It is almost universally asserted today that consumer spending drives employment. This thesis gives support to the general Keynesian idea that government should “stimulate” the economy when it is suffering from a recession, whether it is through fiscal or monetary policy.
At the core, the idea is that if spending on goods and services goes up, then more people are needed in their production. And, as a consequence, more people are able to get jobs, earn a wage, and thus buy goods and services. In other words, it doesn’t matter if government wastefully increases spending — even if it is borrowed money — because the economic wheels start turning and as growth picks up we’ll be able to deal with debt, deficits, and so on.
Not to mention the human suffering through involuntary unemployment and poverty that is averted by such a single act!
Government spending in a recession is therefore seen as an almost costless solution that we simply cannot afford not to make as much use of as possible. So it is easy to understand why Keynesians are at best confused by those arguing against government stimulus, and would likely call them “evil” for opposing something so grand.
The problem is while the logic is easy to follow, it is based on an utterly false assumption. There is no such relation between consumer spending and employment as Keynesians believe is obvious.
The Economy Backwards
Treating the economy as demand driven is placing the cart before the horse. It is easily done if one does not include entrepreneurship or have a conception of what entrepreneurs do in an economy, as is commonly the case in the formal modeling of modern economics.
If we think of the economy in terms of equilibrium, then there is no reason to consider the entrepreneur. As a result, as Schumpeter noted, economics has become Hamlet without the Danish prince: a system view of the economy devoid of both actors and action.
But such a mechanistic view of the economic system is necessary to successfully argue for government intervention as a means to improve economies. The economic organism, in contrast, will always produce unintended consequences that undermine and make impossible such interventionism.
Furthermore, viewing the economy as a mechanistic system is also necessary for the very possibility of establishing and running a socialist economy. Indeed, the market socialists’ attempted rebuttal of Mises’ calculation argument implicitly assumes this mechanistic view. But Mises’ original argument does not — it is based on the view that entrepreneurship is the driving force of the market.
In a mechanistic, circular-flow view of the economy, too little spending is a problem as that causes a general glut, which in turn forces employers to cut costs and lay off workers. This is not how the real economy works, however. As Ricardo noted, "[the actual problem is that] men err in their productions, there is no deficiency of demand.".
The Role of Entrepreneurship
Economists prior to the Keynesian avalanche, which contemporary Say’s Law scholar Steve Kates argues was all about dismissing the organic view of the market economy, had the same understanding of the economy as Mises. What drives the economy is not demand or spending, but entrepreneurship and production.
Indeed, JS Mill famously notes that "Demand for commodities is not demand for labour" in his fourth fundamental proposition on capital. While this statement is subject to much debate and most modern economists cannot make sense of it, it is in effect very straight-forward if one recognizes the role of entrepreneurs.
What is it that entrepreneurs do? They produce in anticipation of being able to sell their goods and services. Whether there "is" demand for the individual entrepreneur’s undertaking depends on people’s valuations of the goods when they are offered. It also depends on what other goods and services they can choose to buy instead. Also relevant is how consumers view the world, because in some situations they will find saving instead of consuming the best course of action.
In other words, entrepreneurs bear the uncertainty of their enterprise. They anticipate that consumers will value their goods and, based on this, estimate the price. That price, in turn, determines what costs the entrepreneur can reasonably expect to cover in production, which means the entrepreneur’s actual choice is for the cost structure in production – the price is an anticipation of consumer value.
Spending Is Inconsequential
What this means is that entrepreneurs speculate about the future in which they will offer their intended goods for sale. Consequently, the investment to produce happens whether or not there “is” spending in the market. Entrepreneurs do not make decisions based on what is, but based on what they anticipate about the future. Production, of course, takes time, so what is at the time the decision is made is not very relevant for what will be when the production process is concluded.
This fundamentally undermines the Keynesian view of the economy, because the entrepreneur will employ people before demand is known — in fact, even before demand can be known. When the entrepreneur is successful, which means the goods are eventually sold at a price that covers the cost of production, there is a relationship between spending (on those goods) and the profitability of the enterprise.
But if the entrepreneur fails, which means there is not sufficient demand to generate revenue to cover the costs, the enterprise still employed workers. Granted, if the entrepreneur does not believe the situation will change, those workers may lose their jobs. But the point is that the jobs are created whether or not there is spending.
The case of the successful entrepreneur actually only strengthens the argument that spending does not drive employment. If the entrepreneur realizes there is a much greater quantity demanded than he dared hope for, does this not drive employment? Not necessarily: there is nothing saying that the entrepreneur must employ more workers.
Rather, if this demand is anticipated to remain in force (it is still speculation), the entrepreneur will invest to increase production. This can be done by simply doubling down on the existing processes, but it is more likely that investments are made in automation. Higher production volumes make it easier to cover fixed upfront cost of machinery, and profits would suffer from relying on variable cost such as wages. Also, employing more people will require training of the workers — also an upfront investment.
But even if we disregard the observation that capital replaces labor (by making it more productive) and instead assume the entrepreneur simply doubles down on the initial production process, the Keynesian demand-driven view still falls. The investment to increase production volume is still in anticipation of future demand — not a response to existing demand.
There is no escaping the fact that production precedes consumption in a very real and fundamental sense: that entrepreneurs endeavor in production before they know that they will be able to sell the goods produced.
Spending is a possible outcome of entrepreneurial production, but not the other way around. The former does not employ people, but the latter does.