Dear Friends,
It seems to me, supply really does drive demand in the creative phase of the creative destruction cycle, and arguments to the contrary are most often based on observation bias. The theory that supply drives demand is Say’s law, but I am changing it a bit. Keynesian economic theory is that demand drives supply which is the opposite of Say’s law. These two theories have been at odds since John Maynard Keynes developed his theory. Keynes theory falls short of the mark, as does Say’s law, but if we combine Schumpeter’s theory with that of Say, the amalgam provides us with a better snapshot of the workings of a healthy economy. This is because an economy is a complex system, and complex systems are by their nature messy, making it impossible to quantify and measure the inputs to any real degree of reliability, therefore economics are a pseudo science or in other words, an art. This is important because our lives are better when we live in an expanding economy with a rising standard of living.
Economics is not a real science in the strictest of terms. The theories cannot be independently verified because the fundamentals cannot be effectively measured. Moreover economics, like any of the humanist “sciences,” are subject to the personal bigotries of the “scientist.” These pseudo sciences have built in traps for those who would promote their theories over those of another. One of those traps is observation bias. In the hard sciences like physics the parameters can be set, measured and quantified. The bias of the observer is irrelevant, a stone dropped accelerates at nine point eight meters per second squared, no matter who is observing it, but since humanistic sciences, economics and climate “science” are not hard sciences based on directly observable phenomenon, but are instead complex systems that have far too many inputs and interactions, so observing and measuring any number of inputs and interactions, many of which are not directly observable at all let alone measurable, gives very little insight into the emergent phenomenon that is different in kind than the sum of the inputs… a key distinction of a complex system.
Since economics is the science/art of a complex system, theories cannot be measured by looking at any of the inputs, but instead must be measured from the emergent phenomenon that rises from the complex system itself. In other words, we cannot reason from the bottom up, like the hard sciences, we have to reason from the top down, and even then, we find observation bias creeping in. In the aggregate demand aggregate supply model, the assumption is that if there is no demand for products and services, any supply is over supply, and therefore demand drives supply. In Say’s law, that supply drives demand, the foundation is that if there is a supply of something there will be demand, even if the demand is at a price point that is lower than the manufacturing cost. In Schumpeter’s theory of creative destruction, the theory rests on the concept that new ideas draw in the means of production until the idea is fully implemented, then the outmoded ideas are destroyed.
All those theories start at some sub function of the complex system, demand, supply, new ideas, etc… then reason from the sub function or input, to the emergent phenomenon. As I have explained this is not an efficient way to reason about complex systems. If we instead look at the desired results, the emergent phenomenon we seek in an economic system, IE. a “healthy economy,” and then reason down, we are more likely to find workable theories that are less subject to observation bias… as long as the term “Healthy economy” is agreed to at the outset. Let’s set the parameters for a “healthy economy,” to be full employment, an expanding economy and a rising standard of living. Notice I didn’t make one of the parameters no recessions. This is because recession’s are clearly a facet of a healthy economy as we have described. We can deduce this by the fact that all complex systems grow in fits and starts, animals and plants grow rapidly, slow, then grow rapidly again, until they have reached maturity. Weather patterns change constantly from rain to clear and back to rain, all complex systems wax and wane and therefore reasoning from the top down, we can reasonably conclude recession is a function of a healthy economy, just as sleep is a function of a healthy body.
The emergent phenomenon of a healthy economy, requires a high utilization of workers, increasing demand for products and services, innovations that improve the standard of living and rising wages relative to the cost of living. From this we can see that driving demand by whatever means has no effect on innovation, it has no direct correlation to wages and only a tangential correlation to demand for labor. Creative destruction correlates well with innovation and tangentially with demand for labor but falls short of the mark when it comes to wages and demand. Say’s law that supply drives demand also falls short. If we combine them however we can get closer to describing conditions required for the emergent phenomenon we are calling a healthy economy.
Justus Moser lamented the fact that the market system invents new products then creates a demand for them. Before there were home computers there was no demand for them, in fact many of the economic brianiacs of the day argued there would never be a need for a home computer, because who needs all that number crunching power? Once the PC came out however, many new uses, from word processing and spreadsheets to computer games followed, giving the home computer uses that exceeded anyone’s initial concept of what a home computer would do. These innovations drove demand for the products they created and for their ancillary products as well. The same holds true for new innovations that have not even been thought of yet.
Aggregate supply aggregate demand, being easy to quantify is therefore scientific appearing, it is an oversimplification however that leads to many negative policies that hinder an economy from being healthy. Moreover it is especially subject to observation bias. This model is easy to understand. The most pernicious effect of this theory is that it’s inherent observation bias gives rise to bad policies. Policies that encourage politicians to deficit spend and redistribute other people’s money. It argues all demand is equal. If that was so then full aggregate demand of anything would give rise to a healthy economy. This is reasoning from the bottom up however. For example, if the only demand in an economy was for cocaine and all the productive resources was put to that end, would that lead to a healthy economy? Of course not, a truly sick economy would arise from such demand, even though aggregate demand exceeds aggregate supply, proving the weakness of the aggregate demand aggregate supply model.
If however, we combine Say’s law with Schumpeter’s creative destruction, reasoning from the top down, we find we have a better description of what is needed to have a healthy economy, ergo… sufficient demand for supply, innovation that betters people’s lives, increasing demand for labor and a rise in real wages driven by the demand for more complex labor. Put simply the theory simply works. Reasoning further down, we can observe the conditions that give rise to creation and the supply produced driving demand. The lower we descend however the more observation bias is likely to come into play. Creation requires as a prerequisite, ease of starting a business, else there can be no creation. This presupposes access to the capital necessary to start a business along with the tax and regulatory environment conducive of it. If these conditions are not met, lacking the supply that creation provides, demand falls short, and an economy fails to meet our definition of healthy. That is why I say, creative destruction must be wedded with Say’s law, to better explain the factors that give rise to the emergent phenomenon of a healthy or sick economy, which then points us to policy directives that will result in a healthy economy.
Sincerely,
John Pepin
