Keynes held that the economy can suffer extended periods of high unemployment because of deficient aggregate spending. A contraction in spending results in businesses having excess inventories and reduced revenues. Businesses respond by cutting back and decreasing their demand for labor. Due to “sticky wages,” this results in a large decrease in employment and incomes for workers. The problem comes full circle and self-aggravating because workers as a whole must restrict their spending due to their reduced incomes.
For Keynes, the solution is found in the government, which can increase the money supply and engage in deficit spending. Monetary and fiscal policies are aimed at stimulating (indirectly) and replacing (directly) aggregate spending, respectively. Instead of focusing on these destructive prescriptions, I want to take a closer look at the central placement of aggregate spending in his analysis.
Establishment economists toe Keynes’s line even today. Consider this highly-cited American Economic Review article from 2022:
The fact that some goods are no longer available has two effects on consumer choice. First, it makes it less attractive to spend overall and induces consumers to postpone spending to the future.
These income losses can depress spending in the rest of the economy.
…we only need to replace enough income to sustain the pre-pandemic level of spending in the sectors still active.
The usual multiplier emerges because the initial stimulus increases incomes, which are then partly spent on all goods; this higher spending creates still higher incomes and so on.
The focus on spending extends to those who are self-described proponents of free markets. Milton Friedman critiqued the Keynesian framework but consistently resorted to discussion of aggregate spending (he commonly referred to it as “aggregate nominal demand”). Following in Friedman’s footsteps, market monetarists and others focus on aggregate spending and have adopted a monetary policy prescription aimed at stabilizing aggregate spending.
An Old Error
Viewing the economy through the lens of spending flows is not new. In 1803, Jean-Baptiste Say countered crude mercantilist ideas that business depressions are the result of consumers not spending their money (in so doing, he explicated what came to be known as Say’s Law). The mercantilist conclusion is an easy trap to fall into, especially from the businesses’ perspective: “My business is doing poorly and it seems many other businesses are doing poorly. It must be because consumers aren’t spending enough!”
Say took it a step further and considered the source of demand. He concluded that one’s ability to demand a product on the market is constituted by one’s supply of other goods. That is, supply enables demand. Any apparent deficiency in aggregate spending is actually a “bad” mix of production. In this context, “bad” means that entrepreneurial expectations aren’t meshing with what consumers actually want.
What about “hoarding” money? Couldn’t we see a build-up of cash balances broadly, resulting in prior supply outstripping the products currently available for sale? The answer is yes, but this does not invalidate Say’s Law because money itself is a good that is demanded by market participants. If people hoard cash en masse, it means they prefer holding onto the money over the goods that are currently for sale at their current prices. It indicates, once again, that entrepreneurs in general were mistaken about what goods consumers would want to buy (see Rothbard’s America’s Great Depression, chapter 1, for more on what could cause that). Notice that this analysis is based on people’s values, not on abstract flows of spending. It implies that prices and production plans can and will change, not that aggregate spending needs a boost.
Values and Prices
Even in this case, however, the unexpected increase in the demand for money is simultaneously a decrease in demand for non-money goods (or increase in supply of non-money goods). A new constellation of prices emerges that reflects market participants’ demand for money and the variety of non-money goods over the given stocks of money and non-money goods. (After all, an individual’s demand for money and demand for non-money goods is given by his unitary value scale—for the individual, units of money and non-money goods are ranked on one scale of preferences.) This means that recovery from such a slump is hastened by price flexibility, not some exogenous source of or stimulus to spending. Recovery would be hampered by widespread price controls, money printing, and government spending.
The point is that flows of spending cannot be at the center of good economic analysis. Instead, good economic analysis places values and prices at the center. Spending is a consequence. It is a calculated result after individuals consider and form their preferences, after two potential traders meet, after a potential double coincidence of wants is identified, after they haggle, after a price is agreed upon, and after the property is exchanged. As Hutt put it,
Spending is incidental. If prices in general rise, then in such transactions as must be made through spending, an increased number of money units must be offered for any quantum of non-money. Each price established represents what must be spent if a good is to be sold and purchased. The increased spending is, then, a consequence not a cause. It is the valuing process, not the spending (which follows the valuing) that determines prices.
Joseph Salerno expanded on Hutt’s insight:
Money prices are formed directly by the interaction of the value scales of buyers and sellers on markets. Spending has no causal significance in determining money prices; logically and chronologically the payment of a sum of money, like the handing over of units of the good sold, occurs only after a price has been agreed upon by buyer and seller. The physical transfer of a bundle of monetary assets from buyer to seller and bundle of goods from seller to buyer is the consummation and not the cause of the price event.
Circles and Latticeworks
I see two main reasons why aggregate spending has taken on such a central role in macroeconomic theorizing: (1) data on spending is readily available and easy to play around with; and, (2) it’s easy to simplify an economy down to two “agents.” Regarding the first, anyone can look at and download data from FRED, including all the income and expenditure data from the Bureau of Economic Analysis. It’s easy to fall prey to the illusion that these statistics have a life of their own, divorced from the values and exchanges of market participants. For example, when estimating whether the economy will enter a recession, many will come to the easy conclusion that a recession—defined as a drop in GDP—will be caused by a collapse in one or more of the spending components that comprise GDP. But this is like saying that your gas tank has less gas in it because it has less gas in it, ignoring your decisions to drive to and from various locations over the past few days.
The second reason is that it is too easy to simplify our complex economy down to two agents: households and firms. This is, in effect, what the crude mercantilists did when they concluded that economic downturns are caused by consumers failing to spend enough of their money on the products offered by businesses. It’s also the basis for the Keynesian circular flow framework. Coupled with “sticky wages,” it leads to the conclusion that one unexpected drop in spending results in a drop in income, which results in another drop in spending, which…you get the idea. The economy spirals into a depression with deep and long-lasting unemployment problems.
But a more appropriate way to think about the economy is as a dynamic latticework. The economy is the actions and exchanges of millions of people, each with their own values, their own plans, and their own property. The latticework includes individuals working in various stages of production, transforming natural resources into capital goods and, eventually, consumer goods. The latticework includes entrepreneurs making judgments about what consumers will want in the future and what resources are available today to fulfill those prospective demands.
Rothbard offered the latticework analogy. According to him, what holds it all together is the price system and economic calculation:
…the price system, and the profit-and-loss incentives of the market, guide capital investment and production into the proper paths. The intricate latticework can mesh and “clear” all markets so that there are no sudden, unforeseen, and inexplicable shortages and surpluses anywhere in the production system.
One thing is not present in this way of looking at the economy: aggregate spending.
