Wednesday, July 14, 2010

Demand & Economic Growth

A Swedish reader asked me to comment on this argument that he heard (translated by me):

"The National Product consists of paid activities- It is income generating activity transactions. In order for that to arise someone has to demand these activities. Someone has to pay in order for someone else to get paid. It's as simple as that. Demand is the direct cause of the National Product. If there is no demand for a certain service, then it won't be performed.

Take the example of a hair cut. It won't take place if the barber simply cuts with his pair of scissors in air. A customer that demands the hair cut is required for it to be performed in the first place. And the number of hair cuts isn't pre-determined or determined by any "structural factors". When you walk into a "drop-in-salon" or lay yourself on a barber's chair, the number of performed hair cuts will increase"

So what's wrong with this reasoning? Nothing directly, actually. If no one wants a certain product, and in the context of GDP statistics, is willing to pay for it, then these products will never be produced or will at any rate have no value. If ypu produce stuff that no one wants than the value of that stuff is zero. The same thing is essentially true in the case of services: if you offer services that no one wants then the value of these services is zero.

In order for stuff to have any value they have to be supplied, and demanded. You can't have one without the other.

However, the reasoning seems assume that if things are demanded then they will simply appear. That is true as long as the people who demand it can find and interact with these people. But that is often not the case, not least during recessions. During recessions, producers stand ready to produce investment goods, but since only few people for good reasons (little or no market exists for the final products they produce) see the purchase of that profitable, these products aren't demanded.

So while it is true that a necessary (but not sufficient) requirement for products to be valuable is that they are demanded by someone, this doesn't imply that "lack of aggregate demand" is the key to understanding recessions. Instead the key is to understand that the offers made by producers mismatch with the demands of consumers and other producers, something which is often the result of central bank manipulation of interest rates, as Austrian Business Cycle Theory explains.