The article below is an excerpt from my book Money Cycles.
“I shall suggest that, fairly interpreted, “Say’s law of markets” survives as the most fundamental “economic law” in all economic theory.”
The tale and discussions above are related to a
tremendously important economic principle brought to prominence more than two centuries
ago. This principle today goes by the name Say’s
Law, or Say’s Law of Markets. It is named after the writings of Jean-Babtiste
Say especially in his second edition of A
Treatise on Political Economy published in 1814 (first edition published in 1803). [2] In the chapter that developed the concept of what would
later become known as Say’s Law, [3] he sets out to refute the assertion that if it weren’t
for a lack of demand, production would always be abundant. This is what Say
writes in the opening paragraph of the chapter,
It is common to hear adventurers in the
different channels of industry assert, that their difficulty lies not in the
production, but in the disposal of commodities; that products would always be
abundant, if there were but a ready demand, or market for them. When the demand
for their commodities is slow, difficult, and productive of little advantage,
they pronounce money to be scarce; the grand object of their desire is, a
consumption brisk enough to quicken sales and keep up prices. But ask them what
peculiar causes and circumstances facilitate the demand for their products, and
you will soon perceive that most of them have extremely vague notions of these
matters; that their observation of facts is imperfect, and their explanation
still more so; that they treat doubtful points as matter of certainty, often
pray for what is directly opposite to their interests, and importunately
solicit from authority a protection of the most mischievous tendency.
“It is
worth while to remark, that a product is no sooner created, than it, from that
instant, affords a market for other products to the full extent of its own
value” and “…the mere circumstance of the creation of one product immediately
opens a vent for other products.” [5]
The popular, and frequently
misinterpreted, definition of Say’s Law, [6] alledgedly coined by Keynes, [7] is that supply creates its own
demand. Say himself however never made that statement, [8] a statement which appears to imply that anything produced will be sold: [9]
In its crude and
colloquial form, Say’s Law is frequently understood as supply creates its own
demand, as if the simple act of supplying some good or service on the market
was sufficient to call forth demand for that product. It is certainly true that
producers can undertake expenses, such as advertising, to persuade people to
purchase a good they have already chosen to supply, but that is not the same
thing as saying that an act of supply necessarily creates demand for the
good in question. This understanding of the law is obviously nonsensical as
numerous business and product failures can attest to. If Say’s Law were true in
this colloquial sense, then we could all get very rich just by producing whatever
we wanted.
Say hence never implied that supply necessarily equals demand. Keynes, on
the other hand, appears to have assumed that supply always equals demand when he
wrote: “Thus Say’s law, that the aggregate demand price of output as a whole is
equal to its aggregate supply price for all volumes of output…” [10] Such an assumption infer that there could never be a glut of any
commodity or product. Perhaps Keynes never understood Say’s Law as, again, Say
himself never assumed supply would necessarily always be equal to demand (and
that there hence indeed could be a glut of certain goods) when he wrote: [11]
…how does
it happen, that there is at times so great a glut of commodities in the market,
and so much difficulty in finding a vent for them? Why cannot one of these
super-abundant commodities be exchanged for another? I answer that the glut of
a particular commodity arises from its having outrun the total demand for it in
one or two ways; either because it has been produced in excessive abundance, or
because the production of other commodities has fallen short.
Due to the confusion easily fostered, intended or not, by the short-hand
definition of Say’s law that supply creates its own demand, a more accurate and
informative definition or descpription would be that it is production which opens a demand for products, [12] or there can be no demand without
supply [13] or, alternatively, that all power
to demand is derived from production and supply. [14] Horwitz explains more of what Say actually did say,
If
we want to get a more accurate understanding of Say’s Law, perhaps we should
consult what Say himself had to say about his supposed law. In the passage
where he gets at the insight behind the notion that supply creates its own demand,
Say writes: “it is production which opens a demand for products. Thus the mere
circumstance of the creation of one product immediately opens a vent for other
products.” Put another way, Say was making the claim that production is the
source of demand. One’s ability to demand goods and services from others
derives from the income produced by one’s own acts of production. Wealth is
created by production not by consumption. My ability to demand food, clothing,
and shelter derives from the productivity of my labor or my nonlabor assets.
The higher (lower) that productivity, the higher (lower) is my power to demand.
Horwitz concludes the section by explaining,
…Say’s
Law has nothing to do with an equilibrium between aggregate supply and
aggregate demand, but rather it describes the process by which supplies in
general are turned into demands in general. It is always the level of
production which determines the ability to demand.
A key lesson from Say’s Law is
that production (supply) comes first and that consumption (demand) follows, or
is derived from, production. As it’s not really money we demand, but instead
the goods and services we can buy with money (i.e. purchasing power), and as
the only way we can attain money is through exchanging goods and services for
money, it is ultimately production that
is the source of demand. In Say’s own words: “Money performs but a
momentary function in this double exchange; and when the transaction is finally
closed, it will always be found, that one kind of commodity has been exchanged
for another.” [15] Unequivocally, if we want to consume more, we first need to produce
more.
In its simplest form, Say’s Law is an economic tautology: [16] “one cannot consume without first producing, and what one produces
becomes a basis for determining what one consumes.” One needs to have something
available for consumption in order to consume; and having something to consume
means that it first needs to be produced. If nothing is produced then there
will be nothing to consume is the common sense message. Again, with reference
to the islanders, that’s why they had to produce (catch fish, gather coconuts)
before they could have anything available to consume – without production
(supply), there could be no consumption (demand). Furthermore, the more that
was produced, the more that could be consumed. The two go hand in hand. That
such simple logic, such common sense, is actually disputed in the field of
economics must be labelled a mystery. [17]
Before the time when money became the medium of exchange, people had to
produce some other good or service in order to have something to offer in an
exchange. If you did not produce something others wanted you would have nothing
to offer in an exchange, making you unable to demand anything. This principle
is however no different under indirect exchange (where money is used) as one still
needs to produce something, or sell previously acquired assets, in order to
acquire money for then to acquire the goods wanted. Stated differently, in a
money economy consumers must first buy money with their production for then to
sell their money in exchange for the goods and services they demand. Of course,
savings are a source of demand, but they will eventually be depleted unless
they are replenished through through the act of producing something others
demand. Borrowings unbacked by savings (i.e. credit and money expansion) are
also a source of demand, but they would eventually have to be repaid with
future production as consumption without production is unsustainable.
The fallacy of those denying Say’s law lies in failing to recognise that
demand can only ever increase in a sustainable fashion through increased
production; that is, they fail to recognise that demand is only limited by production [18] and instead blame production gluts in certain industries on a deficiency
of demand and a scarcity of money. It’s almost as they treat demand as an
independent entity that at times stands in the way of some producers being able
to sell all their produce. This view is the victim of an important economic
fallacy; that one somehow can transition from production to consumption-led
growth. [19] One of Say’s contributions was to demonstrate by applying economic logic
that “…consumption and production are interrelated, as opposed to being two
separate and independent activities…” [20] Again, the ability to consume is derived from production.
Say’s Law underscores the importance of production as the driver of
demand. Production increases economic wealth while consumption decreases it,
something Say explicitly recognised when he wrote: [21]
…if the nation be in thriving
condition, the gross national re-production exceeds the gross consumption.
Economic growth, which leads to increased wealth, is therefore created
through the act of producing more than is consumed, and, as we shall again
visit later, employing the difference in investments that increase production
still further. [22] For there to be something to consume, something first has to be
produced. The only way therefore to increase consumer demand in a sustainable
fashion and without reducing wealth and depleting savings, is to first increase
production before increasing consumption. Production therefore precedes
consumption. It is production that drives consumption and not the other way
around. It really is that straight forward and represents no “chicken or egg
paradox” to economics whatsoever. Additionally, Say explains that encouraging
consumption is of no benefit to commerce, firstly because demand in general is
“brisk” relative to production, and secondly because the difficulty lies in
supply (producing the means for consumption) and not in actually stimulating
demand (consumption). [23] Any economic policy aiming to improve citizens’ living standards must
therefore stimulate production, not consumption; Say explains: [24]
Thus, it is the aim of good
government to stimulate production, of bad government to encourage consumption.
It is not by chance many western countries today
face grave financial difficulties: economic policies have for decades been
obsessed with, and encouraged, consumption while production have been largely
forgotten about and moved to far-away countries where it is more cost efficient
to produce. In short, these policies have not only ignored Say’s Law, but
directly contradicted it. Broadly speaking, a most important lesson from Say’s
law is that it highlights the superior importance of production over consumption;
if you produce (supply) what people demand, consumption (demand) will follow. Grasping
this has always been important. But it’s acutely important today as the surge
in “spend ourselves to richest” economic policies implemented particularly
during the last decade or two have run amok. Supposedly meant to revive
economic growth, these policies are having disastrous, but predictable, effects
for many, if not most, developed nations. It’s almost as Say was writing about
today’s economic situation in the U.S. and most countries in the EU when he in
the passage below (emphasis added) described an economy in decline: [25]
In a community, city, province, or nation, that
produces abundantly, and adds every moment to the sum of its products, almost
all the branches of commerce, manufacture, and generally of industry, yield
handsome profits, because the demand is great, and because there is always a
large quantity of products in the market, ready to bid for new productive
services. And, vice versa, wherever, by reason of the blunders of the nation or
its government, production is stationary, or does not keep pace with consumption,
the demand gradually declines, the value of the product is less than the
charges of its production; no productive exertion is properly rewarded; profits
and wages decrease; the employment of capital becomes less advantageous and
more hazardous; it is consumed piecemeal, not through extravagance, but through
necessity, and because the sources of profit are dried up. The labouring
classes experience a want of work; families before in tolerable circumstances,
are more cramped and confined; and those before in difficulties are left
altogether destitute. Depopulation, misery, and returning barbarism, occupy the
place of abundance and happiness.
Also explicitly recognised by
Say’s law is that there can be no such thing as a general “overproduction” as,
at the end of the day, products are bought with products; “It is because the
production of some commodities has declined, that other commodities are
superabundant.” [26]
Say is pointing out that there can be too many goods produced of a particular
kind, but that there can never be too many goods produced of all kinds. Writes
Hazlitt: “In sum, Say’s Law was merely the denial of the possibility of a
general overproduction of all goods and services” [27] This
insight, that too much production in some areas are accompanied by too little production
in other areas, is essential in understanding economic imbalances and, as we
shall discover later, the business cycle. As Anderson writes (quoting Thomas Sowell):
“Disequilibrium in the economy can exist only because the internal proportions
of output differ from consumer’s preferred mix – not because output is excessive in the aggregate.” [28] Say
submitted that such a disequilibrium does not arrive by natural means and can
only truly come about through “some violent means,” [29]
…there must needs be some violent means, or
some extraordinary cause, a political or natural convulsion, or the avarice or
ignorance of authority, to perpetuate this scarcity on the one hand, and
consequent glut on the other. No sooner is the cause of this political disease
removed, than the means of production feel a natural impulse towards the vacant
channels, the replenishment of which restores activity to all the others. One
kind of production would seldom outstrip every other, and its products be
disproportionately cheapened, were production left entirely free.”
In essence, Say is pointing
out that overproduction of some goods and underproduction of others is no
inherent feature of a free market economy. For demand to equal supply, “…the proportions must be
right…there must be equilibrium.” [30] It
therefore takes some special effort to not only distort this equilibrium in the
first place, but, more importantly and of greater consequence, to also “perpetuate”
the disequilibrium. Say suggests in the passage above that interference in the
market by politicians or some other authority may bring about such imbalances
between supply and demand as reflected in scarcity of some goods and gluts of
others. The elasticity of money is one such interference that brings about
imbalances, or disequilibrium, in an economy. In general, whenever output differs from consumers’ preferences on a large enough
scale, economic problems inevitably will arise.
We’ll round up this part with a quote from Ludwig von Mises that sums up neatly the importance of Say’s Law in the field of economics (emphasis added): [31]
…He [J.B. Say] proved his
case, while his adversaries could not prove theirs. Henceforth, during the
whole rest of the nineteenth century, the
acknowledgment of the truth contained in Say’s Law was the distinctive mark of
an economist. Those authors and
politicians who made the alleged scarcity of money responsible for all ills and
advocated inflation as the panacea were no longer considered economists but
“monetary cranks.”
This
inherent truth described by J.B. Say does not change with time. Although
twisted and ignored by policy makers and other supporters of inflationist
policies, this fundamental law of economics still applies today just like it
will for another 200 years. Regrettably, the number of “monetary cranks” today
far outweighs the number of economists, certainly with respect to those
positioned to affect economic policies. [32]
[1] (Hutt, 1974, p. 3) .
[2] Allegedly, it
was the U.S. economist Fred Manville Taylor who in 1925 first coined the term
“Say’s Law” when he wrote: “I shall therefore put the proposition we have
discussed in the form of a principle. This principle, I have taken the liberty
to designate Say’s Law; because, though recognized by many earlier writers, it
was particularly well brought out in the presentation of Say (1803)” (Meng,
2006, p. 296) .
[7] Hutt writes: Today's textbooks usually express Say's law most carelessly, using a
description of the law which, I think, Keynes was the first to use. It asserts,
they tell their readers (without mentioning Keynes) that "supply creates
its own demand" (Hutt, 1974, p. 3) . Keynes actually did write those exact
words in his General Theory when he explained three assumptions he had made the
classical theory (theories developed by the classical economists) depend on.
The third of these were: “that supply creates its own demand in the sense that
the aggregate demand price is equal to the aggregate supply price for all
levels of output and employment” (Keynes, 1935, p. 14) . He again made
reference to the same statement when he on the next page wrote: “The classical
doctrine, on the other hand, which used to be expressed categorically in the
statement that “Supply creates its own Demand….”
[8] It was not without reason (Horwitz, 1997) described one of the
problems in the social sciences when he wrote the following in an article about
Say’s Law: “One of the problems in the world of ideas, particularly in the
social sciences, is that the insight behind old ideas can get lost as new ideas
crowd the intellectual landscape. Often, the historian of ideas has the
thankless task of reminding his colleagues that what they think some long-dead
writer said is not, in fact, what he was talking about at all.”
[9] (Anderson W. L., 2009) .
[10] Keynes writes (where Z is the
aggregate supply price of the output from employing N men, the relationship
between Z and N being written Z=f(N) = Aggregate Supply Function, and where D
is the proceeds which entrepreneurs expect to receive from the employment of N
men, the relationship between D and N being written D=f(N) = Aggregate Demand
Function):
The classical doctrine, on the other hand, which used to be expressed
categorically in the statement that “Supply creates its own Demand” and
continues to underlie all orthodox economic theory, involves a special
assumption as to the relationship between these two functions. For “Supply
creates its own Demand” must mean that f(N)
and f(N) are equal for all values of N, i.e. for all levels of output and
employment; and that when there is an increase in Z( = f(N)) corresponding to
an increase in N, D( =f(N)) necessarily
increases by the same amount as Z. The classical theory assumes, in other
words, that the aggregate demand price (or
proceeds) always accommodates itself to the aggregate supply price; so that,
whatever the value of N may be, the
proceeds D assume a value equal to the aggregate supply price Z which
corresponds to N. (Keynes, 1935, p. 15) .
[15] (Say, 1971, p.
134) .
[17] Rothbard offers
the following explanation: “Say's law is simple
and almost truistic and self-evident, and it is hard to escape the conviction
that it has stirred up a series of storms only because of its obvious political
implications and consequences” (Rothbard, 2006, p. 27) .
[19] The roots of this fallacy
[25] (Say, 1971, p.
140) .
[30] (Anderson B. M.,
1949, p. 390) .
[32] The
inflationist view permeates governments primarily because it is boon for them
as it allows bureaucracies to grow bigger and become more powerful. It is
therefore very difficult for free market economists to get a seat at the table
as they advocate limited governments and loathe deficit spending.
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