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No, Growth is Not a Result of Demand

October 4, 2017 3:11 pm A+ / A-

Counterintuitive  Economics

The  Keynesian fallacy fails to take into account basic economic logic.

Yesterday evening I was invited by facundo Ramirez to the “Universidad Nacional de Moreno”. Thanks to the  “Nueva Opción Estudiantil” group, I was able to  participate in a lively debate about the economy, economic politics and, at last, discuss different points of view about how to overcome poverty in Argentina.

A year ago I was in another debate that, as  I remember, extended for almost three hours. The level of passion and excitement in students and lecturers never decreased.

I remember something from that date that drew my attention. One of the lecturers, no less than the dean of the Department of Economy and Administration, maintained that “everybody knows that growth is driven by demand” and the only restrictions to this fabulous economic advance device were of political nature.

The idea was that if the government pursued an expansive fiscal and monetary policy, consumption would rise continually and there would be no limits to economic growth. However, politicians are subdued, neoliberals or just enemies of the people so they care in excess about  fiscal balance.

I’ve recently  encounter this analysis once again in a digital media outlet called “Visión Desarrollista”. An analyst who was being interviewed stated that:

“I would say I believe in a Keynesian-structuralized vision of growth. I believe in two main premises. The first of which states that growth is a result of demand, and the investment tends to react in front of the demand”.

Certain ideas, evidently, resist perishing. In fact, since at least the 30s this ideas are considered the Holy Grail of the economic thought.

In what is left of this article I will try to show why we have lived wrongly.

A Problem of Logic

The first problem faced by the  idea of the demand as a motor of growth is of pure logic. We say there is economic growth when there is a greater amount of goods available for consuming. Speaking in technical jargon, the economy grows when the Frontier of Production Possibilities moves to the right. When this happens, production grows and, thus, so do the possibilities for consumption.

Anyone can test the fact that to consume more you need, first, to generate a bigger income by looking into his personal economy or that of his family. In other words, to be able to increase my demand of goods and services I need to increase my income first.

If a worker wants to increase his demand of fan heaters he would have to start by earning a raise. How could he achieve that? Certainly by increasing how much he produces.

Before demanding you need to produce. If I do not produce anything worthy in the market, then I wouldn’t  have an income and my demand would be equal to 0 (zero). Production, then, comes before demand and this is not the cause but the result of the economic growth.

The Government is Not Warren Buffett

Besides this basic logical problem one should still consider the following:

1) The government cannot increase aggregate expenditure, taking into account that what it spends in one sector has to be taken from another previously.

2) However, if the government takes money from an unproductive sector to assign it to a productive area, that public investment will create benefits, essentially paying for itself.

3) By improving economic efficiency, public spending may increase economic growth, resulting in greater gross production values.

However, this postulation is too unreal. It is the equivalent of supposing that the Ministry of Economy is Warren Buffett and has an extraordinary ability to assign resources in the most effective possible way.

But things are not like that. In first place, the government has a problem with incentives.
Its spending decisions are mainly affected by elections and the influence of different power groups. That way, the government spends according to social and political criteria, both of them distant from economic efficiency.

Another problem is information. And at this point, not even Warren Buffett could make it work. There is no way the central offices of government know the numerous and varying necessities of such a  huge number of individuals. Only businessmen in a free market are capable of identify and satisfying, in a process of trial and error, the needs of the people.

Facing the problems of incentives and information daily, in reality public spending is the opposite to the idealized image many have. In the end, it always ends up taking from productive sectors to give it to unproductive areas.

The result, in this context,  growth does not increase but slows down.

Aggregate Supply is the Key

To conclude, it is worth pointing out one of the basic lessons in macro economics: prices and production are determined by the intersection of demand and the aggregate supply.

That is to say, just like in a specific market, prices and quantities are established by supply and demand, in the macro sector occurs something similar. Here, the pattern of the aggregate supply curve becomes the key. The fact is that government can increase the aggregate demand whatever it wants, but if supply is vertical (and there is an agreement that in long-term this is the case) then eventually growth will remain the same. 

 

In the long-term, the curve for aggregate supply is vertical because supply does not correspond to price level. In that context, expansionary fiscal and monetary policies do not increase growth but (as can be seen in the graphic) cause an increase in inflation.

A specific example of this was, undoubtedly, the 2011-2015 period, in which the fiscal deficit and the amount of money issued were multiplied. The economy, far from growing, stagnated in aggregated terms.

Growth is not a result of demand. Production must increase in order for individuals and businesses to have money. Only after will demand increase.

Believing that government, just by issuing decrees and laws, can increase growth is comparable to giving it a magical power which, in practice, can only offer short-terms summers that soon end in crisis.

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