Putting an end to Say’s law, or the law of markets

The ensuing political economy recommendations are at the heart of so-called supply-side “economic policies”, according to which it would suffice to “let do, let pass”. ² or, more concretely, to minimize regulations and other impediments to production and trade, for the economy to function at its best. These recommendations are at the heart of the principles of European economic policy (see the article “The all-market at the heart of Europe’s triple failure”) and generally in so-called liberal economic programs. As for Say’s Law, it is present in a more sophisticated form in many macroeconomic models, known as general equilibrium models. At a deeper level, it is implicitly or explicitly used in common economic reasoning.

It’s surprising, to say the least, that a patently false “law” is still considered right almost two centuries after it was formulated. This article aims to present and refute it.

The time has come to solve France’s main problem: production. We need to produce more, we need to produce better. So we need to act on the supply side. On the supply side! It’s not contradictory with demand. Supply even creates demand.

François Hollande, January 2014 ³

What is Say’s law or the law of markets?

Known as the law of outlets, it simply states that “supply creates demand”. To quote Jean-Baptiste Say: “the very fact of the formation of a product opens, from that very moment, an outlet for other products”. ⁵

For JB. Say and his successors, production generates purchasing power, which makes it possible to sell new products. Here’s his reasoning:

It’s worth noting that a finished product offers, from that moment on, an outlet for other products for the full amount of its value. Indeed, when the last producer has finished a product, his greatest desire is to sell it, so that the value of this product does not disappear into his hands. But he’s no less anxious to get rid of the money he makes from selling it, so that the value of the money doesn’t go down either. The only way to get rid of your money is to ask to buy something. As we can see, the very fact of producing a product opens up an outlet for other products.

Jean-Baptiste Say

If we follow this line of reasoning, it is supply that needs to be stimulated, not demand, which cannot be insufficient. Supply-side policies aim to “make life easier” for companies (lower labor costs, deregulation, innovation incentives, etc.). That, in a world open to international competition, we should help our companies rather than disadvantage them seems reasonable, or at least debatable. On the other hand, to believe that this supply-side policy would be enough to restore the health of the economy as a whole is based on the reasoning of JB Say, which is indisputably false.

It contains three obvious errors.

The three errors underlying Say’s Law

It’s not production that generates purchasing power, but sales.

In Jean-Baptiste Say’s time, we could probably imagine that everything produced would find a buyer, so great were the shortages. Let’s not forget that Ireland suffered a famine in 1851, after the death of JB. Say. But this has long been false. Crises of overproduction have punctuated our history for a number of reasons: the power of our machines enables us to produce massively and far beyond the consumer’s capacity to consume, competition can lead to excess production (each competitor hoping to sell its products while the others fail to do so), market research and marketing services are not infallible, etc., etc., etc.

On the other hand, it’s true that the sale of products brings in purchasing power, which the company uses to pay its employees, suppliers, subcontractors and bankers, to pay taxes, to invest and, ultimately, if possible, to pay dividends. Put another way, it’s true that the income of some (in our case, from the entrepreneur’s sales, which he uses to pay his expenses and investments) is the expense of others (those who buy the products sold). This is an accounting tautology.

But there’s an enormous difference between the two statements. The tautological statement does not allow us to conclude that there is a law of outlets, which confuses production and sale(producing a good in no way guarantees its sale) and therefore assumes the impossibility of crises of overproduction or insufficient demand, which is not at all tautological…

John Maynard Keynes and his successors criticized Say’s law, insisting on the role of uncertainty and imperfect information in economic decision-making. If products fail to find a buyer, it’s mainly because the entrepreneur is insufficiently informed, and there are many uncertain events whose perfect anticipation is simply impossible in “real life”.

Say’s “law” overlooks the role of credit

The vision created by Say’s Law is that of a circulation of purchasing power, which can in no way explain the growth of total production. Let’s assume that every product finds a buyer, and that there is indeed no overproduction. In short, let’s ignore the previous argument. Then, for a given year, total macroeconomic expenditure (Dn) is equal to total income (Rn). How can it be that in year n+1, Rn+1 or Dn+1 (always equal by hypothesis) are greater than Rn or Dn?

This would only be conceivable if prices fell as product volumes grew. But deflationary periods of this kind (i.e. permanent, generalized price declines) are so problematic that they don’t last very long; they’re quite rare. In fact, prices always tend to rise, or to remain relatively stable. So how do we get from Dn to Dn+1? Quite simply, through credit. It’s thanks to credit that purchasing power (in the sense of total available money) can increase from one year to the next.

Note that what can increase this available purchasing power is not mutual credit (Peter lends Paul a sum of money which he divests himself of; this credit merely transfers purchasing power) but credit creating money ex nihilo, credit provided by banks (see the module on Money).

To ignore credit is to overlook one of the key mechanisms of the economy. Just think of the current level of indebtedness in the world’s economies…

Money is not a veil over trade

Say’s Law is based on the postulate that “products can only be exchanged for products”. Money would be a veil over exchanges, with no effect on the economy. We sell a product, not to recover money, but to buy another.

This representation of Say’s Law was mathematically formalized by Léon Walras ⁶ who represents money as a commodity, whose price is set to “balance” the markets for all other commodities. Economic models inspired by this representation are known as Walrasian, or general equilibrium, models.

This idea (according to which products can only be exchanged for products) leads the economist who believes in it to be interested only in real goods and services, and not in the impact of money (which is postulated to be zero).

The facts have shown just how wrong this view is. The crisis of 1929 was a crisis of the financial and monetary system. Successive banking, financial and monetary crises ⁷ particularly since the end of the Bretton-Woods agreements. The main reason for this is that money creation by banks is not automatically regulated to the level necessary and sufficient to ensure that production and demand are always adjusted as if by miracle. As money is mainly created when bank customers apply for credit, and destroyed when they repay it, it has a pro-cyclical effect: when the outlook is good, there is a growing demand for credit and money creation; the opposite is true when the outlook is bad. More seriously, in certain situations, such as during the 1929 crisis when many banks failed, the lack of money in circulation exacerbated the economic crisis. In situations of hyperinflation ⁸ the opposite is true: an over-supply of money.

In short, money is not neutral (more on this in the Money module). And Say’s law is wrong for this third reason: the modern economy cannot be reduced to a gigantic barter system, and cannot be analyzed so simply.

Conclusion

Many economists, from Keynes and Ricardo to Malthus and Marx, have criticized this “law of opportunities”.

As Say’s law is false, the political economy recommendations that could be drawn from it are unfounded. It may therefore happen that demand is insufficient to “sell off” production, that the economy is not in equilibrium, in the sense that on the various markets for goods and services, supply and demand would equalize.

It may seem surprising to have to argue so much when unemployment shows that the job market is not balanced, and not sustainable. Or that many sectors may be experiencing production overcapacity. Or that banking and financial crises demonstrate the instability of capitalism left to its own devices.

But economists implicitly inspired by Say have no shortage of imagination to justify their beliefs and remain blind to the realities they prevent them from seeing.

Robert Lucas ⁹ concludes a January 2003 speech to the Association of American Economists ¹⁰ The central problem of recession prevention has been solved, in all its practical implications, and will be for many decades to come. ¹¹ The economists of the New Classical Economy ¹² convinced that the economy is in equilibrium if markets are competitive, deduce that if, in real life, equilibrium isn’t there, it’s because markets aren’t competitive enough. They deduce, for example, that rigidities in the labor market (the minimum wage, the open-ended contract, the labor code, etc.) are the cause of unemployment. In other words, in their eyes, rules and laws that distance the real economy from a theoretical model (that of competitive general equilibrium) are the cause of the imbalances observed! This makes them prescriptive and dogmatic: in their eyes, the world has to fit their model!