Does demand create supply?

By Dr Frank Shostak

According to John Maynard Keynes,

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. 

Whenever there are signs that the economy is likely to fall into an economic slump most experts advise that it is the duty of the central bank and the government to embark on loose monetary and fiscal policies to counter the possible economic recession. In this sense, most experts are following the ideas of John Maynard Keynes.

On this way of thinking, economic activity is presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the earnings of some other individual.

Recessions, according to Keynes, are because consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings. By this way of thinking, if individuals have become less confident about the future, they are likely to lower their outlays and hoard more money. Once an individual spends less, this is going to worsen the situation of some other individual, who in turn is likely to curtail his spending.

A vicious circle then sets in – the decline in individuals’ confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing individuals to hoard more, etc.

Following this way of thinking, in order to prevent a recession from getting out of hand, the central bank must lift the growth rate of money supply and aggressively lower interest rates. It is held that once individuals have more money in their pockets, their confidence increases, and they are likely to start spending again, thereby re-establishing the circular flow of money.

According to popular thinking, one could not have complete trust in a market economy, which is inherently unstable. If left free the market economy could lead to self-destruction. Hence, there is the need for governments and central banks to manage the economy.  

Successful management on this way of thinking is done by influencing the overall spending in the economy. It is spending that generates income. Spending by one individual becomes income for another individual. Hence the more that is spent the better it is going to be. What drives the economy then is spending. 

Productive versus non-productive consumption

In popular thinking the largest part of spending are consumer outlays. Hence, consumer outlays are regarded as the motor of the economy – consumption sets in motion economic growth. 

We suggest that one must make a distinction between productive and non-productive consumption. Whilst productive consumption is an agent of economic growth, non-productive consumption leads to economic impoverishment. 

For instance, a baker exchanges his ten saved loaves of bread for ten potatoes. The potatoes are now sustaining the baker whilst he is engaged in the baking of bread. Likewise, the bread sustains the potato farmer whilst he is engaged in the production of potatoes. What we have here that the respective production of the baker and of the potato farmer enables them to secure goods for consumption. 

What makes the consumption productive here is the fact that both the baker and the potato farmer consume in order to be able to produce consumer goods. The consumption of both the baker and the potato farmer maintains their lives and well-being. 

The introduction of money does not change what was said so far. Thus, the baker can exchange his ten loaves of bread for ten dollars – he then uses the money to secure ten potatoes. Likewise, the potato farmer can now exchange his ten dollars for the ten loaves of bread.

Observe that whilst fulfilling the role of the medium of exchange money has contributed absolutely nothing to the production of bread and potatoes.  

To obtain potatoes the baker had to exchange bread for money and then employed money to secure potatoes. Something was exchanged for money, which in turn was exchanged for something else or something for something is exchanged with the help of money. 

Trouble erupts when money is created out of “thin air”. Such money gives rise to consumption which is not backed by production. It leads to an exchange of “nothing” for “something”.

For instance, a counterfeiter prints twenty dollars. Since he secured this money not through the production of some useful goods, the counterfeiter has therefore obtained the twenty dollars by exchanging nothing for it. 

The counterfeiter uses the newly generated money to buy ten loaves of bread. What we have here is the diversion of real wealth – the ten loaves of bread instead of going to a potato farmer is now going towards the counterfeiter. 

Note that the diversion takes place by the counterfeiter paying a higher price for bread – he pays two dollars per loaf. (Previously the price stood at one dollar per loaf). Also, note that since the counterfeiter does not produce anything useful he is engaged in non-productive consumption.

The potato farmer is denied the bread that he must have to sustain him whilst he is producing potatoes. Obviously, this will impair the production of potatoes. As a result, less potatoes will become available, which in turn will undermine the consumption of the baker. This in turn is going to weaken his ability to produce.

We can thus see that while productive consumption sustains wealth generators and promotes the expansion of wealth – non-productive consumption leads to economic impoverishment. 

Printing money by the central bank produces exactly the same damaging effect as the counterfeiter money does. Likewise, the creation of money through fractional reserve banking produces the same damaging effect. The expansion of money sets the platform for non-productive consumption – an agent of economic destruction. 

Is an increase in demand key for economic growth?

We suggest that an individuals’ demand is constrained by his ability to produce goods. The more goods that an individual can produce the more goods he can demand i.e. acquire. 

If a population of five individuals produces ten potatoes and five tomatoes – this is all that they can demand and consume. No government and central bank tricks can make it possible to increase their effective demand. The only way to raise the ability to consume more is to raise the ability to produce more.

The dependence of demand on the production of goods cannot be removed by means of monetary pumping and government spending. 

On the contrary, loose fiscal and monetary policies are likely to impoverish wealth generators and weaken their ability to produce goods and services – it will weaken the effective demand. In this sense, producers and not consumers are the engine of economic growth.

Therefore, what is then required to revive the economy is not boosting aggregate demand but sealing off all the loopholes for the creation of money out of “thin air” and curbing government spending. This will enable wealth generators to revive the economy by allowing them to move ahead with the business of wealth generation.  

Once the economy falls into an economic slump because of a decline in the pool of real savings, any government or central bank attempts to revive the economy is going to fail. Not only will these attempts fail to revive the economy, they will deplete the pool of real savings further, thereby prolonging the economic slump.  


On this Mises wrote, 

An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund, which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.

Conclusions 

By popular thinking, increases in government spending and central bank monetary pumping strengthens the economy’s overall demand. This in turn it is held sets in motion increases in the production of goods and services i.e. increases in the overall supply. What we have here is that “demand creates supply”. Note that to be able to exchange something for goods and services individuals must have this ‘something’. 

This means that in order to demand goods and services, individuals must produce something useful first. Hence, supply drives demand and not the other way around. Experts who advocate for strong government stimulus measures during an economic slump never bother to ask how those measures are going to be supported.

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