There’s not a lot I agree with Paul Krugman about but his definition of Say’s Law is most certainly one of them. This is from a blog post he wrote on February 10:

When John Maynard Keynes wrote The General Theory, three generations ago, he structured his argument as a refutation of what he called ‘classical economics’, and in particular of Say’s Law the proposition that income must be spent and hence that there can never be an overall deficiency of demand.

He’s wrong about the reason, that it is because income must be spent, but he is right about the conclusion. Whatever may be the state of play in an economy, rapid growth or deep depression, the one point classical economists would agree on was that the level of demand in aggregate had nothing to do with what was going on.

I am sometimes asked why I persist with bringing Say’s Law into the conversation. There are a number of reasons, of which these are the most important.

First, Keynes himself made this his point. He was going to refute Say’s Law. It still seems to me the most direct means to demonstrate that Keynes was wrong if it can be shown and understood that Say’s Law is valid after all. This is a point perfectly well understood by Krugman. This is the Maginot Line of Keynesian economics. If it is ever breached in a serious way the whole of the Keynesian position will be overrun and sent into retreat and disarray.

Second, by bringing the great economists of the classical period into the argument, I am siding with some of the smartest people who have ever lived. Just to have John Stuart Mill, the man with the nineteenth century’s highest IQ on one’s side, adds quite considerable weight to one’s own arguments. If you believe Mill got it wrong you had better have a pretty strong reason for thinking you can see into these things more clearly than he could.

Third, there is a genealogy for these arguments that one can look up. I have become all too aware that virtually no one even amongst historians of economic thought actually knows very much about classical business cycle theory. Expertise in this area is vanishingly small. Yet it is there for anyone to access if they would bother to try. I might mention that an obstacle to even looking is that Keynes explicitly stated that classical theory had no explanation for involuntary unemployment, a statement so ridiculously untrue that it is shameful that saying just this didn’t discredit him on the spot. But the upshot is that no one who wishes to stay onside with the mainstream of the profession ever wishes to make anything of this.

Four, it is important to get people to understand that the crucial issue is aggregate demand. This is Keynes’ innovation. I say this to you, that if you use aggregate demand to explain anything at all in economic theory, you cannot and will not understand anything at all about what you are trying to explain.

If every time you used the phrase aggregate demand you substituted “value adding production” then you would start to see things a bit more clearly. As in, “if employment is to rise we need an increase in aggregate demand” now becomes, “if employment is to rise we need an increase in value adding production”. You employ people to produce, not to buy. Alas, between the writers and publishers of economic texts there is enough heft to stop any such adjustment being made in how we teach and explain economics, but you can do it for yourself. And if you do it, you will then see that nothing that transpired as part of the world’s various stimulus packages could ever have led to recovery since none of it led to an increase in value adding production.

Anyway, there is more along the same lines as this in an article that you can find at Quadrant Online.

And let me just mention the reason for the title. The statement is from David Ricardo and was part of a letter to Thomas Malthus written in 1820. Malthus was arguing that the recession that was then current was due to a deficiency of demand. People preferred to save and not to spend. I will only say that if you think that the depressed level of our economies at the present time is due to too little demand, then so far as the operation of our economies goes, like Malthus in 1820 you do not have a clue.

My economics, so far as macro goes, is pure classical and I do personally believe that economics reached a high point with John Stuart Mill before the coming of the marginal revolution which made some sense is many ways but lost quite a bit as well. This is a continuation of the post on The errors of Keynes’ critics on hoarding and demand deficiency.

What is the question we wish to answer? We would like to know (1) what will cause more people to be employed and (2) what will cause the economy to increase its level of production?

So the answer on both counts is that employment and growth will increase if production increases, if there is more capital in existence that can be used to produce with and if the productiveness of capital can be improved. These are all 100% entrepreneurial decisions. At the back of every entrepreneur’s mind there is, of course, the question whether what they produce will find a buyer so there is always some degree of uncertainty and doubt associated with every entrepreneurial decision. And it goes without saying that no one will produce unless they believe that there will be enough demand for the product or service. But demand here is purely notional and exists entirely in the mind of the entrepreneur as he tries to work out what others will do if the product is supplied to the market.

The second part is that there is no level of output that will not find a market. An economy cannot produce so much that it will exhaust the willingness of a population to buy the lot. Demand deficiency will never be the nature of the problem when an economy goes into recession.

But trying to work out what people will buy in the future is fantastically difficult. Some part of that is determined by the level of demand in the past but all production decisions are forward looking so past and present demand is merely one piece of information to go along with the rest.

So there are two possibilities for demand deficiency as it is thought of by Keynes and the Keynesian model. Firstly, for a variety of reasons, the population in aggregate will not wish to buy everything that the economy at full employment could produce. They have the income but are just not willing to spend, or businesses have the lines of credit but there are not enough ventures for them to pursue for the moment so that the level of investment sags and savings run to waste.

Well, the fact of the matter is that no such economy has ever existed anywhere nor is likely to. Pick any recession you like and you will never find even a glimmer of an explanation in some kind of fall off in demand just as things were going so well. The recession in 2009 was not caused by decisions to save or businesses not wanting to invest. Identify your own explanation as you will, no one has argued that recession began because of demand deficiency, not even Krugman.

So the second part is to ask whether once recession begins there is then some kind of independent fall in demand that makes things worse. The downturn would have only gone one notch but because of this uncertainty it has gone down three notches. But again that’s not right. As the economy goes over the cliff, everyone is working as furiously as they can to keep their own boat upright. They are doing everything they can humanly hope to do to maintain their own businesses or if they are employees, to keep the businesses which employ them from sinking.

But recessions are due because a portion of the economy was non value adding. This is the meaning of a misdirected structure of production. Some of the economy could not maintain profitability and down they go and they pull suppliers down with them and there is a large increase in unemployment that coexists with the fall off in the level of activity.

And every such downturn in the real economy has an inevitable effect on the financial system. Loans are not being repaid and money becomes really tight. This is the situation described by Mill wherein everyone is trying to get their hands on cash. This is not hoarding. This is a financial crisis. To think of this as hoarding cash, as if everyone just went out and decided one day that they wanted to hold more money. This is what you saw in 2008-09. There was a drive to cash up in an economy where the financial system was in the process of losing immense amounts of money through the unravelling of the leveraging that had been rampant. It was musical chairs with money. Eight people but only seven chairs and so some ended up without the finance to keep their businesses going.

And that’s where we were in 2009. The economy was in recession and finance was tight. No one was hoarding cash. There was no demand deficiency. There was a breakdown in the structure of production which lasted for about half a year.

So the question then was what to do. The Keynesian interpreted these events as a fall in demand when the reality was that there was a rotting in one part of the structure of production. The Keynesians therefore said we had to boost demand but they really meant we must boost supply by employing people to create goods and services that would not repay their production costs. So we had the stimulus and the result has been deficits and debt as far as the eye can see without even a hint of recovery.

I, being completely classical, said that the problem was not a deficiency of demand but structural imbalance. There are things to do, such as bringing the level of business taxes down or lowering interest rates (which happens anyway so doesn’t have to be done). Governments can also do some small additional expenditure on various value adding forms of activity but it is a palliative so little can be depended on it.

Recovery will take about a year, as businesses climb out of their shell holes and suss out where profitable areas of activity might now be. It takes a while but is hardly an unconscionable length of time, especially when we have so many forms of income protection around (which stimulate no demand and are purely a form of welfare but so what). And then, if my approach had been adopted, by around 2010 we would have been well into recovery and unemployment would have been falling and the economy’s momentum gathering steam.

But at no moment during the recession would it ever have been sensible to say that the problem was too little demand, too much saving or that hoarding was postponing recovery. That is pure Keynesian junk and has rotted plenty of minds already and it isn’t finished yet, as that review I read this morning clearly showed.

At the aggregate level an economy has no demand side, only supply. Demand is constituted by the supply of goods being placed on the market. If the notion of demand even darkens your thoughts for a moment, just try to see what the supply issue is that is the real issue of any moment. Not being immediately able to guess after a recessionary explosion has gone off where to increase production is not to be classified as a failure of demand.