Mainstream Economics Myth 3: Insufficient aggregate demand causes recessions

In this series of articles, I use the term “mainstream economics” to illustrate what I believe to be the consensus views of economists and the ideas taught at most universities and found it most economic textbooks. However, for this post, I want to be a bit more specific about what I mean by mainstream economics. Perhaps more than anything else, what defines a mainstream economist today is the belief in Keynesian economics, or more precisely a Keynesian explanation of economic downturns and a Keynesian solution to economic downturns.

This view has dominated mainstream economic thought since the 1930s with a brief interruption in the “stagflation” days of the 1970s.  Ever since the global financial crises of 2008-2009, the Keynesian view has effectively monopolized economics.  Certainly in the U.S., and in most of the world, virtually all tenured economics professors, columnists, political advisors and central bankers adhere to the Keynesian religion.

Before we go any further, let me very briefly explain the Keynesian (and mainstream) tale of economic recessions.  First, what do mean by the term “recession?”  Conceptually, let’s call a recession a widespread (or economy-wide) reduction in economic activity (i.e. GDP) accompanied by high or rising unemployment.

The economy is merrily galloping along at full employment and in equilibrium.  Economic growth is robust and everyone who wants a job has a job.  Then, BOOM, out of the blue comes some unpredictable “shock” to the economy.  This shock causes consumer confidence to decline, which results in consumers spending less money than they should, which results in businesses having to cut investment and layoff workers.  With fewer employed workers, consumers as a whole spend even less money, businesses invest even less, layoff even more and  there is a vicious spiral leading to poor (or negative) economic growth and high unemployment.

In econ-speak, the economy suffers from “insufficient aggregate demand.”  That is to say, consumers are not spending enough money to keep the economy running as it had been prior to the “shock.”  In contrast to a free market view of  a self-correcting economy, due to somewhat mysterious structural reasons, such as sticky wages, the Keynesian economy now gets “stuck” in an “equilibrium” of less than full employment.  Finally, the economy cannot get “unstuck” and back to full employment without the aid of government (fiscal and/or monetary) stimulus.

In the next post in this series, Myth #4, we’ll discuss the Keynesian viewpoint that government (especially through monetary policy) can both prevent recessions and get us out of them.  Here, however I want to focus on the first part of the story, the Keynesian myth that insufficient aggregate demand is the cause of recession.

Now, let’s return to the mainstream, Keynesian story of recession.  To believe the Keynesian explanation requires four major assumptions, all four of which are unsatisfactory and/or false.  The first assumption is that the “shock” to the economy, that is the proximate cause of recession, is unpredictable. The second assumption is that the post-shock amount of aggregate demand is below the “correct” or so called “equilibrium” level. The third assumption is that the reduction in aggregate demand is due to “confidence” issues.  The fourth and final assumption is that it is demand, rather than supply that is the key driver of the economy (at least in the short-term).

Let’s start with the first assumption, that the “shock” is unpredictable.  In a small or undiversified economy, it is reasonable to say that some unexpected event might cause an economy-wide downturn.  For example, an economy highly dependent on agricultural output might experience recession due to drought.  An economy dependent on a single commodity (oil, for example) might experience recession if there is a decrease in the global price of that commodity.

However, in a large, diversified economy such as the United States, recessions are not caused by some unpredictable, exogenous shock.  They are caused by an unsustainable expansion of money and credit leading to an unsustainable expansion of investment.  When the “unsustainable” becomes realized, you get a recession.   In the old days, much wiser people than today’s economists and politicians understood that what we now call “recessions” where part of a business cycle.  And not for nothing did they call it a “boom-bust” cycle.  You don’t have the bust without the boom.

The second key erroneous assumption made by mainstream economists is that in a recession, the level of aggregate demand drops below what had been the “natural” or “equilibrium” level.  Of course, there is no question that demand drops from previous levels in a recession. However, if you believe that modern recessions always follow credit and investment booms, as I do, then you should understand that the previous (boom) level of aggregate demand was actually higher than it should have been and not some natural or equilibrium level.  Incidentally, whether equilibrium even exists (preview:  it does not) is something we will cover in Myth #9.

The third foundation of the Keynesian view of recession is that aggregate demand is reduced due to issues of “confidence.”  To paraphrase Keynes himself, “animal spirits” of both consumers and businesses in an economic downturn are depressed.  No doubt this is true.  But poor confidence is a cop-out reason for weak economic activity.  For low confidence is a symptom, not a cause of recession.

The fourth and final problem with the Keynesian explanation of recessions relates to the focus on demand rather than supply.  As we’ve stated already, the “boom” part of the economic cycle is a result of an unsustainable expansion of money, credit and investment.  This investment boom results in over-supply, whether it be over-supply of houses or factories or stores or mines or social networking apps.  When the investment bubble bursts, as it inevitably must, this over-supply must be pruned before robust economic growth can once again return.  It is the painful pruning of over-supply, through bankruptcies, layoffs, closures and investment cuts that is the true driver of the recession part of the cycle.  Hence, it is far more intellectually honest to refer to the cause of recession as excess aggregate supply (stemming from the boom) rather than insufficient aggregate demand (stemming from low confidence).

Long story short, I believe that the mainstream or Keynesian explanation for recessions is positively wrong.  Recessions are not caused by some unpredictable shock which leads a positive feedback loop of poor confidence and low aggregate demand.  Instead, recessions are the inevitable result of an economic boom fueled by an expansion of money, credit and investment.  More or less, this is the story espoused by the non-mainstream economists known as the Austrian school, and in future posts, I’ll cover this explanation in much greater detail.

Finally, as we have done and will continue to do in each of the articles in this series of mainstream economic myths, let’s ask ourselves why this topic is of vital importance.  Once again, we answer that what matters is not so much the explanatory, but the remedies inferred from the explanatory.

If recessions are indeed caused by insufficient demand then government can “cure” recessions by artificially creating more demand (i.e. spending) through the use of monetary or fiscal stimulus.  This is exactly the Keynesian prescription and exactly what economists have advised, and governments have implemented since the Great Depression of the 1930s and in unprecedented scale since the financial crises of 2008/9.

However, if the true cause of recession is the inevitable aftermath of an investment boom fueled by money and credit, then further stimulus is exactly the wrong thing to do.  Stimulus, among many other deleterious things, exacerbates the problem of oversupply, delays the inevitable correction and encourages the kind of risk-taking that caused the boom in the first place.

So as I hope you can see, understanding the root cause of recession is of vital importance to the long-term health of the economy.  And unfortunately, today’s consensus explanation is utterly wrong, and has caused immeasurable damage to the global economy.  We must fight to remedy this.