These are some of the postings on the Societies for the History of Economics (SHOE) website related to my posting of “Deck the Halls with Macro Follies”.

December 7 from Steve Kates

I thought this would be of interest to historians of economics. John Papola, the animating spirit behind the Keynes-Hayek Rap, has now done a video on Say’s Law, the fundamental principle of the pre-Keynesian theory of the cycle. While most of those who come to this site have an interest in the history of economics, not everyone is a specialist in the issues he raises. To help appreciate the video, here are a few bits of background to catch the full flavour of just how beautifully done it is.

John Maynard Keynes introduced the notion of aggregate demand into economic theory. Before his General Theory of Employment, Interest and Money was published in 1936, demand deficiency as a cause of recession was literally and with no exaggeration seen as a fallacy by virtually all mainstream economists. That is what an acceptance of Say’s Law meant. Today, of course, macroeconomics is the mainstream and when recessions occur the first thought in almost everyone’s mind is to restore the level of demand.

Keynes took the idea of demand deficiency from Thomas Robert Malthus who published his Principles of Political Economy in 1820, the most important aspect of which was his argument that recessions are caused by too much saving leading to too little demand. Keynes was reading Malthus’s letters to Ricardo in October 1932 which was the specific reason that he would eventually write a book on demand deficiency as the cause of recession. Most scholars who have looked into the transition from The Treatise on Money do not accept Malthus as the inspiration for Keynes. But since there is general consensus that Keynes formed the idea of demand deficiency in late 1932 and there is no question that Keynes was reading Malthus in late 1932, there are very strong reasons to believe that it was because Keynes was reading Malthus at just that moment that he wrote The General Theory to explain demand deficiency as the cause of recession. But it is a controversial point so some may not accept the notion that Malthus was the inspiration for Keynes as suggested in the video.

Say’s Law, which does not get mentioned by name, was called the Law of Markets during classical times. The principle was not given the name Say’s Law until the 1920s but it was Jean-Baptiste Say in France and James Mill in England who together are responsible for the initial crafting of this bedrock classical proposition. And as a very good first approximation to its meaning there is this, the best short statement on the law of markets and its implications, which was given by David Ricardo in a letter to Malthus dated 9 October 1820. It is briefly referred to in the video as part of a song title as it flashes by:

“Men err in their productions, there is no deficiency of demand.”

Ricardo was trying to explain to Malthus that in his view the recessions that followed the ending of the Napoleonic Wars in 1815 were not due to there having been too much saving and therefore too little spending. It was not even spending that mattered. What had gone wrong was that the goods and services produced did not match the specific demands that people with incomes had (“men err in their productions”). There were therefore unsold goods and services, but not because there was too little spending and too much saving, but because businesses had produced one set of goods (housing in the US to take the most recent example of recession) that could not be sold at prices which covered their costs. The structure of production was wrong which would inevitably, as it always does, affect credit markets as defaults became legion.

And finally there is the question of effective demand which is different from the notion of aggregate demand. Aggregate demand is just a total. Effective demand explains what creates purchasing power. What makes individuals within an economy able to buy more than they presently do is more production of goods that can find a market. Producing saleable products – raising productivity – is the only means by which economies can grow and therefore, beneath it all as Friedrich Hayek explains, there must be more investment in capital (actual productive assets) and more innovation which improves the technology embodied in the capital. An economy is driven by supply, never demand. Only if value adding supply goes up can demand go up.

That is the message of the video. It is a piece of genius that so much can be so condensed into just over four minutes.

December 8 from Marie Duggan

Dear All,

This is really fun! However, the trouble with the logic of the argument is that, as Keynes realized in the 1920s, a lot of businessmen were not borrowing in order to invest in anything real, but in order to speculate in financial markets (as Keynes himself knew all too well!). Between 1978 and 2007, rather the same thing was happening with savings in the US. Those who saved, speculated. So much money went into speculation that asset bubbles were more profitable than real production! Keynes’ gets that complicated story. But I don’t think he advocated deficit spending, as much as he advocated redistributing income from the high-income earners to the middle income earners. He would say today raise taxes on the high-income earners, and cut taxes by the same amount on the middle class (or support public education, which would result in the middle class paying less out), and poof, aggregate demand would zoom.

Marie Duggan

December 8 from Barkley Rosser

Papola’s piece is highly amusing, if definitely skewed to a particular perspective. Two points on that perspective.

One is that Say himself admitted in several places in his main book that his “law” may not always hold and described some historical examples involving the Roman and Ottoman Empires (the latter still existing when he wrote, so “current” rather than “historical” when he wrote) of when people may have been hoarding cash that was neither purchasing goods nor being provided through financial markets lead to real capital investment. Some of these involved people seeking to avoid property taxation by hiding their assets, and indeed the Ottoman Empire experienced increasing stagnation of growth as time passed. Hoarding of cash that is not saved by being put into the financial system has long been posited as a way for a shortfall of aggregate effective demand to come about.

The second is that Ricardo’s explanation of the post-Napoleonic slowdown is a statement of faith, not of clearly proven fact. Do we have evidence that the surpluses in those sectors where men were “erring” by producing too much offset by declining inventories in the other sectors? If that was not the case (and I have never seen anybody present evidence that it was), then indeed the case can easily be made that Malthus was right that there was a shortfall of aggregate demand leading to layoffs, even if one wants to argue that this was strictly a short-term adjustment on the way to a convergence onto a long-run classical equilibrium growth path of superior efficiency and sustainability.

Barkley Rosser

December 8 from James Ahiakpor

Both the facts and logic of which I am aware are painfully in contradiction to Marie Duggan’s claims. I wonder how she came by them.

The number of people employed in the U.S. in 1978 stood at 96.048 million and rose to 146.047 million by the end of 2007. Were the additional nearly 50 million people employed just to engage in speculative activities? Even recent U.S economic history that includes the housing bubble should alert one to realize that the bubble involved lots of real production (houses).

Keynes certainly favored income redistribution from the rich to the poor or middle class. But this derived from his mistaken notion that the savings of the rich are not spent (an argument he started from the Treatise, namely, the paradox of thrift). Had Keynes tried (harder, if he encounted the statement in the Wealth of Nations) to understand Adam Smith’s explanation that “What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a diffrerent set of people,” he might have spared us that folly. J.S. Mill (Works, 2:70) and Alfred Marshall (Pure Theory of Domestic Values, quoted in Keynes, GT: 19) restate Smith’s savings-are-spent explanation that Keynes could have tried to understand. Thus, when the rich are taxed more, its those things that their savings would have been spent on (by the borrowers) that would contract to match the additional consumption of the middle class. Marie’s vision that such income redistributive policies, poof, increase aggregate demand turns out to be a fallacy.

Perhaps, the video would have been additionally helpful to point out the source of Keynes’s problem with saving, namely, confusing it with cash hoarding by private individuals. There was a lot of that during the early 1930s (run on banks, leading to a $8 billion contraction in demand deposits between 1930 and 1933). We don’t have that going on now, thanks to the FDIC (Federal Deposit Insurance Corporations, 1934), although you wouldn’t know it from the reckless money creation by the Fed over the last four years or so.

I’m praying for the arrival of the day when enough economists would stop making excuses for repeating Keynes’s macroeconomic follies.

December 8 from Steve Kates

If I might, a brief reply to Barkley Rosser. On the first issue on Say’s wavering adherence to Say’s Law, in spite of his Letters to Mr Malthus published in response to Malthus’s Principles in 1821, it was not his version of the concept that became standard in the literature. Say thought that unsold goods could be sold if more of other goods were produced. But as Ricardo pointed out at the time, it was not that more of other commodities needed to be produced but there should be less production of what cannot be sold with the resources used instead to produce something else. Anyone who goes to Say to find out what Say’s Law meant is going to someone who never really seemed to understand this principle in full himself. I must say, though, that hiding cash from governments that will take it from you if they find it, the example given by Barkley, is not the kind of example that those who argued in favour of oversaving actually had in mind.

As for the nature of the recessions that overcame Britain from 1813 to 1823, I refer you to an interesting paper, “The Historical Context of the General Glut Controversy” by Tim Davis which may be found in my Two Hundred Years of Say’s Law (Elgar 2003: 133-153). There, in his conclusion, Davis wrote:

“My account of historical events is important because it shows there was no chronic depression during the postwar decade. Instead, the economy was beset by a series of shocks, mostly external, to which it adjusted quickly. Malthus did not recognise the separate crises and so criticised Ricardo’s analysis of postwar events. He believed Ricardo attributed the economic trouble of the entire period to a shift from wartime to peacetime production. This was not the case. Instead, Ricardo recognised the several shocks that occurred and the fact that in the ensuing adjustment, capital and labour were unemployed. With regard to the dispute about ‘oversaving’, Ricardo rejected Malthus’ argument, especially as stated in Chapter 7 of Malthus’ Principles of Political Economy, that excessive investment reduced the demand for labour and contributed to unemployment. Nothing in the historical record suggests that Britain suffered from too rapid an investment program; also, the logic against ‘oversaving’ is compelling.” (Davis 2003: 148-149)

December 8 from Gary Mongiovi

Smith’s assertion that all savings get channeled into spending (as clear a statement of Say’s Law avant la lettre as one can find), is just that–an ungrounded assertion. He offers no persuasive rationale for it. Somehow the savings magically get channeled into spending. If memory serves, John Stuart Mill hints at interest rate adjustments as a mechanism that might bring investment spending into line with saving, but he recognized that in a money economy, where decisions to sell can be separated from decisions to spend, the mechanism could falter in ways that could produce considerable economic distress for a while at least (see Mill’s On Some Unsettled Questions of Political Economy, 1844).

So I doubt if Keynes could have learned anything useful about the problems with which he was concerned by reading what Smith had to say about saving & investment. And in so far as Mill recognized that demand could fall short of aggregate output, at least temporarily, there’s a bit of common ground between him & Keynes. Keynes obviously had read Marshall quite carefully, and outlined a critique of the Marshallian position; we can debate whether that critique is persuasive, but that’s a different issue from the one on the table here.

I always find it curious that anyone takes Say’s Law seriously. It contends that any level of aggregate output will be sustainable, since aggregate spending will always adjust to precisely the level of output the economy has produced–whatever that level may be. In most of the classical literature there’s no robust rationale for it: it’s supported by pretty lame statements along the lines of: well, no one would take the trouble to produce x dollars worth of output unless he wanted to buy x dollars worth of other stuff.

I know that Say’s Law is often claimed to be an element of neoclassical economics, but I’m skeptical about that too. Say’s Law contends that ANY level of aggregate output can be sustained. In neoclassical economics, the only equilibrium level of aggregate output–the only level that can be sustained–is the full employment level. If the system produces a level of output that falls short of the full employment level, then wages, the interest rate and other relative prices are presumed to adjust to move the system towards full employment. I don’t find that argument persuasive myself, but it’s not really Say’s Law.

And as far as the empirical evidence goes, well, I’m no econometrician, but isn’t the US economy going through a patch now where private sector investment spending is falling short of household and business saving? And wouldn’t the high-saving German economy have some real aggregate demand problems if the demand for its exports evaporated? Saying that crowding out is total doesn’t make it so.

No one denies that production is the source of income, or that income is a significan source of demand. The question is whether there is a mechanism which ensures that every dollar of income translates into a dollar of demand: this is not self-evident; if anything, it strikes me as a highly dubious claim.

Gary

Gary Mongiovi, Co-Editor
Review of Political Economy
Economics & Finance Department
St John’s University
Jamaica, NEW YORK 11439 (USA)

December 8 from Sumitrah Shah

Since Paul Krugman as Macro Santa gets to “create things out of thin air” at the end of the video (at least I think it is supposed to be him), maybe we should give him a chance to explain the General Theory as he understands it, with its strengths and weaknesses. It is as lucid an introduction as one could hope for, even though it is sure to enrage some people! But isn’t that the point of the video too?

http://www.pkarchive.org/economy/GeneralTheoryKeynesIntro.html

Gary’s excellent statement about J. S. Mill: “in a money economy, where decisions to sell can be separated from decisions to spend, the mechanism could falter in ways that could produce considerable economic distress for a while at least” seems elementary and yet needs to be repeated.

And speaking of creating things out of thin air, where would be Schumpeter’s investors and innovators be without the facility to use credit to develop whole industries “out of nothing” as it were? His theory of entrepreneurship would be implausible without the banker whom he called the “ephor” of capitalism. The fractional reserve system guarantees that savings out of current income are not necessarily the source of all investment at all times. Savings will, of course, increase out of higher incomes to attain a new equilibrium. And similarly, bankers could balk at lending because there aren’t good investment opportunities around, as they have done in the recent recession by sitting on piles of cash. The relationship between savings and investment spending is complicated, at the very least.

Best,

Sumitra Shah

December 9 from Steve Kates

I am very grateful to Sumitra Shah for posting Paul Krugman’s introduction to The General Theory which gets to the very heart of the issues at stake. This is what Krugman wrote:

Stripped down, the conclusions of The General Theory might be expressed as four bullet points:

• Economies can and often do suffer from an overall lack of demand, which leads to involuntary unemployment

• The economy’s automatic tendency to correct shortfalls in demand, if it exists at all, operates slowly and painfully

• Government policies to increase demand, by contrast, can reduce unemployment quickly

• Sometimes increasing the money supply won’t be enough to persuade the private sector to spend more, and government spending must step into the breach

To a modern practitioner of economic policy, none of this – except, possibly, the last point – sounds startling or even especially controversial. But these ideas weren’t just radical when Keynes proposed them; they were very nearly unthinkable. And the great achievement of The General Theory was precisely to make them thinkable.

The first of these dot points is the refutation of Say’s Law. Let me therefore put the meaning of Say’s Law into the same form used by Krugman: whatever might be the cause of those frequently occurring recessions which do, of course, lead to high levels of involuntary unemployment, such recessions are never caused by a lack of demand.

If anything sounds startling and controversial to a modern economist, it is this. And because of Keynes, the very idea that demand deficiency does not cause recessions is utterly unthinkable today. Aside from a very small handful of those who read this site, such a possibility has not only never crossed their minds, but will be rejected out of hand. Yet the denial of demand deficiency as a cause of recession was accepted by Ricardo, Mill, Marshall, Jevons, Pigou along with virtually the whole of the mainstream prior to 1936 and they did so having thought through the “Keynesian” alternative.

No classical economists would ever have subscribed to the stimulus programs whose deficits and debts are ruining one country after another. The Great Depression ended after four years. The present recession has no end in sight. Why, then, does anyone think Keynes was right and the classics were wrong? That is the point the Macro Follies video is trying to get across.

December 9 from Sumitrah Shah

I thank Steve Kates for his response. My bullet points are directed to his comments at the end of his message.

“No classical economists would ever have subscribed to the stimulus programs whose deficits and debts are ruining one country after another.”
The deficits and debts of at least the U.S. can easily be traced to the enormous redistribution of incomes and wealth towards the top, which led to reduced revenues. Add to that major expenditures of unfunded wars and you have a recipe for deficits and debts. It was not long ago when in the late 1990’s we were running budget surpluses.

“The Great Depression ended after four years.”

Surely the New Deal policies had something to do with that. It is fashionable to be New Deal deniers in some circles, but I don’t think the folks who read this site. In 1937, when Roosevelt was pressured into austerity measures, the economy did slide into another downturn.

“The present recession has no end in sight.”

Could the political gridlock in America have something to do with it? And in other countries, austerity measures are the official policy and they are doing worse than the U.S. If one country after another are being ruined as you claim, it is certainly not due to commitment to meaningful stimulus programs.

“Why, then, does anyone think Keynes was right and the classics were wrong? That is the point the Macro Follies video is trying to get across.”

The “Keynes and the classics” dilemma remains still. But as to the point of the video, the makers are far too clever to settle just for educating the public to their viewpoint. It would be a wasted effort if they didn’t want to ruffle many feathers too!
Cheers,

Sumitra Shah

December 10 from Barkley Rosser

My heavens, Steve. Your latest post is simply crawling with absolute statements, most of which are demonstrably false. Let me simply note your claim that none of the “mainstream” or “classical” economists prior to 1936 thought that fiscal policy stimuli should be used to combat unemployment. Right there on your list is Pigou, who thought so. Much of the Chicago economics department thought so prior to Keynes as well, including Henry Simons and Aaron Director. Going further back, well, I cannot resist; Jean-Baptiste Say himself thought so as well.

December 10 from Steve Kates

You would really have to wonder what the Keynesian Revolution actually was if you follow Barkley Rosser. All those “demonstrably false” statements I make, and yet it is he who thinks that classical economists thought the answer to recessions was a fiscal stimulus. So just what is it that he thinks Keynes did that was so special?

Classical economists did indeed argue that there was a role for public spending to play during recessions, but such spending was seen as a palliative and not the actual solution, such spending had to be value adding and no deficits were involved. It is everywhere across the classical literature, even in the very chapter John Stuart Mill wrote to explain and defend Say’s Law. I will even quote him:

“There is another way in which government can create additional industry. They can create capital. They may lay on taxes, and employ the amount productively.” (Mill [1871] 1921, Ashley edition, p 86)

But the key here is that the money had to be spent productively. None of this digging holes and filling them again kind of stuff, and as you can see, there is no hint of deficit spending since there needed to be taxation to pay for the spending by government. So burying banknotes in disused mine shafts or building pyramids would not have been what any classical had in mind. The mindless waste during the so called stimulus would have been anathema.

The example of Hubert Henderson is quite instructive. Henderson along with Keynes were the co-authors of “Can Lloyd George Do It? which was the Liberal Party election manifesto of 1929. And in it they both supported a public works program to deal with the unemployment of the time which existed before the Great Depression took hold. But after The General Theory was published, there was a famous meeting in 1936 in which Henderson tore into Keynes’s arguments as a form of economic insanity.

Since classical economists all understood that demand is constituted by supply, the notion of a separate aggregate demand function was seen as utterly fallacious. That’s exactly why, just as Krugman wrote, “these ideas weren’t just radical when Keynes proposed them; they were very nearly unthinkable”. And if you look around in every direction today and take in the mess that the stimulus has made of one country after another you will understand why they thought such ideas were as pernicious as they really did think they were.

December 10 from James Ahiakpor

Gary Mongiovi wrote:

Smith’s assertion that all savings get channeled into spending (as clear a statement of Say’s Law ////avant/// la lettre/ as one can find), is just that–an ungrounded assertion. He offers no persuasive rationale for it. Somehow the savings magically get channeled into spending. If memory serves, John Stuart Mill hints at interest rate adjustments as a mechanism that might bring investment spending into line with saving, but he recognized that in a money economy, where decisions to sell can be separated from decisions to spend, the mechanism could falter in ways that could produce considerable economic distress for a while at least (see Mill’s On Some Unsettled Questions of Political Economy, 1844).

It would have been helpful to Gary Mongiovi to have read Smith’s statement he called “an ungrounded assertion” in full in the /Wealth of Nations/ (Chicago, 1976, 1: 359) to appreciate its validity. Define or recognize saving as the purchase of a financial asset for the reward of interest or dividend (share of profits) (Smith, /WN/, 1: 358), and also recognize that issuers of financial assets intend to spend the proceeds. Smith’s explanation becomes very clear. I referred to J.S. Mill’s repetition of Smith’s explanation (/Works/, 2:70), but once again, Gary would rather shoot from the hip–“if memory serves” he says– rather than to read the reference. Mill writes:

The word saving does not imply that what is saved is not consumed, nor even necessarily that its consumption is deferred; but only that, if consumed immediately, it is not consumed by the person who saves it. If merely laid by for future use, it is said to be hoarded; and while hoarded, is not consumed at all. But if employed as capital, it all consumed; though not by the capitalist.

Now, if one defined “investment” as Keynes (/GT/, 62) does as only “the current addition to the value of the capital equipment which has resulted from the productive activity of the period,” it may become difficult to see how savings necessarily become “investment spending.” But if one recognizes investment spending as the employment of savings or loanable funds in the sphere of production that includes the purchase of capital goods, using funds to pay workers before revenues flow in (the wages fund), and funds-on-hand to run an enterprise, that is, both fixed and circulating “capital,” then the classical explanation is easy to understand. One of Keynes’s major problems with understanding the classical literature was the meaning of “capital” as loanable funds that derive from savings. Apparently, his modern-day followers are still having the same problem with the classical language.

So I doubt if Keynes could have learned anything useful about the problems with which he was concerned by reading what Smith had to say about saving & investment. And in so far as Mill recognized that demand could fall short of aggregate output, at least temporarily, there’s a bit of common ground between him & Keynes. Keynes obviously had read Marshall quite carefully, and outlined a critique of the Marshallian position; we can debate whether that critique is persuasive, but that’s a different issue from the one on the table here.

I don’t know how Gary judges Keynes to have read Marshall “quite carefully” when Keynes (/GT/, 19) couldn’t make clear meaning of the Marshall quote:

The whole of a man’s income is expended in the purchase of services and of commodities. It is indeed commonly said that a man spends some portion of his income and saves another. But it is a familiar economic axiom that a man purchases labour and commodities with that portion of his income he saves just as much as he does with that he is said to spend. He is said to spend when he seeks to obtain present enjoyment from the services and commodities which he purchases. He is said to save when he causes the labour and the commodities which he purchases to be devoted to the production of wealth from which he expects to derive the means of enjoyment in the future.

Keynes couldn’t even understand Marshall’s explanation that interest is the reward for saving. Instead his retort is that interest is the reward for “parting with liquidity” or not hoarding cash (e.g., /GT/, 166-67). Why, because he thought, incorrectly, that saving is the same thing as cash hoarding!

I know that Say’s Law is often claimed to be an element of neoclassical economics, but I’m skeptical about that too. Say’s Law contends that ANY level of aggregate output can be sustained. In neoclassical economics, the only equilibrium level of aggregate output–the only level that can be sustained–is the full employment level. If the system produces a level of output that falls short of the full employment level, then wages, the interest rate and other relative prices are presumed to adjust to move the system towards full employment. I don’t find that argument persuasive myself, but it’s not really Say’s Law.

Keynes’s false attribution of the full-employment assumption to classical economic analysis has been a hindrance to many of his followers to understand classical analysis. Indeed, Say’s law or the “Law of Markets” holds at any state of the economy, including periods of involuntary unemployment that may be generated by a commercial crisis or “shaken confidence” (well explained by Mill, /Works/, 3: 574) and Marshall, 1920, 591-92). As Ricardo also explains, during a process of adjustment in the condition of business due to changes in “the taste and caprice” of consumers, “much fixed capital is unemployed, perhaps wholly lost, and labourers are without full employment. The duration of this distress will be longer or shorter according to the strength of that disinclination, which most men feel to abandon that employment of their capital to which they have long been accustomed” (1: 265). Had Gary bothered to re-read Mill on the subject, he also might have recognized Keynes’s mischief in truncating Mill’s otherwise careful statement regarding the necessity of producers to match their supplies with consumer’s taste or demand in order to avoid excess supplies or demands:

Nothing is more true than that it is produce which constitutes the market for produce, and that every increase of production, /if distributed without miscalculation/ among all kinds of produce in the proportion which private interest would dictate, creates, or rather constitutes, its own demand (1874, 73; emphasis added).

But this is what Keynes distorted as “Supply creates its demand,” a phrasing of the law that leaves many people puzzled.

No one denies that production is the source of income, or that income is a significan source of demand. The question is whether there is a mechanism which ensures that every dollar of income translates into a dollar of demand: this is not self-evident; if anything, it strikes me as a highly dubious claim.

All markets are linked through the adjustment of relative prices and interest rates. That is the mechanism. No classical economist ever claimed that the adjustment process was instantaneous. That view is another of Keynes’s distortions of classical economics.

We can hardly make progress in our understanding of the classics and how badly Keynes misrepresented their arguments unless we take the trouble to read them carefully ourselves, especially with the meaning of words as they meant them rather than the definitions Keynes improperly assigned to them. And in the debate over the efficacy of government spending as an aid to aggregate demand, all we need do is ask ourselves this simple question: “From where does the government get the money to spend?” Unless, it is from a central bank’s printing press or borrowing from abroad, why should that increase total spending?

In a letter to T.R. Malthus, J-.B. Say writes:

Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own. To the proprietor of the mines whence this money is obtained, it is a production with which he purchases such commodities as he may have occasion for: to all those into whose hands this money afterwards passes, it is only the price of the productions which they have themselves created by means of their lands, capital, or industry. In selling these, they exchange first their productions for money; and they afterwards exchange this money for objects of consumption. It is then in strict reality with their productions that they make their purchases; it is impossible for them to buy any articles whatever to a greater amount than that which they have produced either by themselves, or by means of their capitals and lands (Say 1821, 2).

The letter clarifies the meaning of the law of markets. The law does not relate to a barter economy. And should there develop an excess demand for money (through the demand to increase hoarding), prices would fall (excess supply of goods and services) unless the supply of money is immediately increased to satisfy that demand. Why the law’s logic is still lost on some people remains a puzzle to me. But I suppose no amount of quoting from the original sources will help those who choose not to understand.

James Ahiakpor

December 11 from Steve Kates

In relation to James Ahiakpor’s post, I do think Say’s Law was embodied in the classical theory of the cycle right up to 1936 but that’s a separate issue from what he wrote in trying to explain the meaning of this principle and how it was mangled by Keynes. If we are historians of economics, part of whose mission is to make sense of the great economists of the past, then it should be our mission to make sense of Smith, Ricardo, Mill and Marshall. James can follow what they wrote and can make coherent sense of their arguments. He can explain their logic and understands their economics. Whether he is right about the superiority of their arguments relative to Keynes, the question I have is whether those who have been critical of what he (and I) have written can themselves follow and make plausible sense of Smith, Ricardo, Mill and Marshall.

Unless you assume that they were complete idiots, that they believed everything produced would immediately find a buyer and that recessions were a theoretical impossibility, then it ought to be part of our own mission as historians of economics to be able to explain what they and the classical school understood about the nature of saving, investment, recessions and economic adjustment. We should also be able to understand and explain why they would have thought Keynesian economics was fallacious from end to end (and please do read Hubert Henderson’s “Mr Keynes’s Theories” which was his Marshall Society Lecture on 2 May 1936 if you are interested in a classical reply to Keynes written by an actual classical economist).

You don’t have to believe what they wrote, just be able to explain why they thought what they thought and why their arguments were persuasive enough to hold the allegiance of their fellow economists for more than a hundred years through booms and busts, good times and bad. I can easily understand and explain Keynes. Piece of cake, end to end nonsense though I think it is. But those who have been critical of James and myself, can they really explain Marshall and Mill in a convincing matter? Reading some of these posts makes me wonder not whether they can because I see that they can’t, but whether they even think they should be able to since they already seem convinced there is nothing there worth knowing.

This is John Papola replying to critics of his video on some website over the course of a few days. It is astonishing that he never takes a wrong turn, gets it right even in the middle of the most complex arguments and explains the classical position on Say’s Law to perfection in a way that no modern economist could ever hope to do.

John December 7, 2012 10:56 PM

I don’t care about what economists write to each other behind JSTOR paywalls and in language and equations that nobody understands. I care about what economists, pundits and politicians say to the general public. I care about what’s driving our cultural understanding about the way an economy works and grows. Since these two things are at odds with one another, I put particular emphasis as a filmmaker on the latter since it matters, and not the former.

And an overwhelming number of them talk about how consumer spending can ‘drive growth’ because ‘consumer spending is 70% of GDP’. That is a fallacy. And when Nobel-prize winning Keynesian economists are saying that consumption grows the economy, I have every right to criticize that position for the fallacy that it is. The fact that they publicly contradict the technical literature and even their own work has nothing to do with my intellectual honesty and everything to do with theirs.

Consumption doesn’t grow the economy. Period. Consumption uses stuff up. It shrinks the stock of value. And I’m fully aware of the technocratic tweak about demand for money and the ideal of nominal spending stability. I’m unaware of any sudden nominal shocks that weren’t reactions to some inciting phenomenon like a rash of business failures. People don’t just suddenly hoard cash for no reason. And regardless, if they do, money supply should be increased to meet that demand. I included this in my 2010 video with Larry White. It’s got nothing to do with this video. It would confuse people to attempt including it.

It’s not an academic paper, Daniel. And thank god… because nobody reads those and no politicians either. Hence we hear that UI benefits are a stimulus and tax cuts for those who have to spend every nickel on consumption are better than those for people who might save the money. That’s the point. That’s what matters because it’s what the public is actually told about policy. It’s false. It’s nonsense. So I honestly and openly criticize it. I’m open and honest about my position. It’s clear. I stand by it 100%. [My bolding]

And continuing two days later

John December 9, 2012 10:53 AM

Yes, in the sense of the ‘supply side’ I’ve enumerated above, real growth is all about the ‘supply side’. It’s about Say’s law and classical econ with productivity and value-added production at the center of the story. But even the framing of ‘supply side’ and ‘demand side’ is wrong in my view, UNLESS you’re distinguishing the ‘supply side” as ‘real’ and the ‘demand side’ as nominal. Why? Say’s law!

Demand, when it’s not generated purely through the printing press, is constituted by supply first. We’re all suppliers/producers, trading with each other. We produce so that we can consume. Production is the means to our consumption ends. That is the secondary message of the video. We produce with the goal of consuming in mind, lest we wouldn’t bother. Nobody wishes to work for work’s sake (unless it is a passion project and thus arguable a consumption activity in it’s own right, like painting or writing, etc).

There is no such thing as a distinct ‘aggregate supply’ separate from ‘aggregate demand’ except as a model to understand the role of monetary policy. In real terms they are one-and-the-same. Every trade at a price which composes total economic activity is both an act of supply and demand at the same time by both trading parties. There aren’t real AS and AD curves that interact. It’s an imperfect model that somewhat abuses the insights drawn from the Marshallian graph. But it can be useful when putting money in the middle and introducing the loose joint of money and monetary policy is what allows the ‘demand side’ to become understandable as separate from exchange between producers. Perhaps I’m redefining these models in my own terms. If so, so be it. This is how I understand macro phenomena.

As Lars Christensen once wrote, another influence of mine, macro and monetary policy is about allowing Say’s law to work, by ensuring that supply creates demand for something other than hoards of cash. And yes, even that is only necessary because of “sticky” wages. If there were less nominal rigidity in the labor market, in large part through government policies that push up minimum and reserve wages, even hoarding would be less of a problem. Guess who else has helped me understand this stuff? Brad Delong. He wrote the ‘missing macro playbook’ where he explained that Say’s law works great unless people increase cash holding to a serious deflationary degree, pointing to John Stuart Mill for support. He even noted that the key was to increase the supply of ‘safe assets’ to meet demand as the answer. He simply went off the rails by claiming that those safe assets should be treasury bills instead of dollar bills. I don’t know why, but I assume it’s about the liquidity trap. He was, after all, among those claiming that the Fed was out of bullets in 2008 and 2009. Man was he wrong on that count, but I’ll leave Sumner to that critique. Anyway…

And then later after someone wrote that he didn’t see what Say’s Law had to do with long-run growth:

John December 9, 2012 10:13 PM

Right here you are tapping into what I view as the root issue.

Say’s law has everything to do with long-run growth because it demonstrates why increased productivity (supply) opens up new markets and grows the economy. The economy grows by finding ways to increase the supply of salable goods.

I see the deep problem beginning with this notion that there are ‘demanders/consumers’ and ‘suppliers/producers’ as distinct groups. There isn’t. There is production and exchange. The two ‘sides’ are not really ‘supply’ and ‘demand’, but one supply for another. Exchange occurs when two people bring value to the table which the other values higher. Both are bringing production, in a real sense, to the table. As Mill said ‘commodities exchange for commodities’ (I’m pretty sure that’s the exact quote).

There is no demand without first supplying value to the market. For most people, they supply their labor and that supply enables them to demand other goods and services. But their supply comes first. There is no income for a good while it is in the process of being produced. It is only AFTER it is produced that it can be sold.

Imagine you and I on a desert island. We both have endless wants and needs. Food, water, shelter, entertainment, healthcare, etc. We have nothing. Now, imagine that you get to work fishing while I do nothing but sunbath. You know for a FACT that I am going to be hunger. You can surely anticipate my potential demand for fish. But if I don’t first produce something for you, no exchange is going to take place. Supply enables ‘demand’. You fish and I loaf around – no dice. No demand. No trade. Even though it’s totally clear that I have a biological need to eat and you could reasonable predict that need.

So ‘Demand’ is not something distinct from supply in real terms. The only way to separate demand from supply is to think purely in monetary terms. When money is in the mix, it can be supplied and demanded as well, but since there is no market for money except as a medium of exchange for other goods, the impacts of changes in the demand for money ripple out to the economy as whole. But let’s leave that to the side for a moment and dig into what my exposition of Say’s law helps us understand.

And then some more from John in which he summarises the issues in four points:

John December 9, 2012 10:14 PM

1. Consumption does not grow the economy.

Consumption is the end, but not the means. Production on each side is the means. We don’t need to worry about consumption AS MACROECONOMISTS. Yes, individual businesses are obsessed with serving customers. But that’s not macroeconomics. And those businesses won’t sell anyone anything if they haven’t earned the money to buy it, through supplying value to others.

Consumption uses stuff up without making us better at producing more tomorrow. It’s ‘unproductive’. Consumption is the ends, not the means. If people decide to consume less, that’s not a macroeconomic problem in and of itself. It’s nothing to worry about, nor is consumption something to b actively encouraged. It NEVER needs encouragement form a macroeconomic perspective. Never.

That’s the fallacy I’m attacking in the video. That we can get richer by taking our money and consuming stuff. Cash for clunkers made America POORER, as just one especially horrible example. An understanding of Say’s law makes that clear.

2. Unemployment benefits may be humanitarian, but they are NOT stimulus.

Imagine we’re a tribe of 10 people. All of us contribute through our hunting, fishing, sowing, building, etc, so that the community may trade and consume the fruits of each one’s production. Each must produce more than they need or produce that which they don’t wish to keep if they are to be contributing to the tribal economy. One of our tribespeople becomes blinded in an accident. The tribe is now poorer for the lack of that person’s contributions. It’s poorer still as a whole for the fact that he is now consuming the productions of the others while not producing anything of greater value (the whole mutual benefit of trade). I’m not saying that the community shouldn’t supper their blind friend. We should. But it’s not stimulus. We aren’t richer for his consumption of our work. We’re poorer, materially. Richer in spirit perhaps. But that’s it.

3. Increasing our production per person grows the economy, and that needs savings.

Increasing productivity is the source of growth because the more we produce, the more we can consume. How do we do this? Through taking the time to invent better mousetraps and apply capital and ingenuity to problems. That process doesn’t generate income immediately. It takes investment. Either the individual or company forgoes consumption in order to fund that investment (stores up fish so that they have time to construct a net) or they leverage the savings of other people, through debt or equity sales. Say’s law, tells us that productivity is central to growth and savings is central to increasing productivity.

4. Recessions are usually production failures first.

The failure of producers to add value in their production is the main cause of recession. This is way firms fail and profits collapse BEFORE the increases in demand for money start to occur, and are a reactive secondary issue. The aggregate level of production is not what matters. It’s that we’re producing goods that will trade at cost-covering prices, revealing that we’ve added value in the production process. If we can’t sell at a profit, that means we’ve destroyed value. Recessions occur when there is a cluster of production errors. Classicals suspected that the monetary system was likely to cause such coordinated failures and the Austrians systematized that insight, noting the centrality of interest rates is coordinating the structure of production.

So Say’s law and the centrality of value-adding production as the enabler of all real demand and growth is embedded in classical theories of the cycle.

The monetary hoarding issue, which Keynes focused in on as a primary cause, is for classicals an important but secondary concern. Say himself wasn’t good on this issue but JS Mill was as was Hayek. We should address monetary disequilbirium by increasing the supply of the good actually demanded – money – and not tricking ourselves through excessive aggregation into believing that any ‘spending’ will do, including and especially consumption.

Is it possible in theory to have a recession causes solely by a money-demand shock or money supply collapse? I guess. Am I aware of any at all? No. If you are, please tell me, because every recession in the US I’m aware of was triggered by real events, especially inflationary bubbles bursting as profits tank.

The conversation continues:

John December 9, 2012 10:53 AM

For the general public, the focus on the importance of consumer spending by an army of Keynesian economists, pundits and politicians is a highly destructive cultural drag. It’s a bad thing for growth that US savings rate fell from its 1950s and 60s highs of 12% all the way down to 0% and even now isn’t back up to that thrifty time. I fault demand-siders in part for that change.

So the general is my audience. Yes, I’m a skeptic of social benefits derived from modern macro and to the extent that fallacious ideas like consumption growing the economy emerge from it, I’m going to continue taking those on for the benefit of our general understanding of what creates the wealth of nations and what uses that wealth up.

The technocratic precision of macroeconomics appears to me to exist mostly within the very large margin of error. It’s a fatal conceit. It’s the pretense of knowledge. And when that work undermines deeper truths, it becomes downright destructive. I don’t know what, if any, good has come from the field of macroeconomics for society. On balance, it appears to have made our understanding of the world worse compared with the classical era of Smith and Ricardo. When I hear Tim Geithner talking about how the Chinese need to increase their consumption so that there is a more ‘balanced’ growth, whatever that means, my conclusion is ‘he doesn’t understand where growth comes from at all’. The focus on the short run and short circuited basic Smithian insights.

As a side note, I don’t dispute and haven’t that Keynes explanation for the cause of a downturn is a collapse of investment spending. This too is a straw man critique that has been made here and elsewhere of my work. Remember, the lyrics from Fear the Boom and Bust (2010) went as follows:

“Business is driven by the animal spirits
The bull and the bear, and there’s reason to fear its
Effects on capital investment, income and growth
That’s why the state should fill the gap with stimulus both…”

Got it. Got it from the beginning. Investment is the volatile driver of the business cycle. Austrians see the same thing and blame it on interest rate elasticity of investment spending (that nexus of savings and investment which Keynes denied existed) rather than an appeal to causeless mass psychological changes as businessmen just lose their nerve.

What Keynes and Keynesians did and DO say is that we can consume our way out, that consumption spending can fill the ‘gap’ for investment spending. It is said ALL the time. Bob Murphy has my short list of exemplars if you’re interested in support for this claim (it was a comment in a former post here):

Papola Has a Barrel of Ink

THAT is what I continue criticizing besides the general idea that using up consumer goods can grow the economy, recession or not.

There is then a query about demand for goods and services to which John replies again:

John December 9, 2012 11:50 PM

I already replied to this. As John Stuart Mill noted, the demand for commodities is not the demand for labor [my bolding but how extraordinary it is to see this in print]. We’ve seen that quite clearly in this recession, where consumer spending recovered and was met by increased productivity and output even as unemployment flatlined (especially when looking a labor force participation).

Firms will do whatever they can to meet demand, including increasing prices, employing more efficient capital equipment, and yes, hiring more people. But, as a small business owner, I can tell you first hand that hiring people is a big commitment and not something I’m likely to do in response to short-term increases in demand. The decision to hire is NOT some hydraulic reaction function of aggregate demand. It’s a complex decision impacted by many factors including the availability of people with the needed skills for the task. There’s a human capital complementarity issue. People aren’t homogenous.

If I recall, the whole idea of stimulus is to restore full employment is it not? The last time I checked, we can have inflation (excessive aggregate demand) AND high unemployment. So demand can cause prices to rise and/or production to increase and/or new workers to be hired. But none of it is hydraulic or guaranteed or reasonably modeled by ex ante computers.

The conversation then turns to the writings of Robert Reich. John again enters into the debate:

John December 10, 2012 10:18 AM

Thanks for posting this. Reich is not an aberration by any stretch either. He’s just an especially crude exemplar of Keynes-inspired consumptionism. This type of rhetoric is pervasive.

Alas, with this post I think you’ve cleared things up for me. I absolutely disagree with your point of view and my video is unequivocally aimed at challenging it with regard to the role of consumption in recovery and macro in general. You’re celebrating as correct the very assertions which I believe to be false from Reich. The entire point of including Keynes and having his lyrics written in the way they are is to draw attention to the notion of consumption as a solution. I’ve been attacked because Keynes said investment was the problem, but that was never in question. I’m attacking consumption as the solution.

‘Second, they’re of course right that increasing consumption will help output.’

Wrong. Consumption doesn’t increase output. It uses it up. The very statement that consumption increases output is, shocking to me. That’s what consumption is. The only way I can understand that we’re at such cross-purposes in our dialog is the issues surrounding aggregation endemic in a Keynesian spending-centric approach vs. what Arnold Kling refers to as a PSST approach.

We don’t need a reason to consume. It can be assumed.

This post, for better or worse Daniel, only further reinforces for me that the grounds on which you attack Say’s law are rooted in a deeply different understanding of the nature of economic relations compared with the classical view.

When has there every been a case where we’ve run out of need in the world? I’ve never heard of such an event. And when we get there, when all our wants are fulfilled, this will not be a problem, it will be nirvana. The framework implicit here is that we should all be thankful that people consume because without it we’d have nothing to do. But we are all producers. If everyone ceased needing consumption, producers would cease needing it too and thus would have no reason to produce for themselves.

We are all producers. We produce so that we can consume. We do NOT consume so that we may produce.

And he continues in reply to the suggestion that production follows demand:

John December 10, 2012 10:39 AM

Wrong. We need other people to produce things that we want. Money is the medium of exchange. The ‘consumer’ is a producer first. That’s how they have something of value to offer in exchange for what we produce. Consumption is the motivating end for us all, but it’s never the means. Production and exchange is the whole story (with the caveat of monetary equilibrium).

And the debate continues. More from John:

John December 10, 2012 2:30 PM

Your promise to pay is predicated on your ability to earn income through some value-adding activity. Moreover, the money you borrow was income generated by someone else who already produced value for others. I stand by it.

This IS economics in the real world. In the real world, ‘output’ is actual goods and services and ‘consumption’ is the using up of those goods and services. What is measured as ‘spending’ is trade between producers. Each person’s ‘demand’ is constituted by the value they or someone else has already contributed to the market.

What makes ‘demand’ a loose joint from supply is money. It doesn’t change the facts, it just abstracts them. So one can, through monetary expansion, create ‘demand’ out of this air without first increasing supply. But the result of this will tend to be inflationary unless there is an excess demand for money. Hence I have always caveated that Say’s law requires monetary equilibrium. That equilibrium does NOT suggest that consumption is important or can grow the economy or increase output. And, from an employment standpoint, we’ve already seen quite clearly that excess demand can occur, producing inflation even with unemployment. High inflation and high unemployment has happened all around the world at different times. The ‘slack capacity’ and ‘output gap’ talk masks the structural issues that make stagflation possible because of excessive aggregation. It’s that same failure to dig in and distinguish between resource consumption that increases productivity and final goods consumption that uses up output for personal satisfaction that is clearly at the heart of this ‘consumption drives the economy’ fallacy. And, yes, it is a fallacy.

What is NOT economics is claiming that ‘consumption increases output’. That is utterly contradictory nonsense.

I have to step away from the debate for now, since I actually do run a real small business and unless we produce, we can’t consume a damn thing. Nobody needs to encourage me to consume. My body demands that I eat, sleep, go to the doctor when I’m sick. My family needs a roof over their head. My son needs to go to school. There isn’t a single policy that should be put in place that encourages consumption. Not one. Zero. Never. Ever.

‘Demand-side’ issues are all about monetary policy. The level of aggregate demand is a monetary phenomena. The fact that Keynesians so deeply misunderstand what’s happening in the actual real world of exchange by fixating on nominal spending is what has clearly, perhaps fatally, damaged our understanding about the way the world works. My videos are aimed at restoring that understanding, because it’s clearly been lost.

The argument continues, this time pointing out that buying presupposes someone else has already produced and sold their goods and services in exchange for money:

John December 10, 2012 2:35 PM

Right. And it’s not even possible for that consumer to buy without someone ELSE producing, unless they got the money printed for them. After all, if they borrowed the money, it came from someone else’s savings which was earned by producing value.

Commodities are paid for with other commodities.

Economists hasn’t advanced since John Stuart Mill. It’s clearly been retarded in deep and disturbing ways by the Keynesian confusion of monetary phenomena with real trade and exchange patterns.

JohnDecember 10, 2012 11:12 PM
‘John seems to believe the opposite though, that we shouldn’t consume what we can produce.’

I have no idea how you arrived at this conclusion. None. It’s totally unrelated to anything I’ve ever written or said.

It’s not the job of economic analysis to say what individuals ‘should’ or ‘shouldn’t’ do. People will consume what they wish to consume and have the means to consume at the price they deem worth paying. But they only have the means to consume because they’ve either produced something for their own consumption or produced something for someone else and traded it for what they want or the money to buy what they want to consume.

Consumption can and should be both assumed and ignored. Our real incomes are the result of effective production. The question we must always be asking is “are we producing the right stuff?”.

The fact that these simple insights are hard, and that many on this blog seem to talk about saving without even realizing they’re talking about saving, only underscores for me how deeply destructive the Keynesian framework is for understanding foundational economic mechanisms. It’s not merely that production and exchange are relegated to ‘micro’. No, they’ve been totally ruined. Consumption increases output, rather than using it up? I clearly have my work cut out for me with the next set of videos.

My book, Say’s Law and the Keynesian Revolution, has been turned into a movie! John Papola, the genius behind the Keynes-Hayek Rap, has now done a movie on Say’s Law, the fundamental principle of the pre-Keynesian theory of the business cycle. Before Keynes, they knew you could have recessions but they also knew that the one thing that could never be the cause of recessions was a deficiency of demand. Too little demand relative to potential supply was a symptom, not a cause. Today all macroeconomics proclaims demand deficiency as the problem itself that must be cured. Therefore we have had one stimulus after another followed by one economic catastrophe after another. In Australia there’s the mining industry and nothing else to drive the economy forward.

To help you understand the video, here are a few bits of background to catch the full flavour of just how beautifully done this is.

John Maynard Keynes introduced the notion of aggregate demand into economic theory. Before he published his General Theory of Employment, Interest and Money in 1936, demand deficiency as a cause of recession was literally and with no exaggeration seen as a fallacy. Today, of course, his macroeconomics is the mainstream and when recessions occur the first thought in everyone’s mind is to restore demand.

Keynes took the idea of demand deficiency from Thomas Robert Malthus, a nineteenth economist who published his Principles of Political Economy in 1821. Keynes was reading Malthus’s letters to Ricardo in October 1932 which was the specific reason that he would eventually write a book on demand deficiency as the cause of recession. The entire economics fraternity refuses to accept this obvious bit of inspiration since it would make Keynes’s claims to originality not quite as honest as the great man would have liked us all to believe. But since there is general consensus that Keynes formed the idea of demand deficiency in late 1932 and there is no question whatsoever that Keynes was reading Malthus in late 1932, there is equally no doubt that the standard story as peddled by Keynes is utterly untrue.

Say’s Law, which does not get mentioned by name in the video, was called the Law of Markets during classical times. The principle was given the name Say’s Law in the 1920s but it was Jean-Baptiste Say in France and James Mill in England who together are responsible for the initial crafting of this bedrock proposition. But as a very good first approximation to its meaning, there is only a rolling momentary credit to the best short statement which was given by David Ricardo in a letter to Malthus in 1821. There he wrote:

Men err in their productions, there is no deficiency of demand.

Ricardo was trying to explain to Malthus that the recessions that followed the ending of the Napoleonic Wars in 1815 were not due to there being too much saving and therefore too little spending. It was not even spending that mattered. What had gone wrong, the same thing that is the cause of all recessions, is that the goods and services produced did not match the specific demands that people with incomes had. There were therefore unsold goods and services, but not because there was too little spending and too much saving, but because businesses had produced one set of goods (housing in the US to take the most recent example of recession) that could not be sold at prices which covered their costs. The structure of production was wrong which would inevitably, as it always does, affect credit markets as defaults became legion.

The notion that recessions were caused by not enough spending, either in 1821 or in 2012, is ridiculous. There is never a deficiency of demand, only a deficiency of purchasing power. And this is the last element you need to understand the plot of the video. What gives someone purchasing power – what makes individuals within an economy able to buy more – is more production. Producing saleable products – rising productivity – is the only means by which economies can grow and therefore, beneath it all, as Friedrich Hayek explains, there must be more investment in capital (actual productive assets not money) and more innovation which improves the technology embodied in the capital. An economy is driven by supply, never demand.

That is the message of the video. It is a piece of genius that so much can be so cleverly condensed into just over four minutes. But if you wish to understand the point, these are the things you need to know. And if you wish to know even more, there is my book as well.

This has not been posted at Quadrant Online.

The following first appeared as an Edward Elgar blog post under the title, “Free Markets, Say’s Law and the Failure of Keynesian Economics”.

I wrote my Free Market Economics: an Introduction for the General Reader (Elgar 2011) at the very start of the financial crisis in 2009 – it was written in white heat between February to May as the text for the course I was teaching in Economic Analysis for Business. What drove the book to completion was my dismay at the return of Keynesian economic theory and policy as the guide to recovery. My assumption at the time was that my book would be one of many such texts written in response to the devastation that would inevitably be brought on by the stimulus. What is to me quite astonishing is that this book is the only book of its kind. I fear that after 75 years of Keynes, virtually no one can any longer see what the problem with modern macroeconomic theory is and why a Keynesian demand-side stimulus could not possibly have worked.

What makes this book different is that the macroeconomics is not just pre-Keynesian and not just un-Keynesian but actively anti-Keynesian. The book also explains Keynesian theory, of course, since it is impossible to teach economics without discussing modern macroeconomics as it is currently taught. Nevertheless, anyone interested in understanding the nature of the business cycle, how to return an economy from the midst of recession to rapid rates of growth, or what is needed to achieve low rates of unemployment from a classical perspective – that is, from the perspective of the free market – ought to look at this book. Let me merely note that free market does not mean laissez-faire.

On the macroeconomics side, the core concept is what has come to be known as Say’s Law which no one understands unless they have personally read the narrow and specialist literature on this fundamental concept. The one person, moreover, from whom you cannot find out its meaning is Keynes. Keynes made it his business to demonstrate that Say’s Law is wrong – the original name of Say’s Law, it might be noted, having been the Law of Markets. Keynes went about his work firstly by setting up his straw man version of Say’s Law and then by refuting a proposition no one had ever supported. Indeed, it is utterly fantastic that Keynes was ever able to convince anyone that classical economists had always assumed full employment was assured even when they were discussing recession, but that he did. This has now entered into the mythology of economic theory which is one of the reasons few economists ever look back at the economic theories that preceded the publication of The General Theory. What a mistake that is!

Since the very point of Say’s Law was to deny absolutely that demand deficiency could have been the cause of recessions even while recognising that recessions were frequent and often devastating, it can be seen just how different a non-Keynesian theory of the cycle is from virtually all versions of macroeconomics today. What my Free Market Economics does is provide a guide to the pre-Keynesian theory of the cycle which not only makes clear what causes economic crises but also why using Keynesian policy to attempt to restore growth through increasing aggregate demand is doomed to failure. Since these Keynesian policies have unquestionably failed, asking why that is ought to have become the main order of business across the economics world. It is a question that has, however, virtually never been asked.

But the book does more than recast macroeconomics in its classical form. The microeconomic sections of the book also provide a different perspective on the nature of the market, the role of the entrepreneur and the unparalleled importance of uncertainty whose significance in economic analysis cannot be exaggerated. The text wages a battle against the other major innovation of the 1930s, the diagrams associated with marginal revenue and marginal cost. Anyone who has done economic theory has been dragged through a set of diagrams that show how the price of individual products are determined according to where the additional cost of producing one more unit of output is equal to the additional revenue that would be received by producing that one extra unit of output. Maddeningly complex while simultaneously shallow, it will leave an economist almost completely unequipped to deal with the genuine questions an economy poses to policy.

This analysis has distracted economists from focusing on what is most important about entrepreneurial decision making by making it appear that profit maximisation is about getting MR to equal MC. The reality of business, however, is that the future is an absolute unknown; economic decisions are seldom about single products and never about whether one more unit of anything ought to be produced. Instead, virtually all economic decisions are based on conjectures built on the past and projected ahead into the future about which nothing can ever be known for sure, and the more distantly into the future decision makers project, the less likely they are to get right.

This, then, is how marginal analysis needs to be explained. Decision making occurs as the expected costs associated with some decision (their marginal cost) are weighed against the expected return (their marginal revenue). Such decisions have nothing to do with deciding whether to produce one more unit of output. It is about making decisions that often put millions on the line and involve years of pre-planning. The free market succeeds because there are many different projections being made by people who venture their own money and who therefore have the most intense interest imaginable in getting it right, and then correcting their errors when things go wrong, as they inevitably do. That is what marginal analysis is actually about.

The book is my update for the twentieth century of two of economic theory’s great classics, John Stuart Mill’s Principles of Political Economy published in 1848 and Henry Clay’s Economics: an Introduction for the General Reader published in 1916, and from which I adopted the title. They knew nothing of Keynesian economics other than its being a common, but at the time unnamed, fallacy that economists had to continuously refute. Keynesian economics is now, however, the mainstream. If you would like to understand what is wrong with Keynesian theory and much else, as well as understanding how to view the economy and economic issues, my book is the place to start.

Free Market Economics: an Introduction for the General Reader has recently been given the RMIT University College of Business Best Book Award for 2012.