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Economic booms and busts Chapter 7

In fact ... the very measures which the dominant “macro-economic” theory has recommended as a remedy for unemployment, namely, the increase of aggregate demand, have become a cause of a very extensive misallocation of resources which is likely to make later large-scale unemployment inevitable. The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate—or perhaps even only so long as it continues to accelerate at a given rate.

Friedrich Hayek (1974). The Pretense of Knowledge.
Lecture given in acceptance of the Nobel Prize for Economics.
In Bruce Caldwell (ed.),
Markets and Other Orders, XV
(Liberty Fund Library, 2014): 367.

I. The role of “aggregate demand”

Business people know that their profits rise and fall with rises and falls in the demand for the products they sell. If more paying customers are streaming through the doors, times are good. Fewer customers, in contrast, mean worsening times—and, for many firms, even bankruptcy.

Likewise for workers. They understand that the greater the demand for their employers’ outputs, the greater the demand for their labour services. When business is booming, their jobs are more secure and their wages rise. When business is bad, jobs are less secure and wages stagnate.

This understanding by business people and workers of the importance of high demand in their industries and firms is correct. But as explained in the previous chapter, our roles as producers can mislead us into making mistaken conclusions about the larger economy. One such mistaken conclusion about the larger economy is that economic downturns—recessions—are caused by too little overall demand. A follow-up mistaken conclusion is that the appropriate cure for recessions is a set of government policies that increase demand.

Because an economy-wide recession affects nearly all firms and industries and not just a few, the demand that is said to be too low during recessions is called “aggregate demand.” Aggregate demand is the overall demand in an economy for all goods and services. The single most influential economics book written in the twentieth century is The General Theory of Employment, Interest, and Money , by the British economist John Maynard Keynes (1883–1946). Keynes reasoned that, just as high demand is key to the success of an individual firm, high aggregate demand is key to the success of a whole economy.

In Keynes’s view, economic recessions are caused by too little aggregate demand. The cure for recessions, therefore, is higher aggregate demand. And the best way to increase aggregate demand is for government to ramp up its spending until economic health is restored—that is, until full employment is reached.

This Keynesian view is widespread. It seems to make so much sense. But it suffers serious flaws. And perhaps its biggest flaw is its focus on aggregate demand.

By focusing on aggregate demand, Keynesian economics ignores the all-important (“microeconomic”) details of an economy. These vital details are how well or poorly each of the economy’s many individual parts “fit” together and work together to generate goods and services for consumers, and to create job opportunities for workers.

If you have all of the parts of, say, an automobile scattered randomly about a large room, the main reason you do not have a functioning car is not that you do not want, or that you fail to “demand,” such a car. Instead, the chief reason you have no functioning car is that those parts aren’t fitted together in ways that allow them all to operate smoothly together so that a drivable and reliable car exists. It’s true that no one will exert the energy and initiative required to assemble all of the parts into a working vehicle if there is no (or too little) demand for such a vehicle. But your desire to have a drivable car is not really the main obstacle standing between you and a working vehicle. The main obstacle is the challenge of mobilizing all the knowledge involved in assembling these pieces into a car and motivating people to put forth the effort to perform that assembly.

The desire of nearly everyone to possess and consume automobiles, along with lots of other goods and services, can be depended upon always to exist. The challenge is to ensure that producers have the knowledge and the incentives actually to produce the goods and services that people want. The challenge, in other words, is to get the economic details right so that producers have both the knowledge and the incentive to produce the “right” mix of outputs.

Relative prices are the main source of both this knowledge and these incentives. Relative prices are the prices of some goods and services relative to the prices of other goods and services. Examples are the price of a Toyota automobile relative to the prices of a Ford automobile and of a Honda auto mobile, or the price of a bushel of wheat relative to the prices of a bushel of rye and of a bushel of rice.

Relative prices are the most important “directors” of economic activity. If the pattern of relative prices accurately reflects the many different demands of consumers as well as the costs of the inputs that can be used to satisfy these demands, then entrepreneurs, investors, and consumers will be led by these prices to act in ways that result in all of the economy’s “pieces” being fitted together into a productive whole. The economy at large will work pretty smoothly.