“The predominant Keynesian thinking has been tested, and it has failed spectacularly”

The evidence that Say’s Law is valid just keeps accumulating. This very nice article with this great title, Why Austerity Works and Stimulus Doesn’t was picked up by Skuter. There it says amongst other things:

After five years of financial crisis, the European record is in: Northern Europe is sound, thanks to austerity, while southern Europe is hurting because of half-hearted austerity or, worse, fiscal stimulus. The predominant Keynesian thinking has been tested, and it has failed spectacularly.

Yes that’s all very well in practice but does it work in theory. This is from a note to a friend that takes the above empirical result into a theoretical dimension.

Every economist knows at some level that

(1) investment is based on saving

and they also all know that

(2) during recessions there is less demand in aggregate for everything that had been produced.

The Keynesian issue has been to put these two together with the first, too much saving, given as the cause of the second, less demand than there is supply.

It was this association that Say’s Law was designed to prevent. Because as we have seen time and again, once you think (1) as the cause of (2) the automatic response during recession is to increase demand as if demand in aggregate were some entity that exists apart from supply in aggregate.

And the crucial bit that was added by the classics was that the only kind of demand that would be effective at job creation over anything other than the short term – that is, would raise the actual level of sales in real terms and therefore the number of jobs – had to be demand that was based on the production of value adding goods and services. You could not raise effective demand or increase employment by digging holes and immediately filling them again.

It shouldn’t be hard to understand and yet it turns out to be almost superhuman. Let me highlight this quote from John Stuart Mill from his Principles.

This theorem, that to purchase produce is not to employ labour; that the demand for labour is constituted by the wages which precede the production, and not by the demand which may exist for the commodities resulting from the production; is a proposition which greatly needs all the illustration it can receive. It is, to common apprehension, a paradox; and even among political economists of reputation, I can hardly point to any, except Mr. Ricardo and M. Say, who have kept it constantly and steadily in view. Almost all others occasionally express themselves as if a person who buys commodities, the produce of labour, was an employer of labour, and created a demand for it as really, and in the same sense, as if he bought the labour itself directly, by the payment of wages. It is no wonder that political economy advances slowly, when such a question as this still remains open at its very threshold.

Mill writing in 1848, three decades past the general glut debates and at a time in which these principles ought to have been embedded in the active consciousness of economists, still can think of no one besides his father and J.-B. Say who understood this proposition well enough never to lose track of its point in the midst of discussion. Buying things does not create jobs. Producing things that are not self-financing through their sale does not create jobs other than in the immediate present.

I would say that hardly anyone got it then or gets it now except that when I teach it, even people who otherwise fail their exam with around a 20% score still get this right. It can be understood if explained properly but whether such people later on in life never confuse buying things with producing things, of this I cannot be sure.

I go along with Mill that “it is no wonder that political economy advances slowly, when such a question as this still remains open at its very threshold”. But open at its threshold it most certainly is, taught to every student of macro except my own as obvious without need of proof.

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