The tendency of effective demand to lag behind the supply of full employment

Please cite the paper as:
Arturo Hermann, (2016), The tendency of effective demand to lag behind the supply of full employment, World Economics Association (WEA) Conferences, No. 1 2016, Capital Accumulation, Production and Employment:, 15th May to 15th July 2016

This paper has been included in the publication
“Capital and Justice”

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Following our long-standing interest for the analysis of economic imbalances, in this work we concentrate our attention on the tendency of effective demand to lag behind the supply of full employment.

In fact, in the post Keynesian oriented analysis, much attention has been paid to the destabilizing effects of the “financial capitalism” of today. Along these lines, a number of important issues have been investigated, from labour market to banking policy, from market imperfections to international relations. Among them, an aspect which has received a good deal of attention has been the marked redistribution of income in favour of the wealthier classes that has occurred in the latest decades. This phenomenon has had an adverse effect on the effective demand because, as is known, the marginal propensity to consume tends to be higher with lower incomes. In these contributions, with the exception of the latter aspects, the role of effective demand has been perhaps put a bit in the background in the explanation of economic imbalances.

In fact, our overall impression is that the emphasis has been more on the effects of financialization on the economic system than on the effects of the chronic insufficiency of the effective demand (of full employment, however defined) on the emergence of financial-led economy.

We have organized the work as follows. In the first chapter, we will address the main aspects of Keynes’s theory of effective demand. We underscore its revolutionary import, together with some aspects of weakness which, in our view, are caused by some adherence of his theory to the neoclassical theory of labour market. In this light, we also briefly compare Keynes’s approach with the main theories of under-consumption.

In the second chapter we will outline a broad theory of effective demand by analysing more in detail the irreplaceable role of public spending and credit creation in sustaining effective demand, and profits for the entrepreneurs.

Then, in the third chapter we will address a number of structural factors that may contribute to render more complex and slow the dynamics of effective demand.

In the concluding chapter, we will focus attention on the policy implications of this analysis for the imbalances of today.

Recent comments



  • Gentilucci Eleonora says:

    An extremely interesting presentation that captures fully the issues related to the effective demand mechanism. In the presentation of Hermann are emphasized the most important implications of such a mechanism. It is a complete and analytical presentation, which highlights the special features of effective demand and captures the links, similarities and points of divergence with other economic theories. The result is an analysis extremely rich and interesting, especially for the implications in terms of policy, in particular in the current economic environment. Public spending on welfare therefore acts as an “automatic rebalancing”, slowing the fall in incomes. But only additional public investment will be able to bring the system close to full employment. Only in this case as ironically Keynes argued, neoclassical theory will again be valid. In this sense, it appears extremely interesting the conclusions of Hermann aimed at proposing a basic income, which together with appropriate education and social activities, would enable adequate structural transformation of the system.

  • Gerson P. Lima says:

    Hermann, in my humble opinion you are right in stating that the trend of the aggregate demand curve is to fall short of the aggregate supply curve point that would assure full or quasi-full employment. Perhaps my paper in the Conference may add one more exogenous cause to your Chapter 3. “The Role of The Structural Factors”, for it brings the demonstration that the monetary policy caused in the United States (1960-2007) a fall in GDP and a simultaneous price index rise. What this econometric experiment suggests is that US monetary policy increased production costs, thus shifting the aggregate supply to the left. Simultaneously the monetary policy increased credit, thus expanding aggregate demand; however, as credit is a cost bearing money, aggregate expansion was less than needed to preserve employment. This finding implies inflation, jobs destruction and lower wages in real terms; that is, a relative fall in demand from workers that was boosted by the Keynesian multiplier thus explaining the increasing aggregate demand shortage.

  • Stefania Perna says:

    I found your presentation very interesting, as it brings together various
    heterodox contributions for the explanation of the tendency of aggregate
    supply to exceed the demand of full employment. My question is: as a
    complement of the policies you advocate, if all prices become more
    flexible, could this help attain full employment?

  • Arturo Hermann says:

    Hi Gerson, I agree with you, high interest rates have at least five negative effects on the development of the system:
    (i) they reduce the marginal efficiency of capital (MEC) by narrowing the difference between interest rate and profit; (ii) they reduce MEC by increasing “the cost of money” for firms, and by negatively affecting consumers’ capacity of spending; (iii) as shown by the theories of credit rationing, this process adversely impinges on the capacity of small and medium firms to get adequate credit from the banks; (iv) the reduction of MEC is accompanied by a parallel incentive for firms to invest and speculate in financial assets; this effect reinforces the same tendency driven by a lack of effecticve demand. As a matter of fact, in many cases financial investments are (or appears to be) safer and less time-consuming than productive investments; (v) and, as a good complement of all of it, high interest rates dramatically increase the burden of interest payments on public debt. These payments amount to a huge sum, ranging from 4-5% to 7-8% of GDP across countries, and contribute to drive the economy down. As a matter of fact, in order to afford such interest payments, the Countries resort, ─ and particularly those with high spreads, which reflect, in a completely flawed way, the “reliability” of the country in repaying the debt (actually, no Country is reliable as they all are unlikely to repaid the debt) ─ to a relevant primary surplus. This means nothing less that public spending is more and more diverted from public goals to rentiers. And this is one of the structural reasons for economic stagnation and income inequalities.

    Hence, the real revolution for lowering the burden of public and private debt and fostering a sustainable and equitable development would imply the following measures: (i) reducing permanently the real interest rates and the public budget deficit; in fact, as shown by the so called “Haavelmo’s theorem”, also a balanced budget has expansionary effects; (ii) placing precise limits to the creation and commercialization of derivatives, and (iii) orienting the activities of the banking system to the real support of production and social activities, in particular for small and medium firms.

  • Arturo Hermann says:

    Dear Stefania, this question is very interesting and requires a manifold answer. As I am trying to show in the elaboration of this work, a better flexibility of prices can contribute ─ in very abstract terms ─ to a better reciprocal adaptation between demand and supply. However, in the complex economic systems of today, markets tend to be highly imperfect at micro and macro level. For this reason, I believe the simple neoclassical prescription of laissez faire utterly inadequate for solving these issues. In particular, the reasons why the so-called Say’s law ─ on which classic and neoclassical economics rest ─ is incompatible with real economies are: (1) the lower propensity to consume of the richer people which, especially in presence of an unequal distribution of income, tends to reduce the amount of aggregate consumption; (2) if this happens, an increased amount of investment cannot make up for less consumption; in fact, since investment expenses are instrumental to consumption, they must bear a well-defined relation with to the production of consumption goods; (3) these aspects are reinforced by the tendency, especially, but not only, in times of boom, towards over investment and multiplication of firms and a consequent excess of production and/or of productive capacity; (4) these effects are likely to be reinforced by the process of credit creation of the banking system.
    Let us start from the point (3): why firms follow a kind of seemingly “waste strategy” which end up reducing their profit margin? For instance, it is easy to see that in virtually every touristic district there is a “supply” of restaurants and hotels far in excess of the average demand for them. This depends on the market imperfections typical of capitalistic systems: (i) every entrepreneurs entering the sector is probably attracted by good prospective gains and hope to be the “first comer” in this venture; (ii) when supply overtakes demand what tends to happen is that prices remain rather stable and so more firms share the same amount of surplus.

    Now the central question arises: when aggregate supply exceeds demand, why prices do not diminish enough to clear the market? There are two central phenomena:

    (I) The circumstance, set forth in particular by the theory of “small menu costs”, that sticky prices do not depend only on “market imperfections” but are needed in order to provide the firms with the time for devising a strategy. As a matter of fact, the decision to change prices necessitates some planning activities in order to foreshadow the possible consequences. As this activity should be made early enough, it constitutes a good explanation of the reason why firms do not quickly adjust their prices even when it would seem more profitable to do so. Moreover, if we conceive of markets not as “exogenous mechanisms” handed down by divine providence, but as institutions created and maintained by public action, and which are embedded in a dense set of social and cultural relations, we can more easily see that a certain stickiness of prices (and wages) constitutes a necessary condition for ensuring a degree of stability and reliability of these relations: if everything were wild flexible, no stable economic and social life would be possible.

    (II) The other related reason why prices do not diminish enough is plain enough: prices are not reduced simply because it is not profitable to do so. This comes about because the aggregate demand, while being fairly elastic upward, is most often notably inelastic downward. For a host of economic and psychological reasons, consumers tend to be much more alert and sensitive to a price increase than to a lack of price decrease when economically feasible. Hence, if firms reduce prices, this is unlikely to trigger a relevant increase in selling. The reason for this can be related to (a) asymmetrical information, in the sense that, also at psychological level, high prices tend to be considered as a “signal” of high quality. Hence, any reduction tends to be interpreted very suspiciously, as an admission of low quality and failure. Another reason for this inelasticity can be traced to (b) the satiation for many products and services. This happens in particular for items which require an active involvement of consumers. For instance, if prices are halved we are unlikely to buy, instead of one, two iPhones, two cars, two books, two concerts, or two kilos of tomatoes.
    (c) To this we must add the paramount fact that a general reduction of prices tends to bring down all incomes; and to increase the real interest rates, with negative effects on the propensity to invest and on consumers’ and firms’ debt burden.


    For all these reasons, a deflationary trend is not only unable to restore full employment but it is likely to worsen economic situation.
    This happens especially if one tries to achieve price reductions through the neo-liberalistic policies of rendering more “flexible” only the weaker segment of the market, as is most often the case for labour force.
    Needless to say, a better flexibility of the markets for product and for labour can be a positive factor. But in order to actually realize this, one should adequately appraise the complexity of socio-economic relations ─ including power and its net of formal and informal hierarchies ─ underlying market structure.
    In this regard, it is also pertinent to undescore that in the real capitalistic systems of today (in reality, “mixed economies”) market “imperfections” at micro and macro level constitute the ordinary way of the functioning of the system. Of course, these “imperfections” can be abated but not completely eliminated because, as noted before, they contribute to the stability of the system.
    For instance, on the one side, mark ups are a clear sign of market power, and hence of a market imperfection. But, on the other hand, many economists think that mark ups play as a necessary incentive for investment. So, how much mark ups should we allow to firms?
    Evidently, there is no easy and univocal answers. Personally, I would narrow mark ups, and at the same time would reinforce the motivations stemming from the “animal spirits”, also by linking these motivations to social objectives. In this sense, it is important to remember that market structure is fully compatible with various forms of market socialism and cooperative economy.
    Or, to take another related example, public spending tends to be considered in mainstream economics as an unwelcome departure from the self-sustaining benefits of market mechanisms. But, as we have tried to show, public spending has always played a central role in providing public goods essential for the existence of the market; and, not least, in ensuring an adequate level of effective demand, and hence of profits, for firms.
    More in general, what seems highly needed to sort out these problems is a thorough process of social valuing. This process, by making more explicit the interests, conflicts and values underlying the various opinions, would render it easier the necessary coordination between macroeconomic and structural policies. In this way, it would become easier to move towards a sustainable and equitable society.

  • Arturo Hermann says:

    Considering that my work is still in progress, I would add another element to the discussion of chapter 1 on the inadequacy of neoclassical theory of market labour. In addition to the aspects already mentioned, the idea that wages should be equal to the marginal product in value raises another relevant problem. As we know, this prescription rests on the hypothesis of a Cobb-Douglas type function characterized by a decreasing marginal productivity beyond a certain “optimum” point.
    If things stand like this, the marginal product beyond such point will quickly become lower than the average product. If all wages are fixed beyond that point, the result will be a parallel increase of mark ups. In order to see these aspects, let us suppose a continuous – and very unrealistic! – growing function with decreasing returns and only one input. it can assume the form, where x stands for labour,

    1. Y = f(X)^0.8

    and the first derivative is,

    2. dy/dx = 0.8/X^0.2

    We obtain the following total and marginal values for the first units (and with the gap growing larger with additional units):

    Numbers of workers: 1 2 3 4 5 6 7 8 9


    Total Product: 1.0 1.74 2.4 3.03 3.62 4.19 4.74 5.27 5.8

    Marginal product: 0.80 0.69 0.64 0.60 0.58 0.55 0.54 0.52 0.51

    In this case, the difference between the average real product and the marginal product grows larger with the increase of the number of workers. Of course, in the case of a continuous function, the marginal product for a labour unit is slightly different from the derivative in the point, which measures the relative variation of y over x for the ∆ tending to zero.
    The same result can be obtained for a – somewhat more realistic – discrete function, for instance,

    Number of workers 1 2 3 4 5 6 7 8 9

    Total Product 8 16 26 38 52 68 82 94 104

    Marginal product 8, 10, 12, 14, 16, 14, 12, 10, 8
    (for an increase
    of labour unit)

    In this respect, the crucial point is whether it is fair or expedient that a decrease of marginal productivity should affect the wages of all the workers.
    After all, one can well claim, marginal means marginal and hence should affect only the marginal unit. Of course, some people can say, the reduction of marginal productivity should apply to all the workers, but it is also true that the choice of moving along a less productive path was taken by the firm and assumed later the form of a contract with the marginal worker.
    Hence, when a worker is hired the wage should be fixed, according to such (unconvincing) theory, in line with his marginal productivity.
    For instance, for the 5th worker of the examples the wages should be 0.58 for the first and 16 for the second function. Now, if a firm chooses ─ and most likely without asking the opinion of the infra-marginal workers ─ to hire the 9th worker at the wages of 0.51 for the first and 8 for the second function, why this should impinge on the wages of infra-marginal workers? By pushing the example to the extreme (but not totally unrealistic) case, if a firm chooses to hire a worker at the marginal product of 1 penny per day, is it fair or reasonable to cut down accordingly the wages of all the workers?
    In this regard, we think it much fairer and expedient that workers should retain their original wage, especially in situations of decreasing labour productivity for which no responsibility can be attributed to them.
    However, and besides our opinion, we think it appropriate to stress that, beyond a number of technical and more “objective” parameters, there are no necessary and efficient laws of wage determination. All these matters find their settlement in the institutional, cultural and psychological dimensions of socio-economic relations.

  • Massimo Mancini says:

    What are the implications of your analysis on public debt sustainability?

  • Arturo Hermann says:

    Your question raises a central issue that, although already addressed in the paper, deserves to be treated at a bit more length.
    I can start by asking this question: when we read in the newspapers that “we are overwhelmed by public debt,” that “the problem is the public debt”, how much grounded are these statements? Very little, I am afraid, at least in the usual sense that “we must pay off the debt.”
    First, let us remember that most of the public debt (net of the portion in the hands of central banks) is equal to private credit, largely in the portfolio of large groups. But it is unlikely to read in the newspapers “we are overwhelmed by private credit”, “Private credit is exploding”, etc; Why? Probably because, through the brain-washing that “we must repay the debt”, neo-liberalism tries to downplay all kind of public action. They make us feel guilty and indebted, and therefore more prone to easily accept the cuts in public spending.
    However, the idea of repaying the debt makes little sense. If “The Paradise can wait”, even much more so for public debt! The two magic words are debt consolidation and bank recapitalization.
    Even countries seemingly “better placed” are very unlikely to pay up their debt. Big finance is well aware of that, but their sleeping is not shaken by a wink! Why? For the simple reason that what they are really interested in (what is really at “stake”) is the interest payments “here and now” on the stock of public debt. These payments amount to a huge sum, ranging from 4-5% to 7-8% of GDP across countries, and contribute to drive the economy down. As a matter of fact, in order to afford such interest payments, the Countries resort, ─ and particularly those with high spreads, which reflect, in a completely flawed way, the “reliability” of the country in repaying the debt ─ to a relevant primary surplus. This means nothing less that public spending is more and more diverted from public goals to rent. And this is one of the structural reasons for economic stagnation and income inequalities.

    To see why it is utterly inexpedient (and unnecessary) the idea of paying off the debt, let us consider more closely what it means to repay it. It implies that the creditor delivers the title (such as a Treasury bond) to the state, and gets back the capital plus the interests. The following cases may come about:

    A) If the lender is a citizen or a firm, they might demand the money back in order (i) to cope with various expenses, in a situation of loss of income due to the economic crisis; (ii) to increase consumption or investment, perhaps driven by a wave of optimism.

    It is clear that only in this latter case the repayment of the debt can be beneficial: for example, if the state gets the money by tax evaders or big rentiers and hands it to ordinary citizens in return of the debt.

    B) If the lender is a bank or a financial institution, the repayment of debt, by implying an increase of taxation and/or a decrease of public spending, tends to depress the economy, because such institutions, in the absence of changes in the economic system, would presently place the sums so obtained in “financial instruments”, and perhaps in purchasing newly issued government bonds.

    C) There can be, however, a kind of interesting “jolly card”, represented by the so-called process of “debt monetization”: this measure consists in this: the state or the central bank “prints a lot of money”, and “passes” the sums to creditors in payment of the public debt. This solution is actually none other than a return to the classic power of seigniorage, which entitled the state the prerogative of printing money to “finance” its expenses. But what can be the effects of this proposal, over which there is a heated debate? Would it trigger inflation or will it ginger up the economy? In my modest opinion, it would get none of these effects, but would only trigger another speculative bubble, with near-zero effects on the real economy. In fact, if we do not change the “fundamentals” of the economy, what could the bankers do with “fresh money” but to speculate in securities and derivatives?
    Hence, the monetization of the debt would carry an effect not dissimilar from the “quantitative easing”, where the “fresh money” is created by the central bank in exchange of (mostly unrepayable) public and private debts owned by the banks. In this light, moving along a path of quantitative easing constitutes a positive factor. However, if we want that “the horse drinks” (e.g. that firms make productive investments), we need to abate the toxic fumes of speculation and orient banking system towards the support of productive activities.

    D) A related solution can be a partial or total cancellation of debt. I agree with this approach but think it paramount ─ in order not to quickly engender another debt spiral – that this provision be accompanied by a substantial change of the economic “fundamentals”.

    What Policy Actions?

    As we have tried to show, the real issue is not paying off the debt, but to ensure the degree of sustainability of public debt, which is synthesized by the following equation, where ∆Y is the GDP growth rate, Y is the real GDP, μ the primary deficit, D is the stock of debt, G government spending and T taxation, and i the real interest rate.

    1. ∆Y = μ (Y/D) + i with μ = (G – T)/Y

    The 1 can also be expressed as,

    2. D/Y = μ/(∆Y – i)

    The 2 gives the long run equilibrium of the ratio Public Debt/GDP. For instance, with μ, ∆Y and i equal respectively to 2, 4 and 3 we get a ratio debt/GDP of 200%. We obtain 150% for values of 3, 4 and 2; 100% for 2, 4, 2; and 75% for 3, 5 and 1.
    From this it is clear that as long as there is a low growth, and primary deficits real interest rates do not decrease enough, not only there will be no debt repayment, but its absolute and relative level is bound to increase. In particular, if the difference between ∆Y and I tends to zero, as it is often the case today, the debt will become more and more unsustainable.

    But what are the effects of real interest rates, and of the public budget deficits on GDP? As evidenced by numerous contributions, high real interest rates bear a negative effect on GDP, because they narrow the so-called marginal efficiency of capital, i.e. the difference between profit rates and interest rates. Moreover, other negative effects are an increase in the “cost of money” for firms, and an increase of “credit rationing” to the detriment of small and medium-sized firms. And, not least, the fueling of the “psychology of the rent”.
    Public budget deficits have an expansionary effect, because they “create” effective demand. However, the policies of deficit spending, although preferable to the policies of “austerity”, have the notable drawback to feed the spiral of debt and interest payments. Since, as shown by the so-called “Haavelmo’s theorem”, also a balanced budget is expansionary, it is much better to reduce the public budget deficit to values of 1%-2%. It would also be desirable that public spending be efficient (within a principle of subsidiarity and complementarity with private action) and that taxation be fair and actually progressive for higher incomes and rent.
    The real revolution for lowering the burden of public debt and fostering a sustainable and equitable development would comport with the following measures: (i) reducing permanently the real interest rates and the public budget deficit, (ii) placing precise limits to the creation and commercialization of derivatives, and (iii) orienting the activities of the banking system to the real support of production and of social activities, in particular for small and medium firms.

  • Arturo Hermann says:

    As a way of conclusion, what are the implications of my contribution for the theme of the Conference?
    The main implication is that economic imbalances, as they carry a systemic and global nature, require a systemic and global policy strategy for their solution.
    This demands a better coordination of policies at “horizontal” level ─ for instance, between macroeconomic and structural policies ─ and at “vertical” level ─ between local, national and supranational dimensions. Trying to emphasize a dimension or two at the expense of the other(s) can be very harmful for the effectiveness of policies. This happens because stressing, say, only local and national dimensions make us forget that many issues have a supranational dimension, a typical example in this respect being the problem of effective demand. If, for the reasons we have tried to put forward, there is a structural and global tendency of effective demand to fall short the full employment level, the hope “to solve” the problem by erecting more national and local barriers is likely to be totally ineffectual, if not more harmful for the objective. In fact, if the overall cake shrinks, it seems much brighter to counteract this tendency than the illusory attempt to get a larger slice through a beggar-thy-neighbour policy.
    On the other hand, acknowledging that the issue of effective demand bears a supranational dimension should not make us overlook the need of elaborating a policy action based on the experiences and needs of more local levels. There are not easy solutions, of course, but I believe that an improved process of participation and social valuing can help sort out these complex issues.
    Such process can benefit by providing a good theoretical foundation to policy action, which also comports with the reduction of fragmentation often present in social sciences. For the issue of effective demand, all the theories dealing with it can be employed for appraising the manifold aspects of the phenomenon. As a matter of fact, the theories addressing more directly the issue ─ underconsumption, Keynesian, secular stagnation and steady state ─ not only can usefully complement with each other but can also interact with other theories ─ such as institutionalists, Marxists, socialists, environmentalists ─ underscoring the structural contradictions of economic systems.
    A more comprehensive theoretical perspective would positively impinge on policy action, for instance by providing a better awareness that, say, measures of fiscal stimulus can be expedient but should be coupled with a strategy addressing how to manage and orient for the better the structural transformations of the system.