The economics profession faces a crisis of credibility in the wake of the global financial malaise of the past 10 years. This crisis is not due to insufficient theoretical innovation or a need for more complex mathematical and ‘behavioural’ models, but rather because of insufficient conservation of classical economic principles in the mainstream of the profession.
Perhaps the central classical principle – now wholly discarded in modern mainstream economics – is Say’s Law.
Just about every great economic debate is a derivative of the Say’s Law debate. Or put another way, a correct stance on Say’s Law is vital to thinking soundly about economics.
Say’s Law is fundamental to the reality of voluntary exchange. Jean-Baptiste Say argued that demand is constituted by supply. Some have rather crudely rendered Say’s Law as “supply creates its own demand”, a version that has been used as a straw man by Keynesians for decades and may be confused with the Marxist labour theory of value or the old fallacy that labour must earn enough to “buy back the product.”
Economist Paul Cwik more helpfully explains that Say’s Law is simply the reality that “we produce in order to consume.”
Cwik’s version is elegant and essentially correct, but may still leave room for confusion. In arriving at a definition of Say’s Law, it is useful to start by thinking about what exchange is: the mutual offering of goods and services between people (a haircut for your bottle of milk or a ride in my car for your money).
Seeing exchange as a ‘mutual offering’ shows demand-and-supply is not an unsolvable chicken-or-egg problem. People produce what in their best judgement others want, IN EXPECTATION that others are producing/will produce what they want. The simpler the setting, the less that people have to rely on market signals like prices. Two people deserted on a tropical island, for example, can discuss beforehand what each one will make and offer to the other. Sheila and Bruce could agree that Sheila will go catch fish and Bruce will go find coconuts, and later they could mutually offer surplus fish for surplus coconuts (i.e trade).
As exchange becomes more widespread among hundreds, thousands or millions of people, a money and price system develops so that one can produce what others want using market prices as a signal of consumer preferences. But the essence does not change: people produce what they judge others want in expectation that others will produce what they want.
Say’s Law, then, can be stated as follows: The value of goods and services anyone can purchase is equal to the market value of what they supply. Or in an aggregate/macroeconomic sense, the value of goods and services any group of people can purchase is equal to the market value of what they supply.
Since economic value is subjective and therefore forever fluid, Say’s Law only applies to a subjective conception of value. Supply into the marketplace ALWAYS provides the means for the supplier to purchase other goods and services, but only to the extent of the subjective value placed by others on that supply at any given time. Even if supply failed to create any purchasing power at all for the supplier because it was considered completely valueless in the marketplace, this would not be a contravention of Say’s Law but merely another manifestation of it. It would also distinguish Say’s Law from the Marxists’ labour theory of value in recognising the crucial fact that the act of production alone is insufficient to create purchasing power, but rather the act of producing something which is valued by someone else who has also produced something valued in the marketplace.
If one only engaged in meaningless, valueless ‘production’ like digging holes in the middle of nowhere or fashioning arbitrary objects no one wanted or needed, one would clearly obtain no means for purchasing anything from others. Suppose Sheila and Bruce went their separate ways without consulting one another, Sheila catching fish and Bruce finding coconuts only for Bruce to later tell Sheila he is allergic to seafood and Sheila to tell Bruce she is allergic to coconut milk. Neither could trade their surplus produce. Neither could demand anything from the other.
We can now understand why David Ricardo said,
Men err in their productions, there is no deficiency of demand.
Ricardo was commenting on the great debate that had arisen in the 19th Century between he and Thomas Malthus on the cause and cure of economic downturns. Malthus espoused the view that became the cornerstone of Keynesianism and the modern mainstream, which is that recessions are caused by too much saving and a resultant fall in demand. This led, according to this view, to a general glut or general overproduction. Producers would sit with unsold stock and falling revenues and would have to lay off workers. A recession would ensue. Malthus, and later, more emphatically, Keynes, advocated saving less and spending more to recover from the recession.
But the validity of Say’s Law renders the Malthusian-Keynesian view incorrect. Since demand itself is funded only by supply that is valued in the marketplace, the widespread business errors revealed in the recession must be the result of widespread errors in estimating what value the market would place on the goods and services supplied. Why entrepreneurs would “err in their productions“, as Ricardo put it, on such a large scale is a rich and crucial topic for another day, suffice to say that while widespread error can occur by natural social processes, the more common and damaging kind is that caused by state action, be it from the misguided central plans of government and their war-making, regulations, taxes and price controls, or monetary central planning by central banks. These interventions, especially when they block efficient price adjustment, serve to make information opaque, distort incentives for long periods of time, create moral hazard, and make error concentrated, hard to discover, and hard to rectify once discovered.
If men (and women) “err in their productions“, then recovery efforts must be focused on rearranging productive efforts to better serve consumers’ needs. This is a very different diagnosis from the Keynesian one which emphasises a mysterious demand deficiency (explained by waning “animal spirits“) to be treated with money printing and state and household debt spending. In a Say’s Law diagnosis, entrepreneurs need as few obstacles as possible to discovering what products and services are needed in the marketplace. Since the price mechanism is the primary information signal to entrepreneurs, market price flexibility is absolutely essential to a proper recovery. Also, since capital and labour have been misallocated and some capital wasted altogether, an adjustment process must take place in which productive resources are reallocated. This process requires more not less saving to tide workers and entrepreneurs over and accumulate sufficient resources to redeploy in new endeavours1.
We can begin to see how a rejection of Say’s Law – the Malthus/Keynes assertion that demand calls forth supply, rather than that mutually valued supply creates the means to demand – informs how mainstream economists to this day think about the causes and cures of recessions and justifies the recourse to central economic management by the state. If the prudent act of individual saving, when done en masse leads to destructive social outcomes, as this school of thought argues, then it becomes easy to justify a body of managers called the state using coercive directives to rectify this market error. And if the principle is conceded that virtuous individual action can lead to chaotic social outcomes, then all manner of central state planning can be justified as not only of public benefit but as fundamentally essential.
It is the validity of Say’s Law that stands as the gatekeeper of economic freedom and prosperity. Without it, economic fallacies justify state force, which is multiplied in the name of public salvation.
- Cwik, Paul. “Austrian Business Cycle Theory: A Corporate Finance Point of View.” The Quarterly Journal of Austrian Economics 11, No. 1 (2008): 60–68.