Boosting demand isn't a magic bullet


I like Simon Jenkins a lot, so I was sorry to read this in his column yesterday:

Forget "It's the economy, stupid." Switch to "It's demand, stupid." If the 20th-century revolution in economics meant anything, it was that unless people go out and buy things, there will be no jobs, no incomes, no growth. Governments can worry about borrowing, lending, inflation, fiscal rectitude, whatever until the cows come home – but without demand there is recession.

I don't think this is true. Overall spending has recovered – its sluggish recent growth is a symptom, not a cause, of the recession. The attempt to boost aggregate demand fiscally in the United States failed miserably. The Keynesian economist Paul Krugman, who Jenkins approvingly cites, says that this was just because the stimulus was too small. Effectively, Krugman thinks the value of stimulus is unfalsifiable – even a clear refutation of its effectiveness is just proof that we didn’t do enough of it.

We cannot avoid a recession after an artificial boom driven by cheap credit. During the boom, people made a lot of bad investments, both financially and in terms of the skills they trained in. These bad investments have to be undone. Businesses set up to satisfy a demand that isn’t really there have to fail. Skills learned to fill jobs that are no longer wanted have to be replaced with new skills. There is no alternative to these processes. Boosting demand, either through fiscal or monetary policy, will just cause a delay in the recalculation process by messing around with the market signals people use to decide how they should reinvest their money and time.

Some people will favour generous unemployment support and the like for people at the sharp end of the recalculation process – I don't, but you can oppose stimulus without necessarily opposing a generous welfare state. The debate over stimulus isn't a left-right argument about justice, it's an economic one about the nature of booms and busts.

Jenkins is right to criticise the way quantitative easing was carried out, with money printed and given to banks. Certainly that was a poor way of doing QE, but QE cannot create wealth even if done “properly”. To avoid or reduce credit deflation, it may be justifiable. Such is the nature of a central bank system. (Targeting nominal GDP to avoid deflation and limit inflation during a boom would probably be an improvement, but central banking is a fundamentally flawed system.) As a tool for stimulating the economy, it is worthless. Fiscal stimulus (even if we could afford it) is also useless, simply interfering with the market signals of what people really want.

Simon Jenkins is wrong to say that the problem is a lack of demand. We need time and clear signals about what consumers want and what they don’t want. When a credit-driven boom drives something up, it must come down again. Bad investments have to be undone before we can return to real growth. Politicians aren’t powerless – they can make the recalculation process easier by reducing taxes and regulation.  But they can’t defy gravity and think that boosting aggregate demand will avoid the need to liquidate bad time and money investments. The longer they try to avoid the inevitable, the longer this recession will last.