The concept of demand management, as a necessary activity that the government needs to undertake, essentially did not exist before Keynes and his new theories of the macroeconomy. Prior to Keynes, the consensus was that the natural balance of demand and supply in the economy would keep the economy in equilibrium, and the government need not manage demand. This idea was based on the simple demand and supply that underpins economics. Demand management wasn’t thought to be necessary. Because as the economy produces output on the supply side, the value that it generates automatically feeds through to the demand side.
For example, if an economy is producing a million pounds worth of output, that million pounds worth of output is being paid partly in wages to the workers and firms that produce it, and partly in profits to the entrepreneurs that hold the capital and run the businesses. As the workers and entrepreneurs then spend these earnings, a million pounds of demand is created. In this way, the total value of supply and the total value of demand must always balance. Because everything that is made creates value to the individuals making it, which they then spend for their consumption. This idea is sometimes called Say’s Law, after the 19th century French Economist John-Baptiste Say, who coined the phrase, “Supply creates its own demand.”
He said, in one of his economic writings, that “a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.” This means, in everyday language, that as soon as you make something, you create value that someone who made it is going to go out and spend. However, Keynesian economics fundamentally disagrees with the notion that supply creates its own demand. Because in the Great Depression, we observed a period of time where there appeared to be exceptionally low demand in the economy. Keynes believed this was due to consumers and firms becoming averse to spending the income that they had earned through production.
Because after the radical collapse of the stock market, and the loss of wealth, they were scared to do so in case there was another stock market crash, or some other cataclysmic economic event. Consequently, there was too much supply and not enough demand, as the monies that would normally give rise to demand were being saved. Keynes believed that this excess saving was a problem for the economy, and called it the paradox of thrift. The problem with thrift– which means frugal saving for the future– is that although for an individual it’s prudent to save, if the economy suddenly moves into a scenario where everyone is attempting to save, then today’s demand would be reduced.
And, therefore, so would the ability of firms to sell their goods and services. So the paradox is that by saving for the future– an apparently prudent activity– an individual can actually damage the economy today. This is where demand management comes from as an economic concept. In the case that private economy of firms and workers are oversaving and not providing sufficient demand, then there’s a need for the government to intervene. By bolstering demand, creating demand by spending, the government is stepping into the vacuum, which is left by households and entrepreneurs who are oversaving. So for Keynes, the government needs to get involved in the economy when households and firms are oversaving and underspending.
This is an idea that President Roosevelt fully embraced in his economic policy. Demand management essentially means that the government makes up for the demand that is lacking from the private sector– from those consumers and firms who are not spending. The government does this by spending money accrued through taxation, or by borrowing. However, in times when households and entrepreneurs are saving too much, it isn’t efficient to tax them. Because doing so would decrease private demand even more. The Keynesian solution is to finance government spending through deficit finance. That is, the government borrows, and the borrowed money is used to fund this extra demand in the economy.
And then when the economic events, which cause the lack of demand, have passed and confidence is restored in the economy– for example, after the Great Depression– the economy begins to move out of this period of cataclysmic risk and worry and households and firms reduce their saving. The government is then able to claw back the money it’s previously borrowed through taxation, repay its deficit, and restore the government financial position. So depending on the cycle of activity, the process of recession, decline, and growth in the economy, the government should be managing the economy over the economic cycle.
Although the concept of demand management was born out of the Great Depression, it has been an ingrained part of economic policy in nearly all Western economies ever since. For example, prior to the coalition government coming to power in 2010 in the UK, the previous labour administration, under more than a decade of the management of the economy– by the then Chancellor Gordon Brown– used a form of cyclical demand management, with a fiscal rule that the government could spend and save over the economic cycle. This meant that the government could spend in periods when private demand was inadequate, and then save in periods when private demand was buoyant. So long as over the complete cycle, the budget was neutral.
Therefore, monies which had been borrowed to finance spending would be repaid. Of course, it’s not simple to implement the Keynesian demand management policy. This is for a couple of reasons. Firstly, although the underlying notion is that there is too little demand caused by too much saving in the private sector, the government doesn’t always know what the balanced position in the demand and supply in the economy should be. So it can potentially spend too little or too much. If the government inadequately adds to demand in the economy, then the economy will stay below equilibrium. And if the government spends too much, then that will create inflationary pressure because demand will outstrip supply, and prices will begin to rise.
The second concern is that the use of deficit financing to facilitate demand management caused the deterioration in the government’s fiscal position. This forces the government to rack up increased debt. And although this may be prudent over the business cycle, it means that, over a period of time, the government finances will deteriorate. And this is a potential problem because governments, like any other agent in the economy, can only finance the activity if the people lending to them think they will credibly repay in the future. We have seen what happened in the Greek economy, when investors lost confidence that the government would be able to repay its debts.
So borrowing a large amount poses risks to the government and the credibility of its public finances and the credibility of its own ability to repay its debts. Nevertheless, the notion of demand management is an entrenched idea in modern economics, which is born strongly out of Keynesian thinking, against a backdrop in which demand management wasn’t considered a tool by governments in the economy. This is another way in which Keynesian thinking radically shaped modern economics.