From the time of Adam Smith’s “Wealth of Nations” through the early twentieth century, economists nearly unanimously agreed on how an economy works: For an individual to prosper and an economy to grow, people must work and produce a good or service to sell for income, which they can then either save or spend on other goods and services. Value-adding work—that is, production that covers its costs—was seen as the key to prosperity and the driver of the economy.
Virtually all economists—from Smith to David Ricardo to John Stuart Mill to Jean-Baptiste Say—affirmed the common-sense view that production drives growth. In fact, as these “classical economists” understood, production creates demand because, at bottom, production is demand. What someone produces is all he has to sell for an income he can then spend.
To understand this, imagine an economy starting from scratch on an island. How would inhabitants prosper? They would have to produce something through effort, which would then enable them to trade with other inhabitants. If person A wanted the spear of person B, person A would have to make something—say, sandals—and trade his sandals for the spear. In effect, his production of sandals constitutes his demand for the spear. Although our economy is more complex, the relationship between production and demand holds.
Crucially, however, production is worthless if it does not add value. If whatever is produced does not cover the costs of producing it plus a profit, no value is added and no demand is created. If no inhabitant of the island wants sandals, person A’s production goes to waste and he must produce something new before he can trade (“demand”).
We Either Spend Our Incomes Now or Later
Economists once took this common sense for granted. Here is how Ricardo described it: “The shoemaker when he exchanges his shoes for bread has an effective demand for bread…. And if his shoes are not in demand it shews that he has not been governed by the just principles of trade, and that he has not used his capital and his labour in the manufacture of the commodity required by society,— more caution will enable him to correct his error in his future production.”
Furthermore, it was assumed that every producer would spend his income on something. Two propositions thus followed. First, attempts to manipulate demand were futile since demand is the result, not the cause, of production; and second, demand deficiency—or “overproduction”—was an impossibility.
Among the first to challenge this view was Thomas Malthus, who in the early nineteenth century postulated that the recessions England experienced after the Napoleonic Wars were due to demand failure—that is, purchasing power falling below the total number of goods and services on the market.
Malthus argued that, while production created the power to demand, individuals sometimes lacked the will to demand. In other words, people may choose not to spend their incomes: “A nation must certainly have the power of purchasing all that it produces, but I can easily conceive it not to have the will…You have never I think taken sufficiently into consideration the wants and tastes of mankind. It is not merely the proportion of commodities to each other but their proportion to the wants and tastes of mankind that determines prices.” From this he concluded that, if consumers hoard their incomes, the supply of goods and services on the market can outstrip demand.
Production Is the Problem, Not Demand
Not so, said Ricardo, who represented the view of nearly all economists throughout the nineteenth and into the twentieth century. Ricardo noted that the “wants and tastes” of human nature are insatiable, so that the “will is very seldom wanting where the power exists.” At the very least, the natural desire for “capital accumulation”—investment in things like technology, research, or other inputs that go toward improving final goods on the market—props up demand: “We all wish to add to our enjoyments or to our power. Consumption adds to our enjoyments,–accumulation to our power, and they equally promote demand,” stressed Ricardo.
In other words, the composition of demand may change (more investment goods and fewer consumer goods), but the idea of total demand deficiency was unfounded. “Men err in their production, there is no deficiency of demand,” he implored.
By 1936, however, the concept of demand failure made an unexpected comeback. John Maynard Keynes discovered Malthus’s writings in the early 1930s and quickly became enthralled. “I have become completely absorbed in re-writing my life of Malthus, and sit by the hour by my desk copying bits out and composing sentences and wanting to do nothing else with stacks of books around me,” wrote Keynes.
Following World War I and his role in the peace process, Keynes was already the most influential economist in the world by the time he published “The General Theory,” which borrowed from and built upon Malthus’s economics. Keynes contended that demand deficiency was the cause of recession and that government spending could stimulate production, precisely the fallacy the classicalists repudiated.
Keynes Failed to Study Before Pontificating
Unfortunately, so focused was Keynes on Malthus and the notion of demand failure that he hardly bothered to study classical theory beyond Malthus’s work. In fact, as I’ve noted before, so superficially familiar was Keynes with the classical school that he leveled the unbelievable claim that it had no explanation for recessions: “Classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemployment, which in the above sense involuntary, cannot occur….”
Equally preposterously, he charged his predecessors with believing the grossly oversimplified notion that “supply creates its own demand”—that is, merely producing a good guarantees its sale. Had Keynes read Ricardo or virtually any other classical economist, he would have known that production creates demand only if consumers desire what is produced.
As Robert Torrens put it, production creates demand assuming there are “proper proportions”—that is, assuming the structure of supply must match the structure of demand: “In every conceivable case, effectual demand is created by and is commensurate with production, rightly proportioned…. Vary our suppositions as we will, increased production, provided it be duly proportioned, is the one and only cause of extended demand, and diminished production the one and only cause of contracted demand.”
In other words, if production does not correctly anticipate consumers’ preferences, it doesn’t create demand. Furthermore, and contrary to Keynes’s wildly irresponsible assertion, failure to anticipate consumers’ demand preference was one way classical economists explained recessions. According to Torrens: “The want of due proportion in the quantities of the several commodities brought to market, which operates thus injuriously upon capitalists, inflicts equal injury upon the other classes of the community…. The ruin of the cultivator involves that of the proprietor of land; and when the motive and the power to employ productive capital are destroyed, the productive labourer is cut off by famine.”
Never One to Drop a Bad Idea
While many theories developed to explain recessions before Keynes, demand deficiency was regarded as an obvious fallacy. As Mill explained, “demand for commodities is not demand for labor”—that is, spending on goods and services does not increase employment.
Regrettably, however, Keynes’s ideas were undeniably appealing during the Depression. Even though the economy didn’t recover until the conclusion of World War II—after more than a decade of fruitless Keynesian spending—the theory swept the economics profession and has remained deeply embedded in our educational, political, and cultural communities ever since.
Indeed, despite numerous experiments since the 1930s, never has Keynesian policy precipitated a peacetime economic recovery. In fact, during the 2008 crisis, Keynesian “stimulus” architects promised that, with stimulus spending, unemployment would not rise above 8 percent. Absent the spending, however, they alleged unemployment would reach upwards of 9 percent. Despite these assurances, the herculean spending effort—some $800 billion—left the economy unmoved, and unemployment peaked well above 10 percent.
Undeterred by such failures, these economic models remain entrenched in academia and political institutions. Worse, policies like food stamps, minimum wages, government training and workforce programs, and government spending are at least partly advocated to boost growth, when in fact they accomplish the opposite.
The truth is that work and value-adding production make an economy prosper, and eliminating disincentives to doing so, such as high taxation and regulatory burdens, stimulates growth. But until we discard the idea that demand is the driver of economic performance, our policies will continue to do more harm than good.