What is demand?

It occurs to me that many misunderstandings of economics today come from a confusion with "demand" and "need". A common broken window fallacy is to say things like "World War 2 boosted demand for tanks and similar resources to fight off the Nazi's, and since a depression is essentially a lack of demand, World War 2 (and big government spending in general) ended the Great Depression. Furthermore, the bombing raids that destroy people's homes increases demand as well, as those people will now need to buy new homes.", or similar reasoning.

"What actually brought the Great Depression to an end was the enormous public spending program otherwise known as World War II."

- Paul Krugman

These statements only appear to have some genuine reasoning behind them because the english language has two different uses for the word "demand".

In one sense, demand can mean a need or desire. It is certainly true that war can create very pressing needs in society, both for protection from destruction and repairs for the damages it causes, just as it is true that breaking a shopkeeper's window creates a need from him for a new window.

Look at this thriving economy!

But the other meaning that I think economists are more familiar with when talking about markets is desire enabled by purchasing power. It doesn't matter how much I want something if I don't have the ability to purchase it from someone else. An increase in purchasing power, not need, is what increases demand.

So with this distinction, we can immediately see a problem with the idea that that destruction increases demand as it focuses on generating need as compared to empowering already present needs. But to avoid further logical blunders and to understand the full extent of the damages of destruction, one must understand what purchasing power is.

So where does purchasing power come from? If you ask your average Joe how you can increase your purchasing power the first response you'll likely here is "get more money". This appears to be true at first. If I want to make more purchases, I need to have more money. If you look at supply and demand charts, the axis beside whatever you are trying to purchase is measured in dollars as well. 

But it goes a little bit further than this. If money itself was what enabled demand, then simply printing more money could increase demand. This is exactly the mistake people make when they support "stimulus packages" that will save the economy by giving everyone more money, thus letting them buy more things and fixing the economy forever. But that's only looking at half of the story. Money is just a commonly used medium of exchange. Take out the extra step, consider trade in the term of bartering, and you can see its true nature.

To be able to demand anything you need to produce something someone *else* demands. To be able to offer something in trade, you need to have produced that thing that you offer in trade, just as they needed to produce the thing they are offering to you.

On markets, products are exchanged against products.

With this, we can see that words like "supply" and "demand" are really entirely relative terms. They're two sides of the same coin. The graph above would be just as accurate, nay, more accurate to say "quantity A" and "quantity B" instead of "quantity" and "price". The x-axis could be the quantity of wheat demanded while the y-axis could be the quantity of corn, alcohol, televisions, gold, or dollars. My supply is your demand and your demand is my supply.

Jean-Baptiste Say, along with his market

So in answer to the original question, purchasing power comes from production, from the supply of goods that can be offered in trade. This is the essential lesson of Say's Law of Markets.  If one wants to increase demand, simply printing more money will do you no good as it adds no more things to indirectly trade for. People will receive a sudden increase in dollars and mistakenly believe themselves to be rich only to find that they have nothing to buy. Its a medium of exchange with nothing to mediate between. Furthermore, this reveals new light on the destruction of war. Not only does destroying things fail to increase demand, but it actually reduces demand as people now have less products to trade against to other people!

In short, production of what people want is what creates demand, while the destruction of things people want destroys demand.

How to Secretly Rob a Nation

How does one rob an entire nation? There are quite a few ways, actually. Most under the name "taxation", but I want to look at one that is done secretly, where very few people even realize they're being robbed. I'm talking about printing and loaning fiat currency.

Say, that some nice property you got there.

It'd be a shame if something... happened to it.

First let me explain what I mean when I say taxation is theft though.

All taxation is theft and extortion by definition. If Fat Tony rolls around demanding "protection money" from the local laundromat, we call that out as extortion, and rightfully so. The laundromat owner had no choice about contracting the mafia to protect him. They simply threatened him into accepting their "services".

But how is this different from the actions of a government? You do not "sign up" to be governed. If you think you're government's charging too high a price, you can't switch over to another company. The government is nothing more than the biggest mafia in town, both pretending to have some kind of "rightful claim" to your money, when you really have no choice about it. The only real difference here is that the taxman might actually believe his claim.

Your money or your life!

All government taxes aren't quite so obvious though. If I want to find out how much money was robbed from me directly in a sales tax, for example, it's right there next to all the legitimate trades on the receipt. I think I'm right in saying that people aren't "shocked" to find out the government took their own cut of a deal that had nothing to do with them.

Other ways are a little more surprising. For example, the inflation of a fiat currency.

Now what is inflation? How does it work? The simple answer is, money is a good, and like any other good, it is subject to the law of supply and demand. With a high supply of something, it's price drops because it's more easily attainable. We value rare things more highly *because* they are rare. If we gained the abilities of King Midas and could turn things to gold with a simple touch, the price of gold would not be very high.

So when the supply of money rises, when it inflates, the value of money falls. It has less purchasing power. You can't buy as much with the same amount of money any more, because that money is less valuable. The supply of something rises and falls for many natural reasons, like the discovery of a new gold mine for example, so you'd expect inflation in any society with any currency. However, as total supply is really hard to upset naturally, the value of money normally stays pretty consistent.

However, the inflation of a fiat currency is *not* a natural reason. Have you ever heard the phrase "money doesn't grow on trees"? The phrase means that money is not something easily attainable, and is used to encourage someone to save and to be more thrifty. People need to act responsibly with their money, and not be wasteful.

Well, for the Federal Reserve, money does grow on trees. Better yet, they don't even need to wait on the trees to bear fruit, they can just print the money themselves. If these banks are ever strapped for cash, they can literally just print money for themselves. This is not earned money. This is the creation of money ex nihilo.

How does this work out as theft from you and me though? That new money is getting it's value by stealing it from your saved money. While the central bank and government now have a lot of new money, the money you have is worth less and less. It is *exactly* the same as a tax.

Luckily for the ones printing the money, they are the last ones to feel the effect of the inflation. After they've printed the money, they still hold basically the same purchasing power as they did before. People haven't figured out that the money supply has gone up yet, and haven't had time to readjust prices.There are absolutely no downsides to them for printing more money. They have everything to gain and nothing to lose.

And it doesn't just stop there. Then these bastards have the nerve to loan the new money out and charge interest on it! But hey, I can't condemn charging interest entirely. After all, people need to be compensated for the sacrifice of their money over so much time. They worked long and hard to earn it. That money represents the contribution they've made to society by producing things people wanted, and we're creating an opportunity cost of what else they could have done with this money they earned oh wait this money was never earned the central bank just printed that money out of nothing and didn't do any work themselves even in the past to earn it nor are they taking on any personal risk by departing from their money!

And still! Still! Even while they're earning interest, if you miss your payment they get to take away your stuff as collateral! They can take your property away from right under your feet, at no personal risk for themselves. Not to mention that when the Federal Reserve loans it's money to the government, they have to tax you to pay for it! They have the all the money they could ever want, and can just sit back and get all your stuff too.

And the best part is, the nation never even sees it happening. You never face the taxation directly. All you know is that the price of everything seems to be going up, the economies in the tank, when you hear this great news from the central bank that they're going to get everything under control with nice sounding systems like "quantitative easing". You're not sure what that means, but it sounds soothing and really smart, so it must work, and you trust them to make things right.

I don't think I could come up with a more brilliant scam if I tried.

The Broken Window Fallacy

"Life, which you so nobly serve, comes from destruction, disorder and chaos. Now take this empty glass. Here it is: peaceful, serene, boring. But if it is destroyed...
[breaks glass and robots come to sweep it up]
Look at all these little things! So busy now! Notice how each one is useful. A lovely ballet ensues, so full of form and color. Now, think about all those people that created them. Technicians, engineers, hundreds of people, who will be able to feed their children tonight, so those children can grow up big and strong and have little teeny children of their own, and so on and so forth. Thus, adding to the great chain of life. You see, father, by creating a little destruction, I am in fact encouraging life. In reality, you and I are in the same business." - Jean-Baptiste Emanuel Zorg, The Fifth Element

I mentioned the broken window fallacy in my last post on Paul Ryan, and thought it would be good to go over it a bit more here.

The fallacy of the broken window is possibly the most famous parable in all of economics. It was originally created by Frédéric Bastiat, a french economist, in 1850. It's essential purpose is to show that destruction does not help the economy, but in fact, hurts it. While this seems painfully obvious to most people, this fallacy comes up a lot, especially with politicians.

The parable basically goes like this.

A shopkeeper's careless son breaks a window. The shopkeeper was upset by this, naturally, but whenever he talked to anyone about it they just said "That sucks, but what would happen to the glazier if no one ever broke windows?"

The shopkeeper must now pay six francs to the glazier to fix his broken window. This act of destruction has therefore encouraged trade. That's obvious, or as as Bastiat said, "that which is seen".

It is wrong, however, to say that breaking windows is a good thing, that it benefits society, and that it encourages economic growth, then you are ignoring "that which is not seen."

If the window had not been broken, the shopkeeper could have spent his money on something else such as shoes, and he would still have his window. All these things are not seen, and that's what has been lost.

This accident has kept the shopkeeper for improving his life, but instead must work to get back where he already was.

The moral of the story is, of course, that destruction destroys things. It very clearly shows the idea of an opportunity cost, that is, the cost of what the shopkeeper could have done with his time and resources. If breaking windows really helped the economy grow, how much more would economic good could we do if we destroyed the entire house instead? Or even the rest of the town?

This fallacy has sneaked into modern economic theories in many ways.

By inflating the money supply, the Federal Reserve "encourages investment" by making the dollar worth less and less, making people want to buy things.

Keynesian's so called "wartime prosperity" employs men and scarce resources so that they may be blown up while also blowing up the other countries men and scarce resources.

During the Great Depression, farmers were payed to not grow crops and kill excess livestock so that the price of food would go up under the Agricultural Adjustment Act while people were starving. Destroying crops not put food in people's bellies.

Obama's "Cash for Clunkers" program bought up old cars with taxpayer money, then had those cars destroyed to encourage people to buy new cars.

Why, just a year ago Paul Krugman spoke of how faking an alien invasion would theoretically save the economy! These people are nuts!

"If we discovered that space aliens were planning to attack and we needed a massive build-up to counter the space alien threat, and inflation and budget deficits took secondary place to that, this slump would be over in 18 months. And then if we discovered, "whoops, we made a mistake," we'd [still] be better..." - Paul Krugman

Economic growth is no different than GDP to these people. Just a number on the screen. Spending, even wasteful spending, is what's important to them, and because of this flaw they miss the entire point of spending: Production. The purpose of the economy is the satisfaction of man's material desires by the production of goods and services.

A Problem of a Central Bank

In today's economy, banks essentially deal in the business of buying and selling money.

When you put your money in a bank, they are buying that money off of you and offering interest in return. Similarly, when you accept a loan from a bank, you are buying money from them and they charge you interest. Because of this, the interest rate banks charge is essentially the money's price, and like all things that are sold, is subject to supply in demand.

If they have a low supply of money, they have a high price (high interest rate), and if they have a high supply of money, they have a low price (low interest rate). This is very important and acts as a price signal to tell people when it's time to save, and when it's time to invest.

If the interest rate is high, people want to sell their money to the bank and deposit their savings there. And if the interest rate is low, then people want to buy money from the bank to start up new businesses.

This is also beneficial because this tells entrepreneurs that there are savings in the bank, and once their new product or service is on the market, there will be people with plenty of money to buy it. Not only is that the cheapest time to invest, it is also the most appropriate time to invest.

So again, put more simply, a bank that has a:

1. Low supply of money = Wants to attract savers = high interest rate

2. High supply of money = Wants to attract entrepreneurs = low interest rate

But then we get a problem.

Arrogant politicians and economists come in and establish themselves as a Central Bank. This is a kind of super-bank that is meant to steer the economy and has the ability to print currency.

Thinking themselves smarter than the free market, they manipulate these interest rates to where they believe the economy will be stimulated. Because fiat currency (money that is valued not because it is tied to some kind of standard like gold, but is legally mandated to be valued) is easy to print, this Central Bank has as much money to lend out as it can print.

So at one point this Central Banks sets their own interest rate unnaturally low, which it does easily and happily, since it can have a high supply simply by printing money, it falsely believes it's stimulating the economy, it wants to exert control debt, etc. It could be any of those reasons, and is most commonly some combination of them. The point is, banks quickly buy up the new cheap money.

So now that the banks have a high supply of money, they set a low interest rate of their own. Those looking for loans, naturally, love this. But this new money has been confused with real loanable funds, backed by savings, when it is really just inflation. This easy money leads to a short time of prosperity, as people and businesses can get cheap loans very easily. Prices drop and risky investments get funded. This is known as an economic "boom". Oh, and this boom proves to the Central Bank that they successfully stimulate the economy.

But this boom cannot last forever. People are consuming without the savings to back it, and soon enough they are grasping for resources that just aren't there, and were never there to begin with. This along with the failure of some riskier investments that would not have been funded in a free market (malinvestment) at the worst possible time leads to a bust. In worse cases, this leads to a bank run, where everyone panics and demand their money from a bank at once. Of course, since the banks loan out a good portion of your money, they don't have it all, leading to the bank collapsing.

The Central Bank that wanted to improve the economy ends up inevitably wrecking it. And with the general idea that we need to increase spending to get out of this bad economy (i.e. quantitative easing, bailouts, stimulus packages, etc.), we end up damning ourselves even further. A true market needs to be backed by real savings. Only after that can we have spending, investment, and true, safe, growth.

Also, don't forget that because the Central Bank is giving itself free money, it is causing inflation and devalues the dollar, which essentially works out as a tax on you, since your money is worth less and less now that they gave themselves money for free. So yeah, enjoy that.

For more on the problems of a central bank, and to see where I got those cartoon pictures, it is from a 30 minute video called "The American Dream".

Here's a link to the video: http://www.youtube.com/watch?v=ExBE651_vOY&feature=plcp
Here's a link to their site: http://www.theamericandreamfilm.com/index.php