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.
Such
misunderstandings are frequently more than just simple errors; they can have
profound effects on our theories of the social world, our interpretations of
history, and our proposals for policy. In economics, one can find numerous
examples of this phenomenon. My task here is to explore one of them: the way in
which Say's Law of Markets (named for the great Classical economist Jean-Baptiste Say) has been fundamentally misunderstood by
economic theorists and laypersons alike, and to explore some of the
consequences of this misunderstanding.
W. H. Hutt once referred to Say's Law as "the most
fundamental 'economic law' in all economic theory."1 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.
In a somewhat more
sophisticated understanding, one which John Maynard Keynes appeared to pin on
the Classical economists, Say's Law is supposed to be saying that the aggregate
supply of goods and services and the aggregate demand for goods and services will
always be equal. In addition, Say was supposed to have been saying that this
equality would occur at a point where all resources are fully employed. Thus,
on this view, the Classical economists supposedly believed that markets always
reached this full--employment equilibrium. In one sense this is trivially true.
If we compare the actual (ex post) quantities of goods bought (demanded) and
sold (supplied) they will always be equal. Whatever is sold by one person is
bought by another. Presumably, however, Keynes thought the Classical economists
meant something else, perhaps more along the lines of "market economies
will never create general gluts or shortages because the income generated by
sales will always be sufficient to purchase the quantity of goods available to
buy." There is a strong sense in which this is true, but by itself it does
not assure that full employment will take place because obvious examples of
significant unemployment and unsold goods can easily be pointed to. And, in
fact, this is what critics of Say's Law have done. By pointing to the various
recessions and depressions that market economies have experienced, they claim
to show that Say's Law was at the very least naive, and probably downright
wrong.
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."2
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 non-labor assets. The higher
(lower) that productivity, the higher (lower) is my power to demand.
In his excellent book
on Say's Law, Hutt states this as: "All power to
demand is derived from production and supply.... The process of supplying -
i.e., the production and appropriate pricing of services or assets for
replacement or growth-keeps the flow of demands flowing steadily or
expanding." 3 Later, Hutt was to be
somewhat more precise with his definition: "the demand for any commodity
is a function of the supply of non-competing commodities." 4
The addition of the modifier "non-competing" is important. If I sell
my services as a computer technician, it is presumed that my resulting demands
will be for goods and for services other than those of a computer technician
(or something similar). The goods or services competing with those that I sell
can always be obtained by applying my labor directly, so I am unlikely to
demand them. The demand for my services as a computer technician is a result of
the supplying activities of everyone but computer technicians.
This way of viewing
Say's Law gets at the interconnections between the various sectors of a market
economy. In particular, it makes sense of the claim that "the employment
of all is the employment of each." As each worker finds employment, he or
she is able to turn around and demand goods and services from all other
non-competing suppliers, creating the opportunity for their employment. From
this perspective, 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.
This process can be
seen in the differences between small, poor, rural towns and wealthier suburban
areas. In the small town, the fact that less value is produced by residents
means that their ability to demand goods and services is correspondingly
limited. As a result, the selection of products, the number and diversity of
sellers, and the degree of specialization among producers is quite limited. By
contrast, in the wealthier suburb, there is an amazing array of products, with
a large number of diverse sellers all offering very specialized goods. Perhaps
most important is that in the wealthier area, there is a greater degree of
competition, as the market can support multiple sellers of particular goods
given the level of wealth being generated by producers. Say points out that this
explains why a seller will likely get more business as one among a large number
of competitors in a big city than the sole seller of an item in the more
sparsely populated countryside.5 The key to being understanding
Say's Law of Markets is that it is production that must come first. Demand, or
consumption, follows from the production of wealth.
To a degree, Say's Law
is just an extension of Adam Smith's insight that "the division of labor
is limited by the extent of the market." 6 Smith's point was
that the degree of specialization that one would see in a given market depended
upon how much demand there was for the specialized product. Thus, small towns
rarely have ethnic restaurants beyond the very popular Chinese and Italian, nor
do they have radio stations that specialize in very narrow musical formats
(oldies from the 1970s only, for example). Larger, wealthier communities can
support this degree of specialization because there is sufficient demand,
deriving from a larger population and a larger degree of wealth being produced.
It is in this sense that production (supply) is the source of demand.
Because all movements
between supplying and demanding have to take place through the medium of money,
it is somewhat oversimplified to say that production is the source of demand.
Actually demanding products requires the possession of money, which in turn
requires a previous act of supply. We sell assets or labor services for money,
which we then use to demand. Money is an intermediate good that enables us to buy
the things we ultimately desire. However, we have to be careful to remember
that what enables us to purchase is not the possession of money, per se, but
the possession of productive assets that can fetch a "money's worth"
on the market. When we sell that asset (or our labor services) we receive
wealth in the form of money. As we spend that money, we demand from the wealth
our production created. However, because we do not spend all of our wealth that
we temporarily store as money, but choose to continue to hold some of it in the
monetary form, the demand for current goods and services will not precisely
match the value of what has been produced, as some money remains in the
producers' possession. Thus it looks as though, given the existence and use of
money, Say's Law, even rightly understood, leaves open the possibility that
aggregate demand is insufficient to purchase what has been supplied.
However, if the
monetary wealth is stored in the form of bank-created money, such as a checking
account (but not Federal Reserve Notes), then that withheld consumption power
will be transferred to those who borrow money from the bank that created it.
The money I leave sitting in my checking account is the basis for my bank's
ability to lend to others. The power to consume that I choose not to utilize by
leaving my production-generated wealth as money is transferred to the borrower.
When she spends her loan, her addition to aggregate demand fills in for the
"missing" consumption demand resulting from my decision to hold
money. There is, therefore, no excess or deficiency in aggregate demand, as
long as the banking system is free to perform this process of turning the
saving of depositors into the spending of borrowers. Say's Law of Markets
cannot be fully appreciated unless one understands the working of the banking
system and its role in inter-temporal coordination.7
Because all market
exchanges are of goods or services for money, all markets are money markets,
and the only way there can be an excess supply or demand for goods is if there
is an opposite excess supply or demand for money. Take the more obvious case of
a glut of goods, such as one might find in a recession. Say's Law, properly
understood, suggests that the explanation for an excess supply of goods is an
excess demand for money. Goods are going unsold because buyers cannot get their
hands on the money they need to buy them despite being potentially productive
suppliers of labor. Conversely, a general shortage, or excess demand for goods,
can only arise if there is an excess supply of the thing goods trade against,
which can only be money. Recessions and inflations are, therefore,
fundamentally monetary phenomena, as Say's Law points us in the direction of
looking at what is going on in the production of money to explain the breakdown
of the translation process of production into demand.
Unlike Keynesian
critics of Say's Law of Markets who saw deficient aggregate demand resulting
from various forms of market failure as causing economic downturns, we have
argued that a more accurate understanding of Say's Law suggests that there is
no inherent flaw in the market that leads to deficient aggregate demand, nor is
the existence of real-world recessions a refutation of the Law. Rather, once we
understand the role of money in making possible the translation of our
productive powers of supply into the ability to demand from other producers, we
can see that the root of macroeconomic disorder is most likely monetary, as too
much or too little money will undermine that translation process. Despite
having been dismissed in the onslaught of the Keynesian revolution, Say's Law,
when properly understood both in its original meaning and its relationship to
the banking system, remains a powerful insight into the operations of a market
economy.