Jean-Michel Basqiat, ‘Profit 1’ (1982)

Supply and demand quandary

Both neoclassical and Keynesian economics have got it wrong, writes Michael Roberts

Is it supply that drives an economy or demand? Such was the question asked by Keynesian economics blogger and Bloomberg columnist Noah Smith. Smith often raises issues that enlighten us on the differences (and similarities) between mainstream neoclassical and Keynesian economics and, in so doing, where Keynesian theory and policy differs from a Marxian analysis.

In a recent article, Smith questioned the traditional neoclassical view of economic growth: namely that real GDP expansion depends on employment plus productivity (output per employee).1 This neoclassical view, says Smith, means that while Keynesian monetary and fiscal policies might get an economy out of a slump, they can do little to raise long-term productivity growth. But he begs to differ.

This ‘supply-side view’ is inadequate, says Smith. Boosting demand with Keynesian-style measures of cheap money and government spending could create the conditions for raising output permanently onto a new and higher trajectory: “it may be time to momentarily step away from economic orthodoxy and look at demand-based policies to help boost productivity”. There is a ‘demand side’ view of long-term economic growth.

Smith cites Verdoorn’s law2 as relevant to this thesis: “Dutch economist Petrus Johannes Verdoorn describes a correlation between output and productivity - when growth is faster, productivity also grows faster.” This, claims Smith, “leaves open the tantalising possibility that the reverse is happening - that high levels of aggregate demand also drive up productivity”. So, when there is a boom in demand, this leads to more sales and output, and encourages companies to invest more; as a result, there is rising productivity. Thus demand creates its own supply - the reverse of Say’s law, as promoted by Ricardian and neoclassical economics, that supply creates its own demand.

So has neoclassical economics got things back to front and all we need to do in economic policy is to keep “running the economy hot, through continued monetary and fiscal stimulus”? Well, the first thing to say is that Smith’s reference to Verdoorn’s law, to support his argument that Keynesian-style demand boosts will sustain increased productivity, is misleading. Actually, all that Verdoorn shows is that “in the long run a change in the volume of production - say about 10% - tends to be associated with an average increase in labour productivity of 4.5%”. This correlation proves nothing about causation. So output and productivity growth are correlated - surprise! - but is it total ‘demand’ or output growth that stimulates productivity growth, or vice versa?

Smith cites research that is supposed to show the causal connection from demand to supply, but when you check that research you find that the authors cited - Iván Kataryniuk and Jaime Martínez-Martín3 - conclude: “some of the deterioration of the TFP [productivity - MR] growth outlook in recent years may be explained by a negative business cycle, but structural weaknesses remain behind the slowdown in medium-term growth, especially for emerging countries”. So it is not demand that is the main cause of long-term productivity growth.


From a Marxist view, what is missing from this debate - as always between mainstream neoclassical and Keynesian disputes - is profit and profitability. Sure, it is obvious that, when an economy is booming and demand for goods is strong, then companies will usually increase investment in new technology, as well as employing more workers (but I say ‘usually’, because in this long depression, it seems companies have increasingly kept cash or invested in financial assets - ie, their own shares - rather than in productive assets).

An expanding economy leads to a virtuous circle of growth, investment and even productivity growth. But that virtuous circle eventually turns into a vicious circle of slump, a collapse in investment and output that cannot be corrected by easy money or fiscal stimulus. Why does a boom turn into slump? The Marxist view is not because of some unexplained shock to the harmonious development of the market economy (the neoclassical view) or some unexplained change in the ‘animal spirits’ of entrepreneurs to invest (the Keynesian view). It is because, in a profit-making economy (ie, capitalism), profitability and profits fall back. When that happens, as it will at recurring intervals, then output, investment and productivity will follow. There is a profit cycle.

The Marxian view argues that it is the Keynesians who have it back to front. Supply leads demand, not vice versa. But this is not the same as the neoclassical view that supply creates its own demand (Say’s law). For Marx, Say’s law was a fallacy.4 In a monetary economy, there is always the possibility of a breakdown (both in time and inclination) between sale for money and purchase with money. Hoarding of money can cause a collapse of sales and purchases. But what causes that possibility to become a probability or reality? For Marx, it is a fall in the profitability of capital.

In the Keynesian world of macro-identities, national income (NI) equals national expenditure (NE). National income is composed of wages and profits, while national expenditure is composed of consumption and investment.

‘NI = NE’ can be decomposed to: ‘Wages +Profits = Consumption + Investment’. If we assume that workers do not save, but spend all their wages, then the equation becomes: ‘Profits = Investment’.

This is an identity that does not reveal the causal direction. The Keynesian view is that investment (demand) creates profits (supply). But the evidence is against Noah Smith and the Keynesians. The body of empirical evidence is that changes in profitability and profits lead to changes in investment.5 And it is this that decides when there are cyclical booms and slumps - and also the long-term growth path of a capitalist economy.

Smith says that “much more research is needed” to see whether demand creates supply or vice versa. But the research is already there. It is well established that ‘easy money’ (low interest rates and ‘quantitative easing’)6 will not work in restoring long-term productivity growth - as Keynes also concluded in the 1930s and the evidence of the last 10 years confirms. The search for some ‘natural rate of interest’ that establishes full employment and maximum potential output growth is a mirage (reaching for the stars).7

And studies (including my own) show that the (Keynesian) ‘multiplier’ effect of boosting government spending, or running the economy ‘hot’ (Smith) is much weaker (and even inverse in direction) than the impact of the profitability of capital on growth and productivity.

Clearly, in this long depression, hysteresis is in operation8: namely that low growth in output and profits has pushed investment and productivity growth onto a permanently lower trajectory. But this is not the result of a lack of ‘effective demand’ per se, but comes from the failure of the profitability of capital to return to pre-2008 levels and/or to grow fast enough.

Smith may suggest that neoclassical theory has got it ‘back to front’. But so has Keynesian theory.

Michael Roberts blogs at thenextrecession.wordpress.com.


1. www.bloomberg.com/opinion/articles/2018-12-04/maybe-we-have-the-economic-growth-equation-backward.

2. See https://en.wikipedia.org/wiki/Verdoorn%27s_law.

3. http://econbrowser.com/archives/2018/12/guest-contribution-what-are-the-drivers-of-tfp-growth-an-empirical-assessment.

4. Eg, www.marxists.org/archive/marx/works/1863/theories-surplus-value/ch17.htm.

5. See https://thenextrecession.wordpress.com/2017/04/25/hmny-the-profit-investment-nexus-keynes-or-marx.

6. https://thenextrecession.wordpress.com/2015/11/11/keynes-marx-and-the-effect-of-qe.

7. https://thenextrecession.wordpress.com/2018/08/26/the-feds-star-gazing.

8. https://thenextrecession.wordpress.com/2017/07/13/will-reversing-austerity-end-the-depression.