Foreword
Keeping a Child's Eye in Economics
While mainstream economists debate how the "three-horse carriage" drives economic growth, expanding demand and propose more policies to stimulate consumption, Professor Xie approaches the issue from a perspective like a curious child, he asks a simple question: What is demand?
It turns out that a need is not demand. Only a need backed by purchasing power constitutes demand. And this purchasing power is not money itself but the goods and services that back money. People accept money not because it appears colorful, but because it is a claim to goods and services. Therefore, when it appears to be using money to buy goods and services, the essence remains an exchange of goods and services for other goods and services. If you have no goods or services to offer, then your willingness to buy goods and services from others remains a need, not demand. Goods and services arise from production and supply. This also shows that monetary expansion alone cannot increase demand.
There is a longstanding tradition of emphasizing supply and understanding the economy from the supply side. This tradition is the remarkable , which holds that: "A product, once produced, opens up a market for other products of equivalent value." In short, "supply creates its own demand". Or even shorter, "supply creates demand". Originated from Say's Law, Professor Xie's thoughts expand on it. He argues that:
Supply, and supply alone, creates demand; demand and supply are essentially the same thing, viewed from different perspectives.
Following this argument, Professor Xie further asserts that only investment can drive economic growth
Never forget that you can only exchange your own goods and services for those of others, and goods and services can only be produced through investment. This can be paraphrased as, without supply, there can be no demand; demand is something that must be created through investment.
Mainstream economics believes that increasing the ratio of consumption can drive growth, and strives to lower the savings rate—this is a complete reversal of cause and effect. Professor Xie emphasizes that only investment drives growth, thereby burying the "three-horse carriage" theory, once and for all.
The survival of the "three-horse carriage" theory stems from more than a mere misunderstanding of demand. Another reason is that the theory also conflates GDP accounting with GDP production, mistakenly using a descriptive accounting formula to explain actual economic output.
The formula GDP = C + I + G + NX merely categorizes expenditures for the purpose of accounting for GDP. It does not explain how GDP is created. You cannot say that if consumption (C) or investment (I) drops, then increasing government spending (G) will keep GDP unchanged. First, GDP accounting requires no causal logic, but GDP creation does; failing to distinguish this confuses cause and effect, mistaking consumption—which results from production—for the source of GDP. Second, private consumption and investment involve spending one's own money, while government expenditure is done with other people's money; the two are fundamentally different.
People spend their own money on real needs, and seek value for money. Every dollar spent typically corresponds to an equivalent creation of value. This does not deny the possibility of mistakes in private expenditure or investment. But such errors are unlikely to be systematic.
The story is different when spending other people's money, which may go on things that are unnecessary or not worth the cost. Such expenditure does not contribute to GDP.
Because outputs are not directly additive in one dimension, macroeconomics uses value to measure output, the sum of expenditure. But only value-for-money expenditure counts. Professor Xie introduces the concept of pseudo-GDP, which is expenditure that does not yield real value. The introduction of this term explains why fiscal deficits and monetary expansion by government lead to pseudo-GDP, creating short-term paper prosperity but reducing long-term wealth and suppressing potential economic growth.
Indeed, insufficient demand is caused by a private sector hesitant to spend. This reluctance exists because businesses simply cannot turn a profit. If private enterprise finds no return worth pursuing, what gives government the expectation of finding one? Pouring money into unprofitable ventures merely vaporises wealth and kills future growth.
It is widely accepted that developed countries grow more slowly. But Professor Xie contends that under a market economy, the wealther an economy becomes, the faster it should grow. Modern growth comes from roundabout production using capital goods such as machines. The wealthier the economy, the more capital it can accumulate for roundabout production, so it is only logical that its growth should accelerate. This also means that the slowdown in developed countries is not a consequence of being developed, but of market distortions. It futher suggests that we should encourage production rather than consumption to boost growth: primitive societies had the highest consumption rates but the lowest growth rates, while modern societies consume a smaller share of output yet grow much faster.
Since wealth accumulation promotes economic growth, unprofitable investments that waste resources are an obstacle to growth.
In a Robinson Crusoe economy, Robinson's fruit constitutes demand for Friday's fish, and Friday's fish constitutes demand for Crusoe's fruit. Although demand arises from supply, the two remain distinct at the micro level, which is why the supply-and-demand model works there. The same principle holds at the macro level: demand still arises from supply. However, aggregate demand and aggregate supply are not separate forces but two sides of the same coin. Therefore, the supply-and-demand framework breaks down at the aggregate level, and the mainstream AD-AS model rests on a false premise. More generally, any macroeconomic theory that divorces aggregate demand from aggregate supply is built on unsound foundations.
A deep-rooted tenet holds that high growth entails high inflation—that the cost of fast economic growth is high inflation. But from a supply-side perspective, this provokes a question Professor Xie asks: if growth drives higher output and higher output lowers prices, how does the conclusion that prices should rise follow? He argues that inflation is driven solely by excessive money supply, dismissing demand-pull inflation entirely. As for so-called cost-push or imported inflation, they demand strict scrutiny. This misguided conclusion perfectly illustrates the inherent flaws of basing economic theory on the AD-AS model.
Economics textbooks typically classify exchange rate regimes as either fixed or floating, fostering the illusion that floating rates fluctuate while fixed rates do not move. Yet beneath the surface, real exchange rates continuously adjust, regardless of whether the regime is fixed or floating—only the mechanism of adjustment differs. Even under a fixed regime, nominal stability is an illusion; the real exchange rate constantly adjusts through shifting wages and prices. Under a floating regime, the real rate adjusts directly through the nominal rate. So the essence of exchange rate regimes is a matter of adjustment costs: is it more cost-effective to adjust the real exchange rate through the nominal exchange rate (a floating regime) or wages and prices (a fixed regime)? Thus, Professor Xie concludes: given flexible wages and prices, long-run currency overvaluation or undervaluation becomes a total myth. This may sound shocking, but the logic is watertight.
Do not dismiss this as mere theory. To this day, the U.S. and China have been fighting over exchange rates.
Of course, wages are rigid on the downside in the real world, so temporary currency overvaluation is possible. But long-term undervaluation is impossible. Consequently, the earlier accusation that the CNY was undervalued is proven false. In fact, critics claimed the CNY was severely undervalued as late as 2014, only to pivot by 2015 and declare it overvalued. Real economies do not transform that quickly. This flip-flop vindicates Professor Xie's view that currencies cannot remain undervaluded for long.
Few question the idea that pegging the exchange rate means importing inflation. Professor Xie disagrees, arguing that this dilemma only arises when monetary policy is misapplied to target growth and employment rather than price stability. The internal value of a currency (the domestic purchasing power) and its external value (the exchange rate) are two sides of the same coin and should remain consistent. If all central banks focused solely on price stability, this dilemma would vanish. So too would the Mundell Trilemma, which only occurs because monetary policies are misapplied to pursue goals other than price stability.
In economics textbooks, it is taught:
An appreciation of a country's currency makes its exports more expensive for foreigners and its imports cheaper in domestic currency, leading to fewer exports and more imports; a depreciation of a country's currency makes its exports cheaper for foreigners and its imports more expensive in domestic currency.
But Professor Xie corrects this, and says:
An appreciation of a country's currency suppresses its exports, which in turn drives up their foreign prices; conversely, a depreciation of its currency boosts export volumes, which subsequently lowers their prices abroad. Meanwhile, appreciation makes imports cheaper, thereby inviting higher inbound volumes; depreciation makes foreign goods costlier, thereby lower imports.
This might seem a trivial detail, but the devil is in the details. Understanding this nuance is key to grasping how exchange rate changes transmit through the economy and their consequences.
Once Professor Xie explains these principles, everyone can understand them—but without his explanation, even a Nobel laureate like Paul Krugman had struggled with them.
In his book Return of Depression Economics, Krugman's Capitol Hill Babysitting Co-op case suggests issuing more babysitting coupons when demand is weak. It is just as the mainstream economics call for issuing more currency. But Krugman is mistaken: a coupon or currency itself is not demand. The real demand lies in one's ability to provide babysitting services in return. Printing more coupons does not improve anyone's ability to babysit. So it does not increase demand.
I have been friends with Professor Xie Zuoshi for many years, and I know well that he is a man who steadfastly holds to his academic convictions. To the world, he can't help but seem too naive—some would even say too foolish. Is there a connection between this and creativity? From observing Professor Xie, I have found that there is. Genuine scholarship requires raising doubts exactly where others see only unquestionable common sense, and that requires keeping a childlike heart.
Professor Xie's economics is not only complete and internally consistent, but also lucid and pure—just like the man himself! In this book of Professor Xie's, every chapter and every section delivers surprises and a powerful intellectual impact. It is a book well worth buying and reading!
Deng Xinhua
August 27, 2019
