Thursday, February 12, 2009

Design Fault in the Modern Economy

Trained economists take a long time to understand the real meaning of "aggregate demand" which the man in the street seems to be able grasp within a second. Why? Because there is a design fault in the modern economy which is predicated on constant investment not consumption.


When the man in the street hears the word "demand," he thinks like a businessman. Demand means people come and buy things from you.

If people do not come and buy, there is no demand, and this is bad for business. You must go and get people to buy.

If the problem persists, you can threaten to sack your workers (for you to save costs, rather than for you to bring out the profits you have made all the while to hold up the operation).

You can appeal to the government to cut interest rates, cutting taxes, and cutting contributions to retirement funds - so that people will have more money to spend (which is good for your revenue) and your interest payments will be lower (if you have the cash).

You hope that the ordinary consumers will get more into debt (if the banks are willing to lend in a declining economy) so that you can get your business out of debt.

How long do you think this reliance on the increasing indebtedness to the consumers can go on?

If their current spending level cannot save you in the first place, it is unlikely that their future spending will be any better - given that they may lose their jobs, their share investment has fallen in value, their real estate value has declined and there is less social pressure to buy things to keep up with their neighbours.

It is more likely that prudence and the general fear over the uncertain future will keep them from increasing their spending in the coming weeks and months.

The consumption policy to economic recovery is doomed to failure.


The secret to keeping the modern economy alive is government spending and investment. Why?

There is a design fault in the modern economy. In the old traditional rural economy, people produce things that they need. Whatever amount of rice they have produced, they share amoung themselves and are content.

In a modern economy, we produce things that we ourselves do NOT need. We produce things we think our people will buy, whether they need it or not.

So the share of the output which would have belonged to us as profit in the traditional economy has now become unsold stock. So we need somebody else to buy the stock so that we can translate that into profit in monetary terms.

The need for this monetary translation of stock to become profit is the design fault of the modern economy.

The only demand that can arise to give this monetary translation of the profit-stock is either government spending on projects or new investments by the private sector.

With investment, the economy uses the excess of the output, over and above current consumption needs, to increase its future output. It is this productivity growth in production by the current generation that will produce the means of employment for the next generation.

It is the abstinence of the current generation in its current consumption that provides the basis for the future expansion of the economy. This abstinence is called savings and innovation is required to convert savings into investment.

The decline in current investment is the result of wrongful production of output by the last generation. Such wrongful unproductive output are things like funny financial instruments (which give unprecedented rewards to their inventors) and real estate (especially those that are involved in luxury rather than necessities) and consumption goods.

Why the production of only consumption goods wrong? (a) Because there is no effort made to invest in future production. (b) Because the workers are never paid sufficiently for them to have the income to spend until businesses can make money, unless the workers get into debt. This is the worst policy option.

The second worse policy option is for the government to spend. But this is necessary and that is the basis of expansionary fiscal policy.

The best policy is for investment to be forthcoming. How? Confidence and optimism.

1 comment:

de minimis said...


This is a masterful explanation of the myth of the non-economist's view of aggregate demand.

What is particularly resonant about this post is the proposition on government spending and investment.

I hope that you will take some time to write about optimism and confidence. Governments throughout the world decry the lack of confidence. The public is fearful of economic uncertainty/decline. Aside from innate confidence and optimism of individuals, I wonder what would be the key ingredients of a government's economic policy to engender optimism and confidence?