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The Poison Eating at the Heart of Macroeconomics

Economics / Economic Theory Sep 24, 2014 - 05:51 PM GMT

By: Frank_Hollenbeck


Mario Draghi, in one of his latest speeches, prodded governments to ease austerity to spur aggregate demand (an oxymoron). The IMF director, Christine Lagarde, recently urged the ECB to continue its easy monetary policy until aggregate demand picks up. U.S. Treasury Secretary, Jack Lew, has, for years, suggested government actions to boost aggregate demand. He has in turn lectured Germany, Japan, and China on the need to encourage demand.  It is sad that such economic nonsense is constantly promoted by some of the world’s most influential people, including many leading economists, and that this continues to serve as the foundation of much of contemporary macroeconomic theory.

This faulty widespread educational indoctrination about aggregate demand is similar to past universal beliefs in truisms that weren’t- like the sun revolving around the earth.

We never need to boost demand.  The reason we work, we produce, is to consume; there is never a lack of demand.  The primary function of prices is to ration output against an insatiable desire to consume or demand. As Ricardo said in 1820, “men err in their production; there is no deficiency of demand.”

A good macroeconomist would never say that aggregate demand is a problem in a barter economy. Yet, economists teaching macroeconomics or politicians or journalists who took their courses continue to be confused. Even Keynes in his criticism of Say’s Law did not really want to understand the barter case. In his general theory, he uses a quote from Mill:

First, let us suppose that the quantity of commodities produced is not greater than the community would be glad to consume: is it, in that case, possible that there should be a deficiency of demand for all commodities for want of the means of payment? Those who think so cannot have considered what it is which constitutes the means of payment for commodities. It is simply commodities. Each person’s means of paying for the productions of other people consists of those which he himself possesses. All sellers are inevitably and ex vi termini buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply: everybody would be able to buy twice as much, because every one would have twice as much to offer in exchange. - Mill, “Principles of Political Economy” Book III, chapter XIV, §2

Keynes then concludes that doubling output won’t necessarily double demand since there may be a mismatch between demand and supply creating idle resources (unemployment). This was duplicitous since Keynes conveniently omitted Mill’s next three sentences:

It is probable, indeed, that there would now be a superfluity of certain things. Although the community would willingly double its aggregate consumption, it may already have as much as it desires of some commodities, and it may prefer to do more than double its consumption of others, or to exercise its increased purchasing power on some new thing. If so, the supply will adapt itself accordingly, and the values of things will continue to conform to their cost of production.

Let us take a closer look at the barter case with a simple example.

Suppose we have an island economy, with Robinson Crusoe as its only inhabitant.  He has woven some nets and spends his days fishing.  Now suppose you arrive by boat on the other side of the island.  After getting familiar with your surroundings, you start visiting the island and stumble onto Robinson who has many fish drying in the summer sun.  You are very hungry since you have not eaten in many days. Therefore, you have a great demand for Robinson’s fish. But aside Robinson’s initial altruistic nature, he will not give you any fish until you have something to offer Robinson in return. In other words, you have to supply, before you can demand.

Now, it is true that you cannot produce anything. You have to produce what Robinson wants.  You have to have the right supply. Nevertheless, you cannot satisfy this demand until you supply first.

This is the simplest version of Say’s Law, that “supply creates demand”, or, more accurately, “that the right supply constitutes demand”. This law lies at the heart of the controversy between the economists who advocate direct government intervention in the economy and those that do not. Keynesians believe that the only thing that is important is demand; but in the example the only thing that is important is that you are hungry.  Classical economists believe that what is more important is the right supply; something Robinson wants in exchange for his fish.

Now, suppose Robinson agrees to catch more fish than he can possibly consume in exchange for coconuts that you intend to climb trees to harvest.   If neither of your tastes changes, then our simple economy can continue forever in this equilibrium. There is no unemployment or idle resources.  Of course in real life, tastes change, and supply is constantly being readjusted, causing resources to sit idle and labor to suffer unemployment, to satisfy an ever-changing structure of societal demand for different goods and services.  It is this ever changing “structure of desires” that drives changes in supply.

Suppose, one day, Robinson decides he no longer likes coconuts. What is the solution?  Remember, the only reason Robinson would catch more fish than for his personal consumption is to trade for other goods and services. He does not lack demand, just the right supply at the right price to satisfy his demand.

Do we have a problem of too little demand for coconuts? Should the government take fish away from Robinson Crusoe to purchase coconuts from you to fill this gap in demand for coconuts?  Any reasonable person would say “NO” - hence, the stupidity of economic discussions about an output gap, or demand policies to reach potential GDP. Also, Robinson Crusoe will probably fish less since he is now forced to share the fruits of his labor with the government.  As an individual, you may be initially better off, but society’s standard of living is reduced, since it is producing less fish and producing coconuts no one wants. The government’s actions have induced a deviation from the composition of output that would have normally been freely determined.

The carpenter, who was fully employed during the housing boom years, needs to find another job such as on an oil rig possibly working at an even higher salary. Extending unemployment benefits just delays the necessary adjustment. Current government policies focused on reigniting, among other things, a housing boom can only be viewed as totally misguided as trying to reignite a demand for coconuts.

The same is true if the government interferes with relative price changes (deflation), or real wage cuts that may have occurred, had you both instead agreed to a different ratio of fish for coconuts.

The obvious solution is for you to find something else that Robinson wants for his fish (e.g., mangos). The capital you created to climb coconut trees may now never be used again and you may be temporarily unemployed. But government redistribution policies to fill a temporary gap in demand for coconuts are not the solution.

We must remember a fundamental reality of economics:  we have a limited amount of resources to produce a limited amount of goods and services to satisfy an infinite desire to consume these goods and services. We can get more goods and services in the future if today we sacrifice resources, and current consumption, to build capital goods.

Robinson Crusoe will get more fish if he goes hungry to build a net. He needs to give up current consumption for more consumption in the future. He won’t get more fish by simply being hungrier, or having a greater demand for fish.

Neither monetary nor fiscal policy will add resources or capital. Therefore, neither will improve, irrespective of the short term reallocation effects, the lot of the average man. Common sense dictates that neither legal counterfeiting nor taking from Peter to give to Paul raises living standards.

What about aggregate demand in a monetary economy instead of a simple barter economy?  Keynes highlighted a possible problem in his General Theory. Yet, from his analysis, an aggregate demand shortfall is only concerning in a monetary economy when the general public significantly increases its cash holdings (hoarding) and input and output prices are sticky. (See explanation here) Not only is this a special case, but a situation that may never have occurred (classical economist considered hoarding unimportant and changes in hoarding even less so).

This fetish with aggregate demand, where we lump together the demand for Ferraris with the demand for apples, is the poison eating at the heart of macroeconomic theory.  The problem is never one of aggregate demand, but of supply being misaligned with demand.

Today, we must change the direction of economic policies if we are to avoid a disaster.  The solution is not to solve an imaginary problem of demand but to concentrate on having the private sector provide the right supply at the right prices.  We need to concentrate on policies that free up resources to allow the private sector, through the profit motive, to provide the goods and services closer to what society wants.

Frank Hollenbeck, PhD, teaches at the International University of Geneva. See Frank Hollenbeck's article archives.

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© 2013 Copyright Frank Hollenbeck - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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