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Aggregate Demand Does Not Drive The Economy

Author: Vale

There can be no permanent improvement in any country unless there is an increase in production

Harold G. Moulton

aggregate demand drives economy fallacy

A populist "consumer demand" argument has been flowing around the blogs for a while now. It goes something like this: Consumer spending in the USA makes up 70% of GDP (actually it is closer to 40% when broken down by definition), and since the poor spend everything they earn and don't save, increase the amount of money available to them either through welfare benefits or a higher minimum wage, so that they will spend it back into the economy and increase aggregate demand. They conclude that this will stimulate business activity and multiply prosperity through the economy. On the surface, this argument must seem plausible to a lot of people because there are many who are buying into it. Unfortunately for them, these claims are not vetted by economic theory or reality. There are many problems to address.

  • It Must Be Taken From Someone Else

The first problem is that if extra money is being provided to the consumer it must come from some place. It's not being dug up out of the ground or grown on trees. The source must either be taxpayers for entitlement benefits or employers for minimum wage increases. This plan makes one group better off by making another group worse off. Since 40% of consumer spending comes from the top 20%, and naturally, the spending distribution follows the income distribution, how much of an effect could the poor's spending really have if it is taken from the non-poor?

  • Consumption Destroys Goods

The second problem is revealed when one thinks about what happens in the process of consumer spending: resources are consumed and destroyed. So then, it would be a superior plan to remove the factor that destroys the resources in this cycle of taking money from one group and giving it to another. But of course, by cutting out the middle man, this would mean that money is sent directly to the producers. This then reveals the circular logical flaw that it makes no sense to give money to producers, right after taking it from them. The net effect would be zero. Only is it a worse result when the resources that the business produced is destroyed in the process by giving it to an intermediary. The net effect becomes negative. The fact of an economic system is that if a consumer isn't producing at least as much value as he is destroying, then his net effect to that system is negative!
Combining the above two points, how does taking wealth from a producer, only for it to accrue back to him after losing resources he produced (and which are destroyed by a consumer) create wealth? The simple fact is that dividing wealth doesn't multiply it.

  • Fiscal Multiplier for Government Spending

Similarly, on a grand scale, the government can artificially inflate demand through spending. But once again, it must tax citizens to do this. The concept of the fiscal multiplier is one of the first principles that one learns in an introductory economics class, and the idea is that if the multiplier is greater than 1, the government spending spurs economic activity, but if it is less than one it destroys net economic activity. I have come across estimates all over the board, but there is a dearth of published estimates from credible sources that detail modeling assumptions. However, the highly respected Quarterly Journal of Economics published a piece from Barro and Redlick in 2011 and they found that the multiplier for government spending was less than 0.7, meaning government spending destroyed 30% of the value.

Fiscal multiplier for government spending is less than one

Others estimate it to be zero, but it is not hard to see why it would be less than one, given that resources are taken from one group and given to another to be consumed and destroyed. One could look at the historical record and take government spending to the extremes by looking at centrally planned/communist economies, where all spending was government spending. If the multiplier were greater than one, then the GDP for those regimes would have gone to infinity and it would be the dominant economic system today. But instead how did they fare historically? Furthermore, US government spending over the last five years as a percent of GDP has been among the highest our country has ever seen, but yet our GDP growth is among the lowest it has ever been. These facts tell a lot about the true value of the multiplier.

  • It Has To First Be Created

Third, it is a fact that "we cannot consume what has not been produced." But we can produce much more than we can consume and GDP is defined by the finished goods and services produced in the economy. If we play with the supply and demand curves from Econ 101, and examine each effect in isolation, it is obvious that we could increase GDP if production and supply were increased while holding demand constant, but the opposite situation is not true. Demand could double, but if there is no corresponding increase in supply, the net result will be an increase in prices, so the result ends up being inflation with an unchanged real GDP. If holding both production and prices constant while increasing demand, we run out of goods to buy and GDP hits a wall again. Of course in the long term, both sides of the curves will respond to the other and it's very interconnected, but the fact still remains that supply has to come first.

And one last point pertains to inventions. There wasn't demand for the internet before it was invented. There wasn't demand for the iPhone before anyone had ever heard of it. Nor did demand exist for the Cronut. It was only after these products were created that the demand followed. The supply created the demand. Inventions don't come from consumption - they come from R&D and investment in a new product development. Similarly, factories don't come from consumption - they come from investment from surplus savings. It should be clear that the supply side is what drives growth. The tail doesn't wag the dog.

  • Additional Facts

There are other points that economist Mark Skousen has shown that adds to the discussion. He draws attention to the value of the intermediate goods in production that is not counted in the GDP statistics, points out that the leading indicators are all producer indices, and even details how the consumer confidence index is in fact a survey of business expectations. It's a good read for a few more points that I don't discuss here.


Unfortunately for those who hype the aggregate demand argument, the facts show that it does not hold water.


Comments   

 
# Realist 2014-08-11 09:57
Even 20% might be understated. According to CNBC, the top 5% account for 40%.
"economists have estimated that the top 5 percent of consumers account for nearly 40 percent of consumption."
www.cnbc.com/id/101879219
 
 
# ProudOilman 2013-12-29 23:21
Legions of Obama-drones believe that money and jobs are created out of thin air at no cost. Once we're no longer able to borrow from China because of the Yuan's rise against the dollar, we'll become Zimbabwe or Venezuela with Obama's policies.

It's time to tell these Obama supporters that they don't deserve all this welfare and they need to face the fact that the rich are usually simply better than them. Maybe then, this country shall know the prosperity of Hong Kong.
 

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