Say’s Law and Austrian economics

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.

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33 Responses to Say’s Law and Austrian economics

  1. JohnA

    One way to fix the banks would be to ratchet up their reserve ratio, until it reaches 100% of next month’s at call deposits plus maturing investments.

    I think the banks try to call this process “asset-liability matching”, right?

  2. Georg Thomas

    Of course, it’s great to have congenial support. All in all, however, I’m glad to have in Steve’s book a comprehensive source on the subject-matter, provided by a truly level-headed and reliable authority; I’ve grown rather suspicious of von-Mises adepts, as they tend to go over the top sooner or later, with economically ill-educated anarchist ambitions or crude promises of a crisis-free world, once their “plan to end all plans” has been realised.

    One of the great strengths of Steve’s book is that it has been written first and foremost for the purpose of finding the truth and to achieve clarity, rather than being an effort at supporting a Weltanschauung eager to win an ideological beauty contest.

    The unparalleled clarity of his exposition is evidence of a man who does not copy received wisdom (such as to be found in textbooks) but struggles to understand the issues as an effort at profound independent thinking.

    It is not a rare thing to observe that a good economist is bad at adjacent subjects, such as philosophy. Steve is a good philosopher and historian, and correspondingly his economic reasoning is circumspect, deep and trustworthy.

    I’m looking forward to reading the second edition of Free Market Economics, the best introduction to economics (both for beginners and advanced economists) in the English language.

    I just wonder how it might be possible to improve something as good as this. However, I do expect Steve to accomplish the feat.

  3. Georg Thomas

    I use the term „good economist” somewhat unfelicitously in my above comment – what I mean is this: An economist may be good at certain aspects of economics (say econometrics) – that’s the sense in which I use the term “good economist” in the comment.

    However to be a truly „good economist“ who understands the subject-matter of economics (which isn’t easy, hence so much bad economics by technically good economists), its peculiar nature, and inner nexus, you need to be good at adjacent subjects, such as philosophy or history. And there are not many economists that qualify as “good economists” in that comprehensive sense. In fact, this explains why modern economics is in such a poor state.

  4. Yohan

    Steve’s book on Says law is available at the Mises Institute website (along with hundreds of other classic economic works)

    https://mises.org/books/kates.pdf

    I think the reason why Mises and Hayek did not mention Say’s Law much, was that up until the Keynesian revolution, Say’s Law was a given/standard concept of economics. I don’t think the older economic writers were quite prepared for how the ‘new economists’ were willing to overturn obviously true parts of standard economic theory.

    We even have the high priest of Keynesianism, Paul Krugman, declaring Say’s Law a ‘cockroach idea’. This is Krugram implying Says Law is just wrong, and such wrong idea’s never die and survive like cockroaches.

  5. Hardhead

    OK. So I have counterfeited a few hundred million bucks and now go into a car dealership to buy a $1 Million Bugatti with some of it. I have also given dozens of my mates a few million each, which they believe I inherited from some rich relative, and they are also down at the showroom.

    In no time the local Bugatti dealership is emptied and the owner sends a request to the factory in Italy for a dozen more. The factory produces them.

    Fair enough that the millions were spent on already-produced Bugattis, but hasn’t the buying of those with counterfeit dough “caused” the new dozen to be produced in Italy?

    If Cats are unsure about this, feel free to be rude; to stridently defend Say’ Law regardless and to respond in the usual arrogant manner. Yeah…I’m a fvckwit for asking.

  6. Tel

    I’ve grown rather suspicious of von-Mises adepts, as they tend to go over the top sooner or later, with economically ill-educated anarchist ambitions or crude promises of a crisis-free world, once their “plan to end all plans” has been realised.

    Link to one example of an Austrian economist promising a crisis-free world.

  7. Tel

    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.

    You can print more money, but you can’t print more coffee (not yet at any rate). Personally, I think if you paid a fiver for a cup of coffee you got ripped off unless it was exceptionally good coffee.

    That’s the thing though, prices are subjective. No simple rule exists to translate between coffee and money, unless you have a large and liquid marketplace where many people interact to find that price. Same problem happens with aggregate demand, some people don’t even drink coffee so if total coffee demand goes nuts with stimulus spending, for people who don’t drink coffee that’s a total waste of effort.

    Stimulating aggregate demand really means that the economic choices of a select group of politically connected people get catered to, while the preferences of other people are ignored. Does this help “the economy as a whole”? What does the question mean?

  8. Rafe

    Good call on the Austrian-baiter Tel! The Austrians were blindsided by Keynes in the 1930s because they thought or hoped that the best Austrian insights were embedded in good economics and the time was near when it would not be necessary to even talk about Austrian economics as though it was something strange and different.
    The thing that really fouls up the modern Austrians is the hard core of people who insist that you have to practice the strong form of apriorism that Rothbard and our contemporary Hans-Hermann Hoppe picked up from von Mises. That just makes them look insane in the eyes of the mainstream so their substantive economic insights don’t get serious consideration. The idea of apriorism is that you deduce all the laws of economics by thinking about the idea of human action, and evidence has nothing to do with it.
    That just will not fly among people who have been brought up under the potentially fatal legacy of the triumph of “scientism” which is a totally false conception of the methods of the natural scientist that became popular after Newton and was instituti0nised in the academic philosophy of science when it became professionalised and specialised by the logical positivists and inductivists of the Vienna Circle in the 1930s. The fled from Hitler and established logical empiricism in the Anglosphere postwar. Think of them as Hitler’s revenge!

  9. Louis Hissink

    Vienna Circle – how much cross-pollination with the Frankfurt School, Rafe? The latter also escaped to the Anglosphere during the same period.

  10. Louis Hissink

    Actually it’s the getting something for nothing mindset that is the problem. It ultimately originates in the entrenched belief, held both by the devout as well as the secular, in creation when something was produced from nothing. When is irrelevant – it’s the nonsense of the belief itself that you can produce something from nothing that is the problem, whether divinely or mortally.

  11. One of the reasons Keynesian economics has been able to be sold to the populace is that it is somewhat intuitive, in that at first glance, it makes sense. Businesses routinely produce stuff that they know there is a demand for. But the fact is, is that for every product in demand, there are many more that have been produced which are not.

    Hands up who wanted an iPhone before it was invented? Have a look through the latest edition of Popular Science. How many products in a single issue will ultimately fail in the market?

    Keynesian theory may be beautiful, but it don’t mean its right. If Keynesians really want to help, clear the jungle of red and green tape and eliminate the cronyist substitutes and demand will take care of itself.

    This may be somewhat simplistic, but it demonstrates clearly how supply routinely precedes demand.

  12. Yohan

    The thing that really fouls up the modern Austrians is the hard core of people who insist that you have to practice the strong form of apriorism that Rothbard and our contemporary Hans-Hermann Hoppe picked up from von Mises. That just makes them look insane in the eyes of the mainstream so their substantive economic insights don’t get serious consideration.

    I used to have this criticism. But I realise now the Austrians do not reject empiricism, they use empirical observation and then introspective reflection to build a deductive framework. What they do reject is being able to confirm or falsify economic phenomena based on the laboratory style methods of positivism/scientism, as you say.

    The distinction is subtle to grasp, so much so I have difficulty writing it. It is definitely not the case that Austrians think economics is purely apriori and can be spun out thinking from ones arm chair, but I can see why critics would say this, and claim they are just ideologues.

  13. ar

    In real life, it is refuted every time a Keynesian stimulus is tried.

    In real life, it is refuted rejected every time a Keynesian stimulus is tried.

    If Say’s Law is irrefutable then examples of Keynesian stimulus should confirm it?

  14. RodClarke

    Fair enough that the millions were spent on already-produced Bugattis, but hasn’t the buying of those with counterfeit dough “caused” the new dozen to be produced in Italy?

    And this is exactly what the Austrians call Mal-investment. The new dozen to be produced in Italy will only get consumed if more money gets printed.

    Meanwhile the more money printed the higher food and energy prices are for the poor and those on fixed incomes.

  15. alan moran

    While the identity of production and consumption is always the fundamental one, the appeal of Keynesian notions was that for the first time, in the 1930s we had a situation of fully documented and clear evidence that the economy was operating well below its capacity with high unemployment and with now idle factories that were fully operational producing goods that were in clear demand only a year earlier.

    What the Keynesian view was is that if only confidence can be reignited then the cycle of investment- growth-investment-growth would resume. This did not work in the 1930s and has not worked since. However, the “animal spirits” do exist. Confidence is an important feature of economic activity. Restoring confidence works and the restoration is often through trickery (eg German 1920s hyperinflation stopped once the Government introduced a currency which it said was backed by a mortgage on all land in Germany – a most improbable form of collectable collateral).
    Governments all over proclaim things are going well when they often are not. Is there any role for governments in restoring confidence other than the obvious balance the budget, cut spending etc. ?

    Some may be aware that the momentous event in 33 AD was an economic recession that hit the whole Roman Empire and there was a credit drought as merchants no longer believed each others’ ability to pay their bills (perhaps the events of 2008 were similar) . The Emperor acted as a lender of last resort and guaranteed the credit of those who could put up solid collateral and the crisis passed.

  16. RodClarke

    great comments Rafe and Yohan

    We need to keep the long-run damage of expansionary monetary supply at the fore-front of economic debate. Too many people assume the long-run neutrality of expansionary monetary supply.

    Every rise in food, energy, and housing prices erodes worker productivity and many enterprises dont even get started due to them.

  17. RodClarke

    What the Keynesian view was is that if only confidence can be reignited then the cycle of investment- growth-investment-growth would resume.

    Confidence up for the few at the Bugatti dealership, Confidence down for the many at the green grocer and petrol station.

  18. Rafe

    Louis, the Frankfurt school almost moved to the London School of Economics at the invitation of the socialist Director Beveridge , father of the National Health Scheme but Hayek got wind of it and ran across teh campus to Robbins and together they persuaded Beveridge to change his mind. So the Frankfurters went to the US and then went back home some time after the war. Total waste of space and no affinity with the Austrians, either with the philosophers (who incidentally were mostly mild socialists) or the economists.

  19. Rafe

    Yohan, yes, most of them are ok but a few keep rabbiting on about strong apriorism in an unhelpful way.

    Sadly von Mises thought that positivism/empiricism worked in the natural sciences and never really got hold of Popper’s counter-arguments.

  20. .

    Keynes can’t possibly be right. Demand cannot be manufactured.

    The last 57 years of empirical research has demonstrated that Keynesianism is a bunk theory on false premises and it does not work.

    Mises was right and he was wrong.

    Economics is as Mises described. He is theoretically correct and has been proven so countless times empirically.

    Ignoring finance, mathematics and statistics as relevant disciplines won’t make you a bad economist but it will limit your marketable skills.

  21. .

    Thanks, Alan.

    Otto Lightner
    History of Business Depressions

    will have to add that to the list along with Sidney Homer’s A History of Interest Rates

  22. Georg Thomas

    Tel requested:

    “Link to one example of an Austrian economist promising a crisis-free world.”

    Jesus Huerta de Soto argues:

    “Economic depression is not a crisis caused by the market economy. This is something we have to remove of our mind definitively. The crisis is not a crisis of the market, it is a crisis of state intervention, state intervention which produced the current banking system and credit expansion, which has deceived entrepreneurs, which has distorted the production structure (…). Therefore, in a free market economy does not have to exist economic depressions”. (1)

    After a random search on the internet of no more than five minutes, I was able to retrieve the above quotation from

    http://thehereticaleconomist.blogspot.de/2014/01/austrian-economists-predicted-financial.html

  23. .

    Can someone give me a rundown of de Soto’s work?

    I have had it only described to me through Graeme Bird so it probably has been twisted. Anyway the description he gave made it sound out of whack with Mises, Rothbard, Freidman etc.

    Rothbard said if there was fiat, there should be 100% reserves, no fiat, then free banking.

    Graeme reckoned de Soto wanted to ban any banking that wasn’t 100% backed under ANY circumstances. This sounds…no very laissez faire.

  24. Mindfree

    Hey Steve

    Do you get a discount if you’ve bought the first edition?

  25. motherhubbard'sdog

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

    There is an increase in demand for unicorns. Will this spur an increase in employment and production?

  26. Piett

    This is very interesting, but rather at odds with conventional macro as she is taught!

    A question for you Say’s Law and Austrian guys. We’re all agreed that in a recession or depression, restoring investment is key to recovery.

    Conventional macro would say investment demand is sensitive to the interest rate, which is why central banks lower the rate when the economy goes south. This is increasing the money supply — ‘printing money’.

    You guys think this is mistaken — it won’t have any stimulatory effect. OK, so presumably hiking it has no contractionary effect? So, what would happen if we’re in a depression and the RBA hikes interest rates to 30%?

    a) The economy completely tanks (standard macro).
    b) Nothing happens (this seems to be the logical outcome of Steve’s argument, since monetary policy cannot affect supply).
    c) The economy actually improves (high interest rates avoid mal-investment, the Austrian argument).

    Which would it be?

  27. Nato

    “It is a theory of capital consumption and ignores the irrefutable fact that production is required prior to consumption”. I prefer your line from a comments thread a while ago “in order to buy, you must first supply”. It’s snappier and more accessible during conversations at breaks from work, labouring for a pay check.

    Serious question:
    “Central bank economists make the crucial error of confusing GDP spending frenzy with sustainable economic activity. They are measuring capital consumption, not production.”
    Does this mean that the data we call GDP is actually a GDC? If you’ve got links to any rationale behind the yes/no answer, that’d be v. helpful, but another snappy summation to go with it would be more useful.

  28. Nato

    Sorry. As soon as I typed that bit about links I knew I’d have to delete it, but was caught in the flow and forgot. I can do my own research.

  29. Yohan

    a) The economy completely tanks (standard macro).
    b) Nothing happens (this seems to be the logical outcome of Steve’s argument, since monetary policy cannot affect supply).
    c) The economy actually improves (high interest rates avoid mal-investment, the Austrian argument).

    b. Steve’s work and Say’s law does not claim that monetary policy cannot effect supply. The idea is that bad monetary policy and debt spending distorts the capital structure, savings and scarce resource allocation that would lead to a sustained and stable growth path. I’m no expert on Say that’s why I posted the link to his book.

    c. The Austrian theory does not claim that high interest rates avoids mal-investment. They claim that the setting of interest rates above AND below the ‘natural’ rate of interest leads to mal-investment.

    By ‘natural’ they mean set by real supply and demand in a free banking system without a central monetary authority. By ‘mal-investment’ they do NOT mean overinvestment or underinvestment.

    Real and stable investment comes from business bidding on factors of production to satisfy the wants of consumers, with price determination co-ordinated by natural interest rates (set by time-preference and productivity).

    Monetary authorities manipulating the interest rates and financial markets thus distort the true state of capital and scarce resources in the economy, leading to more frequent booms and busts.

  30. Georg Thomas

    Yohan,

    thanks for your wonderfully clear points under (b) and (c).

  31. Elizabeth (Lizzie) B.

    Another law that is irrefutable is Sod’s Law. I just raced Da Hairy Ape up the steps to the third floor (he in the lift) and fell over in my unseemly haste, shattering my Sicilian ceramic purchase on the delightful marble underfoot.

    Sorry. Couldn’t resist telling you. Demand for Sicilian ceramics has just increased by one.

  32. Tel

    Can someone give me a rundown of de Soto’s work?

    http://mises.org/daily/author/210/Jesus-Huerta-de-Soto

    I’ve just grabbed his book “Money, Bank Credit, and Economic Cycles” onto the Kindle for five bucks. Imagine that, a book for five bucks and instant gratification. Someone should tell Mario Draghi that’s dangerously deflationary, I’m surprised such technology hasn’t caused a worldwide depression or something. Gives me an excuse to sit in the hammock and pretend to be gardening.

  33. Tel

    Can someone give me a rundown of de Soto’s work?

    I’ve made some more progress with “Money, Bank Credit, and Economic Cycles” and it’s a good book but also a bit of work to get into. Not light reading by any means. His basic thesis on banking draws a distinction between four different types of banking activity:

    [1] Money changing, account keeping & clearance : instantaneous transactions with no relationship to credit.

    [2] Regular deposits, or sealed deposits (Roman: depositum) : like a safety deposit box, purely for safe keeping, never paying any interest, possibly requiring a small protection fee. Non-fungible, available at call.

    [3] Irregular deposits (Roman: depositum irregulare): a zero-interest fungible deposit of any good (especially money), available at call, with the bank not necessarily paying back the exact items, but always paying back the exact same amount.

    [4] Fixed-term loans (Roman: mutuum): a fungible loan with full transfer of ownership, typically interest bearing and in the case of bankruptcy given a lower priority amongst creditors than the two types of depositum contract.

    So De Soto goes through lots of history with Greek, Egyptian, Roman, Medieval banks, and how we got through the Colonial era into the Modern. He looks at key legal judgements, and a bunch of economic events surrounding the banking industry.

    As to reserve requirements, the official Roman position on depositum irregulare was 100% reserve, but it was also well understood that many bankers did not follow this, providing they got away with it and always paid back without delay at the correct time, the law never got involved and everything was cool. Thus, an official double-standard existed: keep 100% reserve or at very least don’t get caught keeping less than 100% reserve.

    However, inevitably, various bankers did get caught short when depositum irregulare were called for and the banker was unable to pay, at that point the banker was guilty of a type of theft. Various things might happen:
    * an agreement might be come to whereby the banker pays some interest as penalty for late payment;
    * the bank might be forced into bankruptcy and the banker charged with a crime.

    For mutuum contracts (i.e. fixed term loans) there never was an expectation of 100% reserve, and it seems that the penalty for late payment was somewhat less criminal, presumably an additional interest payment.

    The conclusion that De Soto comes to is that the Romans were correct all along, but we have gone off the rails by commonly confusing case [3] and case [4] where we attempt to have continuously at call deposits that are also interest bearing and with ambiguous transfer of ownership. As a consequence we have messed things up and the best thing to do is restore the Roman legal framework with regard to banking.

    Worth reading the book if anyone wants a solid background on the early history of banking, and how things have changed.

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