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Demand-Side Dogma

January 14, 2003

Media elites have been debating the merits of President Bush's proposed economic stimulus program actively, but not sensibly. That is, the debate itself is seriously misguided. The title of this program reveals the flawed nature of this debate. Since we are supposedly in the thralls of an economic slowdown, we need to stimulate the economy so as to affect its recovery. 

The notion that economies, as a whole, sometimes lack sufficient drive derives from a faulty set of economic doctrines that focus on the demand side of the aggregate economy. According to Demand Side economics, there are times when total spending in the economy will not be enough to provide employment to all who want to and should be working.

David Ricardo and Thomas Malthus argued over this matter, with Ricardo arguing correctly that Demand Side economics was wrong. J.B. Say also proved the irrelevance of Demand Side economics by showing that demand derives from the supply of goods to markets. Ricardo and Say won this debate, and this issue was settled for more than a century.

Aside from a few obscure figures, like J.A. Hobson, few doubted that Ricardo and Say had proven the irrelevance of Demand Side economics. But, Demand Side economics regained respectability when John Maynard Keynes refashioned it in his General Theory of Employment, Interest, and Money. Keynes is responsible for re-popularizing this doctrine.

The current debate over fiscal policy is being argued largely in Demand Side terms. Columnist Molly Ivins attacks the Bush plan in terms that make it sound like bad Keynesian economics. 

However, one cannot question the intent of this policy when examining the statements of the president himself.

"On the one hand, we've got to make sure that we bolster consumer demand by both accelerating the tax cuts that now exist, as well as providing rebates for non-taxpayers, but who filed …And Congress ought to act as quickly as possible to get that money into people's hands as quickly as possible to bolster demand." (Remarks by the President before the National Association of Manufacturers, October, 2001)

President Bush clearly has the Demand Side of the economy in mind with his plan. Of course, there are legitimate reasons for cutting taxes. But, by focusing on the wrong reasons, we fail to see the importance of cutting taxes, not only during recessions, but at any time.

There is no real basis for believing that markets tend towards under-consumption. Human want drives the economy, and there is never an end to that. As Ludwig von Mises argued, man acts to deliver himself from present states of uneasiness to more desirable states of satisfaction. In particular, consumer demand stimulates economic activity. Keynesian deficient demand arguments hinge upon the absurd proposition that some savings 'leak' out of the economic system, so that there is too little investment. 

To Keynes, interest rates reflect only the dictates of Central Bankers, and capital markets have no inherent order to them. This makes it easy for Keynesians to advocate their policies in principle. If capital markets are chaotic, then we should expect collapses in investment periodically, and should welcome government intervention. 

Of course, saving is merely deferred consumption, based on time preference, and investment hinges upon expected returns. Interest rates are the price that regulates credit markets and capital formation. So, interest rates do play a coordinating role in the economy—they coordinate savings and investment, so that savings equal investment. This fact renders the Keynesian variant of Demand Side Economics irrelevant.

There are some, like Paul Krugman, who deride the Austrian alternative to Keynes. However, one need not accept the Austrian perspective to reject Keynes. Chicago economists, like Milton Friedman and Robert Lucas shattered the deficient demand myth decades ago. Now, even most self-described Keynesians reject the spending driven theory of Keynes in favor of ‘New Keynesian’ theories that rely on mal-adjustments in wages and prices.

Both sides of the popular debate are completely out of touch with accepted academic economics. While mainstream pundits argue over which income earners stimulate demand the most, economists argue over which price signals—wages in labor markets or interest rates in credit markets—are to blame for the trade cycle. 

Our problem is a trade cycle, not recurring slumps due to insufficient spending. The key problem that we face is in coordinating the supply of goods with the demand for them through time. Mises and Hayek correctly identified interest rates as being central to this problem. Of course, when government policies force wages up, unemployment ensues. The key point is that demand is irrelevant to unemployment and the trade cycle.

Of course, heavy taxes can slow economic development. So, there are reasons to link taxes to economic performance, but there is a more important point that is being left out of this debate. Taxes are supposed to fund necessary functions of the government. By arguing over how to stimulate the economy, many overlook the fact that government spending consists largely of overt transfers that benefit narrow interests. This issue got more play during the time when campaign finance reform was in the news. By recognizing the irrelevance of Demand Side economics, we can refocus our attention to real issues. 

Coercive transfers are wasteful, inefficient, and inequitable. The Left uses Demand Side Dogma to instill false legitimacy into these policies. The Right plays along with this rhetoric all too often. Since most economists now reject Demand Side economics, we can hope that it will lose its popularity with the general public and the media. It will no doubt be difficult to do away with the simplistic spend and grow thinking that pervades popular thought. The notion that prices coordinate production is subtle and complex, so it is more difficult for people to grasp. 

However, we must correct these popular fallacies in order to properly address the ills that stem from intervention by big government. Tax cuts are not a good idea because we lack sufficient demand at the moment. Tax cuts are a good idea because tax revenue gets spent very badly.


D.W. MacKenzie is a graduate student in economics at George Mason University. Send him MAIL and see his Mises.org Daily Articles Archive


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