How often do we hear that government "austerity" is destructive —that it is the job of government, or their central bank, to "stimulate demand"? Or that growth can be gussied up by gobs of government cash? In this guest post, Frank Shostak is here to dismantle those ideas, and to explain that monetary pumping does not create new wealth, it destroys it ...

Does Government Spending and Money Expansion Create New Wealth or Destroy It?

by Frank Shostak

Many economists claim that economic growth is driven by increases in the total demand for goods and services, additionally claiming that overall output increases by some multiple of the increase in expenditures by government, consumers, and businesses. Thus, it is not surprising that most economic commentators believe that a fiscal and monetary stimulus will strengthen total demand, preventing an economy from falling into a recession. [And conversely, that a withdrawal of govt spending will send it there. - Ed.]

These economists believe that increasing government spending and central bank monetary pumping will increase production of goods and services and strengthen total demand. This means that demand creates supply. However, is this the case?

Why Supply Precedes Demand

In the market economy, producers do not produce solely for their own consumption. Some of their production is used to exchange for what others produce. Hence, in the market economy, production precedes consumption. Something is exchanged for something else. This also means that an increase in the production of goods and services leads to an increase in the demand for goods and services.

According to David Ricardo,

No man produces, but with a view to consume or sell, and he never sells, but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.

An individual’s demand is constrained by his ability to produce goods. The more goods an individual can produce, the more goods he can demand. For example, if five people produce ten potatoes and five tomatoes, this is all that they can demand and consume. The only way to consume more is to produce more.

James Mill wrote,

When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation that constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation’s power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation. . . . Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.

The Expanding Pool of Real Savings Key to Economic Growth

Without the expansion and enhancement of the structure of production, it is impossible to increase the supply of goods and services in accordance with the increase in total demand. Expanding and enhancing the infrastructure depends upon expanding the pool of real savings, which is composed of consumer goods and supports those employed producing those necessary goods and services.

Consequently, it does not follow that increasing government spending and employing loose monetary policy will increase the economy’s output. It is impossible to lift overall production without the necessary support from the real savings pool.

For example, a baker produces twelve loaves of bread and saves ten loaves. He then exchanges them for a pair of shoes with a shoemaker. In this example, the baker funds the purchase of shoes by means of the ten saved loaves of bread, which maintains the shoemaker’s life and well-being. Likewise, the shoemaker has funded the purchase of bread by means of shoes that he had produced.

Assume that the baker has decided to build another oven to increase production of bread. To implement his plan, the baker hires the services of the oven maker, paying the oven maker with some of the bread he is producing. If the flow of bread production is disrupted, however, the baker cannot pay the oven maker, so the making of the oven would have to be abandoned. Therefore, what matters for economic growth is not just tools, machinery, and the pool of labour but also an adequate flow of consumer goods that meet the producer’s needs.

Government Does Not Generate Wealth

Government does not produce wealth, so how can an increase in government outlays revive the economy? People employed by the government expect compensation for their work. One way the government can pay these employees is by taxing others who are generating wealth. By doing this, the government weakens the wealth-generating process and undermines prospects for economic growth.

According to Murray Rothbard, 

Since genuine demand only comes from the supply of products, and since the government is not productive, it follows that government spending cannot truly increase demand.

If the pool of real savings is large enough to fund government spending, then a fiscal and monetary stimulus will seem to be successful. However, should the pool of real savings decline, then regardless of any increase in government outlays and monetary pumping by the central bank, overall real economic activity cannot be revived. In this case, the more government spends and the more the central bank pumps, the worse off wealth generators will be, eliminating prospects for a recovery.

When loose monetary and fiscal policies divert bread from the baker, he will have less bread at his disposal. Consequently, the baker cannot secure the services of the oven maker, making it impossible to increase the production of bread.

As the pace of loose government policies intensifies, the baker may not have enough bread left even to sustain the workability of the existing oven since he no longer can afford the services of a technician to maintain the existing oven. Consequently, the production of bread will actually decline.

Because of the increase in government outlays and monetary pumping, other wealth generators will have fewer real savings at their disposal. This in turn will hamper the production of their goods and will weaken overall real economic growth. The increase in loose fiscal and monetary policies not only fails to raise overall output, but on the contrary, it leads to a general weakening in the wealth-generation process.

According to J.B. Say, 

The only real consumers are those who produce on their part, because they alone can buy the produce of others, [while] . . . barren consumers can buy nothing except by the means of value created by producers.

Conclusion

Most economists and economic commentators claim that increases in government spending and central bank monetary pumping strengthen the economy’s overall demand. This, in turn, sets in motion increases in the production of goods and services. Thus, demand supposedly creates supply.

However, to be able to exchange something for goods and services, individuals must first have something by which to exchange. To demand goods and services individuals first must produce something useful. Hence, supply drives demand, not the other way around.

Increases in government spending divert savings from the wealth-generating private sector to the government, thereby undermining the wealth-generating process. Likewise, monetary pumping results in wealth diversion from wealth generators toward the holders of pumped money. Far from stimulating economic growth, government actions hinder it.

* * * * 

Frank Shostak has over 40 years experience as a market economist and central bank analyst. He is an adjunct scholar of the Ludwig von Mises Institute and a member of the board of editors of the Quarterly Journal of Austrian Economics. He is highly regarded for his skills to convert complex economic issues into plain English. He has written articles that have appeared in The Wall Street Journal and in academic journals in Europe and the US. A follower of common -sense economics and damage inflicted from reckless money creation, his Sydney-based consulting firm, Applied Austrian Economics, provides in-depth assessments of financial markets and global economies.

His post first appeared at the Mises blog.

Pic: Mises Wire

A reminder for everyone, as you all wait patiently for economic miracles from a new government, that while Keynesians claim that the source of economic growth is consumer (and government) spending, so-called Austrian economists such as our guest poster Frank Shostak know that the key to a growing economy is net savings . . .

Real Economic Growth Depends on Savings

by Frank Shostak

New Zealand's consumer confidence index is slowly climbing off the floor from its March low, but only weakly. Meanwhile in the US, their consumer sentiment index fell to 69.5 in August from 71.6 in July. 

What does this portend? A weakening consumer sentiment index is seen as indicating a potential downturn in consumer spending and -- to many economists -- of the economy in general.

Why is this? It's because most mainstream economic commentators agree with each other (and with their mentor, John Maynard Keynes) that the key to economic prosperity is individual consumption rather than saving. Saving, they believe, hinders economic growth because it coincides with weakening demand for consumer goods. In this theory, economic activity is depicted as a circular flow of money in which one individual’s spending is part of the earnings of another.

If, however, individuals become less confident about the future, they are likely to cut back on their outlays and "hoard" more money, thereby diminishing the earnings of some other individual, who in turn also spends less. A vicious circle emerges: the decline in confidence leads to less spending and more hoarding, further weakening the economy and eroding confidence in it.

To arrest the downward spiral, according to this theory, the central bank must increase the supply of money. By putting more money in people’s hands, confidence and spending will increase, and the circular flow of money will pick up again.

All this sounds very convincing, and, indeed, business surveys show that a lack of individual demand is the major factor behind poor performance during recessions. But can demand by itself generate economic growth? What about the supply of goods? Are goods always around, just waiting for demand? Is it even possible for demand itself to be scarce?

Scarcity of Means Thwarts Demand

In the real world, demand is not just desire -- it is desire backed up by wherewithal. It is necessary to produce useful goods that can be exchanged for other useful goods. Bakers who produce bread don’t produce everything for their own consumption, but exchange most of it for the goods of other producers. Through the production of bread, bakers exercise demand for other goods. According to David Ricardo:

No man produces but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.

Tools and machinery (i.e., capital goods) raise worker productivity: they must be made, and they increase growth in the production of consumer goods.

Consumer goods must be available to those who produce capital goods, in order to sustain their life and well-being during production. This allocation of consumer goods is made possible by saving—that is, a decision by some individuals to transfer a portion of their consumer goods now, in return for a greater quantity in the future, to those who are producing capital goods now. Despite what the Keynesians assert, it is saving that enables the production of capital goods. and thereby raises individual living standards. It is  saving, therefore, that is the beating heart of economic growth.

Money and Saving—What Is the Relationship?

Money does not alter the essence of saving but does make it easier for producers to exchange their products with one another. It does not produce goods but only facilitates their exchange. According to Rothbard,

Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing.

In a money economy, payments for goods are still made with other goods—money only facilitates the payment. Thus, a baker exchanges saved bread for money and then exchanges the money for other goods, effectively paying with the saved bread. When a baker exchanges with a shoemaker saved bread for money, the shoemaker receives sustenance to continue making shoes.

Saving makes economic activity possible by means of money. We do not save money itself but employ it to channel the unconsumed consumer goods we have saved toward individuals engaged in production. An individual who hoards money is not saving money per se but rather exercising a demand for it, which is never the bad news that popular thinking believes it to be. Saving does not weaken but rather strengthens economic growth.

Money out of Thin Air and Economic Growth

When money is generated out of thin air however it sets in motion an exchange of nothing for money, followed by money for something—that is, an exchange of nothing for something. This leads to consumption not supported by production, i.e., a diversion of saved consumer goods—which are the products of wealth-generating activities—toward those who hold money made from nothing. Diminishing the flow of saved consumer goods toward producers of wealth weakens the production of goods and in turn the demand for goods, setting in motion an economic recession.

What weakens the demand for goods is not the capricious behavior of consumers but an increase in the money supply out of thin air. As long as the pool of consumer goods is expanding, the central bank and government officials can give the impression that loose monetary and fiscal policies are driving the economy. This illusion, however, is shattered once the pool becomes stagnant or declines. Without expanding the production of consumer goods, all other things being equal, economic growth is not possible.

Conclusion

Most people aspire to a good and comfortable life. Standing in the way of this goal are the means that must be produced to achieve it. Saving permits the expansion of these means. The increase in saving, which supports the increase in the production of goods, also generates an increase in demand for goods. Any illusion that demand can somehow be strengthened through the monetary presses is sooner or later shattered by the impossibility of getting something for nothing.

* * * * 

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

His post first appeared at the Mises Wire.

Says Law explains why we don't need a recession to kill price inflation

Image Source: Unsplash

We need to engineer a good recession, say central bankers, to kill the inflation engineered by those same central bankers. But as Alasdair Macleod explains in this guest post, policy makers who believe a recession will kill price inflation, and therefore allow central banks to reduce interest rates, are simply wrong. This is simply mad macroeconomic dogma.

Updating Say’s Law For Modern Times

by Alasdair Macleod

It was Keynes’ offhand dismissal of Say’s law, or the Law of the Markets, in 1936 which is leading us into an economic and monetary crisis.

It was dismissed by him to invent a role for the state.

That is why Keynes is so popular in the mainstream establishment. By dismissing market reality, he invented a whole new branch of economics. Macroeconomics exchanged statistics and mathematics for human action, the prospect of centralised management substituted for ambiguity.

In this article I look at the flaws in macroeconomics, the state theory of money (an old recurring theme from John Law onwards), misleading statistics measured in unhinged fiat currencies, and why Keynesian fears of a general glut are misplaced — all of which stem from the error of dismissing Say’s law.

Importantly, Say’s law ties the volume of production to demand, so policy makers who believe a recession will kill price inflation, and therefore allow central banks to reduce interest rates, are simply wrong.

The state-educated mainstream is so sold on macroeconomic theories and the state management of economic outcomes that reasoned debate gets no traction. The only solution is for a final economic and monetary crisis to bring an end to all macroeconomic dogmas.

The origin of macroeconomics

Jean-Baptiste Say wrote his ground-breaking book on economics in 1803, revising subsequent editions. His Traité D’économie Politique, as it is known in French in short form, described the division of labour and the role of money as the agent for turning specialised production into general consumption. It became known as Say’s law or the law of the markets, and was the first commandment of classical economics, until Keynes persuaded us otherwise in his General Theory published in 1936.

Keynes denial of Say’s law was in the spirit of Humpty Dumpty — ″’When I use a word, it means just what I choose it to mean – neither more nor less.” He rewrote economic definitions to suit his thesis. Humpty Keynes redefined economics to exclude the inconvenient reality of Say’s law, along with many others that logically followed from it. It was necessary for Keynes to deny it in order to ease in a role for the state, allowing governments to intervene in the relationship between production and consumption. 

The invention of macroeconomics, which played down the unpredictable human element expressed in markets, in favour of statistics and mathematical analysis, can be traced to Chapter 3 in his General Theory, where he wrote:

“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.”

Say’s law was summarily dismissed, hardly mentioned again in his seminal work. The whole basis of Keynes’s new macroeconomics, that vitally important chapter of economic theory which remains to be written, boils down to that one little word, “If” heading the quote above. “If” is a supposition and certainly not evidence leading to the discovery of an entirely new branch of economic science. It was a simple trick, dismissing the inconvenient truth early in his thesis so that he could proceed to construct a fantasy. 

Keynes should have been dismissed as a quack, like John Law who propounded similar theories and ruined France in 1720. And like Georg Knapp, a German economist of the Historical school, who published his state theory of money in 1905, arguably encouraging the Kaiser’s government to build up armaments before the First World War at no visible cost to the people, and to continue to finance itself by inflationary means after Germany’s defeat.

Yet with Keynes’s little “if”, here we are nearly ninety years later still travelling along his intellectual rails full tilt into the buffers of economic destruction. The reasons why Law, Knapp, and now Keynes and their theories rose from obscurity to fame are that their theories appeal to governments, seemingly conferring on them an economic role, enhancing their control over their citizens, and therefore the justification for increased power and revenues. The last thing they will consider is that these theories are flawed, until the evidence of a final crisis forces them to face up to their fallacies.

Despite Keynes’s intellectual fraud, the division of labour and the role of money cannot be denied. But the world has moved on from the simpler world of J.B. Say. At the time of the French Revolution when he was observing the economic activities of people, tradesmen probably refused to take credit for payment, accepting only gold and silver coin because paper assignats followed by mandats territoriaux were successively descending into worthlessness.

The more things change...

Plus ça change, plus c’est le même chose! Today, under neo-Keynesian policies directed by the state, it is only forms of credit that intermediate between our production and consumption, and coins are only tokens. Over two centuries ago in rural France, consumption for most was more a question of survival than access to the luxuries we are familiar with today and reckon to be our right. Production was basically local, whereas today it is global. And we now have factories, when few existed in the predominantly agricultural economies of Say’s time because the industrial revolution in France had barely started.

Yet, despite all these differences Say’s central proposition still holds -- Say's Law, the Law of Markets, still links production to consumption; and it still rules out a general glut of goods due to a collapse in consumption. It still holds -- and as long as reality is what it is, it always will. No employment: no demand. No demand: no employment.

However, rehabilitating Say’s Law into modern economics must take account of today’s economic and monetary conditions. Neo-Keynesians ignore the consequences of credit’s loss of purchasing power in their static models. This may confuse the issue for them, but Say’s law still holds whether transactions are in money or credit. (Here, we are defining legal money as a medium of exchange without counterparty risk — gold and gold coin.) Now that we have only fiat currencies whose values in terms of goods are continually deteriorating, statistical evidence is worthless — despite macroeconomists treating long runs of price and related data as if the purchasing power of a fiat currency is constant over time. I have more to say on this below.

In the days of sound money and the credit which took its value from it, we could see the consequences of economic progress and regression on both individual prices and also their general level. Today, we labour under the delusion that what we knew to be true under sound money still applies to unsound fiat currencies and their dependent credit. In all our statistical comparisons we therefore believe that all price changes still come from the values of goods and services. And by dismissing Say’s law, we dismiss the certainty that the purchasing power of unanchored credit will continue to decline even in a recession. So, what are the true consequences of a deteriorating economic condition for prices in a modern economy?

It is far from a simple matter, but as a starting point we can sensibly argue three points. 

• First, just as Keynes dismissed Say’s Law in order to create an economic role for the state, its rehabilitation must reject his supposition entirely and everything that flowed from this error. 
• Second, that with the dismissal of the state from economic functions, macroeconomic statistics-gathering can only have restricted validity, and economic modelling must be dismissed entirely. 
• And third, in economic conditions leading to unemployment not only does consumption decline but production will as well because the unemployed are no longer producing. In other words, there is no such thing as a Malthusian glut, and the hope in some quarters that price inflation will diminish in a recession as demand contracts will be disappointed.

The rest of this article looks at the major issues arising from the Keynesian dismissal of Say’s Law — the law of the markets.

The errors in modern socialism

Perhaps the starkest example of the difference today between a state-controlled economy and a relatively free capitalist one is found in the contrast between the two Koreas. In the North, they are starving. In the south, people of the same ethnicity are prospering. This is not just a fluke. In the late 1940s, China was descending into communism and abject poverty while Hong Kong rose from the ashes of Japanese occupation and the collapse of the military yen into capitalist prosperity with no natural resources of its own. Concurrently with China and Hong Kong, East and West Germany exhibited the same phenomenon until freedom of movement between the two returned.

The empirical evidence of these failures and success are put down to communist extremism by historians and today’s politicians in the western alliance, and they say are different from democratic socialism. But apologists for state intervention and control can argue as much as they like that communism is different from democratic socialism, but they cannot explain away the fact that communism is simply socialism in extremis sharing the same basic flaws as socialising democracy.

Understanding why this is the case is hampered by the superficial attraction of organisational planning applied to spontaneous markets. The former appeals to a surface form of logic, while the latter lacks a ready explanation. This riddle was laid bare by the great economist of the Austrian school, Ludwig von Mises in his 1922 book Socialism: An economic and sociological analysis. The essence of the argument was contained in a further essay, Economic Calculation in the Socialist Commonwealth, written in 1920 and a hot topic for decades thereafter. 

In that essay, Mises laid down the reasons why economic management and intervention by the state would always fail. As the Russian economist, Yuri Maltsev put it, “Mises exposed socialism as a utopian scheme that is illogical, uneconomic, and unworkable at its core.” Maltsev confirmed this from his personal experience as an economist in the Soviet Union.

The difference between communism and democratic socialism can be likened to the fate of a lobster plunged into boiling water compared with that of a frog, who in the modern cliché is cooked from cold. The relative level of authoritarianism is different from the outset but ends up being similar in its final outcome. The demonstrable failures of democratic socialism have led to ever-increasing restrictions on markets, inching it ever closer to communism. The common denial of capitalism and the profit motive as being somehow immoral is part of the pro-state and anti-market propaganda.

The reason the state always fails in its attempt to manage the economy is partly due to its objectives being political in nature rather than economic, and partly due to the impossibility of it entering into economic calculation. It was the latter point which Mises explained so well in his 1920 essay. Irrespective of the politics, it is impossible for a state which owns the means of production in its central planning to know in advance whether its output will be demanded by consumers. Some of it might well be, but assessing the level of demand in the planning of production is impossible. And the state cannot assess the evolution in a product to ensure it will be freely demanded in future. The state therefore resorts to monopolistic behaviour to enforce consumption.

By way of contrast, the capitalist in a free market will use his specialist knowledge to assess demand and seek to respond by supplying his product to consumers profitably. For him, the customer is king. If he fails, he either cuts his losses, or adapts the product to satisfy consumer demands. Production methods and output evolve to satisfy demand, which together define progress. While the state is unable to evolve its production satisfactorily and therefore lacks the fundamental ability to foster economic progress, capitalists seeking profits in free markets improve economic conditions and standards of living wholly in accordance with Say’s Law. In other words, through specialisation the entire cohort of independent manufacturers and service providers together satisfy the general and evolving demands of the markets.

As a matter of reluctant practicality, social democracy permits capitalism to exist. In common with the early fascist policies of Mussolini, capitalism is tolerated so long as it can be controlled by the state. This control is achieved through extensive product regulation, by partial nationalisation of the economy, and by virtue of the fact that state spending is the largest single element in a social democratic economy. This spending is not funded out of production, but by taxes imposed on producers and consumers. A socialising state is promoted as a benefit for society as a whole, but the reality is that is an economic burden in proportion to its size.

Under the aegis of social democracy, the economy becomes increasingly directed away from market freedoms, and it performs progressively less than its potential to improve the living conditions of the population. The economy’s underperformance is invariably blamed upon the private sector by the state when it is the consequence of the state’s own interventionalist policies.

How statistics mislead us all

The social division of labour means that it is always the individual who deploys his or her skills in order to consume — consumption which is personal to the needs and desires of the individual. While there are needs common to each individual, the consumption of which goods and services an individual actually desires cannot be forecast by any observer. Much of tomorrow’s demand is spontaneous and is not even known in advance to individual consumers. 

Even if they are accurate, the gathering of statistics measuring this demand can only be of its past history. It is a gross error to think that demand statistics valid in the past can be projected into the future and retain any true relevance. We see this in the continual failure of economic modelling and econometric forecasts. It is one thing for an economist to further his understanding of a branch of human science, as a branch of psychology, and another to assume it is a natural science, such as physics or biology. The former cannot be averaged and predicted, while the latter can be statistically quantified. No wonder Keynes, whose primary discipline was mathematics, preferred to dismiss Say’s law in favour of mathematical and statistical analysis.

Mention has already been made above of the mistake in comparing prices of goods and services over time valued in fiat currencies. The chart below of WTI oil, a basic unit of energy upon which almost the entire global population depends, illustrates the enormity of this mistake.

The two prices are in legal money, which is gold, and in fiat dollars, which is currency. Since 1950, when the price of WTI oil was $2.57 per barrel and in gold grammes it was 2.28, in dollar terms the price has soared to around $70 today, a multiple of over 27 times. Yet in gold, it is 1.14 grammes, having exactly halved. In legal money the price has been considerably less volatile than in dollars. The riddle posed to us by this chart is which price should be used for valuing oil — a depreciating and volatile dollar, or a relatively stable legal and sound money?

Clearly, it is long-term dollar price comparisons which are badly flawed. Yet market traders, proud to call themselves macroeconomists without understanding the implications of the term, maintain their long-term charts of oil and other commodities in dollars wholly unaware of their falsity. Furthermore, everything which can be traded is valued in fiat dollars and other currencies, from financial assets to housing. The next chart is of residential property in London, priced in pounds and gold.

Anyone who observes the residential property market in the UK will tell you what an excellent 'investment' it has been, nowhere more so than in London. But this statement only holds for a fiat pound, which since 1968 has lost over 99% of its purchasing power measured in real legal money, which is still the gold sovereign coin. Today, the value of London residential property in gold has risen by a paltry 14% since 1968, compared with 116 times in depreciating pounds. Yet, the plain facts are met with widespread disbelief.

Under the fiat currency regime, values of everything are a flawed concept, reflecting not changes in subjective values so much as that of declining fiat currencies. But this statistical legerdemain which fools everyone extends to other areas of the statistical universe. Labour productivity analysis is a nonsense because of the underlying assumptions, and the lack of consideration of the costs to an employer of employment and other labour taxes. The approach is always from the statist viewpoint, whereby politicians wish to see higher output per worker promoting higher tax returns. It is never that of an employing businessman who is the only true assessor of the costs and benefits of employing the various forms of labour in his enterprise profitably.

GDP and government spending

To confuse gross domestic product with economic growth, itself a meaningless term when economic progress is implied, is a further error. Governments are fixated on GDP, which must always grow. GDP is not economic growth, but growth in the total currency value of transactions, usually over the course of a year or annualised.

If the currency is debased by its inflationary issuance, nominal GDP increases to the extent that debasement feeds into the GDP statistic. Inflation of the currency is particularly associated with increased government spending, so virtually all the increase in it fuels GDP. In the past, governments have regularly outperformed market expectations of GDP growth by the simple expedient of increasing government spending. Investors failing to understand this trick see it as positive, and stock markets rise on the news. GDP is only good for allowing a government to estimate prospective tax income. Otherwise, it is a useless and misleading statistic.

As stated above, GDP is routinely and unconsciously confused with economic progress. But a moment’s reflection will show that progress cannot be statistically measured. Progress is a concept which at its fundamental level is an improvement in a person’s living standard. There is no doubt that entertainment technology, in the form of televisions, gaming computers, and other electronic equipment all of which have fallen in price have improved many people’s enjoyment immensely. GDP incorporating declining prices for these products is bound to undervalue these benefits, and by classifying their prices as deflationary might even claim they detract from economic growth. Yet, government spending which is funded by removing purchasing power from producers and consumers and is therefore a brake on progress is classified as positive due to its inclusion in GDP.

During the covid crisis, when much of the productive economy shut down UK government spending rose to about 50% of GDP, though since then it has declined to an estimated 43% in the last fiscal year (to April 5th, 2023). Similar increases occurred in other nations. In Europe, French government spending peaked at 61.3% of its economy in 2020, declining to 58.1% last year. In Italy it was 57% and 56.7% respectively, and in Spain, 52% and 47.8%. With these levels of state spending, when analysing GDP it is extremely important to decide how to treat it.

Government economists are bound to argue that government spending is important in economic terms, and that GDP growth must include it. Furthermore, on a consumption basis it is argued that spending by government employees must be included, as well as government demand for goods and services. While this might appear to be a valid point, it misses the bigger picture.

While it is true that state employees’ and departmental spending are part of the total economy, the state’s taxes which fund them reduces income available for consumption for those not employed by the state. Government spending as a whole replaces it with the provision of services not freely demanded, which is fundamental to the benefits which flow from Say’s law — the law of the markets.

You don’t have to look far for examples of how state spending is a burden on overall economic activity, and that the successful economic approach is to free up the private sector, eliminating government and its intervention as much as possible. It is this approach which led to the remarkable success of Hong Kong in the post-war decades, compared with the poverty inflicted on the same ethnic people on the mainland under Mao Zedong where government was 100% of the economy.

Convincing the establishment that inflating GDP ends up suppressing economic progress is an uphill struggle. Instead of accepting the empirical evidence, governments routinely use their tax-raising powers to increase economic intervention, spending as a proportion of the whole, and debasing the currency by deliberately running budget deficits.

This leads to a conflict between politicians seeking to represent the electorate’s interests and the state itself. Politicians on the right vying for office are usually free marketeers with ambitions to reduce the state’s presence as a proportion of the total economy. They are appointed with a zeal to take an axe on spending and bureaucracy, but there are good reasons why they never achieve it. When they gain ministerial responsibility, their priority changes to protecting their budgets from being reduced, because cuts in departmental spending amount to a loss of power. Therefore, to the extent that any savings on spending are achieved, ministers always want to come up with other plans to maintain or increase funding levels. The negative economic consequences simply rack up, and the government’s share of GDP inexorably tends to increase.

This is the true legacy of confusing GDP with economic progress. While the transactions that together make up a GDP total can be measured, their true value in terms of the satisfaction and the progress in the quality of life they provide cannot. The only way in which they can be measured is by each individual in a community and nation, and not by those who claim to represent them.
Why there cannot be a general glut

The Keynesian error of believing that a recession leads to a general glut, and therefore a fall in the general level of prices, has its origin in the 1930s depression. But it is obvious that under the conditions of the division of labour, whereby people are employed to produce so that they can consume, this cannot be true in a general sense, because production must decline as well as consumption when unemployment rises. In other words, a general glut of unsold produce cannot arise, because the unemployed are no longer producing.

Nevertheless, Keynesian fears of a glut when a recession occurs and unemployment rises leads modern governments to create demand in a recession by increasing welfare benefits. According to the Keynesian playbook, this funding is stimulative by means of inflationary deficits, intended to help stabilise prices as demand weakens. But without a general glut and a stable currency the overall level of prices is unlikely to change significantly in real terms when there is no government intervention because of Say’s law.

Modern governments intervene by deficit spending without contributing to production. Instead of a recession leading to surplus production, government spending leads to surplus demand. This explains how the inflationary effects of Keynesian stimulation can lead to significantly higher prices, even in a slump, as was seen in Britain’s inflationary crisis in the mid-1970s. It is also entirely consistent with the factors driving an economy into a slump during a currency’s collapse, such as witnessed in the European inflations in the early 1920s.

So, what happened in the 1930s, disproving Say’s law in the minds of the neo-Keynesians?

The first error in their analysis was not understanding the consequences of the inflationary 1920s. They were fuelled by the Fed’s expansionary monetary policies under the leadership of Benjamin Strong, and President Hoover’s anti-capitalist, interventionist policies at the peak of the credit cycle. The inevitable consequences were a speculative bubble followed by a financial crisis between late-1929 and 1932 which wiped out thousands of banks and their credit, which were the backbone to maintaining economic activity. And this was followed by Hoover’s heavy handed interventionism.

Hoover also raised income taxes significantly to fund his interventions. Despite these increases, during Hoover’s tenure the Federal Government’s deficit to GDP soared from a 0.7% surplus to a 6.4% deficit and these deficits continued under Roosevelt, though they lessened as the banking crisis passed.

Not only did banks go bust in their thousands, but there were other factors. The Smoot-Hawley Tariff Act, which built in higher tariffs on top of those of the Ford McCumber tariffs of 1922, was signed into law by President Hoover in 1930. So, not only was bank credit in the economy imploding, but including tariffs the prices of imported goods and therefore the production costs of most American manufactured products were raised to uneconomic levels. It was a fatal combination, because little could be produced profitably at a time when there was little or no bank credit available. Consequently, US GDP contracted from $103.6bn in 1929 to $56.3bn in 1933. This was not the same thing as a general glut, because demonstrably both production and consumption contracted. Primarily, it reflected a collapse in bank credit.

While credit had become freely available in the previous decade, the introduction of tractors and other farm machinery had led to a massive expansion of agricultural output. Prices of agricultural produce, which were already declining due to oversupply, were bound to fall even more when credit was withdrawn by failing local banks in America. The farming community was forced to sell its output at anything they could get for it, because of the lack of credit.

This was a specific market adjustment at a time when worldwide cereal and other agricultural output prices were falling due to overproduction. The slump in prices attributable to the banking crisis hit farmers particularly hard, not just in America but worldwide through values reflected on the commodity exchanges.

Because American farmers were forced sellers of their agricultural output, it was later assumed by Keynes and other economists that there was a glut and that Say’s law was therefore flawed. But the mistake was to miss the links between the collapse in bank credit from bank failures, the pressure on farmers to dump their product at any price, and the coincidence of global overproduction due to the rapid advances made in mechanisation in the previous decade.

The causes of the 1930s depression and its longevity were clear — you need look no further than empirical evidence. Long before Keynes traduced Say’s law, both Hoover and Roosevelt with his New Deal made the depression considerably worse than it would otherwise have been, acting as proto-Keynesians. It was the first time that the Federal Government had intervened in what would otherwise have been two or three years of economic and credit hiatus, which had been the experience of previous episodes. The previous depression in 1920—1921 lasted only eighteen months without statist intervention. Before President Hoover’s tenure, it was generally acknowledged that intervention only made things worse, and that left alone, a slump in business activity would correct itself.

Economists subsequently formulating statist policies badly misread the causes of a slump. They still fail to appreciate that there is a cycle of bank credit, identified by economists of the Austrian school as a business cycle. It is caused by bankers acting as a cohort increasing the quantity of credit to a point when their balance sheet exposure becomes excessive relative to the bankers’ own capital, and they then try to reign in their balance sheets. This is not a conspiracy between bankers, but reflects their human behaviour, and is cyclical in nature. It can be traced for so far as reasonable records exist, in the UK as far back as the end of the Napoleonic wars. And it is a cycle of credit expansion and contraction averaging roughly ten years.

Even for economists, it is always easier to observe the evidence of an economic downturn than its underlying cause. In all the voluminous analysis of the great depression, the cycle of bank credit is hardly mentioned. Only economists of the Austrian school have pointed out that the depression was the natural consequence of excessive credit expansion in the previous decade. And Keynes’s followers with their mathematical and statistical macroeconomics are still blind to the role of bank credit underlying booms and slumps. They think they can model the economy, steering it from one objective to another by supressing free markets. But they cannot model human bankers’ balance of greed for profit and fear of losses.

Economic and monetary policies ignore Say’s law — the law of the markets — persisting in their failed interventions. The response to failure is usually to claim that the error was to not intervene enough. A feature of these failures is for policy makers to seek solace with their international counterparts, doubling down in a group-thinking effort to achieve statist objectives.
The errors in currency management

This week, the persistence of consumer price inflation in the UK has even led a member of the Monetary Policy Committee to say that interest rates will have to be raised to the extent that the UK economy enters a recession. But with broad money supply, no longer expanding, we can see that there’s something wrong with his analysis. At the same time, all commentary on stubborn price inflation is about too much demand for too few goods. Changes in the purchasing power of the currency are never mentioned. While individual prices fluctuate, when the general level of prices increases it can only be because of changes in a currency’s purchasing power.

There is only one reason why the purchasing power of a fiat currency changes, and that is in the behaviour of its users. By adjusting the relationship of their immediate liquidity to their spending, collectively they can have a profound impact on its purchasing power. This is why the state theory of money fails, and the monetary authorities always fail to control the purchasing power of their fiat currency. A currency must be anchored to real money, which is gold coin.

When banknotes were fully exchangeable for gold coin, their purchasing power remained constant irrespective of the quantity in circulation. But banknotes are typically less than a tenth of the circulating medium, the balance being bank credit. The relationship between bank credit and banknotes is almost parity. Therefore, so long as counterparty risk between a bank’s depositors and the bank is not an issue, bank credit will always take its value from the currency. It is the currency which must be credible.

In the first of the two charts above of WTI oil priced in dollars and gold, we can see that the price of oil in dollars was stable between 1950 and 1970, when the dollar price increased from $2.57 per barrel to an average of $3.35. At that time, the dollar was loosely tied to gold through the Bretton Woods agreement, with only national central banks and organisations such as the IMF able to exchange dollars for gold. During that time, M3 money supply increased from $172bn to $750bn, an increase of 336%.

This was not the only example. Between 1844 (the time of the Bank Charter Act) and 1900, the wholesale price index was unchanged, and it was also remarkably stable over that time fluctuating little. But between 1844 and 1900, the sum of Bank of England banknotes in circulation and commercial bank deposit obligations increased eleven times —almost entirely bank credit with the Bank of England’s note issue being little changed — and there was a material increase in the quantity of short-term, commercial bills funding foreign trade as well. Monetarist theory would suggest that the expansion of credit on such a scale would undermine the purchasing power of the currency, but plainly it did not.

The reason the expansion of bank credit need not undermine a currency’s purchasing power is that so long as the level of credit is genuinely demanded by economic activity instead of financing excess consumption, its expansion does not drive up prices. The source of excess consumption is to be found in government deficit spending because individuals always have to settle their debts while a government does not. As mentioned above, governments can always resort to deficit spending.

From this we know that government fiscal and monetary policies coupled with its fiat currency are the sole reasons behind a deteriorating purchasing power for its currency. Indeed, the Keynesians deliberately target a continual rate of debasement reflected in a CPI inflation rate of 2% by using monetary policy in an attempt to regulate credit demand.

The solution: leave markets alone and bring back sound money

If monetary stability is to return, all attempts by governments to manage private sector outcomes which have always failed and will continue to do so must be abandoned. And sound money, that is to say a gold coin standard freely available to ordinary people at their choice must be re-established. Interest rates would then stabilise at risk-free annual rates of just a few per cent set by markets in the context of demand for investment capital and the availability of savings. Market stability will automatically follow. The diversion of human activity into speculation will diminish, benefiting the economy from its redeployment into more productive pursuits. No longer would we have governments attempting to chase monetary objectives which bankrupt homeowners with mortgages as a result of misguided Keynesian policies.

A return to sound money clips the wings of high spending politicians, but other specific changes must also be introduced, reversing Keynesian macroeconomic policies entirely:

• Government spending must be reduced substantially, with an initial target for it to be no more than 20% of the economy. This will reduce the tax burden on productive businesses and workers for the benefit of non-inflationary progress. It will require extensive legislation to be passed eliminating mandated spending commitments.
• The policy of regulating goods and services must be abandoned, and responsibility for judging product suitability handed back to individuals.
• All taxation must be removed from savings, interest earned, and capital gained: savings will have already been taxed when earned. Savings are the necessary source of investment funding for economic progress. And citizens must be encouraged to save for their future, because the state must withdraw from providing widespread welfare, restricting it to a bare minimum for genuine need.
• Inheritance taxes and death duties must be rescinded. Families should be allowed to accumulate and pass on wealth which is otherwise destroyed the moment it is acquired by government. 
• Protectionist trade policies must be abandoned in favour of free trade. The benefit to an economy from the comparative advantage of buying the best suited products from anywhere are enormous, as the evidence from entrepôt economies, such as Hong Kong, confirms.
• Government ministers must not be permitted to accept lobbying by pressure groups and businesses, because their democratic responsibility is to the entire electorate.
• All central bank activities must cease and replaced by a note issuing authority regulating the relationship between gold coin held in reserve and the face value of notes in circulation. The relationship should be laid down by law, funded by government, and for the gold coin to note relationship to be maintained at a 40% minimum at all times. It must be coin and not bullion in order to be available to the entire population. A bullion standard risks foreign arbitrage in potentially destabilising quantities.
• Foreign policy must be amended to not interfere in other nation’s politics, except where national interests are demonstrably affected.
• Government spending must be fully accountable. All revenue received by the Treasury must be hypothecated — no more robbing Peter to pay Paul.

Clearly, these reforms will not happen before an existential crisis serious enough to force a complete policy overhaul. Even then, it depends on government ministers and bureaucrats correctly diagnosing the reasons for the crisis, which with all of them in thrall to neo-Keynesian macroeconomics and the realisation and admission of their own roles in creating a final crisis is extremely unlikely to happen in a Damascene fashion. Instead, a period of policy vacillation is likely, leading to a danger of political instability and a retreat into yet more socialism.

The final crisis brought upon us by Keynesian policies will almost certainly not mark the end of all our troubles.

* * * * 

Alasdair Macleod is Head of Research for Goldmoney. He has been a celebrated stockbroker and member of the London Stock Exchange for over four decades. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy.

Follow him on Twitter.

His article previously appeared at the Cobden Centre, UK.

Government "Stimulus" Schemes Fail Because Demand Does Not Create Supply

Keynesian economists believe in the magical thinking that, if government spends more money, then it creates wealth in the process by allegedly "creating demand." But as Frank Shostak explains in this guest post, the only thing that can create demand for goods is genuine wealth generation. In short, the magical thinking of government "stimulus" schemes fail because demand does not create supply ...

Government "Stimulus" Schemes Fail Because Demand Does Not Create Supply

Guest Post by Frank Shostak

By popular thinking, the key driver of economic growth is the increase in total monetary demand for goods and services. It is also held that overall output increases by a multiple of the increase in money expenditure by government, consumers and businesses.

It is not surprising, then, that most commentators believe that through fiscal and monetary stimulus, government can prevent the US economy falling into a recession. For instance, increasing government spending and central bank monetary pumping will strengthen the production of goods and services.

It follows then that by means of increases in government spending and central bank monetary pumping the authorities can grow the economy. This means that the demand for the Reserve Bank's paper creates the supply of real goods and services -- in short, that demand creates supply. However, is this truly the case?

Why Does Supply Precede Demand?

In the real world, before something can be consumed if must first have been produced. In the free market economy, wealth generators do not produce everything for their own consumption. Part of their production is used to exchange for the produce of other producers. Hence, production always precedes consumption, with something exchanged for something else. This also means that an increase in the production of goods and services sets in motion an increase in the demand for goods and services.

According to David Ricardo:

No man produces but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.

Note that one’s demand is constrained by one’s ability to produce goods, and the more goods that an individual can produce the more goods he can demand. If a population of five individuals produces ten potatoes and five tomatoes—this is all that they can demand and consume. The only way to raise the ability to consume more is to raise their ability to produce more. In this sense, demand is understood as desire backed with wherewithal -- in this case, with real goods.

On this James Mill wrote:

When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation's power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation…. Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.

Expanding Pool of Savings Is the Key to Economic Growth

Without the expansion and the enhancement of the production structure, it will be difficult to increase the supply of goods and services in accordance with the increase in the total demand. The expansion and enhancement of infrastructure hinges on the expanding pool of savings (this pool comprises of final consumer goods). The pool of savings is required in order to support various individuals that are employed in the enhancement and the expansion of the infrastructure.

Consequently, it does not follow that an increase in government outlays and loose monetary policy will lead to an increase in the economy’s output. It is not possible to lift the overall production without the necessary support from the flow of savings.

For instance, a baker produces ten loaves of bread and exchanges them for a pair of shoes with a shoemaker. In this example, the baker funds the purchase of shoes by producing the ten loaves of bread. Note that the bread maintains the shoemakers’ life and well-being. Likewise, the shoemaker has funded the purchase of bread by means of shoes that maintains the bakers’ life and well-being.

Assume the baker has decided to build another oven in order to be able to increase production of bread. To implement his plan, the baker hires the services of the oven maker, paying him with some of the bread he is producing. The building of the oven here is supported by the production of bread. If for whatever reasons the flow of bread production is disrupted, the baker would not be able to pay the oven maker. As a result, the making of the oven would have to be abandoned.

Hence, what matters for economic growth is not just tools, machinery and the pool of labour, but also an adequate flow of consumer goods that maintains individuals’ life and well-being.

Government Does Not Generate Wealth

Government does not produce wealth -- government in general is a consumer, not a producer -- so an increase in government outlays cannot revive the economy. Various individuals who are employed by the government expect compensation for their work. One of the ways it can pay these individuals is by taxing others who are generating wealth. By doing this, the government weakens the wealth-generating process and undermines prospects for economic recovery.

According to Murray Rothbard:

Since genuine demand only comes from the supply of products, and since the government is not productive, it follows that government spending cannot truly increase demand.

Certainly, governments fiscal and monetary stimulus do appear to improve the economy -- if, that is, the flow of existing real savings is large enough to fund all the government-sponsored activities, while still permitting a growth rate in the activities of wealth generators. If the flow of savings is decreasing, however, overall real economic activity cannot be revived regardless of any increase in government outlays and monetary pumping by the central bank. In this case, the more government spends and the more the central bank pumps, the more will be taken from wealth generators, thereby weakening any prospects for a recovery.

For example, when loose monetary and fiscal policies diverts bread from the baker, he will have less bread at his disposal. Consequently, the baker will not be able to secure the services of the oven maker. As a result, it will not be possible to boost the production of bread, all other things being equal.

As the pace of loose policies intensifies, a situation could emerge whereby the baker will not have enough bread left to even sustain the workability of the existing oven. (The baker will not have enough bread to pay for the services of a technician to maintain the existing oven in a good shape). Consequently, the production of bread will actually decline.

Similarly, other wealth generators, because of the increase in government outlays and monetary pumping, will have less savings at their disposal. This in turn will hamper the production of their goods and services and will retard and not promote overall real economic growth. As one can see, not only does the increase in loose fiscal and monetary policies not raise overall output, but on the contrary, it leads to a weakening in the process of wealth generation in general.

According to Jean-Baptiste Say:

The only real consumers are those who produce on their part, because they alone can buy the produce of others, [while] … barren consumers can buy nothing except by the means of value created by producers.

Conclusion

In popular thinking, increases in government spending and central bank monetary pumping strengthens the economy’s overall demand. This, in turn, the thinking goes, sets in motion increases in the production of goods and services, leading to the belief that “demand creates supply.”

If individuals do not allocate enough savings in order to support increases in the production of goods and services, however, the economy cannot expand. In order to be able to exchange something for goods and services, individuals must first have something to exchange. This means that in order to demand goods and services, individuals must first produce something useful.

Hence, supply drives demand, not the other way around. Increases in government spending result in the diversion of savings from the wealth-generating private sector to the government, thereby undermining the whole wealth generating process. Likewise, monetary pumping sets in motion the wealth diversion from wealth generators toward the holders of pumped money.

 Frank Shostak

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. He received his bachelor's degree from Hebrew University, his master's degree from Witwatersrand University, and his PhD from Rands Afrikaanse University and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University.

A version of this post first appeared at the Mises Wire.

"One cannot Sell without at the same instant and in the same act Buying, nor Buy anything without simultaneously Selling something else..." #QotD

"A market for Products is products in Market. The fundamental thus tersely expressed may be formulated more at length in this way: One cannot Sell without at the same instant and in the same act Buying, nor Buy anything without simultaneously Selling something else; because in Buying one pays for what he buys, which is Selling, and in Selling one must take pay for what is sold, which is Buying. As these universal actions among men are always voluntary, there must be also an universal motive leading up to them; this motive on the part of both parties to each and every Sale can be no other than the mutual satisfaction derivable to both; the inference, accordingly, is easy and invincible, that governmental restrictions on Sales, or prohibitions of them, must lessen the satisfactions and retard the progress of mankind."

~ Arthur Latham Perry, from his best-selling Principles of Political Economy (1891)

QotD: The law of markets ...

"Supply facilitates demand, and demand is constituted by supply. If you understand this and the implications, you understand the market economy. And can figure out economic policy."~ Per Bylund.

Politicians–and everyone else—still don’t understand Say’s Law

[Editor's note: How do you do away with a “Law” that had been core to economists’ understanding of the market economy for 150 years? You misrepresent it.
    On Thursday US Energy Secretary Rick Perry on declared "you put the supply out there and the demand will follow." It appears that Perry was attempting to invoke Say's Law, and many professional economists and pundits quickly took to mocking both Perry and Say's Law for making assertions contrary to modern Keynesian orthodoxy.
    Below, economist Per Bylund explains in this Guest Post what Say's Law really says, how Keynes misrepsented it, and why understanding the Law is still a good thing.]

Few concepts are as misunderstood as the so-called Say’s Law. In part, this is the fault of John Maynard Keynes who, needing to do away with it to make room for interventionist policy, did much to make it mis-understandable. How do you do away with a “Law” that had been core to economists’ understanding of the market economy for 150 years? Simple: You misrepresent it. Strawmen are so much easier to knock over than the real thing.

Hence, the “Law” is presently known in the misbegotten terms Keynes gave it, that “supply creates its own demand,” something that is obviously untrue.

Originally, however, Say’s Law was different. It even had a different name. Economists prior to Keynes tended to refer to it simply as the Law of Markets, so-called because it describes in very simple terms the fundamentals of how a market functions. Jean Baptiste Say was simply the earliest to express the law, which may be why it has come to bear his name.

Say noted 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.

This means that

As each of us can only purchase the productions of others with his own productions — as the value we can buy is equal to the value we can produce, the more men can produce, the more they will purchase.

In other words (and this still shocks postmodern economists), production necessarily precedes consumption; and (in the way Keynes’s mis-statement should be re-ordered) anyone’s demand is constituted by their supply.

The Law of Markets thus summarises the nature of market actions where production is specialised under the division of labour. Specifically, that we produce to sell, with the intention to then use the proceeds to buy what we really want. Market production is in other words indirect and not undertaken to directly satisfy one’s own wants. We produce instead to satisfy other people’s wants, and can thereby satisfy our own by purchasing what others produce.

The benefit is that there is a separation between what I want to consume and what I produce, which means we can each specialise in producing something we are comparatively good at instead of producing only what we want to consume. It also means we can specialise in producing only one thing instead of a multitude, thereby cutting switching costs, develop skills and expertise, increase knowledge, and consequently increase output.

But while universal specialisation under the division of labour means that overall output is significantly increased, it also means we become dependent on each other in trade. Not only do we need to sell what we produce to others in order to get the means necessary, but we need to also trade with those who produce what we want to satisfy our wants. We become interdependent – and voluntarily so. This is why Ludwig Von Mises stated that

Society is division of labour and combination of labour. In his capacity as an acting animal man becomes a social animal.

This “social animal” benefits from, engages in, and in fact arises out of market (inter)action. As we can only benefit ourselves by properly aligning our own productive efforts with what other people want, we must understand other people. By doing so, we can better anticipate what needs and wants they have and then busy ourselves with attempting to meet those needs. And because production takes time, production must precede demand.

Because demand is unknown, production is necessarily speculative and entrepreneurial. Actual demand will be discovered when the goods are presented to potential buyers. Entrepreneurs are therefore forecasters, project appraisers, and risk-takers; in an advanced economy they advance funds to owners of labour and capital, and only recoup this investment if they succeed in selling the product.

At the same time, the consumers can only buy if they have themselves engaged in production that satisfies other people’s needs — because otherwise they will only have the willingness but not the ability to buy (and that is not demand). This is not a circular argument but an integration at the “macro” level – and also an explanation for economic growth. The ability to sell goods in the market and thus engage in specialised production requires prior investment [i.e., a ‘wages fund’ – Ed.]. So to specialise one needed to first produce demanded goods in excess of one’s own wants. The same is true today: development of a new good requires investment, and that investment is speculative because actual demand cannot be known until it is too late.

The implication is that there can never be a general glut in the economy and therefore no “deficiency” in what Keynes called “aggregate demand.” It is however certainly possible for there to exist a surplus or shortage of any particular commodity, which happens regularly as entrepreneurs fail to precisely anticipate and therefore meet market demand, but only in the short term.

As all production is undertaken to sell the goods produced to then purchase goods that better satisfy the producer’s want, the inability to sell becomes an inability to demand. We cannot demand unless we first produce the means to demand. It is thus not a “demand deficiency” that someone is unable to sell what he or she produce, and consequently cannot demand goods in the market. Rather, it is a production failure that causes a reduction in effective demand — specifically, an entrepreneurial failure.

If government stimulates demand, then this only subsidises those goods that have been produced at too high cost. Consequently, the entrepreneurial errors are propped up and production therefore remains misaligned with demand.

So it is easy to see why proponents of interventionism would want to do away with the Law of Markets. If demand is not constituted by supply, then markets may not clear and government must save us from ourselves. Something every government today feels compelled to promise.

---

Per Bylund is assistant professor of entrepreneurship & Records-Johnston Professor of Free Enterprise in the School of Entrepreneurship at Oklahoma State University. Website: PerBylund.com.
This post previously appeared at the Mises Wire. It has been lightly edited.

Quote of the Day: Consumption is the product of an expanding economy, not its cause

"The purpose of economic activity is consumption, both now and in the future. Nobody works for no reward. Month to month, and even year to year, consumers who decide to run down their savings can, of course, trigger greater demand and greater GDP growth.

"But that isn’t sustainable. Over long periods of time, consumption isn’t the real driver of growth: it is the product of an expanding economy, not its cause.”
~ Allister Heath, from his Telegraph article ‘Yes, Supply Does Create its Own Demand*'

* Technically not correct ...

[Hat tip Julian D.]
.

Say’s Law in context

 

Peter Anderson explains in this guest post the widest and most misunderstood integration in all of economics.

A broader understanding of "Say's Law of Markets" would assist those who continued to be puzzled by macroeconomic questions, but even better would be to understand the context in which this Law was formulated. Say not only built a case for the essential stability of a free market (in contrast to the instability of the present mixed economy) but also made the case for the free society against every alternative. 

It is an unfortunate facet of the history of economic thought that Jean Baptiste Say (1767-1832) has been largely discussed only for his law of markets or Say's Law. The marginalisation of Say's work as a whole¹ is due largely to his own poor definition of his law of markets – erroneously said by Keynes to read ‘'supply creates its own demand” – which comprises chapter XV in Book I of his Treatise on Political Economy, and to Keynes’s deceitful assassination of his law.²

English Classical Economists James Mill and David Ricardo improved Say’s formulation and integrated the idea of Say’s Law into classical theory: “The production of commodities creates, and is the one and universal cause which creates a market for the commodities produced,” explained Mill; “productions are always bought by productions, or by services; money is only the medium by which the exchange is effected,” expanded Ricardo.  John Maynard Keynes Keynes's attempted refutation of Say's Law in his General Theory however relied upon formulations of the law by J.S. Mill and Alfred Marshall—and from the entirely unknown Harlan McCracken who coined Keynes’s erroneous reinterpretation.² 

Even authors generally sympathetic to Say's writings however have neglected to integrate his law of markets into the whole of his Treatise.  For example, Joseph Schumpeter attributes the Keynesian attack on Say's law of markets as the reason for giving the law more significance than it deserves.³  Even Murray Rothbard – who considers Say as a “proto-Austrian” – states that Say's law of markets is a "relatively minor facet of his thought."⁴

The misunderstanding of the importance of Say's Law is due to looking only at chapter XV of Book I without observing how it fits into the complete Treatise. Say's Law is like a pane in a stained glass window. When one removes the pane it loses its significance; only when the pane is placed in the window as a whole can we accurately view the beauty of the edifice. Such is Say's Law.

Jean Baptiste Say grasped the fundamental problem of economics, in that we live in a world of scarce means, but have unlimited desire or demands. Only such things as sunlight, air, or water are freely afforded to man. Thus man uses nature to transform goods that give utility to others.⁵ In conjunction, Say recognized that all men were both producers and consumers.⁶

From these two basic truisms arises Say's Law. If individuals wish to procure a good they must give something in return that is also desirable to individuals. This is not simply an economic law, but a basic law of reality: production must precede consumption. 

Therefore in order for one to be a consumer one must first be a producer of a good in which others find utility. Thus individuals desire the commodity of money not as an end in itself,⁷ but rather as a means to procure more desirable goods. However, in order to acquire money one must first produce a good that will exchange for money.⁸

The most important point in Say's formulation is that the individual must not just produce and keep on producing, but produce something that is desirable to others. It is from the erroneous statement "supply creates its own demand" that is derived the fatuous notion that Say had said that as long as something is produced it will readily find a market. This was not Say’s Law but Keynes’s caricature of it that cretins such as Krugman still satirise.

This idea conjures connotations of Ricardo's labor theory of value in which a product is endowed with value simply due to the exertion of labor in its production. However, Say explicitly refutes Ricardo's labor theory of value and aptly states that it is consumer demand that induces a producer to undergo the costs of production.⁹  J.B. Say consequently uses his law of markets and apt understanding of utility to demonstrate why gluts of commodities will not be a long run phenomenon. 

Say admits that there can be short-term gluts of a particular commodity. However, this can only happen if supply has not accurately met demand, or if others do not have goods to exchange in return. Say very precisely deals with the first point by showing that the profit and loss mechanism in production will drive producers away from unprofitable production to areas that promise a greater return. The only thing preventing such a beneficial change in production would be the interference of the government or a natural disaster.

As to the second point, Say uses the example of a European backwater such as Poland. He says that it would not be advantageous for a producer to take his goods to a poor country like Poland because they are lacking in goods to exchange. Thus there would be no glut in a poor market such as Poland, merely the inability to exchange goods. Also this would not produce a long-term glut because the producer could take his goods to a wealthier country such as England and quickly find a market – the idea of the adventurer.¹⁰

We have now seen in essence what has become known as Say's Law. However, this law of markets does not have much importance if it is excluded from the rest of the Treatise. For example, Say devotes the last chapter of Book II to analyze the effects of political economy on population. 

J.B. Say comes to a Malthusian understanding that population is limited by means of subsistence. However, Say realises this does not have to continue perpetually . Greater production and cheaper goods allow for population growth and, conversely, whatever may inhibit production in turn decreases population.^{11 12} This acknowledgement combined with the most basic premise of his law – that one good must be exchanged for another good – led Say to rail against those policies that would reduce the amount of goods exchanged and subsequently diminish national wealth. Thus the crux of Say's advocacy for a laissez-faire society is revealed.

J.B. Say did not advocate private property out of some desire to protect the bourgeoisie. Instead Say advocates private property because he views it as the greatest encouragement to increase national wealth. Only when one can enjoy the fruits of their labor will folk feel inclined to produce for others.¹³

Say rails against taxation as well as government debts because they too reduce the amount of wealth to be exchanged in society. Say writes that taxes reduce the consumption of a good and consequently make production of the good less profitable. This has the twofold effect of hurting both the consumer and producer – especially those with specific capital in the taxed area – as well as creating market distortions because some areas of production will now be less profitable. Consequently individuals will move to formerly less profitable areas of production.¹⁴

In the case of government debts they also have a negative effect on exchange and wealth. Say rightly states that loans to the government withdraw productive capital from society only to be wasted by the government. The reduced capital available will mean a reduced quantity of goods to be exchanged and a subsequent diminution of societal wealth.¹⁵

J.B. Say also uses his law of markets to advocate the free exchange of foreign goods. It is unfortunate that Say views exchange in terms of equal values. However, his argument for free trade does not live and die on this point. Instead it should be realised that Say is refuting the mercantilist notion that at least one party must lose from foreign trade. Say uses his law of markets to state that in the case of foreign exchange one needs to give up a good to gain a desired good. Whether the cargo imported is specie or other goods is irrelevant. Goods that have the highest rate of profitable return will be imported. Thus in global exchange goods will flow from where they are less desired to locations in which they are more desired.¹⁶

Finally in regards to money, Say has been accused of missing the point that money is dynamic.¹⁷  However, this is not the case. Say is a strong advocate of a hard currency and decries the state's manipulation – usually through debasement – of the value of the currency. Quite astutely Say writes that the manipulation of the monetary value confuses the pricing system, thus making the adventurer/entrepreneur hesitant to further invest in capital and production. In addition, grievous price controls and taxation usually follow such debasement, which together all greatly limit production and exchange.¹⁸

As stated earlier, Say's Law cannot be accurately understood in and of itself – and certainly not by using Keynes’s basically dishonest formulation. Say's law of markets incorporates catallactics, the impetus for production and the adventurer, subjective value, and a framework for the refutation of violent government intervention that decreases production and exchange. Thus Say's Law cannot be separated from the Treatise as a whole and still be accurately understood.

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Peter Anderson is a senior lecturer in history.
A version of this post first appeared at the Mises Daily.

NOTES:

1.See J.R. McCulloch’s The Literature of Political Economy [originally published 1845]. McCulloch writes that Say’s treaty is remarkable only for its law of markets and its popularisation of Adam Smith’s work – to which Say purportedly added nothing – on the continent.
2.. Steven Kates’s Say’s Law & the Keynesian Revolution explains and thoroughly debunks Keynes’s misrepresentation of the law, and roundly condemns his dishonesty. “Keynes . . . misunderstood and misrepresented Say’s Law,” says Kates. “This is Keynes’s most enduring legacy and it is a legacy which has disfigured economic theory to this day.”
3.Joseph Schumpeter, History of Economic Analysis (New York: Oxford University Press, INC., 1954), 615. Schumpeter does understand that Say’s law is vital to his arguments against the violent hampering of internal and external trade.
4.Murray N. Rothbard, Classical Economics (Edward Elgar Publishing Limited, 1996), 27.
5.Jean Baptiste Say, A Treatise on Political Economy (New York: Sentry Press, 1964), 285-286.
6.Ibid., 471.
7.Here Say misses out on the desire of individuals to hold money for various personal utilities and regards money only as a medium of exchange.
8.Ibid., 133.
9.Ibid., 225.
10.Ibid., 135-137.
11.Say, 374.
12.For a similar conclusion see Human Action for Mises’ discussion of the Industrial Revolution.
13.Ibid., 127-132.
14.Ibid., 465-467.
15.Ibid., 479.
16.Ibid., 148-175.
17.Larry J. Sechrest, 15 Great Austrian Economists (Auburn: Ludwig von Mises Institute, 1999), 52.
18.Say, 234-240.