TCS Daily

Consumed by Myths

By Jacqueline Pham and Ton Long - February 19, 2008 12:00 AM

Stimulus. Every politician and every pundit has a plan to "stimulate" the economy. Yet very few seem to understand that consumption is not the driver of economic growth. Rather this notion is a relic of old Keynesian thinking and a misinterpretation of GDP calculations.

The natural beginning of this discussion should begin with Say's Law. According to Say's Law, supply creates demand. In other words, there cannot be demand without supply. The division of labor allows individuals to work hard to produce goods in a field in which they specialize in order to earn income which in turn will facilitate the purchase of goods from someone else with another specialization. The natural conclusion of Say's Law is that there can never be a recession due to a lack of demand.

One of the major insights of John Maynard Keynes was to claim that Say's Law did not hold in the short run. According to Keynes, Say's Law does not hold up in the short run. According to Keynes, shortfalls in aggregate demand were the main cause of involuntary unemployment and other frictions in the macroeconomy. His solution was to facilitate an increase in aggregate demand through government spending. Since the time of Keynes, this type of prescription has taken many forms (i.e. temporary government employment programs and tax rebates).

The remnants of Keynesian thinking are still alive and well today (as evident from the proposed stimulus package). All in all, the assumption is that consumption is what can alleviate economic downturns. However, this is largely based on a misconception about what causes monetary disequilibria.

When Swedish economist Knut Wicksell wrote <i>Interest and Prices</i>, he introduced the idea of a natural rate of interest. The natural rate was "the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods." (p. 102) Thus when the market rate of interest is equal to the natural rate, the economy is in a state of monetary equilibrium. However, if the market rate should deviate from the natural rate, monetary disequilibrium would occur and lead to economic discoordination and a change in the overall price level.

It seems important to note that when Keynes originally wrote <i>A Treatise on Money</i>, a great deal of his insights were centered on Wicksellian foundations. However, Keynes' <i>General Theory</i> left out these insights (perhaps because they could not be explained away).

Others, however, such as Hayek and many others in the Austrian school as well as monetarists such as Warburton, Yeager, Leijonhufvud, and Clower have critiqued and advanced the Wicksellian theory to more aptly describe monetary disequilibrium and the discoordination that results. The Austrian school largely emphasizes the role of capital, changes in relative prices and the eventual boom and bust due to monetary disequilibrium are caused by monetary expansion (a rate of interest below the natural rate). In contrast, the monetarists largely contend that the excess demand for money (a rate of interest above the natural rate) causes discoordination due to the differing effects on prices resulting from varying degrees of price stickiness that in turn lead to the introduction of noise in price signals and therefore reductions in output.

The important point is that Keynesian solutions to the idea of inadequate demand are somewhat lacking. The lack of an explanation of intertemporal coordination (as was shown through Wicksellian foundations) creates a false sense of belief that actively managed monetary and fiscal policy can facilitate appropriate changes in unemployment without producing macroeconomic discoordination. Of course, the unfortunate and painful lessons of the Phillips Curve management have largely proven otherwise.

Even beyond the pure academic Keynesian thinking (although one could argue it finds its roots there) is a further misrepresentation of the explanations for economic growth by pundits. When tuning in to financial news, one cannot help but to be bombarded with the ridiculous notions that the consumer is what drives the economy. Again, this is a misrepresentation that is facilitated by remnants of Keynesian thought as well as a misunderstanding of the concept of GDP shares.

First, in order to consume, one must earn an income that allows for consumption (even borrowing is based upon one's income and credit standing). If one is not producing, one cannot consume. As we have previously detailed, this is the major insight of Say's Law. Without getting into a discussion of which comes first, demand or supply, it should seem quite obvious that if Keynes is true and Say's Law does not hold up in the short run and that government intervention could facilitate the lack of demand, it would only be admissible to follow such a policy if the benefits exceed the costs. However, a Wicksell-based understanding of intertemporal coordination suggests that the cost could be substantial given the potential subsequent macroeconomic discoordination. Thus, it is doubtful that the benefits of temporary stimulus could exceed the costs of future discoordination.

Second, financial news pundits love to highlight the fact that over 60% of GDP is consumption. Thus, it must follow that consumption is what drives economic growth, right? Wrong. GDP accounting is merely, as the name would suggest, an accounting device. Given the fact that GDP is the total of new final goods and services produced in a given year, it is hardly a surprise that a majority of those final goods would be consumed by a developed country. Discussing the share of GDP as though it were a predictor of relative importance is incorrect. The large consumption share of GDP is not a signal of begin the driver of economic growth, but rather a reflection of the prosperity in the United States. Economic growth is caused by technological innovation and productivity. The result of economic growth.

So while it may be politically popular to promote stimulus packages, these ideas are largely based on misconceptions of the role of consumption that have been rampant since the emergence of Keynes. In reality, actively managing the economy can have serious adverse effects on the economy. For that reason, I'd prefer not to be stimulated.

Josh Hendrickson teaches economics at Wayne State University. He also maintains the blog entitled 'The Everyday Economist'.


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