How can demand be less than supply?

There are some economists who believe that total demand in an economy must equal its total supply. The argument goes something like this: When people sell their produce, they must, almost by definition, receive enough money to buy the equivalent value of other peoples goods. Or to put it another way, the sum total of what people earn from producing their stuff, must be enough to purchase the sum total of all the stuff produced in the economy. So the idea of a lack of demand being a cause of unemployment is seen as nonsensical.

The obvious potential flaw in this argument is that people may choose not to spend all of the money they just earned from selling their produce. The counter argument to this though, is that if people choose not to spend a portion of their earnings they must instead save it. But savings are simply used by banks for investment. Savings can therefore be seen as simply spending on investment projects like building new factories or buying new machinery. Thus saving is simply spending on different types of produce. New plant and machinery are still the fruits of people’s labour and so can provide just as much employment as any other type of produce. This is an argument often used by economists from the Austrian school. I shall be returning to this point later, so I will summarise it as follows:

The Austrian argument…
All earnings must be spent on something, even if that spending is in the form of investing in new plant and machinery.

So if the Austrians are right, there is no way for demand to be less than supply.

Another argument in favour of demand keeping up with supply is that it if weren’t true, there would be huge amounts of unsold goods building up continuously. There would be mountains of the stuff!

A clash of ideas: The idea that demand must equal supply clashes with the notion of the “paradox of thrift” whereby attempts by too many people simultaneously saving, leads to a lack of demand and a downward spiral of recession and unemployment. This idea was popularised by Keynes though it seems it was known of since antiquity.

So who is right, the Austrians or Keynes? The answer is undoubtedly Keynes. There are in fact two separate mechanisms that can lead to a shortfall of demand:

Mechanism 1. A falling money supply: Not many people are aware of the fact that the money supply can fall as well as rise but it most certainly can. This is because our monetary system was designed such that most money has a certain lifecycle. It comes into existence when banks make a loan, and it expires back out of existence when the principal is paid back. During depressions the desire to take out new loans (creating money) falls below the rate at which existing loans are paid back (destroying money). This state of affairs can go on for years, even decades. During the great depression, the money supply in the US fell by around a third.

The fact that there may be a small net expiration of money interferes with the “Austrian argument” made earlier. In a falling money supply environment, not all earnings will be spent on something. A small net flow of earnings will be given back as loan principal repayments where the money will expire out of existence. This is where things get a little more complicated. The thing is, if everyone adjusted their prices downward perfectly in step with the falling money supply, then demand could once again be matched to supply. Unfortunately, the economy is not quite capable of coordinating a fall in prices without some companies getting into trouble. The problem is that the fall in demand will inevitably be uneven and nobody will want to lower their prices unless they get a clear and sustained signal that they need to do so. You never see a restaurant adjusting its prices up and down a few percentage points depending on the previous night’s demand and you would never see an arrangement where a shopkeeper could have his rent reduced by 2% because the takings over the previous week had been below par. Both of these mechanisms can occur to some degree, but it is not quite slick enough to occur without some companies going bust in the process.

At this point we must address the question of why there aren’t piles of unsold goods building up in the process. Surely everything that is made has to be sold, so even if the money available in each round of selling is less than in the one before, prices must fall. Indeed this is true. Virtually everything will get sold, but a portion of them will be at newly distressed prices by people whose companies are in the process of being liquidated.

Mechanism 2. Purchasing non productive assets:

Another problem with the Austrian argument is the notion that savings must be spent on something that requires work to be done, like building a new factory. There are in fact many things that can be purchased as a form of savings that require almost no work to be produced. Land, traded gold, shares purchased on the secondary market. All sorts of financial products correspond either to work that was completed in the distant past, work that will be done at some point in the future, or even no work at all. An aggregate increase in the flow of spending on these types of product will naturally result in a fall in spending on products that require work to be done in the present. So even with a constant, or even rising money supply, there can be a fall in the money available for items that require current labour.

High unemployment for years to come?

Politicians everywhere are proclaiming that we must all reduce our debts and they acknowledge that this process may take many years. What they don’t seem to realise is that the money supply and our levels of indebtedness are almost one and the same thing. Under our current monetary system reducing debt necessarily means reducing the money supply. The employment outlook for the coming years is therefore rather bleak. This is on top of the unemployment that will necessarily come through public sector cuts.

Is there any way to repay debts without the money supply falling?

In a word yes. You may have noticed that earlier on I said “most money has a certain lifecycle”, this is because there is a small fraction of the money supply that does not expire. So called debt free money. Our monetary system can work perfectly well with either type. If new debt free money is injected into the system at the same rate or faster than there is net debt-money expiry, then the money supply can be held constant even as loans are repaid. Unfortunately EU regulations currently forbid the creation of additional debt free money... but in the current environment we may need radical solutions. It is time to change the regulations.