slow-walking approvals. This is the same as imposing a tax on oil production without getting any of the revenue that a tax would normally bring into the Treasury. Instead, as with all quotas the beneficiaries are the companies that are able to sell less output at higher margins until the production restrictions are so severe that there’s nothing left to the industry.
Figure 4.
We can visualize what’s going on when efficient energy production is extinguished as a wheel falling off the capital cart. (Figure 5a). Putting aside how best to address CO2 externalities in the grand debate over what we need to do to keep mother earth happy, the result is that as people search for energy workarounds, the defacto time-price of output is bound to rise. (Figure 5b).
At the same time, in the tandem market for money, where the purchasing power of the dollar is established, when the economy contracts less money in circulation is required thus causing the value of the dollar to further decline. (Figure 5c). Taken together, at the same level of employment it takes more time to produce less stuff which reduces the system’s need for currency. This gives us full employment, falling productivity and declining real wages alongside inflation.
Even if between now and the mid-terms in November the Fed could somehow mop up the extra currency circulating in the system to restore monetary integrity, which it cannot possibly do, we’d still be facing a really bad case of the economic blahs due to the loss of energy production.
When voters head to the polls they will have to decide whether they are working more now and enjoying it less. If they sense that they are facing an unrelenting decline in their living standards for years to come then all the semantics in the world over whether the economy is or is not in a recession will not make a difference to the outcome. In that case, the pocketbook will trump all and advocates of austerity will come out on the short end of the electoral stick.