Say’s Law and the GFC

Let me begin with the point I wish to establish. The problem with macroeconomic policy is the macroeconomic theory that lies behind it.

Macroeconomic theory, so far as the business cycle is concerned, is almost entirely based on explaining the cause of fluctuations in activity and employment on variations in aggregate demand which leads to the conclusion that the means to restore strong rates of growth and full employment is through raising aggregate demand through increases in public spending.

Both the theory and the policy conclusions are wrong. As to the theory, fluctuations in economic activity and employment are not caused by variations in aggregate demand. And in terms of policy, raising the level of aggregate demand through increased levels of public spending will not restore growth and full employment. Such policies will, in fact, reduce real growth and keep unemployment higher than it otherwise would have been.

Everything I say about theory and policy was perfectly well known to every economist from the early decades of the nineteenth century through until the publication of Keynes’s General Theory of Employment, Interest and Money in 1936. But with the coming of Keynes and Keynesian theory, economics has been infested by a conceptual disease that appears almost impossible to eradicate no matter how many failures it has had and in spite of its total absence of success.

The bitter pill that will need to be swallowed by various governments will be matched by the need for the economics profession to renounce at long last the Keynesian infection that has burrowed deep into macroeconomic theory. Governments can, of course, be thrown out and replaced by new ones who are happy to denounce the policies of those who had come before. But how an entire discipline can finally be made to recognise that resident at its very core has been a theory of such devastating error that any policy judgment built from it is almost certain to be wrong, I do not know. I suspect it cannot be done.

What economic theory did in 1936 was discard what had until then been one of its bedrock principles, a principle originally known as “the law of markets” but which is now almost universally referred to as Say’s Law. It was a principle which had been guiding theory and policy for more than a hundred years.

To economists, I point out that Keynes was at pains to demonstrate that his General Theory was a full book-length effort to refute Say’s Law. That was the expressed intent of the book and that is what it most assuredly did. And it is an either-or proposition. Either Say’s Law is valid or Keynesian economics is valid. They are mutually exclusive. If one is right the other cannot be. If you agree with Keynes and reject Say’s Law, then you are a Keynesian because that is all that Keynes wanted you to do. Everything in the General Theory was stitched together in order to show that Say’s Law was wrong. Therefore, if you think Say’s Law is wrong and Keynes was right, then you are a Keynesian.

Before I explain what Say’s Law is, I wish to clear one matter away. Say’s Law is not a proxy for laissez-faire. Although it was the law of markets, it did not in any way suggest there was no role for government. It is not a restatement of laissez-faire. It is not a statement about the role of the state in economic affairs.

I make this point because I often come across statements in which Say’s Law is used as a metaphor for free markets. I therefore wish to guard you against this. It is in no way a political statement of any kind. It is a more or less technical conclusion about how market economies work and from which there is much to learn about how to manage an economy.

Let me also make one more observation. In March I had the honour of presenting the Ludwig von Mises Lecture at the Mises Institute in Auburn. Until that time, I would have said that while only a minority of the profession understand the meaning of Say’s Law, it is a fairly sizeable minority. I am now led to the conclusion that it is only a very small minority who have any idea what the concept means and why it is so important. Economists no longer know enough about Say’s Law even to lead them to an informed rejection of its central message.

Economists can glibly repeat Keynes’s maxim, “supply creates its own demand”—words which every single economist virtually without exception knows—but cannot give you an intelligent explanation why every single mainstream economist before Keynes thought Say’s Law was utterly true and crucially important.

Let me therefore come to explaining the meaning of Say’s Law. And to do this, I will invoke the classical pre-Keynesian words that were typically used to explain its meaning. And there are two such forms of words:

  • there is no such thing as a general glut;
  • demand is constituted by supply.

But even before I explain these, I have to point out one of the profound differences between modern macro-economics, which is utterly Keynesian in its orientation, and classical economic theory as it was understood before the publication of the General Theory.

Macroeconomics, like its Keynesian parent stem, is understood from above. There are great lumps of abstraction that have dealings with other great lumps of abstraction. There are consumers, investors, governments who buy, invest and spend. This is the world as seen from high above on Mount Olympus, say, or amongst economists working on economic questions inside a nation’s capital.

These are abstractions upon which data can be collected, and such numbers can be fed into a computer program. There are no actual people, no human motivations, no actual efforts or failures. There are just major groupings of abstract actions against a colourless background of nondescript undifferentiated individuals, none of whom do anything more remarkable than anyone else. Nothing in this approach will explain innovation, change or growth.

Classical theory was as different as different could be. Classical theory was understood as a relationship amongst people. The focus was brought down to ground level, down to a human scale, where actual individuals lived, worked and strove to get what satisfactions they could from life. Economics was based on individuals finding themselves in a set of circumstances trying to make the best of whatever hand they were dealt.

The crucially important difference was perspective. It was about real live people trying to find ways in which to better themselves which, as the theory showed, also tended to better their communities as well. This is Adam Smith: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” This is the essence of an exchange economy amongst producers. It makes no difference if one is the butcher or the butcher’s assistant, the master brewer or the brewer’s apprentice, each is helping produce something for someone else so that they can earn incomes to allow them to buy what others have produced and put up for sale.

Now where are we? Economists talk about consumption being “a function of income”, while we manipulate broad aggregates. The butchers, brewers and bakers have evaporated into thin air. Even in micro we talk about supply and demand without ever mentioning that behind every point on every curve there is an assumed human being with an assumed set of motivations who is doing particular things for particular reasons.

All that is gone. We are left with a desiccated set of theories in which there is not the slightest evidence that someone has thought past the mathematical relationships to the actual human beings beneath.

Say’s Law is part of the economics of the world of actual people behaving as real people might be expected to behave. The first of the overall definitions of Say’s Law was this: there is no such thing as a general glut. In today’s jargon, this would be translated as: demand deficiency is never the cause of recession. What this meant was that an economy would never enter recession because people did not want to buy more. It went further. It stated that it was inconceivable that an economy would ever be able to produce so much that the population would have so much already that to satisfy their remaining wants did not require everyone who wanted to work to have a job.

This was inconceivable in 1803 when Jean Baptiste Say first wrote what would eventually be called Say’s Law. It was inconceivable in 1936 when Keynes published his General Theory. And it is inconceivable today in the midst of the multitude of products we now take utterly for granted.

Now if one asked a classical economist what people would do if there were some unexpected economic crisis, they would have said that people would likely hang onto their money while danger passed. This is not conjecture; that is exactly what classical economists did say. If business confidence were low or economic conditions became highly uncertain, there would be a reluctance to part with money and so spending would diminish.

Does this prove that demand deficiency causes recession? Of course not. It proves that in recession everyone becomes more cautious until the trouble has passed. It may take a month, maybe three, perhaps in really bad times six months, but eventually optimism returns and the upturn begins. It may take years to return to pre-recession conditions but unless things are made worse by inept government programs, the healing processes of a market economy begin to gather force much sooner than modern theory typically gives it credit for.

But to think that a refusal to spend during a crisis was evidence of demand deficiency—a general glut—was recognised as nonsensical. Recessions were nothing other than a passing phenomenon, and to know the difference was then a simple part of the general understanding of an economist. Today, it is only one economist in a hundred, if even that, who understands such things and keeps them firmly in mind.

Let me now turn to the other way in which Say’s Law was expressed. That was to point out that demand is constituted by supply. Keynes’s mangled version was “supply creates its own demand”.

To any classical economist, the word supply in this context meant “value-adding production”. Even this, to modern ears, is barely enough, so it is important to specify that value-adding meant that the value of output must be greater than the value of the inputs that were used in its production.

In a market economy, where production is for profit and producers who cannot cover costs disappear, it was good enough just to say “supply” because that’s all there was. Now, of course, there are no end of buyers with incomes to spend but who have contributed nothing at all to the sum total of goods and services available that others would willingly pay the full cost of production to possess.

But in the days before massive increases in public spending, the ability to buy was dependent on one’s ability to sell. This is again a ground level view of the operation of an economy. Butchers would buy from brewers, brewers would buy from bakers, and bakers would buy from butchers.

There was then embedded at the very core of understanding of an economy the necessary mutual accommodation in which all producers tailored their own productions to the demands of others while they trimmed their own expenditures depending on how much they had earned. If you build on top of all of this an appreciation that wants are near enough to infinite, the notion that a market economy will be run into the ground by demand deficiency is just about as nonsensical an idea as one can find.

This little apparatus gives you an idea of how the whole process might break down into the occasional recession. The Keynesian falsehood—absolute falsehood—that classical economists assumed away the possibility of involuntary unemployment is still taught to this day. But obviously it was untrue as even the mildest recognition of the existence of the theory of the cycle would show.

The causes of recession were never demand deficiency—there is no such thing as a general glut. They said that and I say that. If you wish to know why economies enter recession, look elsewhere.

And where to look was in the structure of demand relative to the structure of supply. We have our butchers, brewers and bakers selling to each other. I could be political and point out how a new tax on alcohol might affect production and sales or how new regulations in the meat industry could affect relative prices. But really, anything at all can happen to upset the relationship between purchase and sale. Mad cow disease, the return of prohibition, or wheat fields given over to ethanol production; each can have a major effect on production costs, relative prices and product demand.

So too can positive new features in each market. Innovation and new products can upset established markets. Exchange rates can move and export demand can increase.

And of course, the effects of monetary policy and the credit creation system can have major distorting influences on every market. This is probably the most typical cause of recessions but it is not the only one.

This is the classical theory of recession, structural maladjustments of one sort or another. It also makes it evident that recessions will be with us always. This is a theory that makes sense. You can see how the GFC started and built using this theory.

Try explaining the GFC using Keynesian economics. Keynesian theory, so far as explaining the onset of recessions is concerned, is utterly without penetration or insight. It is only because we have known nothing else for seventy years that we put up with it. But it cannot explain a thing.

But not only is Keynesian economics useless in explaining why the recession occurred, it is even less useful in trying to think through what ought to be done next.

A Keynesian sees the problem as demand deficiency. Nothing else is considered. The policy solution is therefore some variant of instructions on how to raise aggregate demand, whether by lowering interest rates or raising public spending. Deficit finance is an intrinsic part of the Keynesian program.

Starting from classical theory and Say’s Law, however, two matters are clear. The problem is not demand deficiency. And to get the economy moving again, the answer can only be found on the supply side of the economy.

The major aim of classical policy was to allow the market to re-adjust. To raise employment it was first necessary to raise the level of value-adding production. All of the emphasis would have been on the supply side.

Moreover, because of Say’s Law, every economist before Keynes would have been aware of the impossibility of a spending-on-anything road to recovery. They would have understood it because they understood in their bones what Say’s Law meant. They would have understood that to produce goods and services whose production costs are greater than their value will slow the recovery process, not hasten it.

It is now as clear as day that the massive expenditure programs carried out around the world as an attempt at an economic stimulus have not worked. They have not even remotely worked. The private sector in the United States has been virtually moribund. Meanwhile, the rate of unemployment rose beyond the highest level projected had there been no stimulus at all and has remained high and is expected to remain high well into the foreseeable future.

Below is a chart dealing with the American economy which is pretty self-explanatory. The solid line is the stimulus expenditure, the bars are the unemployment rate and the dotted line shows the maximum rate of unemployment that President Obama said would have been reached had there been no stimulus.

The only answer Keynesians now have is that the stimulus was not large enough, because there is no question at all that a stimulus was applied to the full extent that was then thought necessary. But the problem is not that the stimulus was too low but that there was any stimulus at all. The stimulus will now need to be unwound, which is where the political process is now heading. The emptiness of Keynesian theory is becoming more evident with each passing day.

The fact of the matter is that not a single stimulus program implemented after the commencement of the Global Financial Crisis has actually worked. Not a single one has created employment. Not a single one has brought the rate of unemployment down.

The two most prominent examples of stimulus programs were the American and the British. The American, as the chart shows, has turned out to be useless. The British led to an equally abysmal result, and the new government of the UK is now in the process of bringing the British economy back into fiscal balance.

Demand is constituted by value-adding supply. Demand is created by producing things other people want to buy. Demand can only be raised where the value of the goods produced is greater than the production costs. Producing goods and services whose production costs are greater than the value of the output at the other end of the process creates neither an increase in demand nor an increase in employment. Once upon a time, to understand this was not quite second nature to an economist but was seen as one of the unintuitive conclusions that came with a proper understanding of economic theory.

In the passage below, I am quoting Friedrich Hayek directly, who is quoting the nineteenth-century economist Leslie Stephen, who was himself repeating one of John Stuart Mill’s most celebrated economic conclusions, first published in 1848, that “the demand for commodities is not demand for labour”. This is what Hayek wrote:

John Stuart Mill’s profound insight that demand for commodities is not demand for labour, which Leslie Stephen could in 1878 still describe as the doctrine whose “complete apprehension is, perhaps, the best test of a sound economist”, remained for Keynes an incomprehensible absurdity.

What to Hayek was a “profound insight”, what to Leslie Stephen was “the best test of a sound economist” was to Keynes “an incomprehensible absurdity”. And so it remains today, not just to Keynesians but to virtually the entire profession, most of whom could not be made to understand this principle under almost any imaginable conditions.

In the straightforward words of today, what Mill wrote was this: “Buying things does not create jobs.” He wrote this before there had been a single stimulus package anywhere in the world. He wrote it because of the pure logic of how economies work. And the logic it was based on was the logic of Say’s Law.

But now we have seen stimulus programs. We have seen the New Deal, the stagflation of the 1970s, the failure of the expenditure program in Japan during the 1990s and now all of the many similar failures around the world. We have actually seen that buying things does not create jobs. But unlike during classical times, we no longer have an economic theory to explain the outcomes that are occurring right before our eyes.

For a discussion of this proposition of Mill’s (as well as many other matters relating to Say’s Law), see my Say’s Law and the Keynesian Revolution (1998). Let me quote myself from this work dealing with these very issues. This was written well before our present failing public spending programs:

Stimulating demand will do the unemployed no good. Raising consumption may, in fact, lower the ability to employ rather than increase it, if it consumes capital that might otherwise have been diverted into payments to labour. The cure for unemployment does not occur through actions taken on the demand side, but through actions which raise production.

How many economists are there today who understand this? The Keynesian revolution has been astonishingly destructive of the ability for economists to think clearly about how an economy works. Mill did not, of course, know Keynes but he knew many “Keynesians”. Mill wrote that amongst the economists of his own time, most at times spoke as if buying goods was identical to hiring labour. “These economists,” Mill wrote:

occasionally express themselves as if a person who buys commodities, the produce of labour, was an employer of labour, and created a demand for it as really, and in the same sense as if he bought the labour itself directly, by the payment of wages.

Of such economists Mill was in despair:

It is no wonder that political economy advances slowly, when such a question as this still remains open at its very threshold.

Not only did economics fail to advance slowly or otherwise; with the arrival of Keynesian economics it retreated back into its Stone Age. Think of this. Because of Keynes, it is probable that economists today understand the operation of our economies less well than did the economics profession of the nineteenth century. If that does not cause you to despair, I cannot imagine what would.

Steven Kates presented this paper at the Freedomfest convention held in Las Vegas in July. Freedomfest brings together conservative, libertarian and free market groups in the United States. Its focus is not just on economic issues, but also on defending political freedom and individual rights. 

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