Paul Krugman, Dean Baker, Mark Thoma, Ben Bernanke and many others call for fiscal policy to boost employment and production. The idea is that the jobs will create more income, more demand, more production, more jobs, even more production and eventually we return to full employment. In essence, they say to the government, "build it and they will come."
They are calling upon the "Say's law fairy".
In 1803, Jean-Baptiste Say wrote...
"It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. ... Thus the mere circumstance of creation of one product immediately opens a vent for other products."
J-B Say's message was that demand is increased by more production. If you were to tell J-B Say that low demand was the cause of low production and unemployment, he would not have agreed with you. He would have said that too many resources were being employed in some sectors of the economy and not enough in others. His explanation would imply structural unemployment.
The economists above know that currently there is no problem with structural unemployment. They have another way to justify more output. If you increase employment through fiscal policy toward full employment, labor will increasingly have power to bargain better wages resulting in more demand. The increased purchasing power of labor will resolve some problems with debt overhang too. There would be a snow-balling effect of output, employment and demand back to full employment (implying an unemployment rate of 5% or less).
J-B Say would have also said that prices, wages and interest rates would have to adjust in order to return to full employment. Yet, there is rigidity in wages. As well, the interest rate is blocked by the zero lower bound. So therefore economists conclude that fiscal policy must be used. Even J-B Say acknowledged the usefulness of public fiscal policy to create jobs.
However, there is a problem not being understood. A lower effective demand limit is blocking the economy from reaching full employment. A fiscal stimulus would not be able to overcome this.
Think of effective demand as the rim of a cup. The cup holds production in terms of utilizing labor and capital. As the economy recovers from a recession, the cup is filled with more production, more employment and matching demand. Say's law is in action only up to the rim of the cup, where production encounters the effective demand limit. If more labor and capital is utilized, the cup overflows... the aggregate profit rate declines and the economy responds by contracting.
The problem now is that the rim of the cup is below the full employment that we became accustomed to in decades past. Fiscal policy is fine to raise production and employment below the effective demand limit, but in error when it expects to push them beyond the limit.
Keynes drew the line in Chapter 3. The Principle of Effective Demand.
"Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile."
The effective demand vision of Keynes will become clear this business cycle. The effective demand limit has always been there stopping business cycles, but the cycles were said to stop at accepted levels of natural unemployment, not any demand limit. However, this time will be different. Just since 2009, the effective demand limit has become a significant obstacle to the historic level of full employment. Economists do not realize this... yet.
The effective demand limit is determined by the percentage of national income received by labor, the primary consumers of finished goods and services. The effective demand principle is... The rate of employing labor and capital is limited by the effective rate of labor's share of national income. This principle refutes Say's law and any other view that expects the economy to a reach a full employment beyond the effective demand limit.
Fiscal stimulus would have to raise aggregate labor share to be successful. Yet, any fiscal job creation would have little impact on the national labor share.
Moral of the story... The rim of the cup does not rise, if you keep filling the cup.
... and there's no "Say's law fairy" to raise the rim of the cup either.