Say It Isn’t So

Few economists openly admit to believing in Say’s Law anymore. It is generally considered a relic of the past, a once dominant theory that had faded away. Although it was prominent in the 19th century, it was swept away in the Keynesian revolution like so much of Classical economics. However, economic theories never die. Say’s Law lives on in conservatives think tanks like the Heritage Foundation and when Marco Rubio (who many favour as the next Republican candidate for President) rose to reply to Obama’s State of the Union address, it was Say’s Law he invoked. Even in the world of economics, some economists unconsciously channel the spirit of Say when they preach about the worries of crowding out and through Walras’ Law which is just a weak version of Say’s. This year’s joint winner of the (pretend) Nobel Prize in Economics Eugene Fama constructed an argument against government stimulus (unconsciously) based more or less on Say’s Law.

Say’s Law is usually simplified to “supply creates its own demand”. What this means is that if consumers wish to buy goods they must first earn money and to do so, they must produce something. Hence by the act of desiring a good they produce a good to supply others. This may seem a bit simple so here’s where Say’s Law matters, firstly in the issue of general gluts and secondly over the issue of crowding out. A crucial part of Say’s Law is that a general glut cannot occur and the economy cannot suffer from overproduction. If one market suffers from overproduction then another must suffer from underproduction. I order for this to hold, markets must clear, that is to say, wages and prices must adjust quickly to reach equilibrium level.

The second and more topical application of Say’s Law regards crowding out. In essence it holds that all wealth comes from production alone so Keynesian stimulus policies are doomed to fail as they merely shift wealth from one area to another without creating anything new. Government spending of $5 billion has no effect on the economy as it means that $5 billion must be raised in taxes. If the government borrows $5 billion, that means there is $5 billion less for the private sector to borrow. In other words any action by the government is automatically cancelled out by an equal and opposite action (or lack of one) by the private sector. Hence government intervention and stimulus is useless.

Ok, so that’s the theory, does it hold? Well the best and easiest rebuttal would be to get you to look out the window at the real world. Right now the economy itself is the best rebuttal to Say’s Law. No general glut? Take a look at the construction sector which has been destroyed by massive oversupply of houses. Markets always clear? Look at the piles of unsold houses that having been lying vacant for five years, some of which will have to be torn down for lack of a buyer. Government crowding out? Well the private sector isn’t spending its reserves, so we’ll be waiting a long time for them to bail us out. Unfortunately the real world is not held in high esteem by the economics profession and reference to it is not considered a winning debate tactic.

The man himself who first developed his theory in 1803
The man himself who first developed his theory in 1803

So why does Say’s Law not hold? Well the central problem is that we do not instantly sell all we produce. If we lived in a barter economy this may be true (considering Say wrote this in 1803 we cannot blame Say for missing out on the finer points of industrial capitalism) however with the introduction of money the edifice begins to crumble. If consumers save then supply will not equal demand and instead will exceed it. If there is saving then there will be unsold goods, markets will not be in equilibrium and there will be excess supply. If we do not spend all our income then there will be under consumption which will cause manufactures to reduce production. These layoffs will cause unemployment and economic decline. In other words if people save and do not spend all their money we have a recession. This was Keynes’ key insight.

There are other problems too such as if people accumulate wealth (you know, the whole aim of capitalism) then we have another problem. Or if people have money as their goal rather than commodities (again a central feature of capitalism as opposed to a barter economy). But a defender might say, even if people save, surely the bank can lend this money out to other people and hence the economy can keep moving? In the good times this usually holds but in a recession savings do not equal investment and banks may just keep deposits in their reserves. Why? Well no bank is going to lend unless it has an idea of the likelihood of getting its money back, especially if its balance sheet has taken a battering. Hence uncertainty in a recession discourages banks from lending and investors from borrowing. Secondly, businesses are not going to invest unless they believe they can make a profit and sell their goods. For this they must believe there is enough demand in the economy. Lack of demand prevents businesses from investing or borrowing money and keeps the economy mired in recession. So in a sense supply is dependent on demand and perhaps it is demand that creates supply.

There is also a problem with the crowding out argument. Economists recognise that crowding out does occur but it is almost never 100%. So government spending does reduce private investment but it is never cancelled out. Secondly, the normal rules don’t apply during a recession. If the economy is in a recession businesses will not want risk investing and may be more concerned with paying down debt than taking on new ones. In this case repairing their balance sheets and replenishing their reserves is the main priority. This means that there will be idle resources in the economy that they government can use without crowding out private investment. So if there is under use of resources then Say’s Law doesn’t hold.

The problem with using Say’s Law to argue against government spending is that it can be used against all spending. If the government taking out a loan means there is less for everyone else then surely this is the case anytime a loan is taken out? If the government building of a road means less money and less engineers, construction workers etc for the private sector to use then surely the same can be said if a private company built a road? Surely every time you buy a good you are depriving the rest of the economy that one good? If Say’s Law holds then private businesses are no more job creators then the government is. Any person they hire is merely taking away one person for every other business to hire. If Say’s Law holds are we not left in some strangely paralytic nihilistic world where action is futile and merely deprives everyone else of that option?

So really it would be more accurate to rename it Say’s Fallacy. Even Say himself repudiated the theory that bears his name (this is surprisingly common in economics) While Say might have been right in a barter economy, the introduction of money undermines his theory. If the aim of the economy is to produce more money instead of obtain resources then supply does not equal demand. Those who sell may eventually buy, but there can be a long time in between. If there is saving, hoarding or accumulation in the economy, then a fiscal stimulus will not crowd out private investment but instead boost the economy. The evidence is clear that markets do not clear and wages and prices are not flexible. Overproduction is a serious problem that cannot be left to solve itself. Supply does not create demand and businesses (such as property developers) aim to have demand prepared to meet their new supply. Property developers go as far as to try and sell their houses before work as begun on building them. Perhaps Say had it the wrong way around, perhaps demand creates supply.

2 thoughts on “Say It Isn’t So”

  1. I agree with almost everything you write, excepting government crowding out which I assume you mean in terms of declining loanable funds as government goes into deficit. In a fixed rate system this would be the case as government is fiscally restricted by what it can tax and borrow, but in a free-floating currency with a central bank there cannot be a reserve constraint on banks’ ability to extend loans. A central bank defending a target rate would be forced to supply whatever quantity of reserves is demanded.

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