Understanding Say’s Law of Markets

I have been in quite some correspondence since the Macro Follies video arrived and from these conversations I can see that there are four bits I may be leaving out in my explanations, the first being the necessity of seeing these issues in aggregate terms, the second the role of consumption, the third that the delay between receiving one’s income and spending does not provide a theory of recession and the fourth the effect of living in a money economy. Nothing I say in adding these in is in any way contrary to the classical understanding of the law of markets or different from anything I have tried to explain before.

Aggregate Concept

Say’s Law is about the economic aggregates of an economy. There may not have been a set of national accounting figures published during the nineteenth century but they still had a grasp of the economy as a whole. Say’s Law never applies to any individual. No individual’s demand is necessarily comprised of that individual’s supply. We borrow each other’s savings, we pay taxes to the government, we give money gifts for others to spend. Say’s Law is a concept that applies to the economy at the aggregate level only. The total demand found in an economy in real terms consists of the total output of the economy in real terms.

Consumption

Say’s Law does, of course, presuppose that as much output as can be produced will be bought but this will only happen if what is produced coincides with what buyers want to buy.

Production is valueless without consumption. If no one wished to buy then no one would produce. But since desires are insatiable there is no reason to worry that if producers can work out what buyers want to buy that that buyers will stop short of purchasing everything produced. Keynes however argued that people in aggregate would earn incomes for producing 100,000 units of output and then only decide to buy 90,000 units of what they had produced. This is the underlying dynamic in an economy that is experiencing a recession due to deficient demand.

And so far as policy is concerned, he seems to have then assumed that businesses would increase employment and production if what they had already produced could find a market. The reality is that businesses will only employ and produce if they believe they will earn a profit from what they produce next. Past sales have only a minor effect on employment going forward. Current sales are only one indicator amongst many in the production matrix of a typical firm. It is why Keynesians were so astonished by the Great Inflation of the 1970s since the combination of high unemployment and rapidly rising prices should have been theoretically impossible.

When looked at from above, if the amount being spent in aggregate is greater than the amount that was earned from producing output – let us suppose the government is running a deficit – then somewhere within the economy there are income earners being short changed since they do not receive in value the amount of value they produced. The spending may have taken place in Washington or Pennsylvania, the shortfalls may show up in Montana or Tennessee. But as invisible as the process is, the effect is quite clear. Some businesses will not earn the returns they expected. They will therefore scale down their level of production or even close down entirely. Ultimately the level of employment will be lower than it otherwise would have been as will the level of national output. A Keynesian will attribute this to too much saving and not enough demand.

The Time Gap between Receiving an Income and Spending

The existence of money adds some complication to the Say’s Law story but not much. There is always the intrinsic time delay between (A) outlaying money in some productive venture; (B) selling products one has produced or earning wages as someone’s employee; (C) receiving the money for what one has produced or earned as an employee which may be delayed through sales on credit or by being paid wages in arrears; and (D) spending the money one has received.

An increased time delay between C and D is not a theory of recession and unemployment.

This is what Mill in his essay “Of the Influence of Consumption on Production” is trying to get across. He was desperate to try to explain to the boneheads of his own time what the conclusions from the Law of Markets are. And it is extraordinary the number of people I have come across who read this essay and then argue that Mill is contradicting himself because he denies demand deficiency at the start of the essay and then talks about people hanging onto their money and delaying expenditure at the end. This is John Stuart Mill we are talking about, the man with the nineteenth century’s highest IQ and whose previous book was his Logic (1843) which was used throughout the nineteenth century and well into the twentieth. He is not likely to have contradicted himself in a way that any bumbling idiot could pick it up. Perhaps they should try to work out more closely what he meant.

And what Mill is trying to get people to understand is that a prior theory of recession is needed to explain why the delay between C and D has occurred. That is the explanation for recession not some blue sky decision not to spend. The increased delay has been caused by something. What is it? That is what needs to be known. And whatever it is has caused the rate of increase in A to diminish as well. But if you believe that the cause has been too much saving, then says Mill, you will never understand the first thing about how an economy works.

The Role of Money

To understand the money side of these things, it helps to go to Wicksell who followed Mill by about half a century (see Chapters 16 and 17 of the second edition of my Free Market Economics). What Wicksell discusses firstly is the natural rate of interest which is the supply and demand for productive resources (machines, bricks, tools, labour hours, everything that can be used in production). Of these, there is only a finite amount (it is a stock) and the potential rate of increase is very slow. Then there is the nominal rate of interest which regulates money and credit, the number of units of purchasing power in an economy. These can be increased at quite a rapid rate, much more rapidly than can the quantum of real resources.

Start with 100,000 units of productive resources and money and credit equal to 100,000 units of currency. Each unit of production thus costs one unit of currency. If the amount of money and credit goes up to 200,000 units of currency, eventually the price of productive resources will rise to two units of currency. But that is eventually. In the meantime, the people who first get their hands on the extra units of currency can buy more since the price level has not as yet risen to the full extent that it will.

But the producers of those 100,000 units of real output will eventually find that they have not been able to exchange what they produced for enough money to allow them to buy products equal in value to the value of the products they sold. If they are running a business, they find they are unable to replace their stock with the revenues they have earned. They have been cheated blind and yet the one place they don’t look for that theft is in the increased demand created by the government since that is what they have been taught to believe is what has been done to save them from the problem that very solution has caused.

And if you have made it this far and would like to see a further continuation of this discussion, see Misunderstanding Say’s Law of Markets which provides a different perspective but on the same issues.

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