Say's law

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In economics, Say’s Law or Say’s Law of Markets is a principle attributed to French businessman and economist Jean-Baptiste Say (1767-1832) stating that there can be no demand without supply. A central element of Say's Law is that recession does not occur because of failure in demand or lack of money. The more goods (for which there is demand) that are produced, the more those goods (supply) can constitute a demand for other goods. For this reason, prosperity should be increased by stimulating production, not consumption. In Say's view, creation of more money simply results in inflation; more money demanding the same quantity of goods does not represent an increase in real demand.

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[edit] What Say said

James Mill restates Say's Law as "production of commodities creates, and is the one and universal cause which creates a market for the commodities produced". In Say's language, "products are paid for with products" (1803: p.153) or "a glut can take place only when there are too many means of production applied to one kind of product and not enough to another", (1803: p.178-9.) Explaining his point at length, he wrote that:

It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products. (J.B. Say, 1803: p.138-9) [1]

He also wrote:

It is not the abundance of money but the abundance of other products in general that facilitates sales... Money performs no more than the role of a conduit in this double exchange. When the exchanges have been completed, it will be found that one has paid for products with products.

Say argued against claims that business was suffering because people did not have enough money and more money should be printed. Say argued that the power to purchase could only be increased by more production. James Mill used Say's Law against those who sought to give economy a boost via unproductive consumption. Consumption destroys wealth, in contrast to production which is the source of economic growth. Production must be guided by demand, however, to prevent the creation of goods for which there is little demand. Thus, supply and demand interact in self-correcting feedback.

It is important to note that Say himself never used many of the later short definitions of Say's Law and that Say's Law actually developed due to the work of many of his contemporaries and those who came after him. The work of James Mill, David Ricardo, John Stuart Mill, and others evolved into what is sometimes called "law of markets" which was the framework of macroeconomics from mid 1800's until the 1930's.

[edit] Recession and unemployment

Keynes (see more below) claimed that according to Say's Law, involuntary unemployment cannot exist due to inadequate aggregate demand. However, involuntary unemployment could be explained in a different way by the 19th century economists, and the neoclassical economists actually used Say's Law to understand and explain even long-term unemployment and recession.

Recession was explained as arising from production not meeting demand in quality. While in general, more is not produced than there could be demand for, some particular products are produced too much and consequently other products too little. This "disproportionality" would lead to a producer not being able to sell the products in cost-covering prices. Hence he will be lacking in the capability to buy and this will cause contraction in other parts of industry, too.

Such economic losses and unemployment were seen as an intrinsic property of the capitalistic system. Division of labour leads to a situation where one always has to anticipate what others will be willing to buy, and this will lead to miscalculations. However this theory does not explain the existence of cyclical phenomena in the economy because these miscalculations would happen with constant frequency.

The kind of unemployment that results is what modern macroeconomics calls "structural unemployment". It differs from Keynesian "cyclical unemployment" that arises due to aggregate demand failure.

[edit] Role of money

It is not easy to say what exactly Say's Law says about the role of money apart from the claim that recession is not caused by lack of money. One can read the second long quotation above by Say quotation (see above) as stating simply that money is completely neutral, although Say did not concern himself about the question. The central notion that Say had concerning money can be seen in the first long quotation above. If one has money, it is irrational to hoard it.

To understand the role of this notion, restate Say's Law. To Say, as with other Classical economists, it is quite possible for there to be a glut (excess supply, market surplus) for one product, and it co-exists with a shortage (excess demand) for others. But there is no "general glut" in Say's view, since the gluts and shortages cancel out for the economy as a whole. But what if the excess demand is for money, because people are hoarding it? This creates an excess supply for all products, a general glut. Say's answer is simple: there is no reason to engage in hoarding. To quote Say from above:

Nor is [an individual] less anxious to dispose of the money he may get ... But the only way of getting rid of money is in the purchase of some product or other.

The only reason to have money, in Say's view, is to buy products. It would not be a mistake, in his view, to treat the economy as if it were a barter economy.

An alternative view is that all money that is held is done so in financial institutions (markets), so that any increase in the holding of money increases the supply of loanable funds. Then, with full adjustment of interest rates, the increased supply of loanable funds leads to an increase in borrowing and spending. So any negative effects on demand that results from the holding of money is canceled out and Say's Law still applies.

In Keynesian terms, followers of Say's Law would argue that on the aggregate level, there is only a transactions demand for money. That is, there is no precautionary, finance, or speculative demand for money. Money is held for spending and increases in money supplies lead to increased spending.

Classical economists did see that loss of confidence in business or collapse of credit will increase the demand for money which would cut down the demand for goods. This view was expressed both by Robert Torrens and John Stuart Mill. This would lead to demand and supply to move out of phase and lead to an economic downturn in the same way as miscalculation in productions, as described by William H. Beveridge in 1909.

However, in Classical economics, there was no reason for such a collapse to persist. Persistent depressions, such as that of the 1930s, were impossible according to laissez-faire principles. The flexibility of markets under laissez faire would allow prices, wages, and interest rates to adjust to abolish all excess supplies and demands.

[edit] Modern interpretations

A modern way of expressing Say's Law is that there can never be a general glut [2]. Instead of there being an excess supply (glut or surplus) of goods in general, there may be an excess supply of one or more goods, but only when balanced by an excess demand (shortage) of yet other goods. Thus, there may be a glut of labor ("cyclical" unemployment), but that is balanced by an excess demand for produced goods. Modern advocates of Say's Law see market forces as working quickly -- via price adjustment -- to abolish both gluts and shortages. The exception would be the case where the government or other non-market forces prevent price changes.

According to Keynes, the implication of Say's "law" is that a free-market economy is always at what the Keynesian economists call full employment. Thus, Say's Law is part of the general world-view of laissez-faire economics, i.e., that free markets can solve the economy's problems automatically (here the problems are recessions, stagnation, depression, and involuntary unemployment). There is no need for any intervention by the government or the central bank (such as the U.S. Federal Reserve) to help the economy attain full employment. All that the central bank needs to be concerned with is the prevention of inflation.

In fact, some proponents of Say's Law argue that such intervention is always counterproductive. Consider Keynesian-type policies aimed at stimulating the economy. Increased government purchases of goods (or lowered taxes) merely "crowds out" the private sector's production and purchase of goods. To contradict this, Arthur Cecil Pigou, who, according to himself, followed Say's Law, wrote 1932 a letter signed by five other economists (among them Keynes) calling for more public spending to alleviate high levels of unemployment.

From a modern macroeconomic viewpoint Say's Law is subject to dispute. John Maynard Keynes and many other critics of Say's Law have paraphrased it as saying that "supply creates its own demand". Under this definition, once a producer has created a supply of a product, consumers will inevitably start to demand it. This interpretation allowed for Keynes to introduce his alternative perspective that "demand creates its own supply" (up to, but not beyond, full employment). Some call this "Keynes' law".

[edit] Keynes vs. Say

Keynesian economics places central importance on demand, believing that on the macroeconomic level, the amount supplied is primarily determined by effective demand or aggregate demand. For example, without sufficient demand for the products of labor, the availability of jobs will be low; without enough jobs, working people will receive inadequate income, implying insufficient demand for products. Thus, an aggregate demand failure involves a vicious circle: if I supply more of my labor-time (in order to buy more goods), I may be frustrated because no-one is hiring — because there is no increase in the demand for their products until after I get a job and earn an income. (Of course, most get paid after working, which occurs after some of the product is sold.) Note also that unlike the Say's law story above, there are interactions between different markets (and their gluts and shortages) that go beyond the simple price mechanism, to limit the quantity of jobs supplied and the quantity of products demanded.

Keynesian economists also stress the role of money in negating Say's Law. (Most would accept Say's Law as applying in a non-monetary or barter economy.) Suppose someone decides to sell a product without immediately buying another good. This would involve hoarding, increases in one's holdings of money (say, in a savings account). At the same time that it causes an increased demand for money, this would cause a fall in the demand for goods and services (an undesired increase in inventories (unsold goods) and thus a fall in production). This general glut would in turn cause a fall in the availability of jobs and the ability of working people to buy products. This recessionary process would be cancelled if at the same time there were dishoarding, in which someone uses money in his hoard to buy more products than he or she sells. (This would be a desired accumulation of inventories.)

Some classical economists suggested that hoarding would always be balanced by dishoarding. But Keynes and others argued that hoarding decisions are made by different people and for different reasons than decisions to dishoard, so that hoarding and dishoarding are unlikely to be equal at all times. (More generally, this is seen in terms of the equality of saving (abstention from purchase of goods) and investment in goods.)

Some have argued that financial markets and especially interest rates could adjust to keep hoarding and dishoarding equal, so that Say's Law could be maintained. (See the discussion of "excess saving" under "Keynesian economics".) But Keynes argued that in order to play this role, interest rates would have to fall rapidly and that there were limits on how quickly and how low they could fall (as in the liquidity trap). To Keynes, in the short run, interest rates were determined more by the supply and demand for money than by saving and investment. Before interest rates could adjust sufficiently, excessive hoarding would cause the vicious circle of falling aggregate production (recession). The recession itself would lower incomes so that hoarding (and saving) and dishoarding (and real investment) could attain balance below full employment.

Worse, a recession would hurt private real investment, by hurting profitability and business confidence, in what is called the accelerator effect. This means that the balance between hoarding and dishoarding would be even further below the full employment level of production.

Keynesians believe that this kind of vicious circle can be broken by stimulating the aggregate demand for products using various macroeconomic policies mentioned in the introduction above. Increases in the demand for products leads to increased supply (production) and an increased availability of jobs, and thus further increases in demand and in production. This cumulative causation is called the multiplier process.

Many modern advocates of laissez-faire economics have rejected Say's Law, except perhaps in the long run. Instead, the emphasis is on the automatic adjustment of the labor market to get to full employment: if wages are allowed to fall, this increases the availability of jobs and allows full employment. More interventionist economists (for example, those at the International Monetary Fund) are quite activist in their approach, advocating the use of state power to destroy unions, minimum wage laws, and the like in order to make labor markets more flexible so that this idealized vision of labor markets can be attained.

[edit] Modern Adherents of Say's Law

Economists such as Thomas Sowell (who wrote his doctoral dissertation on the idea) of the Chicago School have advocated Say's Law. Arthur Laffer, the supply-sider, also adhered to the law, as does the Austrian School.

[edit] See also

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[edit] Further reading

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