Sunday, October 7, 2012

Say's Law correctly stated

Say's Law is one of the cornerstones of modern Economics.  Unfortunately, the most common description of the Law is an incorrect restatement by Keynes. Consequently, Say's Law lost its place as one of the foundation principles of classical economic theory. Beginning in the 1920s Say's Law was largely ignored by most economists.

The importance of Say's Law can be seen in its application by Say. Jean Baptiste Say proposed an explanation for all financial downfalls like the Great Depression and the Great Recession. Had his thesis been understood and popularized by economists in the 20th and 21st centuries much of the stagnation of these economic collapses could have been avoided. Likewise, the ineffective remedies proposed by Keynes and others would not have been followed fruitlessly by governments in Europe and the United States.

What was this magic remedy Jean Baptiste Say proposed? He simply stated in his explanation of Say's Law that private sector profitable production was the only catalyst to economic growth. He further stated that public sector expenditures would slow economic activity and decrease employment. History has shown that Say was right.

Keynes recognized he and Say were diametrically opposed. Keynes aggressively argued for the repudiation of Say's Law. He criticized it in the terms of his favorite economic model, but by doing so ended up by misstating Say's Law. Even so, Keynes' glib description of Say's Law as "supply creates its own demand" was the often quoted definition of the Frenchman's principle. In fact, Say's Law is not about demand. It is about wealth. Say was stating that private sector product creation increases wealth. Say's Law could be stated as product sales create wealth. He wanted to make the point product exchanges include a wealth upside, namely profit. Products embody a profit when they are valued and exchanged. Each sale increases a societies' wealth by the amount of profit. Very simple, but when applied in a financial crisis it changes the focus from government lowering interest rates and borrowing to increase the money supply to making private sector business profitable.

Keynes theory, on the other hand, was that the wealth pump must be primed in a financial crisis. Keynes' theory resulted in government printing new money or borrowing to increase government employment. Keynes and his followers argued more government employment or government projects like road infrastructure would put money into the economic system. This increase in the money supply would stimulate an increase in demand for products (aggregate demand).  Unfortunately, the idea that circulating more money would stimulate businesses to expand did not work. The wealth was in the wrong hands. The wealth was not in the hands of business people to be used to expand their companies, but in the banks controlled by people unsure of the economic direction.

Government production did not include a profit component. Without profit there was no wealth creation. The other element of government "make work" projects was that they are temporary. No private businessman was going to invest in a temporary market. Business required a sustainable income stream. Government projects do not provide that.

According to Say's Law this is what happens in the wealth creation process. A government can borrow and inject money into the economy by building bridges, for instance, to increase the quantity of money in circulation. But there are consequences. The first thing to consider is the debt the government incurs. The amount to be paid back, initially exceeds the amount circulating. If the circulating money is used to purchase products according to Say's Law it (wealth) will grow. Say is just pointing out each sale results in a profit. If the money circulates rapidly and many products are sold, the profits made will increase and greatly exceed the amount of the debt to be repaid. The government can then tax the private business to repay the debt they incurred.

Let's consider a different scenario. Suppose, the government borrows to pay unemployment insurance. The unemployed person uses their payment to pay their rent in a government subsidized apartment. No profit is made. The cost of borrowing exceeds the amount the government gets back in rent. Over time government debts accumulate until the government goes bankrupt.

Say's Law explains why a country can only extract itself from a financial crisis when the private sector is actively expanding (investing). Private sector investment is not an indicator of a vibrant economy, it is the vibrant economy. Government spending has the opposite effect unless it spikes private sector investment.

The following section includes a number of quotes of Jean Baptiste Say. All the quoted material comes from the fifth American translation of his book, A Treatise on Political Economy published in 1832. In history books and economic articles you will find numerous quotes from Jean Baptiste Say, but his most important quotes are often not listed.

"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." In this brief statement Say is making the point that it is a product or service that earns a profit and expands the wealth of a society "to the full extent of its value." The term "full extent of its value" refers to the cost of producing the product plus the profit the seller can make above product costs.

Keynes misunderstood Say's Law. Keynes believed Say's Law occurred in a barter economy, but it actually defined the difference between a barter economy and a monetary economy.  A barter economy does not have a profit. The importance of profit in wealth creation is the key contribution to Economics by Jean Baptiste Say. It is profit that energizes an economy and allows it to grow. As Say noted, "The success of one branch of commerce supplies more means of purchase, and consequently opens a market for the products of all the other; branches." The "more means of purchase" are the profits embodied in every sale of a product or service. Say was making the point that each product sale was increasing the wealth in an economy. Keynes thought it was the cost (interest rates) of money available to purchase products that invigorated commerce. Keynes' failure to understand profit is not surprising since he came from the public sector where profit was not part of his world. Say, on the other hand, was a businessman and knew the critical importance of profit to the functioning of the economy.

Say's understanding of the economy allowed him to understand what was occurring during economic downturns. He realized that "people... bought less, because they have made less profit." What could be more obvious? The economy slows when people have less money or less confidence to spend. Somehow this idea was overturned by Keynes who argued "aggregate demand" determined the vitality of an economy. Say predicted Keynes argument when he stated people's demand for products does not rise and fall, but remains constant. Say made the further point that what rises and falls is a consumer's ability to afford the purchase.

Say went on to strongly criticize the men of government for taxing the economic vitality out of the economy: "The man, that lives upon the production of other people, originates no demand for the productions; he merely puts himself in the place of the producer, to the great injury of production." The greatest oversight of economic management is the failure of twentieth century economists to appreciate Say's analysis of the ineffectiveness of government efforts to increase "aggregate demand" by spending: "the encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone, furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption." If a government wants to extract their citizenry from an economic crisis they need to focus on the "means" of wealth creation and not the circulation of money.

In simple terms Keynes felt that public sector spending could vitalize an economy by circulating more money. Say argued money alone was insufficient. For an economy to circulate money required the creation of new products people desired. Say argued it was private sector production alone that could sustain and grow a vital economy. For over 100 years the governments of the western world have followed Keynes and ignored Say. What is the result? Most western governments are nearly bankrupt from Keynesian borrowing, and their private sector productivity in tatters from lack of attention.

Isn't it time to reject Keynes and embrace Say?