Intro: Growth does not result from an increase in demand, but from an increase in profitable ways to satisfy that demand. The idea that a lack of demand can cause a recession ignores the key point that demand is infinite and that any withheld consumption now must be in anticipation of future consumption.
Mainstream economists often used the term ‘demand’ to explain changes in economic growth in lieu of a true understanding of how what drives production. When growth is strong economists assume that this must be because consumers are demanding more stuff and vice versa. We often here how consumption is ~70% of the US economy so consumer demand must be the key driver of economic growth. Unfortunately consumers demanding more stuff does not magically allow businesses to produce more stuff.
While the growth of a certain good is driven by demand for that particular good, the demand for all goods and services in an economy is infinite (people will always want more stuff, all else equal). It is how much of this demand can be satisfied by the available supply of resources that is what we want to figure out.
What economists generally mean when they say ‘demand’ is the demand for goods at prices that are profitable to produce. Weak growth does not result from a lack of demand, but a lack of profitable ways to satisfy demand. If consumers decide to increase their savings, this means that they demand less consumer goods right now because they want to save more so they can consume more in the future.
It is often feared that a decline in the demand for consumer goods today will be seen as a sign to businesses that consumer demand will be weak for a long time and thus it will discourage investment. If no one is willing to consumer, the argument goes, then who is going to be willing to invest in future consumption.
However, this ignores two fundamental characteristics of human nature; namely that people generally prefer to consume stuff now than in the future, and that people will always look for ways to make a profit. It is useful to think of the behavior of the stock market as a microcosm of the economy. When investors become nervous about the future they sell stocks in anticipation of them losing money. However, when prices fall far enough that the return on investment in stocks is sufficient, investors will buy and prices will rise again.
Weak Consumption Does Not Necessarily Mean Weak Production
It Is sometimes argued that recessions occur due to a lack of demand. On the face of it this does appear to be the situation, but it is the proximate and not the ultimate cause. Let’s assume for illustration that consumer preferences dramatically change such that people become unwilling to buy any goods or services except for food and drink, so the savings rate rises to something like 90%. Such a scenario would not mean that the demand for other goods had fallen to zero but rather than they could not be produced at any price that consumers would be willing to buy.
In such a case all the country’s resources would be channeled into food and drink production. Workers would move into all the different stages of the agribusiness sector. More combine harvesters and tractors would be produced as automakers changed their production away from cars and towards farming equipment. New agricultural production methods would be developed as labour scientists and engineers shift their focus to the industry. Consumers would be rewarded for their frugality in other areas of consumption with the increased availability of affordable fine food and beverages, for instance.
Beyond the initial recession resulting from businesses having to re-orientate their production, there need not be any reduction in overall production. More capital goods would be produced as consumer goods production falls. In fact, because in this example very few resources are actually being consumed, overall production would likely increase as the greater availability of resources would result in higher overall investment.
Over time, all the food that could possibly be consumed could be produced with a fraction of the labour and capital stock that was available to be used in agriculture. Workers would then be able to produce non-food goods with their free time and with the spare resources available.