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Source link: http://archive.mises.org/12622/it-is-not-the-aggregate-demand-stupid/

It is Not the Aggregate Demand, Stupid

May 4, 2010 by

According to Obama’s leading economic adviser, the current double-digit unemployment rate is obviously due to a “shortfall in aggregate demand.” The only “obvious” thing about such a diagnosis and prescription is that they are very useful to the Obama gang. FULL ARTICLE by Jeremie T.A. Rostan

{ 38 comments }

Wayne May 4, 2010 at 9:54 am

Maybe we should send them a link to the video. You know, the rap one about about aggregate demand…..

Bob Roddis May 4, 2010 at 9:59 am

Keynes seemed to have understood that the key to his monetary stimulus was simply the artificial lowering of wages without the victims understanding what hit them. Hayek related that story in a 1977 TV interview here.

Keynesianism is a fraud and a hoax.

Rufus May 4, 2010 at 10:07 am

Other than that every indicator, except housing, is showing that we are well back on our way towards recovery. The vast majority of economists agree that the recession ended in the middle of last year. The only remaining problem is high unemployment (which is why we need GREATER fiscal stimulus).

Daniel Hewitt May 4, 2010 at 12:31 pm
J. Murray May 4, 2010 at 12:36 pm

Those “indicators” are being driven up by monetary inflation. Higher stock prices and higher sales driven by dumping money on the system is not a recovery. We can’t recover when unemployment is high, unless there is this huge efficiency revolution going on that no one has managed to notice yet.

Magnus May 4, 2010 at 3:19 pm

The vast majority of economists agree …

Gee, we’d all be rich, if only the laws of economics were more responsive to politicized credential-whoring and/or voting.

El Tonno May 4, 2010 at 4:06 pm

This is bizarre, I remember an article from January or so (can’t remember from where, but I saved it) affirming that all sectors of the economy very slow going EXCEPT for housing which was booming.

My first thought was about LSD in my coffee.

vimothy May 4, 2010 at 10:17 am

What Keynes actually wrote in the GT was (forgive the long quote, but it’s always worth actually reading someone if one wants to find out what they thought):

IT would have been an advantage if the effects of a change in money-wages could have been discussed in an earlier chapter. For the Classical Theory has been accustomed to rest the supposedly self-adjusting character of the economic system on an assumed fluidity of money-wages; and, when there is rigidity, to lay on this rigidity the blame of maladjustment.

It was not possible, however, to discuss this matter fully until our own theory had been developed. For the consequences of a change in money-wages are complicated. A reduction in money-wages is quite capable in certain circumstances of affording a stimulus to output, as the classical theory supposes. My difference from this theory is primarily a difference of analysis; so that it could not be set forth clearly until the reader was acquainted with my own method.

The generally accepted explanation is, as I understand it, quite a simple one. It does not depend on roundabout repercussions, such as we shall discuss below. The argument simply is that a reduction in money-wages will cet. par. stimulate demand by diminishing the price of the finished product, and will therefore increase output and employment up to the point where the reduction which labour has agreed to accept in its money-wages is just offset by the diminishing marginal efficiency of labour as output (from a given equipment) is increased.

In its crudest form, this is tantamount to assuming that the reduction in money-wages will leave demand unaffected. There may be some economists who would maintain that there is no reason why demand should be affected, arguing that aggregate demand depends on the quantity of money multiplied by the income-velocity of money and that there is no obvious reason why a reduction in money-wages would reduce either the quantity of money or its income-velocity. Or they may even argue that profits will necessarily go up because wages have gone down. But it would, I think, be more usual to degree that the reduction in money-wages may have some effect on aggregate demand through its reducing the purchasing power of some of the workers, but that the real demand of other factors, whose money incomes have not been reduced, will be stimulated by the fall in prices, and that the aggregate demand of the workers themselves will be very likely increased as a result of the increased volume of employment, unless the elasticity of demand for labour in response to changes in money-wages is less than unity. Thus in the new equilibrium there will be more employment than there would have been otherwise except, perhaps, in some unusual limiting case which has no reality in practice.

It is from this type of analysis that I fundamentally differ; or rather from the analysis which seems to lie behind such observations as the above. …

Current May 4, 2010 at 11:19 am

Keynes is putting the issue in very Marshallian terms which makes it difficult to understand.

The effect he is point to is what Wicksell called “Cumulative Rot” and what Hayek called the “Secondary Recession”. If I want to increase my stock of money and I can’t borrow to do so then I must spend less for a period, by doing that I decrease the incomes of others. As a result prices and output both fall, this is very destructive. As a result it’s better if some money is created and prices are stabilised.

This is where Rothbardian hard-money Austrians, which perhaps includes the article author here, and “Free-banking” Austrians differ.

Greg May 4, 2010 at 1:42 pm

Falling prices being destructive is one of the largest mistaken assumptions of modern economics. This subject is treated in length here on this site. Educate yourself.

Current May 4, 2010 at 2:44 pm

I already know all those arguments and I used to believe them myself.

However, while moderate deflation due to economic growth in benign the same can’t be said for the deflation caused by a sharp rise in demand for money. That deflation doesn’t specifically bankrupt projects that represent capital misallocation.

See Steve Horwitz and George Selgin’s articles.

greg May 4, 2010 at 3:20 pm

You are correct! As productivity increases output and decreases unit cost, there would not be a problem as long as wages adjust accordingly. But since no one takes pay cuts, their buying power must be brought in line by inflating the currency and stabilizing prices.

Current May 4, 2010 at 4:53 pm

I detect a hint of sarcasm there ;)

I don’t think that the world is like that anymore. Unions don’t have the power they once did, they get few special favours from government compared to the past. A gradually falling price level due to productivity improvement would be quite possible. My main complaint is about the Rothbardian/early-Hayek idea that a high rate of deflation in a recession is beneficial.

konst May 5, 2010 at 2:46 am

Current,
I thought the high rate of deflation during a recession is the market correction of malinvestments.

The general high rate of deflation sounds like it would be beneficial during a recession though it would not be as steep as the corrections.

Current May 5, 2010 at 8:34 am

Konst,

I don’t think so. Rothbard certainly held the view that a high rate of deflation in a recession is good. Mises held it in some books but not others. Hayek held it at the beginning of his career and changed his mind later.

In a recession caused by ABCT we first have the bankruptcy of projects that relied on the low interest rate. This is the trigger of the recession, but as Hayek pointed out, there is then a “secondary recession”.

Firstly, the agents connected with the unsuccessful projects are affected, they become poorer or unemployed. for example. Anyway, their spending decreases. This is just a reflection of the real effects of the capital waste. When this group reduce their spending they start to threaten other businesses. For example, a man who thought himself rich because of his property investments cannot afford the yacht he wanted. Again, this is a reflection of the real amount of capital society has, it is the reimposition of reality.

But, there is a secondary effect that is different, and avoidable. As the effects of recession spread through the economy people become uncertain about what will happen next. They deal with this uncertainty by holding more liquid assets – more money. However, if the amount of money is fixed, then it is impossible for everyone to hold more money. Deflation is the result of this impasse.

Businesses must adjust prices downwards. Marginally profitable businesses go out of business. However, as long as prices can adjust the recession will end. When this happens though there is no reason for people to hold extra money as an extra hedge against uncertainty. So, they will spend that money causing price to rise back to close to where they were before.

So, by holding the amount of money fixed the economy is forced to go through deflation first, then a corresponding reflation. Why should we bear the cost of all that readjustment? The alternative is a free-banking system with fractional reserves. In that case the banks can measure the amount of increase in the demand for money and increase the stock to compensate, keeping the price level steady.

It is unlikely if the deflation actually purges malinvestments well. The businesses that get into trouble are the ones that rely on trade from those agent who are increasing their money holding. Those businesses aren’t necessarily the ones that are malinvestments.

geoih May 5, 2010 at 10:30 am

Qoute from Current: “Those businesses aren’t necessarily the ones that are malinvestments.”

How could anybody know which businesses are or aren’t malinvestments if the money supply is inflated everywhere?

If people are keeping more reserves than before, then maybe that’s because they should have been keeping more reserves in the first place. If the moeny supply is going to increase, for whatever reason, then they will need to keep more reserves in the future to compensate for the inflation.

Current May 5, 2010 at 6:29 pm

> How could anybody know which businesses are or aren’t malinvestments
> if the money supply is inflated everywhere?

Exactly, so how can deflation get rid of malinvestments. Really, what gets rid of them is competition for capital. Any businesses profit rate must compete against that of other businesses and against the interest rate.

> If people are keeping more reserves than before, then maybe that’s
> because they should have been keeping more reserves in the first
> place.

I agree, in some situations that could be true.

> If the moeny supply is going to increase, for whatever reason, then
> they will need to keep more reserves in the future to compensate for
> the inflation.

No, because if people hold more money then that inflation won’t happen. If everyone increase the amount of money that they hold then prices will fall.

Consider, if every member of a population were given $10 extra at the same time. And, if every member of the population decided to raise the average money stock they normally keep by $10. In that case no changes in prices would occur. However, if they decided to spend that $10 then there would be a rise in prices.

Bob Roddis May 4, 2010 at 10:23 am

Tom Woods has a youtube video explaining the 1920 depression, the one you never hear about. You never hear about it because it disproves the entire Keynesian hoax. With the government doing nothing, wages were flexible downward and the crisis ended quickly.

Gil May 4, 2010 at 11:23 am

Strange how the 1987 crash didn’t spiral into a depression either . . .

Eric M. Staib May 4, 2010 at 10:28 am

“When benefits are included, they average $28.35 more per hour than their nonunion counterparts.”

And work how many fewer hours per week?

Mushindo May 4, 2010 at 11:52 am

I think Ive said this about Keyness central theme on this forum before, but this fine article is a very apt place to say it again:

To say unemployment is caused by insufficient demand, and prescibing policy stimulation of spending to cure it, is the economic equivalent of a physician diagnosing malnutrition as being caused by insufficient defecation, and prescribing a course of laxatives as a cure.

I know, its a distasteful analogy ( pun not intended), but we’re dealing with a distasteful school of thought!

J. Murray May 4, 2010 at 12:51 pm

To be fair, Keynes is right on one regard, that there is a lack of demand that causes unemployment. What he doesn’t say is it’s a lack of demand for what that person is making for the price he wants to sell it at. Unemployment is easily solved by changing jobs or charging less for the product (which includes wages). There are little kernels of truth from Keynes, if you look close enough. He does recognize that “sticky” wages are what creates unemployments, but fails to prescribe the right remedy, which is removing of laws that block the required fall in those wages.

vimothy May 7, 2010 at 1:10 pm

He does not say that. He does agree that IF the fall in money wages leaves AD unchanged then unemployment will be unaffected, but that is quite different, since one of the determinants of demand is income.

Current May 7, 2010 at 1:26 pm

Yes, there are two reasons given in Keynes for recessions continuing. One is sticky prices. The other is the one vimothy gives, which I find quite difficult to understand.

greg May 4, 2010 at 1:03 pm

I have been in residential construction for 23 years, built homes on both coast and I have never seen a union construction worker on any job site, you find them in commercial construction. I agree that sub contractor wages jumped too high, but that was carried solely on demand for experienced labor. They would have gone higher if it wasn’t for the Mexican workers that filled the gap.

Unemployment in the construction business is not what it seems. The problem is that laid off workers are collecting unemployment benefits and performing cash jobs on the side. Many time making more take home money than they did when they were working. Then give these people extensions in employment benefits and they will continue to stay on the sidelines. Unemployment will remain high until the government stops paying them to be unemployed.

We have reached a bottom and you are seeing demand growing as people are increasing their spending. Even the unemployed people with the cash jobs are spending as they feel the low water mark is here. It has nothing to do with government spending, it is just the business cycle.

Scott D May 4, 2010 at 4:15 pm

“Pumping money into the economy for fear of a shortage of aggregate demand would only distort a structure of prices that is already adapting to new spending patterns. Sadly, this is exactly what Obama’s leading economic adviser is prescribing as a cure for abnormal unemployment levels.”They are only thinking in the long run, a rise in the money supply would increase the level of output and the price level of money. Also, the monetary stimulation will raise the velocity of money. Multiplying the (greater) level in the economy of money by the (greater) velocity will equal the (greater) aggregate demand.Once again, this only works in the long-run model. Output (of employment) is fixed in the long run! The economy needs to be jump started in the short run. We need to have a larger impact on output (of employment), not the price of money.”Unemployment will remain high untill the government stops paying them to be unemployed.”This is a much better reason than aggregate demand. Having the government adjust the free market is not how a capitalist society is supposed to work.

adi May 4, 2010 at 1:45 pm

Hoarding means that people start to acquire balances of more liquid assets and try to sell majority of their more illiquid assets. This puts downward pressure on the prices of these financial assets since only speculators waiting for possible capital gains in the future will buy them. Or people hold them if they could not sell them quickly enough or that their own balance for liquid assets is sufficiently high.

In national accounts changes in the values of assets is not recognized as an income or loss. But it might in real life affect their actions (like consumption). Otherwise Americans would not have used their artificially risen values of housing stock as a collateral for loans used to finance consumption.

Keynesian economics could be described as giving “green cheese” to hoarders in the form of government bonds since savers both want to have ultimate security and return for financial investment. As hoarders cannot have both or “moon from the sky”, they are given substitute..

Then it might be perfectly reasonable for keynesian economist to govt to use money to put now non-running factories back to life and that these should employ all available man. All aggregate gross nominal flows seem to increse from these kind of actions for some time!

But it is never asked why this happened in the first place. Why factories are not running and savers are scared. Only some stories about animal spirits or instability of investment function. Or inability for interest rate to equilibrate all different plans of savers and investors for capital projects.

Mr. Economy May 4, 2010 at 1:52 pm

Less than 10% of US labor force is unionized. Of course some industries with high union membership may affect wage flexibility but there is actually a major different reason why wages are inflexible which has to do with indebtedness and rent contracts. If an individual has a lease they locked into and has a large amount of debt, excepting wages lower then previously earned may not allow for the payment of their rent and debt service. It’s easy for people to say that it’s an individuals fault for overleveraging themself but however alot of people use credit just to buy basic necessities to live which constantly increases due to inflation. So yes if wages are flexible then for example a company that originally employed 100 people could keep everyone employed at a lower wage instead of keeping half the people employed at the current wage. Remember if prices for a product like in the capital goods industry declined like 40% then wages would have to decline sometimes more than 40% or possibly less than 40% if lower prices increased demand and led to higher revenues. The problem I believe today is the indebtness and price for rents that prevents wage flexibility because I constantly hear people say I would take a job for lower pay but I can’t pay my bills with this wage.

Matt R. May 4, 2010 at 3:25 pm

“Less than 10% of US labor force is unionized.”

But a larger and larger percentage of state workers are. One need only to look at the fiscal disasters in California and New Jersey to see what this doing.

Current May 7, 2010 at 1:28 pm

Yes. Ultimate price flexibility is impossible, it’s always a matter of degrees. As Joe Salarno has pointed out there are even sticky prices in an auction. And, in any economy contracts are inevitable, and will cause rigidities.

Predrag May 4, 2010 at 8:40 pm

Keynes bases his whole theory on one assumption – involuntary unemployment is a possible long-run market outcome. However, this assumption does not make sense for more than one reason.

Alex May 5, 2010 at 10:05 am

Consider a one-person economy. Total production (and hence real income) and employment (number of hours worked) depends solely on total demand, which will always precede total supply. If the person wants (demands) 4 baskets of goods this period, that’s what he will produce.

In a two-person economy, each person produces for themselves and also trades with the other person (i.e. there is some specialization). Person A decides for a whole host of possible reasons that he does not want as much of Person B’s output as he did before (B is good at hair cutting, let’s say). B may offer his haircutting services at a lower and lower price to A (in terms of A’s goods in exchange), but A’s taste for haircutting has changed, and even if B offered the service for free, A wouldn’t want it. As a result, total output (total real income) of A and B will decline, as will employment (number of hours worked).

In a multi-person economy, neglecting international transactions, there is the production (supply) of goods and services. It is impossible to supply services until after they are demanded. With regard to goods, if the demand falls short of supply, there will be an unplanned (unwanted) inventory build-up that will tend to reduce supply (real income and employment) the following period.

In his numerical example, the author of this article assumes away the fact that total demand for goods and services affects the production of goods and services by stating:

“While aggregate supply is unaffected (100 goods,)…”

Of course, as the author states, in the face of a reduction in total demand for goods and services causing reduced supply, downward price flexibility may re-equilibrate demand and supply, but this argument does not imply that changes in total demand for currently produced goods and services has no effect on future output.

Current May 5, 2010 at 12:03 pm

Alex,

Notice that in your two person economy both supply and demand fallen. B has misapprehended A’s wants, so B’s services don’t have value to A. To look at it mearly from the point that “A’s demand has fallen” is one sided. Looking at it from one point of view it’s an entrepreneurial error by B, looking at it from the other point of view, it’s a change in preferences by A.

The A’s demand is B’s supply and B’s supply is A’s demand. It makes no sense to say that only demand has fallen.

> In a multi-person economy, neglecting international transactions, there is the
> production (supply) of goods and services. It is impossible to supply services until
> after they are demanded. With regard to goods, if the demand falls short of supply,
> there will be an unplanned (unwanted) inventory build-up that will tend to reduce
> supply (real income and employment) the following period.

If we bring in money then we have a real reason to say that Say’s law isn’t true in the short run – liquidity preference.

Without money though the idea above depends upon the definition of “valid demand” and “valid supply”. Everyone involved in an economy both supplies and demands. The traditional Austrian approach has been to accept Say’s definition of demand which includes only what the buyers want. The Keynesian practice is to consider any good that has been supplied in the past as a valid demand. Any change in the behaviour of buyers is therefore considered a change in preferences that brings about a fall in aggregate demand.

Alex May 5, 2010 at 5:23 pm

Current: You said,

“Notice that in your two person economy both supply and demand fallen. B has misapprehended A’s wants, so B’s services don’t have value to A. To look at it mearly from the point that “A’s demand has fallen” is one sided. Looking at it from one point of view it’s an entrepreneurial error by B, looking at it from the other point of view, it’s a change in preferences by A.

The A’s demand is B’s supply and B’s supply is A’s demand. It makes no sense to say that only demand has fallen.”

The point is that A’s fall in demand caused B’s fall in supply. B’s supply does not cause A’s demand. For all services, demand causes immediate supply. For goods, expected demand causes supply, and if demand expectations prove to be wrong then actual demand affects future supply.

Current May 5, 2010 at 5:53 pm

I agree with you to some extent.

This is the difference between the Keynesian perspect and the Austrian perspective. In the Austrian perspective it is up to the entrepreneur (or worker) to supply goods that will fetch a price. If not then it doesn’t count as demand.

Steve Horwitz once phrased Say’s law by saying “production is the source of demand”. The problem here is that it’s well directed production that is the source of demand, because that’s all that others will consider supply. (And of-course this sort of thinking only counts for commodities, not services).

I think that we have to find a sort of common ground on this issue. The Austrian perspective ignores the role that changes in preferences have. On the other hand the normal exposition ignore the fact that entrepreneurs can usually predict some changes in demand and plan for them.

I think Hayek’s discussions of “Coordination problems” were an attempt to look at the same issue in a different light.

Current May 6, 2010 at 12:49 pm

Incidentally,

From which book did you get the two person economy example that you layout above?

adi May 6, 2010 at 1:00 pm

Alex,

even classical economists knew about arguments trying to prove that insufficient demand is cause of recessions.

In Principles of Political Economy J.S Mill stated that demand for commodities is not demand for labour. It just means that with unchanged capital stock it is not possible to supply the increased needs of consumers. Production must be directed from consumer goods to capital goods if capital stock is to be increased. And wages paid by employer to labourers are advances from capital stock already produced.

Demand just determines what are to produced. Changes in the demand must change also composition of capital stock over time so that new goods can be produced.

Mill believed that this change in the structure of production and increased specialization are partly causes of swings in the production. At one point of time there can be underemployment of some resources when structure of economy is changing. But it is impossible to have a “general glut”.

Interestingly Mill believed that services are different from goods in that respect that using services is like employing material and labourers (when increasing capital stock by own account production). As if customer would be employer himself. So that demand for services is demand for labour..

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