Contra Richard Koo and the Keynesians: it is not about ‘aggregate demand’ but about real prices

I do not want to waste your time and my energy with shooting down misguided Keynesian schemes all the time, schemes that have been refuted long ago and should by now be instantly laughed out of town whenever put forward. But arch-Keynesian Richard Koo’s latest attempt in the commentary section of the Financial Times to justify out-of-control deficit spending in the United States as a smartly designed and necessary policy that will keep ‘aggregate demand’ up and lead to recovery, is making the rounds on the internet. Koo’s article is a mechanical and naïve exposition of the 101 of Keynesian stimulus doctrine, clearly aimed at those who still perceive the economy as a simple equation with Y, C, I and lots of G in it. If private demand falls out from under the bottom of the economy, it can be replaced with the government’s demand. Simple.

And wrong, of course.

But the piece is not without some educational value. I promise this will be shorter than my attack on the new money mysticism at the IMF.

Fiscal suicide as recovery strategy

I am not sure if even in Washington there is anybody left who still seriously claims that $1 trillion-plus deficits year-in and year-out are anything but a sure-fire sign of a public sector out of control – a public sector that despite generous and growing staffing levels is simply running out of fingers to put into the many holes from which the money is leaking. Yet Richard Koo wants us to believe there is a method to the recklessness, that this is a finely calibrated strategy to save the economy.

Koo’s story goes like this: The private sector has overdosed on credit in the preceding boom and is now in the process of balance sheet repair. Households and corporations are not borrowing, investing and spending but instead saving and paying down debt. This is sensible and unavoidable, and not even artificially low rates of zero percent can persuade them to change their ways and rather borrow and spend. This is where the government has to step in. It has to borrow the funds that corporations and households save and pay back to their original creditors, and spend these funds for the greater good so that ‘aggregate demand’ is kept from collapsing and the economy from tanking.

Here is Koo:

[However,] if someone is saving money or paying down debt, someone else must be borrowing and spending that money to keep the economy going. In a normal world, it is the role of interest rates to ensure all saved funds are borrowed and spent, with interest rates rising when there are too many borrowers and falling when there are too few. But when the private sector as a whole is saving money or paying down debt at zero interest rates, the banks cannot lend the repaid debt or newly deposited savings because interest rates cannot go any lower. This means that, if left unattended, the economy will continuously lose aggregate demand equivalent to the unborrowed savings.

This is evidently wrong. This view neglects the function of market prices (other than interest rates) and the role of money – two aspects that Keynesians have a habit of ignoring. Let us go through this step by step.

Restating Koo’s scenario to include money-flows and money-balances

If some (or even a considerable number of) corporations and households use their present money balances or present money-income to repay debt, this simply means that rather than holding large money balances themselves or spending their current money-income on investment goods or consumption goods, this money now flows to the creditors of these households and corporations, and these creditors now either hold themselves larger money balances, or they re-invest in investment goods (productive assets, equities or bonds), or buy consumption goods. Only three options are logically available to anybody who receives a money-income: keep it in money, spend it on investment goods or consume it (spend it on consumption goods).

The problem that Koo describes – a drop in ‘aggregate demand’ – can only materialize if the money-income that households and corporations received and previously ‘spent’ again on investment goods or consumption goods (and which thus kept circulating through the economy and maintained ‘aggregate demand‘), is now no longer spent on investment goods or on consumption goods because the creditors who now hold this extra money simply keep it in the form of higher cash balances. If the creditors spent the money that is being repaid to them again on investment or consumption goods, there would be no drop in ‘aggregate demand’ – and to the extent that the creditors lent the funds again to other private-sector borrowers there would, of course, be no net-deleveraging of the private sector in aggregate. Only if the creditors decide to keep accumulating money balances rather than channelling the money income again into consumption and investment will ‘aggregate demand’ drop.

Of course, Koo will maintain that this is very likely indeed. Interest rates are zero, so the incentive to lend the money again is low. Additionally, nobody wants to borrow. So the creditors – and this must include banks, pension funds, insurance companies, in short anybody who has previously extended credit to households and corporations and now gets repaid – will likely keep hoarding money. And Koo would maintain that interest rates cannot fall any further – they are already at zero – so the extra money will not lead to lower rates and thus encourage extra borrowing.

We can now rephrase Koo’s problem. What happens ‘in aggregate’ is simply this: economic actors reduce their money-outlays on non-money goods (investment and consumption goods) and instead accumulate money balances. But this must mean that, all else being equal, money-prices for non-money goods decline. The prices of consumption and investment goods fall and the purchasing power of money rises. This is deflation and is dreaded like the plague by the Keynesians, but wrongly so, as it is very clear that falling prices are exactly what will ultimately stop the ‘hoarding of money’ and encourage spending again – spending on consumption goods and investment goods.

There is no way around the fact that a money-hoarding public considers the money-prices of non-money goods too high, which is precisely why the public keeps its wealth in money, and that it is falling prices that would rectify the situation easily. As the opportunity costs for holding wealth in the form of money rise with falling prices, the incentive to spend the money grows.

Koo ignores falling prices as an essential corrective

Koo only considers interest rates as a mechanism for keeping the economy in balance. He does not consider the role of other market prices. Interest rates are indeed important market prices (so important, in fact, that the central bank should not distort them, and distorting interest rates systematically – almost always to the downside – is indeed every central bank’s mission). Interest rates are relative prices. To be precise, they are the price differential between goods of the same kind at various points in time. But there are other important relative prices to consider, including those between different goods at the same time.

If I consider the current price of a good – whether consumption or investment good – to be too high (to be unsustainably high) I will not spent my current money balances on this good, and, importantly, I may not borrow money – not even at zero percent – to buy it. The cost of borrowing is an important factor in my decision but it is just one factor. I could borrow the money for free and acquire the good but I would still encounter the risk of a price drop in whatever I buy with the borrowed money, and it is evidently that risk that is keeping people in cash at present. If I expect the price to drop in the future it would be better to not buy now, even if funding costs are near zero. (As an aside funding costs are hardly zero for most of us at present, as Koo implies, but this is not important for the argument.)

As we have seen, Koo’s scenario of a drop in ‘aggregate demand’ is only feasible if the desire to hold wealth in the form of money rather than consumption goods and investment goods is high. People rather accumulate cash than spend it on investment goods or consumption goods. At present prices, they prefer money to goods and services.

But hoarding money is a self-correcting process if (and that is a very big ‘if’ in our complete fiat money system) you allow prices to fall. At falling prices the opportunity cost of staying in cash –which gives you great flexibility but does not fulfil any consumption needs and gives you very meagre returns (just the rate of deflation) – rises constantly. (To assume that nobody will spend money in a deflationary environment is nonsense. It ignores ‘time preference’, which is essential to human action and which also explains why interest is a universal concept. To want something means, all else being equal, wanting it sooner rather than later. Current example: Prices of computers and smartphones are falling constantly yet people spend heavily on these items.)

Consider this example of an imaginary entrepreneur

An entrepreneur considers buying investment good X, which would help him realize a certain investment project. The current market price for X is P, and at this price the investment good promises to provide an internal rate of return of p. In Koo’s scenario there are plenty of savings around. So many in fact, that interest rates are zero. The entrepreneur could borrow for free, acquire X and obtain return p. Why does he not do it? Is his decision exclusively driven by the level of interest rates? Obviously not. He may not buy X because he considers P too high and consequently the return p too low. The investment good is too expensive. The low return of p does not compensate for all the risks still inherent in the overall investment project that X would help the entrepreneur realize. If the price P were lower and consequently the rate of return p higher, then the entrepreneur would invest.

On the surface it may look attractive to buy an equity portfolio on credit if the loan rate is 1 percent and the dividend yield 3 percent. But you would still not do it if you fear that the equity market is about to drop by 20 percent.

There is no escaping the fact that if people prefer holding money to buying non-money goods they consider the prices of non-money goods too expensive at current prices relative to the monetary asset. In short, money-prices are too high. This is hardly surprising after the extended monetary expansion that has caused the over-indebtedness of corporations and households in the first place. After an inflationary boom prices are too high and balance sheets overstretched. Importantly, the inflationary boom will not have lifted all prices to the same extent. Relative prices are also distorted.

At the point of crisis, nobody borrows, everybody tries to repay debt (or defaults). The creditors accumulate extra cash balances, partly out of out of concern for the future and partly for lack of investment opportunities. The inflationary boom turns into a deflationary correction. Falling prices are now an essential ingredient for stabilizing the economy. (Again, just as the inflation has not lifted all prices by the same extent, the deflation will not depress all prices by the same extent. Relative prices will now re-adjust.) At lower prices, the desire to hoard money will subside and demand for investment and consumption goods will resurface. Those who did not participate in the boom but kept their savings and their credit standing intact and thus their ability to borrow and spend, are now faced with low interest rates and falling prices. The incentives to put money and credit to work are substantial. This group will play a crucial role in the recovery. Absolutely no state intervention is needed.

What I just described is simply the market at work. Why does this not happen today? Because we live in fiat money system, in a system of fully elastic money, in which central banks keep printing money to stop its purchasing power from ever rising and prices from ever declining. Bizarrely, the central bankers seem to believe they are doing all of us a great favour. “Look,” they seem to say, “five years into the crisis and prices are not falling! Hooray, no deflation!” – Yes, and that is precisely the problem.

A personal example

We have lived in London for 16 years and for quite some time I felt that we could do with a larger apartment or house, given the size of our family. For years we have been potential buyers of real estate in London. During the tail end of the recent cheap-money-fuelled housing boom, we remained on the sidelines. After the bubble burst you might think that this was now a good opportunity to get into the market. But thanks to zero-interest rates from the Bank of England, various bank bailouts, quantitative easing, and other ‘stimulus’ measures, prices have not been falling in many parts of London, or not by much. Fact is, these policies have kept house prices in many parts of the country at artificially high levels in my view. In any case, these policies have certainly not ‘stimulated’ me into putting my own money to work. Lower prices might have done so – as might have any perception that the bubble had clearly dissolved, that the market had been allowed to liquidate what was unsustainable, and that present prices were now ‘real’ uninhibited market prices. Of course, none of this is the case due to highly interventionist policies. In the meantime, all the advocates of aggressive monetary stimulus are high-fiving themselves for having (so far at least) avoided deflation, having protected the housing market (which means protecting those who borrowed recklessly in the boom), and saved the banks.

Current monetary policy is prohibiting the liquidation of imbalances, the correction of prices, the reallocation of resources, the rebalancing of the economy, and the reinvestment of repaid debt. Monetary policy is not aiding the recovery, it is obstructing the recovery. What monetary policy evidently tries to achieve is to create an illusion of recovery and stability. But nobody in their right mind trusts these prices.

That such a deflationary correction as a free market would instigate would go on forever, that “the economy will continuously lose aggregate demand equivalent to the unborrowed savings”, as Koo claims, is simply nonsense. In an uninhibited market this is impossible.

Stimulating demand – with higher prices!

But our monetary masters have even crazier ideas. Not only is any drop in prices and any rise in money’s purchasing power to be prevented at all cost, prices need to keep rising and this – according to the logic of our central bank bureaucrats – will then stimulate the economy. Because all of us are so gullible that we will simply take the phenomenon of even further rises in nominal prices as an indication that things are fine and that we need to spend again.

Here is Ben Bernanke, America’s Printmaster-in-Chief, almost exactly 2 years ago, explaining to the American public why rising prices of financial assets as a result of the Fed’s policy of ‘quantitative easing’ will help them. I quoted this already on numerous occasions. Apologies for doing so again but this is such a wonderful exposition of modern money madness that I keep going back to it. Apologies to Mr. Bernanke for throwing in some of my own comments.


This approach (‘quantitative easing’, DS) eased financial conditions in the past and, so far, looks to be effective again (he said this two years ago, DS). Stock prices rose and long-term interest rates fell (bond prices rose, too. DS) when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance (but not lead to housing investment if house prices are still too high and still obviously distorted. DS). Lower corporate bond rates (higher bond prices) will encourage investment (well, not in bonds, and it won’t cause corporations to invest, as Richard Koo and I explained above. But here comes the real gem:). And higher stock prices will boost consumer wealth (sic!) and help increase confidence, which can also spur spending. (Emphasis mine, DS.) Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion. (Good luck, Ben. DS)

So, my imaginary entrepreneur is supposed to be encouraged to invest in X not by a drop in its price but by further rises in its price! And I am supposed to go home to my wife and say, “The crisis is evidently over. Home prices are going up! Come think of it, those London home prices will never fall. They can only ever go up! Let’s take our savings, take out a mortgage and buy now before the Bank of England makes them even more expensive!”

The state makes a mess of monetary policy – then compounds it with fiscal policy

Back to Richard Koo. The problem he describes will never occur in a free market. In fact, in a free market with hard money at its core, it is incredibly unlikely that the type of imbalances that were the starting point of Koo’s analysis could arise at all. To have large sections of the economy feel dangerously and hopelessly over-indebted requires the type of extended credit boom that can only occur in an elastic monetary system with central banks that can artificially cheapen credit for long stretches of time. The verdict on our monetary system is devastating: Central banks have actively encouraged an extended boom in lending and borrowing that has left prices inflated and distorted, and has left balance sheets overstretched. Now that the boom is over, even easier monetary policy from the very same central banks is hindering the dissolution of the distortions and a return to balance.

But is this mess – created by the state with its mishandling of its money monopoly – now a justification, as Koo claims, for further state action, now in the form of deficit-spending? Certainly not.

The whole concept of ‘aggregate demand’ assumes that for the functioning of the economy it does not matter whether demand originates from the private sector or from the state. It all just adds up to ‘aggregate demand’, to the statistical whole of GDP. But this is way too simplistic and mechanical. The economy is not a bucket filled with aggregate demand, and when some ‘demand’ spills out, we can fill up the bucket again with some other ‘demand’. ‘Demand’ is only ever a homogenous item in the parallel universe of macroeconomic statistics. A market economy is all about specific demand, about the specific use of scarce resources. We are all participating in this market economy and in the extended network of human cooperation that only the market economy allows, because each of us has specific goals and objectives. And if markets are not allowed to operate freely and prices are not allowed to adjust freely, the resulting distortions are a hindrance to our attempt to pursue our specificgoals.

Whenever government spending is high, it means that the market’s allocation of resources and the private use of resources are replaced with bureaucratic allocation of resources and the state’s use of resources. The grave distortions that are already the result of the state’s manipulation of money prices and interest rates are further compounded by an administrative rather than market-driven allocation of scarce means through fiscal policy.

And is it really feasible that the state would simply discontinue whatever it started in the crisis to artificially prop up the GDP statistics once the private sector regained its footing? Would Koo suggest that the state makes redundant the people it hired during the times of deficit spending?

Only solution: a return to markets

Keynesians do not trust the market. Allowing prices to correct, so they claim, would cause never-ending deflationary spirals. This is without any basis in fact. It is rather their policy of fighting market imbalances with more intervention and more imbalances that will move the economy progressively further away from balance and true recovery. Keynesian policies will keep us in a constant loop of distorted markets and growing imbalances. They guarantee us a Groundhog Day of economic depression. Until, of course, patience runs out and the monetary and fiscal overkill – to now stimulate the economy ‘properly’ – is being applied and disaster ensues.

Japan has followed the Keynesian rule-book fairly faithfully without ever shaking off its post-bubble problems. To the contrary, the country’s imbalances get scarier by the day, requiring some brutal catharsis in the not too distant future. Ironically, Richard Koo is an alleged authority on Japan, yet he prescribes the same or similar policies to the US today.

Only a return to free and uninhibited markets, real prices and interest rates, and a return to hard money, can get us out of this mess.

In the meantime, the debasement of paper money continues.

This article was previously published at

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7 replies on “Contra Richard Koo and the Keynesians: it is not about ‘aggregate demand’ but about real prices”
  1. says: Paul Marks

    That the absurd Keynesian Financial Times is considered the main “business” newspaper in this country shows how deep the sickness in the United Kingdom runs.

  2. It is not true to say that if households and corporations are repaying debt that “this money now flows to the creditors of these households and corporations..” In as far as the debt is owed to banks (and that a significant proportion of all debts) repayment of the debt results in the money vanishing.

    Commercial banks, as they say, “lend money into existence”. And when the relevant borrower repays the money, the money vanishes. And anyone who doesn’t know that really needs to work their way thru an introductory economics text book.

    In the paragraph starting “We can now rephrase Koo’s problem”, Schlichter claims that inadequate demand will lead to falling prices. Well if prices fall significantly and wages don’t then firms go bust!!!! So wages have to fall as well. But wages just won’t fall: wages are “sticky downwards as Keynes pointed out”. Try reducing wages in the heavily unionised public sector: you’ll get mass walk outs and strikes.

  3. says: Paul Marks

    Wages are only “sticky downwards” if government intervention (such as pro union regulations) makes them so.

    That is why mass unemployment after the bust of 1921 went and mass unemployment after the bust of 1929 did NOT.

    Far from being a noninterventionist Herbert “The Forgotten Progressive” Hoover did all he could to PREVENT wages adjusting to the crash.

    Hoover (like Franklin Roosevelt after him) was in the grip of the “demand” fallacy.

    Ironically those people who say that World War II ended mass unemployment are correct – but not in the way they think it did.

    What really ended mass unemployment was that real wages (i.e. wages in terms of real “black market” prices, not official prices, were allowed to fall).

    After World War II the Keynesians predicted terrible economic conditions – yet the “Do Nothing Congress” (which vastly cut taxes, balanced the budget, got rid of most government spending and regulations) led to post war prosperity.

  4. says: Paul Marks

    By the way.

    If there are “mass walk outs and strikes in the public sector” this is a good thing.

    As long as the people who “walk out” are held to have resigned.

    No need to pay them any more – no pensions (and no welfare either – as they are voluntarily unemployed).

    The only problem is that governments are in the hands of people who will not face the unions down.

  5. says: Ingolf Eide


    Excellent article.

    Yes, the failure of most commentators to call Koo on his missing endgame is a continuing source of wonder. Not sure how he manages to avoid facing up to this conundrum himself. Still, to his credit at least he recognises something of the depth of the underlying problem.

    Now, a minor quibble. Not about the underlying principles you’ve so clearly laid out but about the degree of time, difficulty and pain likely to follow from pursuing the “right” policies (i.e. for the most part leaving the market to find its own way).

    The accumulated imbalances are extreme enough to require quite a while to work through. Households who borrowed consumption from the future will have to “underconsume” indefinitely until their balance sheets are repaired, as will those who borrowed too heavily for misconceived investments. So too with businesses that geared up to meet all this unsustainable demand; for a while, they’ll be too busy absorbing losses from malinvestments and engaging in costly restructurings to be keen on risk taking.

    Were the market allowed to take its own path, therefore, I think it’d be a long time before money balances stabilised, much less rose. The combination of debt repayment, defaults and restructurings would leave (almost) everyone with less, even in real terms. So yes, prices would fall and some would be prompted to up their consumption and/or investment, but many more would almost certainly stay in the bunker pro tem.

    None of this is intended as an argument against the broad principles you propose. While I’d perhaps be keener on government protecting the more vulnerable from at least some of the fallout, like you I think this path by far the quickest way to eventual recovery and organic growth.

    However, I also think it’s important for free market proponents to be frank about how difficult it’s all likely to be. Those who have been arguing for austerity, for example, but also pretending (or heaven help us, actually believing) that we’ll happily zoom out the other side in no time at all only do damage to their own cause.

  6. says: Paul Marks

    My own chief fear is of the lies.

    People may blame the economic collapse (which is now inevitable) on “cuts” to government spending – even though government spending has not been cut.

    This is because the academic-political-media elite continually talk about “cuts”, so the danger is the majority of people will believe this vast lie.

    The truth – that government spending is NOT being cut, must be got to the people.

  7. says: Antonio

    A decrease in the level of prices is not going to encourage spending. Credit granted at price level A and at interest rate B, cannot be discounted at the reduced price of the replacement of the good (consumed or invested). The credit is already granted and the price of the good cannot be less than this credit granted.

    The opportunity cost of holding cash balances need to be higher than that of spending these balances, through fees and insurance premiums, to cause an increase in demand, production and spending, an economic recovery.

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