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The Fallacy of Demand

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01/03/2001Frank Shostak

As the economic boom continues to fizzle, pundits have theorized that the downturn results from a drop in demand for goods and services. This is said to drive the business sector to unprofitability, which then further depresses stocks and commerce generally. 

The policy recommendation follows logically: government and its central bank must step in to prevent the economy from falling into a slump. The Fed should lower rates to increase demand, then increased production of goods and services will follow suit and consequently, prosperity will be restored.

This consensus view is wrong. It is not a deficiency of demand that is at the root of an economic recession but central bank policies themselves. The major catalyst that sets in motion a boom-bust economic cycle is the monetary pumping and artificial lowering of interest rates by a central bank—which occurs during the boom phase of the cycle. By the time the bust arrives, the damage has already been done. 

A loose monetary stance by the central bank enables the diversion of resources away from wealth generating activities towards wealth consumption, but the effect is difficult to recognize because it is masked by the appearance of rising prosperity. The problem only becomes apparently during the inevitable bust phase of the business cycle. 

The fallacy of the demand led economic recovery

The consumer-demand theory sounds very appealing at first. If consumers are active, this is said to be a good sign for economic health, if consumers do not spend enough then it is seen as a bad. Surveys of business activity show that during a recession, businesses emphasize lack of consumer demand as the major factor behind their poor performances. This framework regards consumer’s psychological disposition as the driving force of an economy. If consumers are optimistic and happy with the economy, no recession can occur--so it is believed.

In the real world, consumer optimism is important, but by itself it will achieve nothing. Production must precede consumption. It is necessary to produce useful goods that can be exchanged for other goods. Thus when a baker produces bread, he doesn’t produce everything for his own consumption. Most of the bread he produces is exchanged for the goods and services of other producers, implying that through the production of bread the baker exercises his demand for other goods. 

To put it differently, his demand is fully covered i.e. funded by the bread that he has produced. Demand therefore, cannot stand by itself and be independent, it is limited by prior production, which serves as means of securing various goods and services. What thwarts individuals' demand for goods and services, is the availability of means to appropriate all the goods and services individuals want. 

These means do not spring "out of thin air"; they have to be produced. The production of goods and services is constrained by the real pool of funding: the resource available to provide sustenance to the economic process. The pool of funding is the quantity of goods available in an economy to support future production. If it requires one year of work for a man to build a tool, but he has only enough apples saved to sustain him for one month, then the tool will not be built-and the man will not be able to increase his productivity.1

In a market economy, money has just one role – to provide the services of a medium of exchange. Money permits the product of one specialist to be exchanged for the product of another specialist. The exchange of something for something also means that consumption doesn’t precede production, i.e. we first have to produce a useful product before it can be exchanged for money and only then we could exchange money for goods we desire. Consumption is fully funded by preceding production. 

Many economists believe that money injections and interest rate manipulations are the keys to navigating the economy along the growth path of stability and prosperity. But in a free and unhampered market, interest rates are the outcome of the supply and demand of savings. Interest rates therefore mirror consumers’ time preferences i.e. their wishes with respect to how much they want to consume at present and how much in the future. In this capacity, they guide businesses in the most profitable allocation of funding. By paying attention to interest rates, businesses are in fact abiding by consumers’ instructions. 

However, once money is pumped it leads to an artificial lowering of interest rates in financial markets. Consequently interest rates cease to reflect consumers’ preferences. This in turn means that businessmen who incorporate in their decision making process interest rates in financial markets, are committing errors - in other words, making investment decisions that go against consumers’ most urgent demands.2  To put the point differently, businessmen are diverting funding from wealth generating activities to non-wealth generating activities.

So long as monetary pumping and the consequent artificial lowering of interest rates remains in force, there is no way for businessmen to know that they are committing these errors. On the contrary, as the loose monetary policy intensifies, it generates apparent profits and a sense of prosperity. The longer the period of loose monetary policy, the more widespread will be the errors, i.e, the disobedience of entrepreneurs regarding the will of consumers.

All this leads to a situation where entrepreneurs are committing themselves to unprofitable businesses, which ultimately must be liquidated. It is this liquidation that is called an economic bust or recession. The trigger to this liquidation is the reversal of a loose stance by the central bank.

The severity of a recession is dictated by the intensity of the previous boom brought about by monetary pumping and the associated artificial lowering of interest rates i.e. by the percentage of "false activities" from total activities. The larger this percentage the more severe the recession will be, since more liquidations will take place. According to Mises, 

It is essential to realize that what makes the economic crisis emerge is the democratic process of the market. The consumers disapprove of the employment of the factors of production as effected by entrepreneurs.3

Recession versus Depression

As a rule, symptoms of a recession emerge once the central bank tightens its monetary stance. Even so, an economic depression is not caused by the collapse of the money stock. The downturn is set in motion by the previous monetary pumping. Moreover, a fall in resource availability triggers declines in bank lending and thus in the money stock. 

Declines in stock prices and prices of goods and services typically follow declines in money supply. Most economists erroneously regard this as "bad news" that must be countered by central bank policies. However, any attempt to counter price declines by means of loose monetary policies will only further undermine the production structure. Furthermore, even if loose monetary policies were to succeed in lifting prices and inflationary expectations (as suggested by professor Paul Krugman), this can’t revive the economy. 

Furthermore, it is a mistake to assess the likelihood of a recession or a depression by looking at the rate of growth of the consumer price index. If this index appears to be steady then it is interpreted as a sign of an economic health. On this Murray Rothbard wrote,

The fact that general prices were more or less stable during the 1920’s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.4

Prices are determined by real and monetary factors. Consequently it can occur that if the real factors are pulling things in an opposite direction to monetary factors, there may be no visible change in prices. While money growth is buoyant, prices may not increase. The crux therefore, is not rises in the CPI, or relative increases in money supply versus rises in goods, but the fact that money supply is rising. It is this increase in money that matters, for it is this increase that sets in motion an exchange of nothing for something.

Likewise drawing conclusions from strength of the GDP statistic might also produce erroneous results. For GDP mirrors consumption and not production of wealth. Hence it is not possible to tell through the inspection of the GDP statistic whether its increase is fully funded.

Lastly, it is erroneous to regard falls in stock prices as causing recessions. The popular theory argues that a fall in stock prices lowers individuals’ wealth and this in turn weakens consumers' outlays. Consumers spending is 66 percent of GDP, so surely a fall in the stock market plunges the economy into a recession. But the prices of stocks mirror individuals’ assessments regarding the value of various companies. A loose monetary policy tends to make this assessment erroneous. 

Were We Are Today

The US economy is severely out of balance. The reason for this is the prolonged loose monetary policies of the US central bank. The money stock M2 has climbed from $3568 billion in January 1995 to $4823 in the third quarter of 2000 i.e. an increase of 35%. The growth in money stock M3 topped 10% for 1998 and 1999. 

The federal funds rate, which stood at 17.6% in April 1980, fell by 1992 to 3% and has remained in the 3% to 6% range for the better part of the 1990--until 1999. Since June 1999 the US central bank has reversed its loose interest rate stance, lifting the federal funds rate by 1.75%. In response to this tightening, the rate of growth of various key economic indicators has begun to decelerate, prompting the beginnings of a liquidation that began with stocks.

The jury is still out, however, as to whether the economy is heading towards a recession, or worse, a depression.  A sharp fall in the personal savings rate raises the possibility that the pool of funding could be in trouble. In November 2000 the personal savings rate fell to minus 0.8 from minus 0.7 in the previous month. 

In the Asian meltdown in the 1990s, money expansion was the preferred method of fighting recession. For instance, in an interview with the Barron’s economics editor5, Milton Friedman argued that in order to fix its economy, Japan should pump money. Similarly, in his writings, Keynes criticised those economists labelling them "the so called economists," who were advocating a hands off approach to the great depression of the 1930s.6

These eminent economists overlooked that monetary pumping cannot expand production, but on the contrary will only dilute it further. If it were otherwise, the printing press would have eliminated poverty worldwide a long time ago.

So if pumping money is a bad policy what then the central bank should be doing during a depression? The central bank should do absolutely nothing other than allow the recession to take place. Only this approach will permit genuine economic recovery to emerge.


  • 1. Richard von Strigl, Capital and Production, Mises Institute p 8.
  • 2. Ludwig von Mises, Human Action (Chicago: Contemporary Books, 1963), p538-86.
  • 3. Ibid., p. 505
  • 4. Murray N. Rothbard America’s Great Depression Sheed and Ward, Inc. Universal Press Kansas City p. 153.
  • 5. Barron’s August 24, 1998
  • 6. John M. Keynes, Essays in Persuasion, London:Macmillan, 1931 p. 176.

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Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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