The previous article discussed how the economic machine works and treated productivity as the foundation of long-term growth. But that leaves a harder question: if productivity keeps rising and more and more goods are produced, does that automatically make a society more prosperous? The answer depends on how we understand “value.”
A person spends ten years digging a giant hole in the desert that serves no purpose.
It took a huge amount of labor, and may have required sophisticated equipment, organization, and capital. But does that therefore create huge value?
Intuitively, no.
If nobody needs the hole, and nobody is willing to pay for it, then it is just a project that consumed a lot of resources. Labor and production happened, but value was not realized in the market.
This simple example reveals the limits shared by the labor theory of value and extreme supply-side thinking:
Production can create potential value, but it cannot determine value on its own.
How much economic value a good ultimately has depends not only on how much labor and capital went into producing it, but also on what needs it can satisfy, how strong those needs are, how scarce the good is, and whether consumers actually have the purchasing power to buy it.
Labor Theory of Value Is Incomplete
Classical economics long tried to explain value from the production side.
Adam Smith distinguished use value from exchange value and broke commodity prices down into wages, profit, and rent. David Ricardo went further by emphasizing labor input, and Karl Marx developed the labor theory of value systematically: the value of a commodity is determined by the “socially necessary labor time” required to produce it.
This framework made an important contribution: it reminded us that goods do not appear out of thin air. Production requires labor, capital, land, time, and risk. Behind prices there are real resource costs.
But it also faces an unavoidable problem:
If labor creates value, does putting in more labor necessarily create more value?
The answer is clearly no.
A good that nobody wants does not become more expensive simply because it took more effort to produce. A calculator made by hand over the course of a year is not worth more in the market than one mass-produced on an assembly line in a second.
Labor input can explain part of production cost, but it cannot by itself explain why consumers are willing to buy, nor can it explain why diamonds are more expensive than water, why limited-edition goods sell for far more than their manufacturing cost, or why some products that took enormous labor end up being scrapped.
The labor theory of value mainly answers this question:
What does it cost to produce this good?
But the market asks another:
How much are people willing to give up to obtain it?
Without the second question, any theory of value only has half the supply side.
How Modern Economics Understands Value
The “marginal revolution” in the 1870s changed economics’ explanation of value.
Jevons, Menger, and Walras each argued that value is not an objective property crystallized inside a good by labor, but rather comes from the consumer’s subjective evaluation of the last unit of that good—its marginal utility.
The classic example is water and diamonds.
Water is essential to life, and its total use value is far higher than that of diamonds. But where water is abundant, the extra utility of one more glass is very low; diamonds are relatively scarce, so the marginal utility and willingness to pay for one more diamond are higher.
So price is not determined by how “important” a good is in total, but by several factors interacting in a particular context:
- consumers’ subjective demand
- the degree of scarcity
- the availability of substitutes
- the buyer’s ability to pay
- marginal changes in supply and demand
Modern economics does not say production costs are unimportant. Costs determine the prices at which producers are willing to supply quantities of goods; demand determines the prices at which consumers are willing to buy them. Market price is formed at the intersection of the two.
More precisely:
Production determines the possibility of value realization; demand determines whether that possibility can actually be realized in exchange.
Without production, there is nothing to exchange. But without demand, goods produced do not automatically become wealth.
Demand Is Not Desire, but Desire Backed by Purchasing Power
People often say, “There is always demand in this world.”
In terms of desire, that is true. People always want larger homes, better medical care, more comfortable lives, and more leisure.
But economics is not about abstract desire; it is about effective demand—demand backed by real purchasing power.
A person may desperately need a home, but if their income is insufficient and they cannot obtain reasonable credit, that need will not turn into a market transaction.
This distinction matters enormously, because production itself does not ensure that purchasing power is evenly distributed to consumers.
Suppose a factory doubles output through automation and lays off half its workers. Labor productivity rises sharply in the statistics, supply increases, and unit costs fall.
But if the productivity gains mostly become corporate profits, while the workers who lost their jobs see their incomes fall to zero, then alongside rising supply, consumption power may actually decline.
At the firm level, that may be a successful efficiency improvement; at the level of the whole economy, it may produce a loop like this:
higher productivity → lower labor income → weaker consumption power → goods cannot be sold → firms keep cutting costs and jobs
So the demand problem is fundamentally also a distribution problem:
It is not enough to know how much income production creates; it also matters who receives that income.
Higher-income groups usually do not spend all their additional income on consumption. When more income flows to capital owners and corporate sectors, a large share may be saved, used to buy assets, or reinvested in production.
If those funds keep turning into new factories and new capacity while household income does not rise in step, a seemingly contradictory but entirely coherent pattern emerges:
- productive capacity keeps growing
- consumer demand grows relatively more slowly
- firms keep investing to sustain growth
- excess capacity expands further
Overcapacity and insufficient demand are not two separate problems that happen to occur together; they are two sides of the same distribution structure.
How an Economy Grows and Why It Crashes Hides the Demand Problem
How an Economy Grows and Why It Crashes uses a very intuitive story to explain economic growth.
At first, islanders catch one fish a day by hand, just enough to survive. Someone decides to eat less for one day and uses the saved time to weave a fishing net. The net raises fishing efficiency, so saving is transformed into capital, capital raises productivity, and productivity creates more fish and a higher standard of living.
This chain of logic is extremely valuable:
Saving → investment → capital formation → higher productivity → more output
It explains well why capital accumulation matters, and it correctly criticizes consumption booms that are not backed by real saving and productive capacity.
But the fish metaphor quietly eliminates one crucial problem: fish naturally have stable demand.
Islanders need to eat fish every day. As long as more fish are caught, they can be consumed. The story therefore makes “producing more” and “creating more value” seem completely equivalent.
Real economies produce not only food, but also:
- housing
- automobiles
- steel
- solar modules
- industrial robots
- commercial real estate
- chips and production equipment
Demand for these goods is neither stable nor capable of infinite expansion.
A household will not buy twice as many cars just because car prices fall by half; a city will not need an unlimited number of new apartments just because housing construction becomes more efficient; and the world will not keep building more bridges and factories forever just because steel becomes cheaper.
Once the market becomes saturated, additional production capacity no longer automatically improves life. Instead, it may show up as inventories, price wars, losses, and debt.
How an Economy Grows and Why It Crashes is best at explaining an early-stage economy that is capital-scarce and has unmet demand.
But when an economy enters a stage of ample capital, excess capacity, and constrained demand, the constraints have changed:
The problem in an early economy is “we cannot produce enough”; the problem in a mature economy may be “we can produce it, but cannot sell it.”
Why China Once Fit How an Economy Grows and Why It Crashes—and Why It Now Runs Into Trouble
Over the past few decades, China’s economy almost perfectly followed the growth path described in How an Economy Grows and Why It Crashes:
- high saving rate
- high investment rate
- large-scale infrastructure construction
- manufacturing capital accumulation
- technology transfer and productivity gains
- exchanging current consumption for future productive capacity
In a stage of capital scarcity, inadequate infrastructure, and a large transfer of labor from agriculture to industry, this model was a huge success.
Railways, highways, ports, power grids, housing, and factories all represented real gaps. Every additional unit of investment could connect new markets, absorb new workers, and raise future output.
At that time, what China lacked was indeed a “fishing net.”
But today, China’s problem is no longer a lack of nets. It has plenty of nets, but not enough domestic purchasing power to consume the fish being caught.
China’s fixed asset investment has long accounted for about 40% of GDP, far above most mature economies; meanwhile, household consumption accounts for only about 35% to 38% of GDP. A disproportionately large share of the gains from growth flows to the government, state-owned sectors, corporate profits, and reinvestment, while the share flowing to household disposable income and consumption remains relatively low.
This creates a self-reinforcing cycle:
household income share remains low → consumption power is insufficient → firms rely on investment and exports → policy continues to support the production side → capacity expands further → the domestic market becomes even harder to absorb all output
New energy vehicles, solar panels, batteries, steel, and some industrial equipment show similar characteristics: the technological progress is real, and the cost declines are real, but genuine technological progress exists alongside subsidy-driven overinvestment.
When domestic demand cannot absorb this output, firms have to expand exports. Export growth then impacts manufacturing in other countries, triggering tariffs, anti-subsidy investigations, and trade protection.
Once external markets contract, the capacity imbalance that exports had temporarily absorbed returns to the domestic economy.
So China’s current problem is not that it cannot produce, nor that productivity is too low. Quite the opposite:
China’s production capacity has grown very successfully, but household purchasing power and final demand have not grown in step.
Why Expanding Domestic Demand Matters Especially
At this stage, expanding domestic demand is no longer just a short-term policy option for “stimulating the economy”; it is a core condition for China’s structural transformation.
The three main demand engines of the past—real estate, infrastructure, and exports—are all facing constraints:
- real estate can no longer resume its role as the national growth engine
- the marginal return on infrastructure investment keeps declining
- exports face trade protection and limits in global market capacity
- continuing to subsidize the production side will further worsen overcapacity
Without stronger household consumption, new capacity in China can only keep searching for foreign markets, or rely on the government to manufacture demand. Neither path is sustainable in the long run.
But expanding domestic demand cannot rely only on consumption vouchers, auto subsidies, and trade-in programs for home appliances. These policies usually require consumers to already have most of the purchasing power; they tend to bring future consumption forward into today, but do not necessarily raise consumption capacity permanently.
A real domestic-demand transition requires raising the household sector’s share of national income, including:
- increasing labor income and household disposable income
- improving health care, education, pension, and unemployment protection
- reducing households’ precautionary saving pressure
- improving migrant workers’ and mobile populations’ access to public services
- shifting more fiscal resources from production subsidies toward households and public services
- allowing capacity with no real demand, and that depends on subsidies for a long time, to exit
Most importantly, the goal is not to encourage households to “want” to consume more, but to make them able to consume, and not forced to save because of uncertainty about medical care, education, and retirement.
Expanding domestic demand is therefore neither consumerism nor an attempt to manufacture false prosperity through money printing. China already has a large amount of idle or underutilized productive capacity. In this situation, transferring purchasing power to households can turn output that could not previously be realized into real transactions.
This is fundamentally different from putting money into new factories:
Money into the production side only creates more capacity; money into households can create real buyers for existing capacity.
China’s past success proved the power of a supply-side model in a capital-scarce stage; its current difficulties show that once productive capacity exceeds domestic effective demand, the growth model must shift from “keep making more” to “let more people afford what can already be made.”
Why I Do Not Accept the “Good Deflation / Bad Deflation” Distinction
The “good deflation / bad deflation” view comes from a book review on the Wiki-listed YouTube channel “Wei Zhichao Reads Everything” (魏知超啥书都读), introducing the free banking economist George Selgin’s book:
Less Than Zero: The Case for a Falling Price Level in a Growing Economy
Selgin’s core argument is that deflation should be distinguished by its cause:
- Bad deflation: total demand collapses, credit contracts, prices fall, and this further triggers unemployment, defaults, and recession.
- Good deflation: productivity rises, unit costs fall, and prices decline; even if nominal prices fall, output, profits, and real purchasing power may still grow.
In this framework, the central bank should not mechanically maintain a fixed inflation rate, but should allow price declines caused by productivity growth to happen naturally. Selgin calls this policy idea the productivity norm: stabilize nominal income rather than force price stability.
This theory offers a useful reminder: falling prices do not necessarily mean productive capacity is worsening. But I do not accept classifying deflation as “good” or “bad,” because that classification focuses too much on whether the initial cause of the price decline came from the supply side or the demand side, while failing to fully consider whether the new supply can ultimately be absorbed by demand.
Technology products are often used as examples of “good deflation.” TVs, computers, smartphones, and software have all become cheaper, yet tech companies have continued to grow.
But these industries have also experienced:
- rapid market expansion
- the emergence of new product categories
- the continuous onboarding of consumers worldwide
- expanding use cases
- strong upgrade and replacement demand
As prices fell, sales volume and total demand grew even faster. What really keeps these industries prosperous is not deflation itself, but:
Demand growth that is strong enough to absorb the new supply released by productivity gains.
Demand for most goods cannot grow without limit.
If car prices fall by half, households will not buy twice as many cars; refrigerators, housing, steel, solar modules, and industrial equipment will all eventually run into market saturation.
When productivity and capacity grow faster than demand, falling prices compress corporate profits. Firms then cut wages, employment, and investment, and falling income further weakens demand.
So even if the price decline initially comes from technological progress, it can still evolve into demand contraction through employment, income, and debt channels.
Distribution cannot be ignored either. If the gains from productivity mostly become corporate profits, without turning into higher wages, lower prices, or broader purchasing power, then growth in productive capacity will not automatically generate matching demand.
For highly indebted modern economies, sustained deflation has another danger: wages, income, and prices fall, but nominal debt principal does not fall in step, so the real debt burden rises. That forces households and firms to cut spending, further depressing demand.
So I prefer to judge deflation through demand and balance sheets, rather than assigning it the labels “good” or “bad” based first on whether the original price decline came from supply or demand.
Why Mainstream Economics Has Not Broadly Adopted This Theory
Selgin’s theory has not been entirely absent from mainstream discussion. Its close cousin—nominal GDP targeting—was seriously studied by academics and central banks after 2008, but it did not become the dominant policy framework.
The main reasons include:
- In practice, it is very hard to distinguish the source of price declines. Technological progress, subsidy-driven expansion, overcapacity, and weak demand often occur at the same time. Central banks cannot determine in real time how much is productivity improvement and how much is demand shortfall.
- Persistent deflation raises the real burden of debt. Modern households, firms, and governments all hold large amounts of nominal debt. Even if prices fall because of productivity gains, if incomes are also affected, debt service pressure may rise.
- Deflation compresses monetary-policy room. If normal inflation is close to zero or negative, nominal interest rates are also lower. In a recession, the central bank is more likely to hit the zero lower bound and lose room to stimulate the economy by cutting rates.
- Wages and prices do not adjust symmetrically. Goods prices can fall, but nominal wages are usually hard to cut. If corporate revenue falls and wages cannot adjust in parallel, firms are more likely to lay off workers than to lower everyone’s pay smoothly.
- Mainstream economics already distinguishes supply shocks from demand shocks. Central banks usually tolerate low inflation caused by productivity improvements or temporary supply changes, but that is not the same as accepting prolonged deflation across the whole economy.
- A 2% inflation target has become the anchor for expectations. Corporate contracts, wage bargaining, bond pricing, and long-term investment all form expectations around this target. Changing the policy framework itself could create additional uncertainty.
So my view of this theory is:
It correctly points out that price declines in individual sectors do not necessarily mean recession, but it incorrectly infers from the fact that “some industries can prosper while prices fall” that “the entire economy can have stable and harmless deflation.”
Price declines in individual goods can be a dividend of technological progress; persistent deflation across the whole economy is still dangerous. Extending the special experience of the tech sector to all goods and the entire macroeconomy easily commits the fallacy of composition.
Value Is Ultimately Formed by Production, Demand, and Distribution
Supply-side economics reminds us: without production, there is no wealth; money and consumption stimulus cannot replace real output.
Demand-side economics reminds us: what is produced must be something someone can buy, if potential wealth is to be realized in exchange.
Modern value theory further shows that value is not the simple sum of labor or capital input, but is formed through the interaction of subjective utility, scarcity, supply, demand, and purchasing power.
These three perspectives do not need to negate one another; they should be combined into a more complete framework:
- Production determines what society can provide
- Demand determines which outputs have market value
- Distribution determines whether demand has purchasing power
- Prices coordinate scarce resources toward different uses
- Institutions determine who ultimately receives the gains from productivity
A healthy economy cannot merely stimulate consumption without improving productive capacity, nor can it merely expand production while ignoring demand and distribution.
In the early stage of development, productive capacity is often the main constraint; once the economy matures, demand, distribution, and the ability of capital to find productive uses may become the new constraints.
This also explains why a growth model that was once successful can eventually turn into a trap.
China’s past success did not prove that How an Economy Grows and Why It Crashes is always correct; it proved that this framework is extremely powerful in a capital-scarce stage. Today’s overcapacity shows that once an economy crosses a certain stage of development, understanding value only from the production side is no longer enough.
Production creates possibility.
Demand gives choice meaning.
Distribution determines who has the ability to make that choice.
Only when these three are coordinated can productivity growth truly turn into sustainable prosperity.