Why Must Supply Precede Demand? Understanding Economic Foundations

In the market economy, wealth generators do not produce everything for their own consumption. Part of their production is used in exchange for the produce of other producers. Hence, in the market economy, production precedes consumption.

This means that something is exchanged for something else. This also means that an increase in the production of goods and services sets in motion an increase in the demand for goods and services.

According to David Ricardo,

No man produces, but with a view to consume or sell, and he never sells, but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.

Note that an individual’s demand is constrained by his ability to produce goods. The more goods that an individual can produce, the more goods he can demand or acquire.

If a population of five individuals produces ten potatoes and five tomatoes, this is all that they can demand and consume. The only way to raise the ability to consume more is to raise their ability to produce more.

The introduction of money does not alter what we have said so far. Observe that money is not the means of payment but the means of exchange. Individuals pay with goods and services they produce—they do not pay with money.

On this Ludwig von Mises wrote, “Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities.”

By means of money, an individual can channel savings (i.e., unconsumed consumer goods) to other individuals, which in turn permits the widening of the process of wealth generation. Whenever the individual deems it necessary, he is likely to exchange his money for goods.

Does a Weakening in Demand Cause Recessions?

It is widely believed that the cause of recessions is a weakening in demand, and thus the way to fix the problem is to boost demand. Whenever an economy shows signs of weakness, most experts are of the view that what is required to prevent the economy from sliding into a recession is to boost the overall demand for goods and services. If the private sector fails to increase its demand, then the government should counter balance this decline in the private sector demand by raising the government demand for goods and services.

The whole idea that the government can grow an economy originates from the thinking that an increase in government outlays gives rise to the economy’s output by a multiple of the initial government increase. Following this way of thinking, it is not surprising that most economists today are of the view that by means of fiscal stimulus, it is possible to prevent the economy falling into a recession.

Let us examine the effect of an increase in the government’s demand on an economy’s process of wealth formation.

In an economy, which is comprised of a baker, a shoemaker, and a tomato grower, another individual enters the scene. This individual is an enforcer (i.e., a government) who is exercising his demand for goods by means of force. The baker, the shoemaker, and the farmer are forced to part with their product in an exchange for nothing and this, in turn, weakens the flow of production of final consumer goods.

As one can see, not only does the increase in government outlays not raise overall output by a positive multiple, but on the contrary, this leads to the weakening in the process of wealth generation in general.

By means of taxation, the government forces producers to part with their products for government services, goods and services that are likely to be on a lower priority list of individuals which weakens the production of wealth. According to Mises, “There is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.”

Not only does the increase in government outlays fail to raise overall output by a positive multiple, but on the contrary, this leads to a weakening in the process of wealth generation in general.

The dependence of demand on the production of goods cannot be removed by means of monetary pumping and government spending. On the contrary, loose fiscal and monetary policies will only impoverish real wealth generators and weaken their ability to produce goods and services, weakening the effective demand.

Therefore, what is required to revive the economy is not the boosting of aggregate demand but curbing government spending. This will enable wealth generators to revive the economy by allowing them to move ahead with the business of wealth generation. Hence, by strengthening the economy’s ability to produce goods and services, we are strengthening the aggregate demand.

What Causes Recessions?

For most commentators the occurrence of a recession is a result of unexpected events such as shocks that push the economy away from a trajectory of stable economic growth. Shocks weaken the economy (i.e., cause lower economic growth), so this view has held. In contrast, we suggest that as a rule a recession is the product of the central bank’s monetary policies. Usually this takes place in response to a tighter stance of the central bank. Various activities that sprang up on the back of the previous strong money growth rate (because of previous loose central bank monetary policy) come under pressure.

These activities cannot support themselves—they survive because of the support that the increase in money supply provides. The increase in money diverts to them wealth from wealth-generating activities. Consequently, this weakens the wealth-generating process.

Because of the tighter stance and a consequent decline in the money supply’s growth rate, this undermines various nonproductive activities. This is what recession is all about.

Given that nonproductive activities cannot support themselves since they are not profitable, once the money supply’s growth rate declines, these activities begin to deteriorate. Obviously, then aggressive fiscal policies, which are going to provide support to nonproductive activities, will restart weakening the wealth-generation process, thereby weakening the prospects for an economic recovery.

Summary and Conclusion

During an economic crisis, the government needs to do as little as possible. With less tampering, more wealth remains with wealth generators, which allows them to facilitate an expansion in the pool of wealth.

With a larger pool of wealth, it will be much easier to absorb various unemployed resources and eliminate the crisis. Aggressive loose monetary and fiscal policies are going to hurt the process of wealth generation, thereby making things much worse.

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