I have been stimulated to write this diary from reading discussions on economic policies on the site. I realised that in order for people to understand some of the arguments and criticisms of the economic policies of the Obama administration it would be useful to understand some notion of Keynes’s (and Kalecki’s) theory of effective demand. As the piece grew in length, I realised that it would be useful to separate the development of economic theory with respect to economic growth and then to separate this from a discussion of what are some of the difficulties that economists are having in trying to come up with economic policies to try and address the current economic crisis. I am concentrating solely on one specific thing in both of these diaries, that is, the role of demand and effective demand and its relation to economic growth in the context of a capitalist economic system. Other economic systems do not have the constraint on growth imposed by the (in)sufficiency of effective demand. I am also deliberately not discussing either financial matters or money in these diaries.
Keynes was very aware of the political aspects of the argument presented in the General Theory. As someone who was a member of the Liberal party and who detested the whole idea of socialism and given the fact that both socialist and communist parties were growing in power as a result of the great depression, he believed that his ideas were a way to save capitalism while recognising its inherent problems and providing protections for people when those problems inevitably and predictably arose. As such, Keynes didn't miss the political aspect of the General Theory. That is why he rushed it to publication without ironing out some of the inherent inconsistencies between what he argued with the microeconomic foundations underlying neo-classical (or marginalist) long-period equilibrium theory and this was irrespective of his colleagues (e.g., Piero Sraffa) warning him of the problems in the manner in which he constructed his analysis.
Perhaps, the most important contribution in the General Theory was Keynes theory of effective demand. I am going to provide some history of the discussion of economic growth in earlier classical economics and the rise of the notion of Say’s Law. Adam Smith (1776) wrote prior to the articulation of what is known as Say’s law. In his discussions of economic growth, Smith stressed the importance of the market and the role of demand in ensuring its growth. Smith argued that the division of labour is limited by the extent of the market; what he is addressing here is that the economic growth and development is constrained by the demand (or market) for the products of industry. In other words, unless there is demand by consumers and producers (either domestically or internationally), there is no sense to alter the manner in which production takes place and to increase investment and production of either more or new products if there is no one to purchase these things. The rise of the notion of Say’s Law shifted the discussion of economic growth from one in which the role of demand was central towards one which only considered the growth of supply. This is appropriate as that became the dominant position in economic theory from the point that it was articulated by James Mill. Mill (1804) argued that production created its own demand. What that means is that he maintained that economic growth was primarily concerned with increasing the production of commodities as there is no difficulty ensuring realisation of the surplus product (specifically, profits and rents). This argument implies that the increased production would have no difficulty of being sold at a price which covered its three primary components (replacement of the value of capital used up in production, payment for wages and rent, and a profit component to ensure that capitalists/entrepreneurs obtained a remuneration which could be used for further investment and economic growth and to cover their own consumption). That is, that there was always sufficient demand to ensure that increased production would always been remunerative. There were some notable objections to this unanimity, e.g., Lauderdale and Malthus, both of whom raised the problem of under-consumption such that the price obtained by new production was not able to cover its costs, replacement of capital used up in production and provide for a profit).
Another way in which to look at this is that the level of savings determines investment; and as such, whatever was saved would be invested in future production (either as expansion of capital or as final products). The acceptance of Say’s Law was maintained through the transition from Classical to Neo-classical (or marginalist theory) in the 1870s. This is the reason that both economists and politicians were completely incapable of developing coherent policies in order to deal with the Great Depression; economic theory maintained that deviations were only a short-term corrective mechanism and that the economy would rapidly return to a situation of economic growth and stability. The articulation of the theory of effective demand simultaneously by Keynes and Kalecki in the light of the great depression was a direct attack on the idea that production creates its own demand. It recognised that cycles and economic instability were a normal part of the capitalist economic system (whether they were due to short-run phenomena (such as stickiness in prices, the inability of altering supply commensurate with demand, inconsistency of level of capacity utilisation wrt its requirements), part of the normal pattern of destruction of redundant capital or its replacement in more appropriate forms, or longer term problems within the system, (such as persistent unemployment due to insufficient demand for labour).
The theory of effective demand maintained that a capitalist economic system is a demand driven (or constrained system). They argued that effective demand (demand backed by payment) not only determines the level and composition of output (its quantity and what products actually are produced), but the level of employment (accepting that full employment is not a property of the system and that the demand for labour will depend on the previous accumulation of capital and expected demand for output), and that expected demand then determines further investment and production. This argument is not only a theoretical discussion in economics, but it is established by historical fact.
The nature of a capitalist system basically requires the constant creation of needs in order to ensure economic growth and to avoid stagnation. If there is product saturation, then there will be limited production of that product as there limited demand for it. This is part of what it means when it is said that capitalism is a demand-driven or demand-constrained system. Whether this creation of demand come about through the creation of new needs, deliberate break-down of consumer durables requiring replacement, creation of new versions of old products to encourage substitution through up-dating, or vertical differentiation (producing higher level or quality versions of a product) what is common between these tactics is the attempt at creation of demand for the products of industry; this holds in both the short-run as well as the long-run. Without demand (either current demand, expected or unpredicted demand), the capitalist system comes to a halt. Put simply, without effective demand, there is no new investment, production or employment in a capitalist economy. This is true at all levels of the economy.
Keynes only addressed the problem of insufficiency of demand in the context of a temporary crisis in the capitalist system; maintaining the link to a neo-classical long-run equilibrium position in which there would be full utilisation of all resources and in which all aberrations in the system would have time to be ironed out (including that demand would adjust to the level of supply).
This brings to our discussion of the history of economic thought in the post-Keynesian and post-Kaleckian period. One of the problems derives from Keynes himself as he was seriously concerned with the transformation of economic policy rather than developing a coherent theoretical analysis. He primarily put the discussion of the theory of effective demand as an explanation of what happens in the context of a cycle (e.g., business cycle, trade cycles, etc.) or an economic crisis as a short-run divergence from the long-period equilibrium position. This is what allowed New Classical economists (like Sargeant, Barro, Lucas, etc) to say that Keynes's argument was inconsistent with the precepts of long-period equilibrium analysis and what forced new Keynesians to place their discussions in the context of monopolistic competition, oligopoly, and imperfectly competitive models. This was the theoretical platform upon which the attacks against Keynesian arguments were launched.
Perhaps, if Keynes had the time to extend his discussion on effective demand to a long-run model, then the argument concerning demand determining production, etc. would not be an argument that is centred outside of the mainstream of economic analysis and, I believe, that the point that demand constantly constrains capitalism as a whole would be being raised by economists. Most politicians do what they are told and rarely understand the manner in which the system functions. The differences that I have touched upon between economists just one this one question is one reason that we see differences between economists addressing the current economic crisis and it is also one reason why there is so much uncertainty as to what will work to provide solutions to these problems.