A query on Say’s Law

Here is a very pleasing letter I have received from someone who read my article in Quadrant on the fifth anniversary of the publication of the Dangerous Return of Keynesian Economics.

Dear Dr Kates

I read your article in the March Quadrant. It was a great source of information and I have used it to refute a couple of Keynesians on facebook discussions I am involved in. I have a few queries.

1. I have been thinking about Mill’s idea “demand for commodities is not demand for labour.” Initially I balked at it, but after a bit of pondering I think I may have it. I want to run my interpretation past you to make sure I’m correct. Here it its: ‘Just because someone wants a product or a service, doesn’t mean they will pay any price to get it. There is a limit to the amount of human labour, measured through paid wages – is worth. If you understand this, you’ll understand why demand for labour cannot be increased by increasing the demand for goods and services.’ Have I got that right? Was Mill talking about the concept of the law of diminishing returns?

2. What I want to be able to do in my little debates is make claims like:

*Keynesian economics doesn’t promote growth, it stifles it.

*Where Keynesian economics have been applied its been shown to not have worked.

*The economic consequences of Keynesian policies are disastrous.

Where can I find evidence to support those claims. A hyperlink to websites/studies would be particularly valuable.

Thanks in advance. Please keep writing these articles for Quadrant. They are great for laymen like me. If I may make one small, respectful suggestion when you make claims and affirmations about the negative consequences of Keynesian stimulus, please give some basic evidence or backing so that I can use this in discussions.

Kindest regards

So I have replied

Dear Matthew

The thing that is still astonishing is that there are any Keynesians left for you to argue with but I guess they’re still out there living in silent resentment about how little appreciated they are. I have, of course, written an entire book on this stuff – Free Market Economics – which is not all that expensive – paperback around $40 through the Elgar website. Alas, your approach to understanding Mill will not get you to what I think you need to understand if you are to have a solid foundation in dealing with Keynesian arguments. The order in which events happen in an economy is not people wanting things and then they are supplied. It is the way we teach micro, with demand first and then supply, but that is not the order in which events occur in reality.

The order in which everything occurs is that entrepreneurs come to conclusions about what they might produce and sell at a profit, then go through the many stages of setting up their businesses which requires a tremendous amount of outlay before they earn a single cent of positive return, and then, when the goods or services are brought to market, buyers may or may not choose to buy enough to repay all of the previous costs. Demand, to be strictly technical about it, is the relationship between price and quantity demanded for an existing product that is already on the market. All production, however, is future orientated and while past sales may provide some clues about what might sell in the future, it is hardly the most important consideration in the minds of entrepreneurs in trying to decide what they will do next. Wasting a tonne of money on pink batts and school halls is great in the short term for pink batt and school hall producers but distorts your economy away from productive activities, raises input costs across the economy and provides no clear direction about the nature of demand say eighteen months ahead.

As for Say’s Law here’s a brief outline.

1) If you pay some people to dig a hole and then pay other people to fill them in again nothing of value has been created so no matter how much money you pay them thinking only of this group there is nothing for them to buy.

2) Every form of economic activity uses up resources. They thus draw down on the available productivity of the economy. Keynesian economic theory thinks of the drawing down as in and of itself stimulatory. No classical economist would have been so stupid. Drawing down on resources – even in some activity that will eventually provide you with a positive return – makes you worse off.

3) The need for economic activity to be value adding is essential. Production is value subtracting. It uses up resources. When whatever has been produced becomes available, it is either just consumed or it becomes part of the productive apparatus of the economy. It is those additions to the productive parts of the economy that are the essential for growth and prosperity. Only if the value of what these newly produced capital assets is greater than the value of the resources that have been used up can the activity be counted as value adding.

4) Only value adding activities create growth and employment over anything other than the short term. Timing is everything, but the flow of new productive assets coming on stream (and it may take years of value subtracting investment for any particular project to become productive) is the only thing that can make an economy more productive, raise living standards, add to employment at the going real wage and then, thereafter, increase the real wage.

5) Why Say’s Law? Amongst the many lessons that Say’s Law provides, and this is from the classics, is that “demand is constituted by supply”. Because of the low state of economic theory today, I now make it explicit what classical economists had meant, “demand is constituted by value adding supply”. Unless what is produced is value adding – that is, it adds more to output than the resources that have been used up in their production – then it cannot add to employment at the going real wage.

6) No stimulus program in the world was value adding. Virtually no government activity, other than some roads and a few infrastructure projects, is value adding. All draw down on resources but do not provide a net addition either in the short term or in the long. NBN is such a prime example, as is the Desal plant in Victoria. We are not better off for spending the money and using up the resources because there is no return. That the construction workers went out and bought goods and services with the money they were paid do not make those projects in any way beneficial to the economy. They are pure waste.

7) Private sector activity often misfires on an individual basis which is what bankruptcy is about. But a properly structured free enterprise economy, where financial institutions lend to the most promising projects for which funds (ie resources) are sought, provides you with the only structure that will provide an overall net rate of growth and an accumulation of capital assets across an economy that will build prosperity.

8) You want to understand what’s wrong with Keynesian economics, it offends against Say’s Law which makes it absolutely clear that only value adding activity adds to growth – demand is constituted by supply. If you keep all that in mind, I can’t see how you could go wrong.

Kind regards

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