Thursday, September 2, 2010

"Spending" versus Consumption: Does Economic Theory Actually Assume People are Human?

Keynesians and Austrians have a lot of economic and philosophical differences, some of which I have tried to spell out on this blog. However, in my view, other than the implied assumption about "homogeneous factors" and the Keynesian view that one can do specific economic analysis with nothing but aggregates, perhaps the greatest gulf between Austrians and Keynesians comes in how people from those camps view actual human economic behavior.

I believe that Krugman, in this blog post ("The Economic Narrative"), does all of us a favor by explaining his position and unwittingly laying out the real differences between the Keynesians and Austrians. If I can reduce it to one sentence, it would be: Keynesians ignore the fact that human beings engage in purposeful economic behavior. Krugman writes:
A straight Keynesian analysis implied the need for a much bigger program, more oriented toward spending, than the administration proposed. And people like me said that at the time — we’re not talking about hindsight.
If, indeed, an economy were a mechanistic operation in which we robotically put inventory on the shelves and then "spend" so we can clear the shelves (so we can put more stuff on the shelves again), then Krugman would be correct. A government program to encourage spending would do the trick.

However, because what Krugman calls spending actually involves purposeful behavior by individuals, we are dealing with different perspectives on the matter. Krugman implies that an economy is made up of two detached arms, one that produces and the other that spends. They are disassociated from one another, and if spending does not occur in large enough amounts or quickly enough, then the other side breaks down.

Austrians, on the other hand, believe that the economy is a very complex web in which producers look to meet the needs of consumers, needs that consumers will meet by purchasing goods. This process is not mechanistic, by any means. Moreover, the processes are related; more production means more consumption, as the base of our "purchasing power" is not how much money government can put into the economy, but rather our ability to produce those goods that people want.

Although Krugman (as we saw in an earlier post) has recognized the presence of asset bubbles, he then turns around and denies that the boom produces systematic malinvestments. However, what does he think a bubble is, anyway? It is the creation of malinvestments.

14 comments:

Anonymous said...

Could you please explain 'more production means more consumption'

If I own a lemonade, stock it with more lemonade, more people will consume lemonade? Isn't that backwards? Doesn't demand come before supply?

Anonymous said...

says law

Fotsir Kovelak said...
This comment has been removed by the author.
Bob Roddis said...

Could you please explain 'more production means more consumption

I thought the complete sentence explained what was meant:

"Moreover, the processes are related; more production means more consumption, as the base of our "purchasing power" is not how much money government can put into the economy, but rather our ability to produce those goods that people want."

The processes are simultaneous. Everyone is buying and selling all of the time, if only their labor. "Demand" means subjective demand of individual humans based upon their individual values, tastes, time preferences and available funds and stuff to trade. Entrepreneurs must figure out what people actually want and at what price. That's the thick real world data that Keynesians are oblivious to and ignore. The process is not mechanical and it's not reflected in a bunch of superficial aggregates.

Fotsir Kovelak said...

People's demands are unlimited, and you can't just expect to get something for nothing.

It is through providing for other people's demand that you are able to satisfy yours.

Imagine if no one produced anything. All we would have to consume is what was produced by nature.

So when we add human production to nature's production, we are able to consume more. More production=more consumption.

So in your lemonade example, you would only give lemonade to people who are able to give you something in return. Both of you have to bring a form of production to the exchange in order for it to take place. Through the exchange you will both be able to consume more.

Jonathan M.F. Catalán said...

Anonymous (both),

First, I think Say's Law is frequently oversimplified. Supply does not come before demand, nor does demand come before supply. Say's Law is built around the fact that humans have a limitless demand for wealth. In that sense, demand precedes supply.

There has to be a distinction between this abstract demand for wealth and a tangible demand for existent economic goods.

When talking about demand for economic goods, these economic goods have to exist before they can be demanded. So, in the most primitive of societies, with no division of labor, it is necessary for man to produce what he intends to consume. In a primitive division of labor society, therefore, it is also necessary for man to produce something that another man may want, so the two can exchange their goods (assuming a double-coincidence of wants).

This is what Say would mean when suggesting that in order to demand one must produce. Since trade is mutually beneficial, one can only demand and attain an existing economic good from another by providing something of greater value in return (subjectively speaking, of course).

Finally, in regards to the first comment, production is a necessary precondition for tangible demand. To use your own example: assuming no other source of income, before you can demand anything you need to produce something that gives you the purchasing power to fulfill your desires (in this case, lemonade).

I hope this clarifies the issue.

Bob Roddis said...

To make a Led Zeppelin analogy, there was no "demand" for Led Zeppelin until people actually heard them for the first time. Once they had changed the paradigm of what a good band should be in the minds of consumers, investors in Strawberry Alarm Clock found themselves without customers at profitable prices. Is the government supposed to bail them out of their bad choices and bad predictions of consumer taste?

SirThinkALot said...

If I own a lemonade, stock it with more lemonade, more people will consume lemonade? Isn't that backwards? Doesn't demand come before supply?

Well no actually, human demand is effectively infinite, but there is a FINITE amount of resources avaliable to satisify human demand. Which is why we study economics in the first place.

to use your example: if more people suddenly show up at your stand wanting lemonade, that wont make more lemonade appear, you need to make lemonade before hand, and for that you need lemons, sugar, ice water, and cups, all of which need to have been produced beforehand themselves(and all of which require their own capital goods to produce). If too many people show up, you'll most likely be forced to raise the price to reflect the underlying scarcity of your lemonade(and all the ingredents that go into it).

That reminds me of this awesome(free) flash game:

http://www.addictinggames.com/lemonadeworld.html

Anonymous said...

Mr. Anderson:

"
However, because what Krugman calls spending actually involves purposeful behavior by individuals, we are dealing with different perspectives on the matter. Krugman implies that an economy is made up of two detached arms, one that produces and the other that spends. They are disassociated from one another, and if spending does not occur in large enough amounts or quickly enough, then the other side breaks down.

Austrians, on the other hand, believe that the economy is a very complex web in which producers look to meet the needs of consumers, needs that consumers will meet by purchasing goods. This process is not mechanistic, by any means. Moreover, the processes are related; more production means more consumption, as the base of our "purchasing power" is not how much money government can put into the economy, but rather our ability to produce those goods that people want.
"

(bolding mine).

While I think you're oversimplifying what Krugman thinks ...

This is what confuses me about Austrians, in a nutshell. Is it correct to say that by your analogy, all that needs doing is to produce more goods, and any economy would automatically recover? All the housing market need do is build more houses?

What I think Krugman and Keynesians believe: without demand, no need for production. Without production, no demand. Without spending power, also no demand. Spending (public or private) creates spending power. Dollar bills do not know if they are spent by government or by private industry. Thus, if private industry stops spending, government dollars can take their place.

Turn a key, inject battery voltage. Starter motor spins. Flywheel turns. Engine coughs and sputters, or starts, depending on other ignition parameters.

Anonymous said...

Anon said: "What I think Krugman and Keynesians believe: without demand, no need for production. Without production, no demand. Without spending power, also no demand. Spending (public or private) creates spending power. Dollar bills do not know if they are spent by government or by private industry. Thus, if private industry stops spending, government dollars can take their place."

Where I think your analysis breaks down is here - spending itself does NOT create spending power - how can one spend before they have "spending power"? Not logical. What creates spending power? Production. Creation of wealth. By producing, I can create something of value for which to trade for the lemonade (or for which to trade for dollars to trade for the lemonade).

If the gov't hands me dollars and I use them to trade for the lemonade, how much are they worth? Where did the dollars come from - producers or are they newly printed? If they are merely printed by the gov't, and given to random individuals, what are they worth, intrinsically? What happens to the value of dollars that were gained by my producing when the government can just print more and give them to someone else? They are worth less. What if the government takes the dollars from the producers and gives them to random individuals to spend? The producers spend less - the "spending power" merely changes hands, minus the beaurocratic cost of executing that redistribution (which is important to note), among other things... And what affect does that have on the producer's motivation to produce?

A little refresher course on indifference curves comes to mind.

Anonymous said...

Just to add to my post above (I guess I'm "Anon 2"), the difference between public and private spending is that private "spending power" is created by production, but public "spending power" is created by taking from private producers (or printing money), because the government does not and cannot produce. Taking from the private producers always has an affect on production. Therein lies the human component, the indifference curves.

Anonymous said...

@ 10:04am

"
Anon said: "What I think Krugman and Keynesians believe: without demand, no need for production. Without production, no demand. Without spending power, also no demand. Spending (public or private) creates spending power. Dollar bills do not know if they are spent by government or by private industry. Thus, if private industry stops spending, government dollars can take their place."

Where I think your analysis breaks down is here - spending itself does NOT create spending power - how can one spend before they have "spending power"? Not logical. What creates spending power? Production. Creation of wealth. By producing, I can create something of value for which to trade for the lemonade (or for which to trade for dollars to trade for the lemonade).
"

That's not quite what I meant by "spending power", though I see where you've misunderstood ...

Spending power is indeed created by spending: the dollar in my pocket came from a dollar's worth of my labor. My bosses' spending on me created my dollar.

We won't have the discussion of how dollar one gets created without government spending it ...

But, if a dollar bill is created by government and put in my pocket, can't I spend it on lemonade, and thus put that dollar into the productive economy, where the lemonade producer and his suppliers are enhanced?

The injection may be inflationary, but it may also keep the lemonade producer and his suppliers in business, which is both pretty handy on a hot day and good business for everyone (as long as inflation is under control).

If I have no dollar bill in my pocket, then I cannot buy lemonade. If enough people do not have dollar bills in their pocket, there can be no lemonade stands.
If enough people have dollar bills but only a limited number and need to spend them on meat and milk to survive (where your indifference curves come in!), then lemonade stands won't survive.

Right?

So, does it make sense that without demand, there is no need for supply, and in the limit case, only those goods needed for survival are produced?

jgo said...

"Is it correct to say that by your analogy, all that needs doing is to produce more goods, and any economy would automatically recover?"

Not just any products will do. You have to produce and offer things and services that other people want to buy, at prices at which they are willing to buy them.

The problem with the artificially created "boom" is that it encourages the production of stuff that people don't really want so much. The signals have been distorted by the government issuance of scrip (and e-money), and it takes people a while to catch on... some people longer than others. IOW, it encourages mal-investment.

Such mal-investment results in economic losses, just a happens in any fraud.

Anonymous said...

@jgo:

"
Not just any products will do. You have to produce and offer things and services that other people want to buy, at prices at which they are willing to buy them.
"

And what of the pst at 6:33pm above yours?

What if they have no money? Or are fearful about where their continued money stream is coming from? What if they are simply not willing to buy goods at any price, deciding instead that liquidity is better?

"
The problem with the artificially created "boom" is that it encourages the production of stuff that people don't really want so much.
"

On the contrary: it seems that it encourages production of stuff that people VERY MUCH want, right up to and past the point of them being able to pay for it. Then the bust: their assets are devalued, their credit is shut down, their salaries cut or cut off.

No spending power. No spending.