Tag Archives: Say’s Law

Say’s Law and Austrian economics

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I have for the first time come across an article that invokes Say’s Law exactly right. It has come up on the Mises Daily website, is by an economist by name of Patrick Barron and titled, Why Central Bank Stimulus Cannot Bring Economic Recovery. It has surprised me to see it since even though Say’s Law is at the heart of the classical theory of the cycle, Austrian economists have tended to ignore the single most important theorem in economics, I think because it is hardly mentioned by either Mises or Hayek. It is also a principle that predates what is Austrian about Austrian economics, going back to the earliest days of economics, first having been discussed by James Mill in 1808 and definitively stated in no uncertain terms by John Stuart Mill in 1848 following the general glut debate (1820-1848). So what does Barron say is the problem with the central bank stimulus?

They are following Keynesian dogma that increasing aggregate demand will spur an increase in employment and production.

Exactly so! The number of economists across the world who understand this is infinitesimal. Aggregate demand is so ingrained it is almost ineradicable. Even Austrian economists of the most pedigreed kind get this wrong. Not this time. And what’s more, he reminds us that this error is a product of Keynes and The General Theory. Say’s Law understood correctly states demand is constituted by supply. Here Barron points out just this very thing:

Keynes tried to prove that production followed demand and not the other way around. He famously stated that governments should pay people to dig holes and then fill them back up in order to put money into the hands of the unemployed, who then would spend it and stimulate production. But notice that the hole diggers did not produce a good or service that was demanded by the market. Keynesian aggregate demand theory is nothing more than a justification for counterfeiting. It is a theory of capital consumption and ignores the irrefutable fact that production is required prior to consumption.

I only wish it were all that irrefutable. In real life, it is refuted every time a Keynesian stimulus is tried. Amongst economists it is the most immovable of dogmas. But let us continue.

Central bank credit expansion is the best example of the Keynesian disregard for the inevitable consequences of violating Say’s Law. Money certificates are cheap to produce. Book entry credit is manufactured at the click of a computer mouse and is, therefore, essentially costless. So, receivers of new money get something for nothing. The consequence of this violation of Say’s Law is capital malinvestment, the opposite of the central bank’s goal of economic stimulus. Central bank economists make the crucial error of confusing GDP spending frenzy with sustainable economic activity. They are measuring capital consumption, not production.

Highlighted here is the difference between the market rate of interest (money) and the natural rate (things). Very nineteenth century but universally accepted by economists right through to 1936. Even Keynes made it central to his Treatise on Money, but that was in 1930 before he came across Malthus. Keeping the monetary side of the economy separate from the real side is crucial to even the most rudimentary understanding of how an economy works.

We must remember that the very purpose of central bank credit expansion is to trigger an increase in lending in order to stimulate the economy to a self-sustaining recovery. But this is impossible. At any one time there is only so much real capital available in society, and real capital cannot be produced by the click of a central bank computer mouse. As my friend Robert Blumen says, a central bank can print money but it cannot print software engineers or even cups of Starbucks coffee to keep them awake and working.

Me and his friend Robert should get together. I harangue my classes holding a $5 bill in one hand and a cup of coffee in the other and ask if they can see the difference. And you would be amazed how hard it is to see the difference, not then and there, but when it counts. Economists are forever pointing out how much money various businesses have stashed away in banks as if the existence of such money stocks is equivalent to a stock of unemployed labour or capital goods available for investment.

So we come to his conclusion, where he discusses not just the wasted effort through trying to stimulate demand by printing money, but the actual wilful ruining of economies by their sensationally misguided attempts to increase the level of spending:

The governments and central banks of the world are engaged in a futile effort to stimulate economic recovery through an expansion of fiat money credit. They will fail due to their ignorance or purposeful blindness to Say’s Law that tells us that money is the agent for exchanging goods that must already exist. New fiat money cannot conjure goods out of thin air, the way central banks conjure money out of thin air. . . . In fact rather than stimulate the economy to greater output, bank credit expansion causes capital destruction and a lower standard of living in the future than would have been the case otherwise.

It’s all insane, really, but what may be more demented than anything is the refusal of the mainstream to perhaps think about this standard macroeconomic theory of theirs. You know, insanity as in doing the same thing over and over again and expecting different results. As in thinking an increase in aggregate demand will lead to an increase in anything before there has been an increase in production.

Not for the first time do I suggest that anyone interested in Say’s Law and much else should pick up a copy of my Free Market Economics, although I would hold off at the moment for a couple of months. The copyedited manuscript of the second edition arrived via email just today so I will have a very intense week in front of me in going through it with a fine tooth comb. It will be out in September when you can then pick up the new improved edition for yourself.

A query on Say’s Law

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

Dear Dr Kates

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

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

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

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

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

*The economic consequences of Keynesian policies are disastrous.

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

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

Kindest regards

So I have replied

Dear Matthew

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

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

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

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

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

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

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

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

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

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

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

Kind regards

Say’s Law and Hollande posted at SHOE

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I posted the following comment on the SHOE list (Societies for the History of Economics) on 25 January.

This only came to my attention a few days ago but apparently François Hollande, the President of France, quoted what he believed to have been the actual words J.-B. Say used to describe the meaning of what we today refer to as Say’s Law: L’offre crée même la demande. He quoted it because he intends to use this maxim as a guide to policy in directing the French economy. Here is the quotation, in French:

Le temps est venu de régler le principal problème de la France : sa production. Oui, je dis bien sa production. Il nous faut produire plus, il nous faut produire mieux. C’est donc sur l’offre qu’il faut agir. Sur l’offre ! Ce n’est pas contradictoire avec la demande. L’offre crée même la demande.

François Hollande – January 14, 2014 [My bolding]

This only came to my attention because of an article reprinted from The Financial Times dated 19 January and written by one of the FT’s columnists, Wolfgang Münchau.

This was the relevant para:

“Last week, we heard another Frenchman, President François Hollande, proclaiming: ‘L’offre crée même la demande’, which translates as ‘supply actually creates its own demand’. If you want to look for the real political scandal in France today, it is not the sight of the president in a motorcycle helmet about to sneak into a Parisian apartment building. It is that official economic thinking in Paris has not progressed in 211 years.”

This is significant to me for two reasons which I have discussed in past threads on this site, not to mention in my Defending the History of Economic Thought. First, economic ideas of the past are never transcended in the sense that once something better has been devised, older ways of looking at things never come back. As we can see here, older ideas retain a life of their own and may, in the right circumstances, turn out to be relevant in understanding contemporary events. With the now generally recognised failure of the Keynesian stimulus packages, the question has become, what should be done now?

There can be no doubt that the Socialist President of France, who more than anything else would have liked to have spent the French economy into recovery, but having personally experienced the consequences of trying to use Keynesian economic policies, has concluded that economies are not driven by a public sector stimulus. Hollande is therefore looking in another direction and has embraced Say’s Law as best he understands it.

You may be sure Hollande did not do this lightly. This awareness has come as the result of the bitter fruits of experience. The stimulus packages of 2009 are today’s debt and dying economies.

Which brings me to my second issue which is also something I have discussed on this website. The classical economists may well have been right that there will be no recovery until demand is again constituted by actual value adding supply. And what is interesting is that Hollande, far from leading the way in his approach to economic theory, is following in the footsteps of others who are trying to achieve a turnaround in their economies. This is again from the article in The Financial Times:

“The third significance lies in the fact that the new consensus spans the entire mainstream political spectrum. If you live on the European continent and if you have a problem with Say’s Law, the only political parties that cater to you are the extreme left or the extreme right.”

Economic policy everywhere is, according to this article, guided by Say’s Law. I don’t actually believe that is literally true, but the problem remains that while policy makers are trying to walk away from Keynes there are no longer any guideposts on what to do since almost no economics text will explain the actual meaning of Say’s Law, the classical theory of the cycle and what needs to be done to generate a recovery when the economy is in recession.

History of economic thought has its uses as economics. It is not the history and philosophy of science, it is not the discarded ideas of Dead White Males. It is part of the collective wisdom of economists that we, as historians of economic thought, do our best to keep alive.

Say’s Law and François Hollande

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Following the discussion on L’offre crée même la demande, which are the words the French President used last week to indicate that economic policy will now follow more classical directions, and in particular adopt Say’s Law as the guide to policy, I have pulled this posting out of storage which was put up in December 2012. Having just watched the video again, I am even more astonished than I was then how accurate this is as a representation of the underlying ideas. But central to understanding Say’s Law is to understand that it is a macro concept related to how an economy works, rather than being a micro concept about individuals. In spite of everything you might have learned in a conventional economics course, Say’s Law was the foundation for understanding the classical theory of the cycle. If you want to know what causes recessions and then how to deal with them, you must understand Say’s Law.

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 now been posted at Quadrant Online.

Art Laffer and Say’s Law

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laffer - us govt spending fall

There is an article by Arthur Laffer at The Spectator that you can find here here. And I only mention it because I want to point out that Laffer had himself tried to resurrect Say’s Law back in the 1980s. If you look at the original supply side revolution which is coincident with the Reagan Revolution, the literature is filled with Say’s Law, and even amongst the comments at the Spectator article, there is this:

Rubbish. Say’s Law (the formal name for the views in this article) has been refuted. I hope Krugman sees this article.

Me too. I hope he does see it. And I hope he does try to buy into this. He would for a change be taking on someone his own size in the heavyweight division. The cuts to public spending are the only way into resurrecting growth. Who knows, the sequester may yet make Obama an economic hero by having the American economy turned around on his watch. Not his doing but there you are.

And if you would like to see a bit more on Arthur Laffer and Say’s Law, this is the place to look. Jude Wanniski was the third in the triumvirate in the supply side revolution, along with the Great George Gilder.