Say’s Law Is Back

Ideas on Liberty
August 1999

by Mark Skousen

“Keynes . . . misunderstood and misrepresented Say’s Law. . . . This is Keynes’s most enduring legacy and it is a legacy which has disfigured economic theory to this day.”
—Steven Kates^[1]

In researching my forthcoming book, The Story of Modern Economics (to be published by M. E. Sharpe next year), I came across a remarkable new work by Australian economist Steven Kates, Say’s Law and the Keynesian Revolution. According to Kates, John Maynard Keynes created a straw man in order to produce a revolution in economics. The straw man was Jean-Baptiste Say and his famous law of markets. Steven Kates calls The General Theory “a book-length attempt to refute Say’s Law.”

But to refute Say’s Law, Keynes gravely distorted it. As Kates states, “Keynes was wrong in his interpretation of Say’s Law and, more importantly, he was wrong about its economic implications.”^[2] And Kates is sympathetic to Keynesian economics!

How Keynes Got It Wrong

In the introduction to the 1939 French edition of The General Theory, Keynes focused on Say’s Law as the central issue of macroeconomics. “I believe that economics everywhere up to recent times has been dominated . . . by the doctrines associated with the name of J.-B. Say. It is true that his ‘law of markets’ has long been 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. . . . Yet a theory so based is clearly incompetent to tackle the problems of unemployment and of the trade cycle.”

Unfortunately, Keynes failed to understand Say’s Law. By incorrectly stating it as “supply creates its own demand,” he proposed, in effect, that Say meant that everything produced is automatically bought. Hence, Say’s Law cannot explain the business cycle.^[3]

Keynes went on to say that the classical model under Say’s Law “assumes full employment.” Other Keynesians have continued to make this point, but nothing could be further from the truth. Conditions of unemployment do not prohibit production and sales from taking place that form the basis of new income and new demand.

Moreover, Say’s Law specifically formed the basis of a classical theory of the business cycle and unemployment. As Kates states, “The classical position was that involuntary unemployment was not only possible, but occurred often, and with serious consequences for the unemployed.”^[4]

Production and Consumption

Exactly what is Say’s Law? Chapter 15 of Say’s A Treatise on Political Economy describes his famous law of markets: “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.”^[5] When a seller produces and sells a product, the seller instantly becomes a buyer who has spendable income. To buy, one must first sell. In other words, production is the cause of consumption, and increased output leads to higher consumer spending.

In short, Say’s Law is this: The supply (sale) of X creates the demand for (purchase of) Y.

Say illustrated his law with the case of a good harvest by a farmer. “The greater the crop, the larger are the purchases of the growers. A bad harvest, on the contrary, hurts the sale of commodities at large.”^[6]

Say has a point. According to business-cycle statistics, when a downturn starts, production is the first to decline, ahead of consumption. And when the economy begins to recover, it’s because production starts up, followed by consumption. Economic growth begins with an increase in productivity, new products, and new markets. Hence, production spending is always ahead of consumption spending.

We can see why this is the case on an individual basis. The key to a higher standard of living is, first, an increase in your income, that is, your productivity, either by getting a raise, changing jobs, going back to school, or starting a money-making business. It would be foolish to achieve a higher standard of living by spending savings or going into debt to buy a bigger house or new automobile before you increase your productivity. You may be able to live high on the hog for a while, but eventually you will have to pay the piper . . . or the credit card bill.

According to Say, the same principle applies to nations. The creation of new and better products opens up new markets and increases consumption. Hence, “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.” Then Say added, “Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.”^[7]

The Cause of the Business Cycle

Say’s Law states that recessions are not caused by failure of demand (Keynes’s thesis), but by failure in the structure of supply and demand. Recession is precipitated by producers miscalculating what consumers wish to buy, thus causing unsold goods to

pile up, production to be cut back, income to fall, and finally consumer spending to drop. As Kates elucidates, “Classical theory explained recessions by showing how errors in production might arise during cyclical upturns which would cause some goods to remain unsold at cost-covering prices.” The classical model was a “high-sophisticated theory of recession and unemployment” that with one fell swoop by the illustrious Keynes was “obliterated.”^[8]

In his broad-based book, Kates highlights other classical economists, including David Ricardo, James Mill, Robert Torrens, Henry Clay, Frederick Lavington, and Wilhelm Röpke, who extended Say’s Law. Many classical economists focused on how monetary inflation exacerbated the business cycle. They were precursors of the Austrians Ludwig von Mises and F.A. Hayek.

Free-market economists, such as W. H. Hutt and Thomas Sowell, have tried to rehabilitate Say’s Law, but none carries the punch of Steven Kates.

Notes

1. Steven Kates, Say’s Law and the Keynesian Revolution (Northampton, Mass.: Edward Elgar, 1998), p. 1
2. Ibid., p. 212.
3. John Maynard Keynes, The General Theory of Employment, Interest and Money (London: Macmillan, 1936), pp. 25–26.
4. Kates, p. 18.
5. Jean-Baptiste Say, A Treatise on Political Economy (Augustus M. Kelley, 1971 [1832]), p. 134.
6. Ibid., p. 135.
7. Ibid., p. 139.
8. Kates, pp. 18, 19, 20.