Thursday, 27 February 2014

Say’s Law and the Permanent U.S. Recession

Mainstream media discussion of the macro economic picture goes something like this: “When there is a recession, the Fed should stimulate. We know from history the recovery comes about 12-18 months after stimulus. We stimulated, we printed a lot of money, we waited 18 months. So the economy ipso facto has recovered. Or it’s just about to recover, any time now.“

But to quote the comedian Richard Pryor, “who ya gonna believe? Me or your lying eyes?” A Martian economist arriving on earth would have to admit the following: the US economy has experienced zero real growth since 2000. This is what I call the permanent recession. Permanent, because, unlike past downturns – there will be no recovery. To make the case for this view, I will rely on the ideas of several classical and Austrian economists: JB Say, James Mill, von Mises, Rothbard, W. H. Hutt and Robert Higgs.

I will begin with the JB Say, who is known for the eponymous Say’s Law. To explain I will quote from Say’s Treatise on Political Economy:

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. … Thus the mere circumstance of creation of one product immediately opens a vent for other products.

Say ‘s law can be explained in the following terms:
1. The way that a buyer demands a good is by supplying a different good.
2. The supply of one type of good constitutes the demand for other, different goods.
3. The source of demand is production, not money. Money is only a temporary parking place for past production.
In the modern economy with division of labor, most of us demand goods when we supply our labor. I work as a software engineer. I supply my labor writing computer software. And from that supply I am able to demand other goods, such as coffee.

Say’s ideas were used to settle a debate between the British economists David Ricardo and Thomas Malthus believed the recessions were caused by a general glut. The idea of a general glut is the The concept of a glut for a single good is easy enough to understand: there is more supply on the market than demand at the offered price. A glut can be alleviated by a fall in the price of that good. The producers of the good may take a loss if the market price is below their costs, but the market can always clear at some price.
The idea of a general glut is that all markets for all goods are in surplus. And for some reason, prices are unable to fix the problem. Ricardo opposed Malthus, arguing that the concept of general glut violates

sound economics and clear thinking. He argued this point using Say’s Law: because demand is constituted by supply, aggregate demand, meaning the demand for all goods on the market, consists exactly of all things supplied. Aggregate demand is not only equal to, but identical to, aggregate supply. The two can never be out of balance. And if a general glut is a logical impossibility, then it cannot be the cause of a recession.
The idea of aggregate supply and demand in getting out of balance has appeared many times in the history of economic thought. The same idea is either called overproduction or underconsumption, depending on whether the problem is too many goods or not enough purchasing power. Keynesian economics is a form of underconsumption theory. The overproduction/underconsumption theory has been debunked by sound economists, but like a zombie, it refuses to die.

It is acknowledged by both sides that, if Say’s law is true, then Keynes’ entire system is wrong. Keynes knew this, so he took upon himself the task of refuting Say’s law as the very first thing in his General Theory. Keynes’ argument was that Say’s Law is only valid under the conditions of full employment, but that it does not hold when there are unemployed resources; in that case we are in the Keynesian Zone where the laws of economics are turned upside down.

But, as Stephen Kates explains in his book Say’s Law and the Keynesian Revolution (subtitled How Economics Lost its Way), Keynes failed in his attempt to overturn Say’s Law. Kates show beyond any dispute that Say and his fellow classical economist were well aware that there could be as unemployed resources, and that Say’s Law was still valid in that case.

To summarize, there is no such thing as a general glut or a demand deficiency, we can have idle resources, and Say’s law is still valid. So how did classical economists explain recessions? Producer error. Producers had produced the wrong mix of goods.