Category Archives: Law of Markets

Explaining Say’s Law

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This is a submission to the SHOE website dealing with Sumitra Shah’s posting re Krugman.

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.

Krugman’s intro to the General Theory

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This is from Paul Krugman’s introduction to The General Theory:

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.

There it is. It could not be put more perfectly than that. And the very first point is precisely what all pre-Keynesian not only denied, but described as utterly fallacious. This is Say’s Law which is as integral to modern economic theory as it was anathema to those who came before. More from Krugman:

[Keynes] quickly shows that the conventional view that wage cuts were the route to full employment made no sense given the realities of the time. . . .

Read Keynes’s speculations on the virtues of mercantilism [ie protectionism] and the vanishing need for thrift. . . .

The real classical model, as Keynes described it, was something much harder to fix. It was, essentially, a model of a barter economy, in which money and nominal prices don’t matter, with a monetary theory of the price level appended in a non-essential way, like a veneer on a tabletop. It was a model in which Say’s Law applied: supply automatically creates its own demand, because income must be spent. And it was a model in which the interest rate was purely a matter of the supply and demand for funds, with no possible role for money or monetary policy. It was, as I said, a model in which ideas we now take for granted were literally unthinkable. . . .

Keynes confronts naïve beliefs about how a fall in wages can increase employment, beliefs that were prevalent among economists when he wrote, but play no role in the model we now call ‘classical.’ . . .

The crucial innovation in The General Theory isn’t, as a modern macroeconomist tends to think, the idea that nominal wages are sticky. It’s the demolition of Say’s Law and the classical theory of the interest rate in Book IV, ‘The inducement to invest.’ One measure of how hard it was for Keynes to divest himself of Say’s Law is that to this day some people deny what Keynes realized – that the ‘law’ is, at best, a useless tautology when individuals have the option of accumulating money rather than purchasing real goods and services. Another measure of Keynes’s achievement may be hard to appreciate unless you’ve tried to write a macroeconomics textbook: how do you explain to students how the central bank can reduce the interest rate by increasing the money supply, even though the interest rate is the price at which the supply of loans is equal to the demand? It’s not easy to explain even when you know the answer; think how much harder it was for Keynes to arrive at the right answer in the first place. . . .

But the classical model wasn’t the only thing Keynes had to escape from. He also had to break free of the business cycle theory of the day.

There wasn’t, of course, a fully-worked out theory of recessions and recoveries. But it’s instructive to compare The General Theory with Gottfried Haberler’s Prosperity and Depression3, written at roughly the same time, which was a League of Nations-sponsored attempt to systematize and synthesize what the economists of the time had to say about the subject. What’s striking about Haberler’s book, from a modern perspective, is that he was trying to answer the wrong question. Like most macroeconomic theorists before Keynes, Haberler believed that the crucial thing was to explain the economy’s dynamics, to explain why booms are followed by busts, rather than to explain how mass unemployment is possible in the first place. And Harberler’s book, like much business cycle writing at the time, seems more preoccupied with the excesses of the boom that with the mechanics of the bust. Although Keynes speculated about the causes of the business cycle in Chapter 22 of The General Theory, those speculations were peripheral to his argument. Instead, Keynes saw it as his job to explain why the economy sometimes operates far below full employment. That is, The General Theory for the most part offers a static model, not a dynamic model – a picture of an economy stuck in depression, not a story about how it got there. So Keynes actually chose to answer a more limited question than most people writing about business cycles at the time. . . .

Rather than getting bogged down in an attempt to explain the dynamics of the business cycle – a subject that remains contentious to this day – Keynes focused on a question that could be answered. And that was also the question that most needed an answer: given that overall demand is depressed – never mind why – how can we create more employment?

Alesina paper on austerity

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Alberto Alesina has written another paper on why cutting spending is good for you. Titled “The Design of Fiscal Adjustments” it demonstrates what anyone who understands Say’s Law perfectly well understands, that cuts to public spending lifts an economy rather than depresses it. The abstract, cautiously written of course, but you will get the drift:

This paper offers three results. First, in line with the previous literature we confirm that fiscal adjustment based mostly on the spending side are less likely to be reversed. Second, spending based fiscal adjustments have caused smaller recessions than tax based fiscal adjustment. Finally, certain combinations of policies have made it possible for spending-based fiscal adjustments to be associated with growth in the economy even on impact rather than with a recession. Thus, expansionary fiscal adjustments are possible.

Say’s Law the video

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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.

My Elgar blog post on Free Market Economics

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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.

What happens to I when there is an increase in C etc?

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I was sitting with a bunch of economists the other day when I mentioned something that had occurred to me in writing my Defending the History of Economic Thought. I said that one of the main differences between the way we teach economics “today” (since about the 1930s) in comparison with previous eras is that we today depend on diagrams rather than logic and reasoning. We therefore manipulate these diagrams up and down, back and forth without every learning the economic logic that lies behind. It is therefore easier but superficial and usually indefensible if someone tried to explain the actual economic logic and relationships, which no one does. Micro, macro – all the same. Everything of importance is explained using some kind of diagram. Keynesian economics was to me the most obvious case in point. It is impossible to tell a coherent story about how the goods and services materialise from an increase in the mere spending of more money. The Y=C+I+G+(X-M) diagram did not even attempt to explain the economics. It just showed the result in a kind of before and after way without really explaining what went on underneath.

So, I was asked, don’t you think that those chaps who did all the work on the national accounts were right? Yes, of course, the national accounts are exactly right since the equation is then an identity, Y≡C+I+G+X-M, true by definition. But with Keynesian economics you cannot simply raise C and assume that Y goes up by the same amount since the elements, C,I,G,X and M are not independent of each other. If you raise C there may well be an increase in M so then where are you, same with the increase in any of these? And you know what, the conversation died right then and there, instantly. My point proved in two different directions, that using diagrams stops people from understanding the logic of the economics and that Keynesian economics cannot be defended and explained in words.

“In countless ways one of the best introductions to economics ever written”

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I would also strongly recommend Steven Kates’ Free Market Economics. An Introduction for the General Reader which is in countless ways one of the best introductions to economics ever written; and this assessment includes amongst other things the author’s superb ability to put economics into perspective in terms of the history of economic thought.

I keep going back to this fantastic book. Lucidly written, it can be read with tremendous gain (to students of economics of any level, beginner to advanced scholar) in a few days, maybe even in just two days. At the same time, it is so substantial as to invite countless returns for further appreciation.

As a person strongly influenced by the Austrian school (including its post-Misesian anarchist wing), what gives me a special kick is the fact that the author, who ‘heretically’ recognises a substantial role for government and the state, offers an accurate and brilliant account of a free economy.

Of course, this places Kates much closer to (the great Austrians) Mises and Hayek than to the anarchist successor school, whose anarchist stance I do not share at all, while recognising the school’s considerable intellectual achievments.

I hope Georg Thomas won’t mind my retrieving his kind and generous comment from the thread that followed my putting up a reading list in the history of economics the other day. And I hope you won’t mind if I say that this is how I think about the book myself.

Moreover, the book is, in my view, unique. It explains everything found in an introductory text on economics but in no chapter is its explanation the same. Everything is saturated in the role of the entrepreneur and builds from the crucial importance of uncertainty.

It never assumes there is no government, but instead assumes that there is and that this government will make laws and regulations that are sometimes a net benefit but are also usually the very reason economies underperform and all too frequently fall into recession.

It explains value added across an entire chapter. The fact of the matter is that without understanding value added properly it is impossible to understand good policy from bad. And so far as I know, this book is unique in explaining this crucial part of economic reasoning at the introductory level.

In teaching supply and demand it assumes no one can ever know where either of those curves actually is, a very different way of thinking about markets. The traditional form of marginal cost pricing is shown to be an inane framework that provides no insight into how either prices are set or volumes determined. Instead it explains the margin as the dividing point between the present and the future which the farther into one looks, the less that one can know anything relevant about what is going to take place.

It disdains Keynesian economics even while explaining modern macro, showing why it is an insulting form of nonsense, and I might add, is the only book to my knowledge anywhere to do so. If you know of another written within the last forty years, you must let me know.

Instead, it explains prosperity and recessions using the classical theory of the cycle which was based on a proper understanding of Say’s Law. It is definitely, and I do mean definitely, the only place in the world you can find out about Say’s Law and how Keynes mangled its interpretation leaving the world’s economies in the mess they are in with no theoretical guidance system with which to find our way out.

And as the title makes clear, the point of the book is to explain why there is no other means to manage an economy than through the free market which is not the same as laissez faire.

How to Get the Book

The book is available in paper from the Edward Elgar catalogue for £23.96. And if you would like to read it in an electronic format, this is where you should go which is taken from the Elgar website:

http://www.ebooks.com
http://www.books.google.com/ebooks
http://www.google.co.uk/ebooks

View our ebooks that are with Dawsonera
View our ebooks that are with EBL
View our ebooks that are with Ebooks.com
View our ebooks that are with MyiLibrary
View our ebooks that are with EBSCOhost
View our ebooks that are with Ebrary
View our ebooks that are with Google

Here is the link to the google ebooks in the UK where the price is a mere $A29.00.