How Economies Really Work

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 the one thing that could never cause a recession 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. in October, 1932, Keynes was reading Malthus’ letters to Ricardo, which was the specific reason 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’ 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 who 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, was that the goods and services produced did not match the specific demands of people with incomes. 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 affect, as it always does, 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.

Steve Kates’ most recent book is Free Market Economics: an Introduction for the General Reader