Thursday, 27 February 2014

What is "Say's Law"? And Why It's So Important.

What is Say's Law? And why is it so important in the field of economics? In order to put light on this I've included a few definitions and explanations below with links should you wish to study the subject in more detail. 

According to Mises Wiki (my bold):
Say’s Law or Say’s Law of Markets is a principle attributed to French businessman and economist Jean-Baptiste Say, stating that there can be no demand without supply. 
He theorized that the activity of production opens a demand for the products produced. Thus the mere creation of one product immediately opens an avenue for other products. To put it 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 nonlabor assets. The higher or lower that productivity is, the higher or lower is my power to demand other goods and services.
According to Wikipedia:
Say's law, or the law of market, is an economic principle of classical economics named after the French businessman and economist Jean-Baptiste Say (1767–1832), who stated that "products are paid for with products" and "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". In Say's view, a rational businessman will never hoard money; he will promptly spend any money he gets "for the value of money is also perishable."
Say's law was generally accepted throughout the 19th century, though modified to incorporate the idea of a "boom and bust" cycle, which was viewed by some as natural and inevitable, and others as an expansion of the supply of credit. During the worldwide Great Depression, in the first half of the 20th century, a school of economics called Keynesian economics arose, disputing Say's conclusions. The debate between classical economics and Keynesian economics continues today.
Say was not the discoverer of "Say's law", but the name appears to have stuck to the popularizer of this economic theory, which was in circulation at the dawn of the Industrial Revolution.
Murray N. Rothbard wrote the following about Say's Law (click the link to read the full article):
Say's law is simple and almost truistic and self-evident, and it is hard to escape the conviction that it has stirred up a series of storms only because of its obvious political implications and consequences. Essentially Say's law is a stern and proper response to the various economic ignoramuses as well as self-seekers who, in every economic recession or crisis, begin to complain loudly about the terrible problem of general "overproduction" or, in the common language of Say's day, a "general glut" of goods on the market. "Overproduction" means production in excess of consumption: that is, production is too great in general compared to consumption, and hence products cannot be sold in the market. If production is too large in relation to consumption, then obviously this is a problem of what is now called "market failure," a failure which must be compensated by the intervention of government. Intervention would have to take one or both of the following forms: reduce production, or artificially stimulate consumption. The American New Deal in the 1930s did both, with no success in relieving the alleged problem. Production can be reduced, as in the case of the New Deal, by the government's organizing compulsory cartels of business to force a cut in their output.
Stimulating consumer demand has long been the particularly favored program of interventionists. Generally, this is done by the government and its central bank inflating the money supply and/or by the government incurring heavy deficits, its spending passing for a surrogate consumption. Indeed, government deficits would seem to be ideal for the overproduction/underconsumptionists. For if the problem is too much production and/or too little consumer spending, then the solution is to stimulate a lot of unproductive consumption, and who is better at that than government, which by its very nature is unproductive and even counterproductive?
Say understandably reacted in horror to this analysis and to the prescription. In the first place, he pointed out, the wants of man are unlimited, and will continue to be until we achieve genuine general superabundance — a world marked by the prices of all goods and services falling to zero. But at that point there would be no problem of finding consumer demand, or, indeed, any economic problem at all. There would be no need to produce, to work, or to worry about accumulating capital, and we would all be in the Garden of Eden. 
In 1950, Ludwig von Mises wrote the following about Say's Law (my bold),
...during the whole rest of the nineteenth century, the acknowledgment of the truth contained in Say's Law was the distinctive mark of an economist. Those authors and politicians who made the alleged scarcity of money responsible for all ills and advocated inflation as the panacea were no longer considered economists but "monetary cranks."
The struggle between the champions of sound money and the inflationists went on for many decades. But it was no longer considered a controversy between various schools of economists. It was viewed as a conflict between economists and anti-economists, between reasonable men and ignorant zealots. When all civilized countries had adopted the gold standard or the gold-exchange standard, the cause of inflation seemed to be lost forever. 
In the 19th century and a few decades into the 20th, it was therefore generally acknowledged and accepted that Say's Law formed an integral part of economics - if you did not accept it, you could not consider yourself an economist. But then along came John Maynard Keynes and turned things upside down (again!) with his publication of The General Theory. Mises writes (my bold),
Lord Keynes's main contribution did not lie in the development of new ideas but "in escaping from the old ones," as he himself declared at the end of the Preface to his "General Theory." The Keynesians tell us that his immortal achievement consists in the entire refutation of what has come to be known as Say's Law of Markets. The rejection of this law, they declare, is the gist of all Keynes's teachings; all other propositions of his doctrine follow with logical necessity from this fundamental insight and must collapse if the futility of his attack on Say's Law can be demonstrated.
In Keynes own words from his General Theory (my bold),
The classical doctrine, on the other hand, which used to be expressed categorically in the statement that “Supply creates its own Demand” and continues to underlie all orthodox economic theory, involves a special assumption as to the relationship between these two functions. For “Supply creates its own Demand” must mean that f(N) and φ(N) are equal for all values of N, i.e. for all levels of output and employment; and that when there is an increase in Z( = f(N)) corresponding to an increase in N, D( =f(N)) necessarily increases by the same amount as Z. The classical theory assumes, in other words, that the aggregate demand price (or proceeds) always accommodates itself to the aggregate supply price; so that, whatever the value of N may be, the proceeds D assume a value equal to the aggregate supply price Z which corresponds to N. That is to say, effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limit. 
If this were true, competition between entrepreneurs would always lead to an expansion of employment up to the point at which the supply of output as a whole ceases to be elastic, i.e. where a further increase in the value of the effective demand will no longer be accompanied by any increase in output. Evidently this amounts to the same thing as full employment. In the previous chapter we have given a definition of full employment in terms of the behaviour of labour. An alternative, though equivalent, criterion is that at which we have now arrived, namely a situation, in which aggregate employment is inelastic in response to an increase in the effective demand for its output. Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.
In effect, Keynes' theories rest on the refutation of Say's Law - if Say's Law is correct, then Keynesian economic theories must collapse as a result. 

It should therefore be obvious that Say's Law is a very important concept for economists and why it should be an important one for policy makers as well. Fiscal and monetary stimulus are again proving to be less than effective in reviving economies and creating sustainable employment around the world (e.g. the US, UK, Japan). Free market economists are inclined to point the finger at interventionism as the primary cause of the long and painful recessions across the globe (read this for an recent discussion on this subject). On the other side, modern day Keynesians simply claim both fiscal and monetary stimulus have not been sufficient, hence we need more of both (e.g. here).