Really simple macroeconomics: Why businesses, employees, and investors disagree on what to do about the economy, and why nobody wants to fix the trade deficit.

Recently, I emailed to some friends this Mark Thoma post, "A New, Progressive Washington Consensus Remains a Feasible Goal" and got back an email asking what "aggregate demand" means. This was my reply (slightly edited), which upon reflection seems worth sharing with Realitybase readers because it helps explain why the various political factions line up behind different policies to address our economic stagnation.

Origin of the Aggregate Demand Term.  Typically, economics texts start with the concepts of "supply" (what quantity of an item sellers will offer at various prices) and "demand" (how much buyers will buy depending on price) and how the interplay of those two forces results in a market-clearing price and affects suppliers' plans for expanding/contracting capacity to supply such stuff in the future (shifting next season from corn to beans to cotton, etc.).  Building on this, the texts turn to macroeconomic issues—how zillions of those individual markets, plus tax systems, transfer payments, savings rates, the money supply/velocity, etc. work together to influence things like unemployment, inflation, and "business cycles" (economy-wide expansion or contraction of total economic activity).  In the macroeconomic context, texts use the term "aggregate demand" for the sum of all buyers' purchases of all goods and services in the US.  Notice that in the micro context, the discussion tends to be about "tendencies" and "preferences" and "curves" and "elasticity/inelasticity" of demand "functions," but in the macro context aggregate demand generally means what actually was purchased and sold last month or last year; so maybe "aggregate demand" is not the most felicitous or obvious term to describe the sum of all actual transactions, but there we are. 

Here's how "aggregate demand" fits into the current political economy debate in Washington.

GDP and Aggregate Income.  The official definition of Gross Domestic Product ("GDP") is that it equals Personal Consumption Expenditures + Business Investment (in such things as offices and factories) + Government Expenditures (consumption and investment but not transfer payments like unemployment insurance or Social Security) + Net Exports (unfortunately for the US a negative number for the last 30+ years).  Each of these four buckets of production can only be sustained if the customers (personal, business, government, and foreign) keep buying at the same levels—thus, maintaining their respective contributions to aggregate demand.  (The GDP calculation doesn't know or care whether the money spent to support aggregate demand is from current income or is borrowed, as much of it was in the housing bubble.)  Except for build-ups and draw-downs of inventories, aggregate demand must (as a matter of the applicable double-entry accounting identity and common sense) equal aggregate production and sales. It's the production and sales that give people/institutions incomes that allow them to contribute to aggregate demand by buying more goods and services.  So if aggregate demand declines, aggregate incomes must also decline in the same amount, which is the opposite of what most of us desire.  Of course, incomes tend to decline more and faster for the least powerful and often not at all for the most powerful, a cause of increasing inequality. 

Keynesian Stimulus of Aggregate Demand by Government Deficit Spending.  It has been observed that aggregate demand varies from time to time depending on how much money people have to spend (which is strongly influenced by unemployment, wage rates, and the availability and cost of credit), their degree of optimism or pessimism about the future ("animal spirits" in Keynes's phrase), and other factors.  The key Keynesian insight about the Great Depression was that really deep, prolonged reduction of economic activity is not necessarily self-correcting as had always been assumed (and is still assumed by right-wing economists and the former Washington Consensus).  He showed how aggregate demand can get stuck at a low equilibrium level and is hard to get started again—because employment and wages, on which 70% of aggregate demand depends, are stuck or keep spiraling downward—and pessimism reigns.  Keynes said government should kick-start economic activity into self-perpetuating growth by temporary deficit spending to replace the part of aggregate demand that went missing from the private and business sectors (foreign trade was not a big factor in those days).  Note that if government increases spending but keeps its budget balanced by increasing taxation, there is little or no stimulative effect because personal and/or business aggregate demand is further reduced approximately a dollar for each dollar of increase in aggregate government demand/outlays.  Therefore, an unavoidable consequence of deficit hawkishness is that it precludes the use of Keynesian stimulus and tends to drive GDP down instead of up.  So who wants to eliminate the possibility of Keynesian stimulus by keeping the federal budget in balance? Lenders do. They are deathly afraid of inflation because the debt securities they hold will immediately lose market value as interest rates climb, and if held to maturity the loans will be repaid with dollars that have less purchasing power (which tends to make it easier for debtors to repay).

Business Investment Aggregate Demand Stimulus.  Republicans and business/finance interests typically argue that we can stimulate aggregate demand (and jump start the economy) by encouraging an increase in Business Investment by lower corporate tax rates, paying subsidies, providing other benefits that add to business profits, and reducing tax rates for high-earners.  Whether the economy as a whole responds or not, these policies are mighty welcome to businesses and their top executives. Although theory provides some support for such actions, the problem is that in recent decades we've been doing a lot of that and the macroeconomic benefits have been very poor to non-existent.  Businesses have not been investing in plant and equipment in America at historic rates but have been paying bigger dividends, buying back their own stock, buying other companies, and building facilities abroad.  Even when Acme Industries does buy some new machine tools for its Cleveland plant, if they buy those machines from Germany, to that extent there is no increase in aggregate demand or US GDP.  Thus, in our highly globalized economy, some part, maybe a large part, of any increased Business Investment demand "leaks" offshore.   

Personal Consumption Expenditure Aggregate Demand Stimulus.  Labor- and consumer-oriented Democrats (and Keynes) say government gets the biggest, most immediate and strongest aggregate demand increase for its deficit-spending buck by putting money into the hands of poor and middle class people who will spend every dime of it immediately—thus quickly increasing aggregate demand in the consumer expenditure bucket.  Obviously, this is in the self-interest of the recipients even if it doesn't work for the economy as a whole.  When the US economy was largely self-contained, such boosts to aggregate demand created opportunities for domestic businesses and their employees to produce more and earn more.  Now, however, to a considerable degree increased aggregate consumer demand "leaks" to offshore factories and service centers and stimulates increased production and incomes in Chindia instead of here. 

Net Exports Are Killing Us.  The part of the GDP equation that is being largely neglected by politicians is Net Exports.  Obama has announced a goal of increasing exports by a certain implausible amount, but if imports increase by the same amount (as they probably will), there will be no improvement in Net Exports and no resulting improvement in GDP.  He's blowing smoke in our faces.  Further, as net offshoring of jobs continues, the wages and salaries associated with the lost jobs are pulled out of aggregate consumer demand domestically.  Similarly, businesses, pursuing cheaper labor and other cost advantages, are reducing their aggregate demand for new/expanded domestic plant and equipment in America and are investing instead in Chindia—adding to aggregate business demand and incomes there instead of here.  These effects and the "leakage" of remaining domestic consumer demand and business demand for imported capital goods create a continuing economic downdraft that is apparently stronger than the lift from any Keynesian countercyclical government deficit spending.  To my great frustration, we are arguing in Washington about how to get the economy back to the trend line and ignoring the fact that the trend line has been plunging downward for at least 11 years.  Deck chairs. Ice bergs. Arrrgh!  Why is this balance-of-trade ice berg being neglected in Washington—by Republicans and Democrats? I think it's because Wall Street, multinational corporations, and other powerful interests are profiting handsomely from the status quo, and both parties are heavily reliant on these interests to finance their election campaigns.

Update on Sunday, May 8, 2011 at 06:33AM by Skeptic

As an example of business using profits to repurchase their own equity shares we have this from Center for American Progress: