A major problem of economic thought is that economics is not recognized as a complex non-linear system. Non-linearity generally means that the system can not be described as the sum of independent non-interacting components. Of course humans are inherently predisposed to exactly that kind of thinking. Humans are always looking for causes to explain effects. In fact such inquiry never gets old. Just consider the age old quest for the “first-cause”, that is, the beginning of the universe.

When you think about it, nearly all real world problems are non-linear. In fact most scientific research deals with creating idealized linear versions of non-linear problems so that they, the idealized versions, may be solved. Reductionists then claim to have understood the problem, which of course they haven’t.

Economics is in its simplest interpretation driven by the balance between the supply and demand of finite resources. To explain this, there are two theories.

  • Keynes’s law says that demand creates supply.
  • Say’s law says that supply creates demand.

Of course neither are correct. This is very much a chicken and egg conundrum. Regardless of this each theory has fervent believers. If you adopt a larger perspective it is not hard to understand which kind of thinking led to the two theories. Keynes’s theory was created in an era where the supply-side had been depressed leading to pent up demand. Say’s law was most likely generated in a background of optimism where people would buy anything that could be supplied.

Naturally, it is easy to commit the error of overgeneralization, that is, generalizing a subset of all situations to all situations.

We have just exited a situation where the supply-side dominated and where people where willing to buy anything. We are now entering a situation where the oversupply has to be diminished through creative destruction.

It is tempting to go to far with the demand side-cure which is cheap credit and stimulus checks. The problem here is that all the unprofitable enterprises(*) created during the bubble are not fully destroyed.

(*) The idea of selling houses to people who can’t afford them or the idea that you can make money on any kind of dot-com venture.

If supply-destruction is not allowed to go its course and change the economic behavior of people from over-optimism to more realistic levels, the result is one bubble after the next. This is what has happened over the past decade. Of course, the corrective phase must not last so long as to create over-pessimism, which is equally economically destructive.

In other to avoid this it is paramount that economists (and you too!) do not let your inherent optimism or pessimism convince you that the choice is between either Keynes’s law or Say’s law but that they are equally important and should be as closely balanced as possible for a stable economy.

Originally posted 2008-11-12 07:06:22.