Say's Law of Markets
Jude Wanniski
October 3, 1997

Supply-Side University Economics Lesson #4

Memo To: Students of Supply-Side University
From: Jude Wanniski
Re: Say's Law of Markets

In his 1981 book, Reaganomics: Supply-Side Economics in Action, Bruce Bartlett wisely opens with a discussion of Say's Law: "In many respects, supply-side economics is nothing more than classical economics rediscovered. The essence of Say's Law, named for the great French economist Jean Baptiste Say, is that goods are ultimately paid for with other goods. Thus is production which limits the satisfaction of human wants, not the ability to consume, which, in the aggregate, is unlimited. Consequently Say argued that '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 see that production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.'"

Say's "Law of Markets," propounded in 1803, remained the keystone of classical economic theory, until it was "mortally wounded" by John Maynard Keynes in his 1936 book, The General Theory of Employment, Interest and Money. The words "mortally wounded" is to be found on p. 379 of the most popular economics textbook of the last half century, the 14th edition of Economics by Paul Samuelson of MIT and Richard Nordhaus of Yale. Indeed, of all the textbooks we have checked, Say's Law is either written off as archaic or ignored completely. An understanding of Say's Law and how it happened to be discarded by the economics profession here and around the world is necessary to an understanding of why I find it necessary to conduct these classes. A theory that says it is bad for government to encourage consumption instead of production must be stamped out if governments and the economists they employ wish to encourage consumption instead of production. Keynes had to kill Say's Law, which he restated as "Supply creates its own demand," in order to formulate his own law, that "Demand creates its own supply," which justifies the idea of taxing those who are not consuming fast enough and giving it to those who will. This was the heart of the Keynesian Revolution, which of course means that an overturning of Keynesian influence requires a rehabilitation of Say's Law. Supply-side economics of course goes far beyond Say's Law into a vast complex of legitimate debates on how to increase the wealth of nations. The law of markets is the basic starting point, on which all supply-siders agree, as did all classical economists.

Of the college textbooks available, the one that treats Say's Law with some seriousness is the 1993 edition of Economics: Principles, Problems, and Policies by Campbell McConnell of the University of Nebraska and Stanley Brue of Pacific Lutheran:

The essence of Say's law can be understood most easily in terms of a barter economy. A shoemaker, for example, produces or supplies shoes as a means of buying of demanding the shirts and stocking produced by other craftsmen. The shoemaker's supply of shoes is the demand for other goods. And so it allegedly is for other producers and for the entire economy: Demand must be the same as supply! In fact, the circular flow model of the economy and national income accounting suggest something of this sort. Income generated from the production of any level of total output would, when spent, be just sufficient to provide a matching total demand. Assuming the composition of output is in accord with consumer preferences, all markets would be cleared of their outputs. It would seem that all business owners need do to sell a full-employment output is to produce that output; Say's law guarantees there will be sufficient consumption spending for its successful disposal.

Even the Keynesians acknowledge that Say's law always works in a barter economy, but that it was obvious in the monetary economy of the Great Depression that there was a surplus of aggregate supply and insufficient aggregate demand. In the Samuelson text, here is how this is treated:

A long line of the most distinguished economists, including D. Ricardo, J.S. Mill, and A. Marshall, subscribed to the classical macroeconomic view that overproduction is impossible. Even during the Great Depression, when a quarter of the American labor force was unemployed, the eminent economist A.C. Pigou wrote, "With perfectly free competition there will always be a strong tendency toward full employment. Such unemployment as exists at any time is due wholly to the frictional resistances [that] prevent the appropriate wage and price adjustments being made simultaneously."

As the quote from Pigou suggests, the rationale behind the classical view is that wages and prices are sufficiently flexible that markets will "clear," or return to equilibrium very quickly. If prices and wages adjust rapidly, then the short run in which prices are sticky will be so short that it can be neglected for all practical purposes. The classical macroeconomists conclude that the economy always operates at full employment or at its potential output.

Here is how I treated Say's Law in The Way the World Works, p. 166:

To understand the Keynesian model, it must be remembered that Keynes devised it in the midst of the greatest economic contraction of modern times, his General Theory of Employment, Interest and Money appearing in 1936. In addition, Britain had been in depression throughout the 1920s as well, with the unemployment rate rarely dipping below 10 percent and at times touching 20 percent. Keynes gives little indication in his theory or writings in general that he is aware of the disincentive effects of high tax rates on commerce. And neither he nor his legion of followers distinguish between tax rates and tax revenues, which are always treated as one and the same. It seems incredible, but at the time Keynes penned his General Theory he was surrounded in Britain by both mass unemployment and the highest tax rates on personal incomes in the world, yet he made no connection between the two.

It is no wonder, once this oblivion on his part is taken into account, that Keynes could open his General Theory with no savage an attack on classical theory. He ridicules the heart of classical theory, Say's Law, which is that "Supply creates its own demand," by restating it in his terms and then announcing that the law is "equivalent to the proposition that there is no obstacle to full employment." But can this be true if there is so much unemployment?

Jean-Baptiste Say (1767-1832) is thus too easily disposed of by Lord Keynes, who sees the periodic crises of capitalism as involving "under consumption," rather than Marx's "overproduction," although both concepts are precisely the same. Consider the following accurate summary of Say's position by an unfriendly essayist: "Say's optimistic productivism was not shaken by the economic crises of the early nineteenth century. He held that all overproduction could be only partial. Either certain products are too abundant in one place only because in another men have not produced enough to purchase them or, if products pile up everywhere, it is because of artificial hindrances to their exchange. An economic crisis is therefore in large part a social and political crisis. Were customs barriers, which obstruct the exchange of products for products, and privileges, which hinder the exchange of products for services, wiped out, subsequent crises would be this one stroke be reduced materially."

Policymakers throughout the industrial nations had done exactly the opposite of what Say's Law implied in arranging the Great Depression. Yet Keynes opens his tract by blaming Say, dismissing classical theory, and wrapping up The General Theory without a single mention of tax rates or tariffs.

What Keynes saw around him were unemployed men and women, ready, able, and willing to work, but an investor class unwilling to assemble them into productive enterprises. Instead of "investing," by which Keynes meant the risking of capital in ways that might create new wealth, investors were not investing sufficient amounts of real resources to equal the amount of real resources saved at full employment. In other words, the economy at full employment desired to save, say, 10 percent of its output, but investors were not willing to invest that amount.

The "unfriendly essayist" quoted above, Ernest Teilhac, wrote in the Encyclopedia of Social Sciences, 1934. It obviously did not occur to him that the stock market Crash of 1929 was caused by exactly the kind of supply shock that Say had warned about, which Teilhac even mentions. If government interferes with the exchange of American shoes for European shirts and Japanese stockings, by putting a tariff wall against shirts and stockings, surplus shoes will pile up in the United States, surplus shirts will pile up in Europe, surplus stockings will pile up in Japan. This is why my linking of the Crash of C29 to the Smoot-Hawley Tariff Act of 1930 is the key to understanding why Say was right and Keynes was wrong. If the Crash occurred because of a speculative bubble, as the Keynesians insist, then the "glut" of overproduction can be explained by a breakdown of Say's Law. Wall Street did not wait for Herbert Hoover to actually sign the sharp increase in our tariff wall in June of 1930. It crashed in the last week of October 1929, when congressional opposition to the tariff turned to support. Because Europeans could not ship goods to us because the tariff wall made them uncompetitive, they could not earn the dollars to buy goods we had been planning to export to them. Smoot-Hawley did not cause the Great Depression. It did put the world on the slippery slope that did result in Depression. Hoover and President Roosevelt compounded the problem by increasing tax rates between American transactors, the domestic equivalent of putting up a wall between American producers and those of the rest of the world. Our example to the rest of the world led everyone else to put their walls up as well, and the world economy crumbled, in accordance with Say's Law.

It is actually easiest to understand Say's Law in the international economy, because the money changing hands as shoes and stockings are exchanged are in different currencies. Keynes argued that overproduction occurs because in a monetary economy there is a "leakage" that does not occur in a barter economy. That is, Keynes theorized that the shoemaker would sell his shoes for dollars and then not spend the dollars, which would mean shirts and stockings would pile up in surplus. Rich people were the culprits, Keynes suggested, because they had a higher marginal propensity to save than poor people, who have a higher marginal propensity to spend:

The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy... that an increased desire to hold wealth... must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished. It is of this fallacy that it is most difficult to disabuse men's minds. [The General Theory of Employment, Interest and Money, London: MacMillan, 1936, pp. 211-212.]

This lovely quote was supplied to me by an e-mail from Jamie Galbraith, an economics professor at the University of Texas, whose father, John Kenneth Galbraith, is primarily responsible for developing the hypothesis that the 1929 Crash was simply the bursting of a speculative bubble. [The Great Crash - 1929, Houghton Mifflin Company, 1954]. In preparing this lesson, I'd queried Jamie on where younger academics stood these days on Say's Law and he indicated that they are indeed being "seduced by old JBS." In the quote, we see Keynes arguing that a dollar spent on buying shirts is more effective than a dollar saved, even though the dollar saved is lent to someone who will spend it. It is of course Keynes who is fallacious, but he was successful in selling his argument during the Great Depression because it led to a political solution. The dollar saved by the rich person would be lent to the government, which would spend it on public works and thus give employment to people who would use their paychecks to buy the surplus shoes.

Among those younger academics being "seduced by old JBS" is Paul Krugman of M.I.T., the resident economist on Microsoft's Slate webzine. In the current issue of Foreign Affairs, Krugman never mentions Say's Law, but he wields it like a sword in slashing away at the current crop of doomsayers, who worry about a global glut. Among them is William Greider, who has a book out on global overproduction, and showed up on the op-ed page of the NYTimes on Oct. 1, "When Optimism Meets Overcapacity." With 6 billion people on the planet, most of them poor, Greider manages to argue that there may not be enough demand for all the plant capacity going into place. fi And when people realize this, the speculative bull market bubble willburst, and we will be in for another Great Depression. Hmmm.Krugman, who is now horrified to learn that he is in the early stages of becoming a full-fledged supply-sider, deals with this in Foreign Affairs, which you should definitely read as part of this lesson.

[T]he spread of industry to newly emerging economies and the rapid growth in exports from those economies has fed the sense that global productive capacity is growing headlong, far too fast for demand to keep up. Indeed, some global glut adherants, notably William Greider, not only believe that growth will lag behind capacity, but warn that the growing gap between potential supply and demand will provoke an economic crisis like that of the 1930s, with output plunging. The doctrine of global glut, then, is a response to some real changes in the world economy.

In the essay, Krugman belittles the mercantilist notion that there is anything necessarily wrong with the U.S. trade deficit. It is in this context that we can see Say's Law at work. If the United States runs a trade deficit with country X, for example, it simply means that we are buying their shoes with our dollars, and they either have to buy our shirts with those dollars, or save the dollars in dollar instruments, such as dollar stocks and bonds. When they buy dollar stocks and bonds, the people who sell them that paper will have dollars to spend on goods and services, and all of them will be spent. There can be no "leakage" of aggregate demand. Even if Country X keeps the dollars under a mattress instead of buying dollar assets, this absence of dollar liquidity will automatically show up at the Federal Reserve, which will automatically supply exactly the number of dollars hidden under that mattress. Old J.B. Say had it right. Krugman, who understands this perfectly, goes so far as to bash Keynes, perhaps the first time in the history of Foreign Affairs that it has allowed this to happen in its pages.

More or less modern concerns about excessive productivity emerged in the 1930s and 1940s. It was natural that some observers would tie the lack of jobs during the Great Depression to the widespread introduction of mass production techniques in the 1920s. Keynesian economics, which legitimized concerns about overall inadequacy of demand, provided an intellectual framework for the idea. During the late 1930s and early 1940s, many economists subscribed to a doctrine often referred to as "secular stagnation" that was quite similar to global glut. Secular stagnationists pointed out that well-off families tended to save a higher fraction of their income than poor ones; thus, they argued, per capita consumer spending would not keep pace with growth in per capita income. The economy could therefore maintain full employment only if investment spending grew much more rapidly than income, which seemed unlikely. So the secular stagnationists predicted a return to depression conditions once World War n was over, and a tendency toward ever-growing unemployment rates over time.

Where Krugman differs from modern supply-siders is that he has essentially reverted to the passive classical posture of the 19th century. Given the Keynesian experience of the last half century, in which all attempts to manage aggregate demand by textbook policies led to failure, it is no wonder that younger, intelligent economists are rejecting those teachings. They are indeed wending their way back to J.B. Say and embrace the law of markets, but as yet they have no active theory on how to improve the wealth of nations. In my limited exchanges with Krugman, he dismisses my activist ideas out of hand on the grounds that I am not a trained, professional and have not sufficient credentials to engage him in discussion. Jamie Galbraith, Ph.D., on the other hand, has all the credentials, but we have a friendly relationship and engage in discussion because we are both looking for ways to improve the world economy. His editorial in the Sept. 29 issue of The Nation, denouncing the idea of a natural rate of unemployment, is in the demand model, although I agree with his conclusions. He says: "The essence of a Keynesian is the belief that the economy can be made to perform better, that we do not live in the best of all possible worlds." By that measure, I'm more Keynesian than Krugman, and I will stipulate that Keynes made an enormous contribution to our understanding of the world political economy and how it works. Krugman, though, is at least on the supply-side path, having come to terms with Say's Law, whether he yet will admit it or not.

Next week will be devoted to Q&A on the first four lessons. Please submit as many as you like and I'll try to get around to all, one way or another. If you are interested in reading more in the area of Say's Law, Thomas Sowell's 1972 history is still in print and available via [Say's Law: An Historical Analysis, Princeton University Press.] Another book useful for your library is Henry Hazlitt's compendium of essays, including Say's quoted above and John Stuart Mill's [The Critics of Keynesian Economics, Van Nostrand, I960].