Understanding Say’s Law

I gave my School seminar last Thursday on Say’s Law and I have to tell you that what struck me more than ever is how hard it is to see the point. I used to think it was obvious. But it has taken me a quarter of a century to see all kinds of parts of it that are invisible and I wouldn’t swear I have it down as completely as John Stuart Mill. I can see that there are four bits especially I may be leaving out in my explanations, the first being the necessity of seeing these issues in aggregate terms, the second the role of consumption, the third that the delay between receiving one’s income and spending does not provide a theory of recession and the fourth the effect of living in a money economy. Nothing I say in adding these in is in any way contrary to the classical understanding of the law of markets or different from anything I have tried to explain before. Can I also say that my biggest regret on the day of the seminar is that I didn’t just go off to the pub next door – or the coffee shop across the road – with the three Cats who came along, for whose presence I was extremely grateful. If they are ever in the city at any time and would like to take me up on this invitation, the drinks are on me. Now back to Say’s Law.

Aggregate Concept

Say’s Law is about the economic aggregates of an economy. There may not have been a set of national accounting figures published during the nineteenth century but they still had a grasp of the economy as a whole. Say’s Law never applies to any individual. No individual’s demand is necessarily comprised of that individual’s supply. We borrow each other’s savings, we pay taxes to the government, we give money gifts for others to spend. Say’s Law is a concept that applies to the economy at the aggregate level only. The total demand found in an economy in real terms consists of the total output of the economy in real terms.

Consumption

Say’s Law does, of course, presuppose that as much output as can be produced will be bought but this will only happen if what is produced coincides with what buyers want to buy.

Production is valueless without consumption. If no one wished to buy then no one would produce. But since desires are insatiable there is no reason to worry that if producers can work out what buyers want to buy that that buyers will stop short of purchasing everything produced. Keynes however argued that people in aggregate would earn incomes for producing 100,000 units of output and then only decide to buy 90,000 units of what they had produced. This is the underlying dynamic in an economy that is experiencing a recession due to deficient demand.

And so far as policy is concerned, he seems to have then assumed that businesses would increase employment and production if what they had already produced could find a market. The reality is that businesses will only employ and produce if they believe they will earn a profit from what they produce next. Past sales have only a minor effect on employment going forward. Current sales are only one indicator amongst many in the production matrix of a typical firm. It is why Keynesians were so astonished by the Great Inflation of the 1970s since the combination of high unemployment and rapidly rising prices should have been theoretically impossible.

When looked at from above, if the amount being spent in aggregate is greater than the amount that was earned from producing output – let us suppose the government is running a deficit – then somewhere within the economy there are income earners being short changed since they do not receive in value the amount of value they produced. The spending may have taken place in Canberra or Sydney, the shortfalls may show up in Perth or Brisbane. But as invisible as the process is, the effect is quite clear. Some businesses will not earn the returns they expected. They will therefore scale down their level of production or even close down entirely. Ultimately the level of employment will be lower than it otherwise would have been as will the level of national output. A Keynesian will attribute this to too much saving and not enough demand.

The Time Gap between Receiving an Income and Spending

The existence of money adds some complication to the Say’s Law story but not much. There is always the intrinsic time delay between (A) outlaying money in some productive venture; (B) selling products one has produced or earning wages as someone’s employee; (C) receiving the money for what one has produced or earned as an employee which may be delayed through sales on credit or by being paid wages in arrears; and (D) spending the money one has received.

An increased time delay between C and D is not a theory of recession and unemployment.

This is what Mill in his essay “Of the Influence of Consumption on Production” is trying to get across. He was desperate to try to explain to the boneheads of his own time what the conclusions from the Law of Markets are. And it is extraordinary the number of people I have come across who read this essay and then argue that Mill is contradicting himself because he denies demand deficiency at the start of the essay and then talks about people hanging onto their money and delaying expenditure at the end. This is John Stuart Mill we are talking about, the man with the nineteenth century’s highest IQ and whose previous book was his Logic (1843) which was used throughout the nineteenth century and well into the twentieth. He is not likely to have contradicted himself in a way that any bumbling idiot could pick it up. Perhaps they should try to work out more closely what he meant.

And what Mill is trying to get people to understand is that a prior theory of recession is needed to explain why the delay between C and D has occurred. That is the explanation for recession not some blue sky decision not to spend. The increased delay has been caused by something. What is it? That is what needs to be known. And whatever it is has caused the outlaying of money in A to diminish as well. But if you believe that the cause has been too much saving, then says Mill, you will never understand the first thing about how an economy works.

The Role of Money

To understand the money side of these things, it helps to go to Wicksell who followed Mill by about half a century (see Chapters 16 and 17 of the second edition of my Free Market Economics). What Wicksell discusses firstly is the natural rate of interest which is the supply and demand for productive resources (machines, bricks, tools, labour hours, everything that can be used in production). Of these, there is only a finite amount (it is a stock) and the potential rate of increase is very slow. Then there is the nominal rate of interest which regulates money and credit, the number of units of purchasing power in an economy. These can be increased at quite a rapid rate, much more rapidly than can the quantum of real resources.

Start with 100,000 units of productive resources and money and credit equal to 100,000 units of currency. Each unit of production thus costs one unit of currency. If the amount of money and credit goes up to 200,000 units of currency, eventually the price of productive resources will rise to two units of currency. But that is eventually. In the meantime, the people who first get their hands on the extra units of currency can buy more since the price level has not as yet risen to the full extent that it will.

But the producers of those 100,000 units of real output will eventually find that they have not been able to exchange what they produced for enough money to allow them to buy products equal in value to the value of the products they sold. If they are running a business, they find they are unable to replace their stock with the revenues they have earned. They have been cheated blind and yet the one place they don’t look for that theft is in the increased demand created by the government since that is what they have been taught to believe is what has been done to save them from the problem that very solution has caused.

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10 Responses to Understanding Say’s Law

  1. sfw

    There’s a lot there to think about. I was going alright till this sentence.
    “When looked at from above, if the amount being spent in aggregate is greater than the amount that was earned from producing output – let us suppose the government is running a deficit – then somewhere within the economy there are income earners being short changed since they do not receive in value the amount of value they produced.”
    There’s a lot there to think about. What you state has never occurred to me before.

  2. Nathan

    Hi Steve,

    You state “If the amount of money and credit goes up to 200,000 units of currency, eventually the price of productive resources will rise to two units of currency. But that is eventually. “

    Okay, so this appears to be an acknowledgement that prices can be upwardly “sticky”. So if that is the case then surely wages (which are just another price) can be downwardly sticky.

    You talk about the case where the stock of money increases faster than the stock of real resources. What about the reverse case, where the stock of money increases more slowly than the stock of real resources? Unless producers lower their prices instantly in response, the market is not going to be able to sustain the same level of economic activity as it did before.

    So there’s your explanation for the slowdown between C and D. Insufficient money growth (i.e. demand) and sticky prices. Standard Keynesian economics, and it’s entirely consistent with your reasoning.

  3. Empire

    Unless producers lower their prices instantly in response,

    Tactical discounting is SOP for business. Wage stickiness is exacerbated by regulation. Business cops a haircut on GP, but more people find themselves standing in the bread line. The prescribed cure (deficit spending) then prolongs the malaise.

    The only nimble party in this tragic comedy is the first mover – the producer who “instantly” lowers prices.

  4. Tel

    You talk about the case where the stock of money increases faster than the stock of real resources. What about the reverse case, where the stock of money increases more slowly than the stock of real resources? Unless producers lower their prices instantly in response, the market is not going to be able to sustain the same level of economic activity as it did before.

    So you are proposing that government can adjust the money supply faster and more accurately than markets can adjust prices. Care to put forward some evidence perhaps…

    Here’s a chart of the price of computer RAM, over the past 60 years, see any price adjustment there?

    http://www.jcmit.com/mem2015.htm

    Now you are just jumping to tell me that the computing industry has been moribund due to failure of demand, right?

    There’s another aspect to this though. Put the price of prime steak on the same chart alongside the computer RAM, and they don’t follow the same curve. Markets can adjust prices along multiple dimensions simultaneously, Keynesian stimulus fails to do that (or when governments attempt to do that, they typically get it wrong). Prices contain information about the world… valuable information.

    So there’s your explanation for the slowdown between C and D. Insufficient money growth (i.e. demand) and sticky prices. Standard Keynesian economics, and it’s entirely consistent with your reasoning.

    Steve defines step (C) as “receiving the money for what one has produced or earned as an employee”. However, monetary growth necessarily implies that someone receives money for what was *NOT* produced; thus the boon of every money printer.

    Printing money does not in any way close the gap between C and D, it does allow a third party to exploit this gap for his or her own ends. The incentive here is obvious, but the benefit to the community is highly questionable.

  5. robk

    Then there’s the idea of reasonable profit and what the market will bare. Also the value of some repeatedly traded derivitive before the product exists. Try rolling that in.

  6. Pauline Young

    Steve
    My husband and I were two of the Cats who attended your talk on Thursday. It was very impressive and thanks for the invitation but if we are back in your vicinity again, the drinks will be on us. Your wise writings are well worth the price of a beer or flat white.

  7. Steve Kates

    Dear Pauline – I look forward to your visit, and I will let you buy the first round but I’ll get the one after, and the chips. Just email me ahead just to be sure I’m there – [email protected]
    .
    But I have to take this up from Nathan:
    .

    There’s your explanation for the slowdown between C and D. Insufficient money growth (i.e. demand) and sticky prices. Standard Keynesian economics, and it’s entirely consistent with your reasoning.

    Sticky wages and prices upwards is such a unique concept that has never been mentioned before by anyone. Sticky downwards is pretty empty as a notion but you can see how wage earners might try to resist a reduction in the money wage. But who is going to resist an increase in wages, and as for prices in general, the only resistance comes from the usual constraints of the market? The spread of demand through the economy and the piecemeal rise in prices goes back to David Hume in the 1750s and has never been doubted. Yours is the most original idea I have come across in years. Not entirely sensible, but definitely original.

  8. Simon

    Sorry to ask Steve but how do you factor in all the schooling and upskilling that never gets utilized because people settle for crapper jobs/better hours etc. Is it over supply of skills or an undervaluing of an existing product? Basically, how is it seen by the two theories?

  9. motherhubbard'sdog

    Keynes however argued that people in aggregate would earn incomes for producing 100,000 units of output and then only decide to buy 90,000 units of what they had produced. This is the underlying dynamic in an economy that is experiencing a recession due to deficient demand.

    It is also the dynamic of an economy that has a trade surplus.

  10. .

    There’s your explanation for the slowdown between C and D. Insufficient money growth (i.e. demand) and sticky prices. Standard Keynesian economics, and it’s entirely consistent with your reasoning.

    That’s largely caused by wage regulation and central banking.

    Whilst free banking and total wage deregulation is “radical”, I totally support it too, Nathan.

    However there is a conundrum in what you say – if money growth is caused by demand (consistent with empirical evidence that M3 drives M1), then you’re ignoring the fact that the (private, read actual) banking system can expand money supply by simply changing their leverage and assets ratios. This is also how the banking system can absorb some price adjustments without any need to accommodate through central banking.

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