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February 14th 2013 print

Steve Kates

Adding the value of nothing

There is something very nearly wilfull about policymakers' adherence to a theory whose shortcomings have been manifestly obvious for so long. Yet still they persist, determined to ignore that it is the adding of a value which determines if an economy flounders or flourishes

It is good to see a bit of attention being focused on the most important economic issue of our time, the disappearance of Say’s Law at the center of economic theory. Its absence has been a catastrophe but, alas, a catastrophe of which almost no one is presently aware. In fact, if anything, mainstream economic theory still congratulates itself for having finally seen its way past what it presumes to call a fallacy.

Here is Paul Krugman blogging at the New York Times on February 10th:

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

Krugman points to the existence of money in corporate accounts as evidence that people are not spending, they are “hoarding” instead. Does he really think money is like coal, that it goes up in smoke and disappears when it is used?

It is the most superficial of all observations to point out that, in recession, not everything that was produced was bought. What the classical economists did was recognize that the fallacy of fallacies was to believe the problem was a deficiency of demand. But to understand their meaning the key phrase was that “demand would be constituted by supply”. And in that there is all the difference in the world.

To make the classical point, let me re-phrase this as ‘demand is constituted by value-adding supply’, which properly captures their meaning. For an economy to grow and employment to increase, the central requisite is that the goods and services produced have to be value-adding. Since production absorbs valuable inputs – labor time, raw materials, fixed and circulating capital – there is value lost during production. The value of the what was produced, if it was going to increase the aggregate level of output and lead to higher employment, has to be greater than the value of the inputs that have been used up.

I need hardly point out the series of non-value-adding outputs that have proliferated under the name of ‘stimulus’ across the world. There are vast quantities of valuable inputs being absorbed in various kinds of non-value-adding forms of production. Solyndra might be the most prominent example, but they are everywhere. And such expenditures are almost invariably the products of government.

Add to the problem of public-sector expenditure the vast bureaucratic structures that have been put together and whose role is to manage our economies, but whose value added is minimal at best and whose cost certainly exceeds any possible value created. Similarly with welfare expenditures, which may have important social purposes but are, once again, non-value-adding.

And finally, there is the immense body of regulation that has the effect of adding to costs without creating a single dollar’s worth of additional value.

Businesses are attempting to create that net addition to value not only by producing more output relative to the normal costs of production, but they must help support an immense bureaucracy, fund the welfare state and comply with regulatory burdens that increase every year.

The problem with just about every economy in the world is not a deficiency of demand but a deficiency of value-adding supply. The so-called stimulus following the GFC has made things many times worse by diverting resources from productive activity and into various dead end forms of production supported by governments.

Macroeconomic theory is built on a fallacious foundation in which demand deficiency is seen as the core reason for recession and demand stimulation as a positive counterweight to the fall-off in activity. I need hardly point out that the facts of the world do not support any such conclusion.

Then again, neither did the classical theory of the business cycle which had at its very foundation the concepts built into what we today refer to as Say’s Law.

In closing let me refer to something written by the former editor of the Wall Street Journal, Robert L. Bartley, in his penetrating look at the economic boom of the 1980s, The Seven Fat Years. The book was about was how Ronald Reagan’s economic policies turned around the US economy after the dismal Carter years. If one turns to page 49, there the following will be found:

“I remember Art Laffer telling me I had to learn about Say’s Law. ‘That’s what I believe in,’ he professed. ‘That’s what you believe in too.’ ”

It is what he believed in, and if you would like to one day see our economies returned to prosperity that’s what you should believe in too.


Steve Kates teaches economics at RMIT University. His most recent book is Free Market Economics: an Introduction for the General Reader