Tuesday, 1 February 2011

How Keynes failed to comprehend Say’s Law.

John M Keynes tried to make Say’s Law into the fundamental issue defining macroeconomics. “I believe that economics everywhere up to recent times has been dominated, much more than has been understood, by the doctrines associated with the name of J.-B. Say. It is true that his 'law of markets' has been long abandoned by most economists; but they have not extricated themselves from his basic assumptions and particularly from his fallacy that demand is created by supply. Say was implicitly assuming that the economic system was always operating up to its full capacity, so that a new activity was always in substitution for, and never in addition to, some other activity. Nearly all subsequent economic theory has depended on, in the sense that it has required, this same assumption. Yet a theory so based is clearly incompetent to tackle the problems of unemployment and of the trade cycle.” [1]

In his attempt to “return to the doctrines of Montesquieu” [1, 4], Keynes completely botched the analysis and meaning of Say’s Law.

Keynes suggested that Say’s law meant that “supply creates its own demand” [2]. Basically, the infamous error that has led to so much misery in the twentieth century comes from Keynes’ unfounded belief that Say’s law leads to all produced goods being purchased and consumed. The resulting analysis derived from this irrational fallacy was that Say’s Law cannot explain the business cycle [2] and also makes an assumption of “full employment”, a point still maintained by Keynesians even today [5].

There is of course a major flaw in this logic. The circumstances that lead to high levels of unemployment do not forbid production and a resultant consumption from occurring.

A new equilibrium will come from this altered supply and demand structure.

Kates [6] extrapolated Say’s law in relation to unemployment more eloquently than Keynes ever could, “The classical position was that involuntary unemployment was not only possible, but occurred often, and with serious consequences for the unemployed”.

But what is Say’s law and why was Keynes so wrong?
Say’s [3] law of markets was defined in his grand work, “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”.

Simply put, this statement means that a producer in the selling of a product becomes a consumer and purchaser. The revenue obtained through the production of a good that is traded successfully creates a market in the distribution of free or disposable income. The producer does not create wealth and goods simply to collect the means of the transaction, money, but for another end. That is, the producer creates wealth in order to consume. To do this, the producer becomes a buyer and a consumer and thus creates demand.
The simple answer here is that production is the cause of consumption. Without sales, one cannot make purchases. In other words you need to not only produce in order to buy and consume, but to sell. To sell you need to produce items and services that people want and you need to do this in an economically sound manner.

This is you also need to make a profit. Marx may have thought of profit as theft from the worker, but without profit, there is no reason to produce. Worse, a loss means that the available capital is actually decreased and the ability to consume is further diminished. So profit is an essential part of the exchange process.

We see from Say’s law that improved production leads naturally to greater levels of consumer spending or:

  • The supply of X creates the demand for Y.
Here supply means not just production, but the production of goods that consumers actually wish to buy. These are goods that are sold.

Economic growth starts when productivity increases. New goods create new markets and a new equilibrium.
Logically, it is simple to see that spending for the production of goods and services must come before the spending of capital in order to consume.

Keynes’ hypothesis and greatest fallacy was a failure to understand Say’s law. He understood it to mean that recessions are caused by failure of demand.

Says had proposed that recessions are caused by failure in the structure of supply and demand.

What is means is fairly simple, recession is follows production errors. When a producer fails to determine just what a consumer really wants, they continue to make and stockpile goods that cannot be sold at a profit (if at all). This was a common situation in the USSR where goods were estimated to be worth less than the value of the materials used in their manufacture.

As the stockpile increased, producers cut back on production, income (the profit margin) shrinks and there is less capital available to buy consumption goods. The end result is that consumer spending eventually drops to precipitously low levels.

Keynes did not want to fix capitalism; he wanted to make his own tower. Unfortunately for us all it is a tower of cards that has repeatedly fallen over in the wind of change due to having been made on a foundation of logical flaws and grossly misstated errors.

References
[1] John M. Keynes (1939) The General Theory, French Ed. Preface
[2] John Maynard Keynes, (1936) The General Theory of Employment, Interest and Money (London: Macmillan), pp. 25–26.
[3] Jean-Baptiste Say (1832), A Treatise on Political Economy, p. 134.
[4] Devletoglou, Nicos E, 1969. "The Economic Philosophy of Montesquieu," Kyklos, Blackwell Publishing, vol. 22(3), pages 530-41.
[5] http://www.slate.com/id/9593
[6] Steven Kates, (1998) Say’s Law and the Keynesian Revolution (Northampton, Mass.: Edward Elgar), p. 18

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