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Thursday, October 7, 2010

The Myth of Say’s Law

Jean Baptiste Say (1767–1832) is credited with Say’s law or Say’s law of markets (“loi des débouchés”, in French), of which Walras’ law appears to be a modern neoclassical restatement. Although Say did not use the expression “law” to describe his views, his writings on this subject are to be found in A Treatise on Political Economy (or the Traité d’économie politique in French), Book 1, Chapter 15 (Say 1832: 132–140; the first edition of which was published in 1803) and in the Catechism of Political Economy (Say 1816: 103–105).

In modern formulations of Say’s law, there are two main variants of it:
(1) Say’s Identity
According to Baumol (1977: 146), this

“is the assertion that no one ever wants to hold money for any significant amount of time, so that, as a result, every offer (supply) of a quantity of goods automatically constitutes a demand for a bundle of some other items of equal market value.”

(2) Say’s Equality
Again, according to Baumol (1977: 146), Say’s Equality

“admits the possibility of (brief) periods of disequilibrium during which the total demand for goods may fall short of the total supply, but maintains that there exist reliable equilibrating forces that must soon bring the two together.”
The issue of what J. B. Say himself thought is complicated by the fact that there was more than one edition of his Treatise on Political Economy. The second edition was published in 1814 and has a revised version of Say’s law (Baumol 1977: 147), while in the first edition the law of markets is not so complete. It was only in the second edition of the Treatise on Political Economy (1814) that Say’s discussion is identifiable as a “form of a type of Say’s equality, i.e., supply and demand are always equated by a rapid and powerful equilibration mechanism” (Baumol 1977: 159).

A reading of the modern interpreters of the law of markets make it clear that by Say’s equality, Say did not mean that downturns in the business cycle cannot occur. Say was attempting to show that there could not be a general glut or general overproduction of all commodities, and that there could never be an overall shortfall in aggregate demand. Say’s view was compatible with the possibility of downturns caused by individual commodities being overproduced. That is, there could be specific but limited types of commodities where overproduction occurred relative to demand for those commodities. Say’s law of markets appears to be compatible with short-term gluts of specific commodities. As Steve Keen has argued:
“[sc. before Keynes] mainstream economics did not believe there were any intractable macroeconomic problems. Individual markets might be out of equilibrium at any one time – and this could include the market for labour or the market for money – but the overall economy, the sum of all those individual markets, was bound to be balanced” (Keen 2001: 189).
On the neoclassical and classical view, there could not be a downturn caused by an overall deficiency in aggregate demand: slumps were caused by sectoral imbalances/sectoral disequilibrium or by external shocks. Aggregate supply could never exceed aggregate demand (Kates 1998: 4–5).

John Maynard Keynes in the General Theory had this to say about Say’s law:
“From the time of Say and Ricardo the classical economists have taught that supply creates its own demand;—meaning by this in some significant, but not clearly defined, sense that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product …. As a corollary of the same doctrine, it has been supposed that any individual act of abstaining from consumption necessarily leads to, and amounts to the same thing as, causing the labour and commodities thus released from supplying consumption to be invested in the production of capital wealth” (Keynes 1936: 18–19).
Keynes’ remark about the classical economists is correct (Baumol 1999: 200). For example, Adam Smith held these ideas:
“In all countries where there is tolerable security, every man of common understanding will endeavour to employ whatever stock he can command, in procuring either present enjoyment or future profit. If it is employed in procuring present enjoyment, it is a stock reserved for immediate consumption. If it is employed in procuring future profit, it must procure this profit, either by staying with him, or by going from him. In the one case it is a fixed, in the other it is a circulating capital. A man must be perfectly crazy who, where there is tolerable security, does not employ all the stock which he commands, whether it be his own, or borrowed of other people, in some one or other of those three ways.” (Smith 1811: 198).

“What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people. That portion of his revenue which a rich man annually spends is, in most cases consumed by idle guests, and menial servants, who leave nothing behind them in return for their consumption. That portion which he annually saves, as for the sake of the profit it is immediately employed as a capital, is consumed in the same manner, and nearly in the same time too, but by a different set of people, by labourers, manufacturers, and artificers, who re-produce with a profit the value of their annual consumption. His revenue, we shall suppose, is paid him in money. Had he spent the whole, the food, clothing, and lodging, which the whole could have purchased, would have been distributed among the former set of people. By saving a part of it, as that part is for the sake of the profit immediately employed as a capital either by himself or by some other person, the food, clothing, and lodging, which may be purchased with it, are necessarily reserved for the latter. The consumption is the same, but the consumers are different” (Smith 1811: 240).
These passages are essentially an assertion of Say’s Identity (Baumol 1977: 158). Keynes also states:
“Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment” (Keynes 1936: 26).
This was perhaps a mischaracterization of Say’s actual ideas (Kates 1998; Keen 2001: 189–190). In this passage, Keynes was refuting the reformulation of Say’s law by John Stuart Mill and Alfred Marshall. Say did in fact acknowledge that downturns in the business cycle could happen. Baumol has even argued that
“Say and other writers recognized that the zero value of the sum of excess demands, or supply creates its own demand (“Say’s identity”), may not hold in the short run. Say’s passage in his Letters to Malthus … even suggests an explanation – a desire to hoard or, as we would now put it, a temporary excess demand for money. But they thought the market would fairly quickly and automatically restore equilibrium” (Baumol 1999: 201).
In other words, it appears that Say eventually partly though not fully understood what Keynes himself believed: changes in liquidity preference can cause insufficient demand and involuntary unemployment. Both Say and J. S. Mill in some writings even appear to have allowed that failures in aggregate demand can cause recession (Hollander 2005: 383-284).

However, the general view of Say and the 19th century classical economists seemed to be that recessions and involuntary unemployment could occur, but mainly by sectoral imbalances (though Hollander maintains that Say and Mill glimpsed that failures of aggregate demand might be involved), and that Say’s law of markets was the mechanism by which equilibrium was rapidly restored in a free market economy (Kates 1998: 14).

So what does all this prove? That Say’s law of markets is true? Hardly.

In fact, Keynes still refuted the version of Say’s law in J. S. Mill and Marshall, even if they did not understand Say properly.

And a careful examination of Say’s writings on demand and production shows that his reasoning is deeply flawed. A good starting point is this passage in Say’s Catechism of Political Economy (1816: 103–105):
On what does the vivacity of the demand depend?

On two motives which are—1st. The utility of the product, that is, the necessity the consumer has for it:—2nd. The quantity of other products he is able to give in exchange.

I conceive the first motive. As to the second it appears to me that it is the quantity of money that the buyer possesses which induces him to buy or not.

That is also true: but the quantity of money which he has, depends on the quantity of product with which he has been able to buy this money.

Could he not obtain the money otherwise than by having acquired it by products?

No.

If he had received the money from his tenants?

His tenant had received it from the sale of part of the products to which the earth had contributed.

If he had received the interest of a capital lent?

The undertaker who employed that capital had received the money which he paid, on the sale of a part of the products to which his capital had concurred.

If the purchaser had obtained this money by gift or inheritance—?

The giver, or he from whom the giver had obtained it, had it in exchange for some product. In every case the money, with which any product is purchased, must have been produced by the sale of another product; and the purchase may be considered as an exchange in which the purchaser gives that which he has produced, (or that which another has produced for him), and in which he receives the thing bought.

What do you conclude from this?

That the more the purchasers produce, the more they have to purchase with, and that the productions of the one procure purchasers to the other.

It appears to me, that if the buyers only purchased by means of their products, they have generally more products than money to offer in payment.

Every producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product; for we do not consume money, and it is not sought after in ordinary cases to conceal it: thus, when a producer desires to exchange his product for money, he may be considered as already asking for the merchandise which he proposes to buy with this money. It is thus that the producers, though they have all of them the air of demanding money for their goods, do in reality demand merchandise for their merchandise (Say 1816: 103–105).
Say believed that any short-term glut in particular commodities would be quickly eliminated.

First, Say holds that buyers of commodities cannot obtain money except by having acquired it from the sale of other commodities. This is also expressed in A Treatise on Political Economy, Book 1, Chapter 15:
“A man who applies his labour to the investing of objects with value by the creation of utility of some sort, can not expect such a value to be appreciated and paid for, unless where other men have the means of purchasing it. Now of what do these means consist? Of other values of other products, likewise the fruits of industry, capital and land. Which leads us to a conclusion that may at first sight appear paradoxical, namely, that it is production which opens a demand for products” (Say 1832: 133).
Here Say is clear that only production of other commodities provides the money to pay for “products” (a related question is what he means by “capital”: if this means investment money then it is obvious that Say naturally thinks of money as a commodity too). A form of this idea is sometimes encountered on libertarian blogs. For example, one will find Austrians asking questions such as “how could people have money if they hadn’t produced something to exchange for money?”

The answer is that without production people would have no commodities (= wealth) for consumption. They might still have money. The premise of such a question is that without prior production there is no money to purchase commodities. This commits Austrians to the view that money is a “produced” commodity. But today we live in a fiat money world. Money is no longer “commodity” money. It is not “produced” in the way that gold and silver are dug out of the ground. Today fractional reserve banking creates money through debt, and open market operations create new money in the form of bank reserves. This is the real world in which we live, and even in Say’s own time fractional reserve banking was creating fiduciary media without prior creation of commodities.

Say’s law appears to require a world where money is produced like any other commodity, and this is one condition for the law of markets to work. But the condition does not exist today: Say’s law is irrelevant to modern fiat money using economies, where money also has a store of value role.

The second fatal and ridiculous flaw in Say’s argument is the belief that “every producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product.”

In fact, it simply isn’t the case that producers of commodities (whether individuals or businesses) or the recipients of the money profits of the firm like workers or owners will always use the money they earn from the sale of commodities “only for the purpose of employing that money again immediately in the purchase of another product.” Money can be saved and it can become idle. Capitalism also has markets for real and financial assets. Money can flow into the purchasing of financial assets. If there are financial assets or real assets whose prices are rising, modern capitalists, producers and even workers might decide to start speculating on asset prices. This would take money away from the purchasing of commodities and instead tie it up in exchanges on asset markets, as money alternates between being (1) held idle before buying assets and (2) purchasing assets, and then being held idle again by the new owner of the money in preparation for further speculation.

Another fatal flaw in Say’s reasoning is that money has no utility and cannot be used as a store of value:
“for we do not consume money, and it is not sought after in ordinary cases to conceal it” (Say 1816: 104).

“For, after all, money is but the agent of the transfer of values. Its whole utility has consisted in conveying to your hands the value of the commodities, which your customer has sold, for the purpose of buying again from you; and the very next purchase you make, it will again convey to a third person the value of the products you may have sold to others” (Say 1832: 133).

“Money performs but a momentary function in … double exchange; and when the transaction is finally closed, it will always be found, that one kind of commodity has been exchanged for another” (Say 1832: 134).

“When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus, the mere circumstance of the creation of one product immediately opens a vent for other products” (Say 1832: 134–135).
It is clear that Say believes in neutral money, and he is deeply mistaken in thinking of money only as a neutral “veil” with no store of value function (for the concept of neutral money, see Visser 2002). Say’s analysis also ignores the role of financial markets in affecting demand for money.

It should be noted of course that Say’s ideas were later developed by the Classical economists, so Say’s law in that historical sense is not the same as the ideas found in Say’s own writings.

So what was Say’s law in its developed form and as held by modern defenders of it?

Thomas Sowell (1994: 39–41) argues that in Classical economics Say’s law can be expressed by these propositions:
(1) The total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output [an idea in James Mill].

(2) There is no loss of purchasing power anywhere in the economy. People save only to the extent of their desire to invest and do not hold money beyond their transactions need during the current period [James Mill and Adam Smith].

(3) Investment is only an internal transfer, not a net reduction, of aggregate demand. The same amount that could have been spent by the thrifty consumer will be spent by the capitalists and/or the workers in the investment goods sector [John Stuart Mill].

(4) In real terms, supply equals demand ex ante [= “before the event”], since each individual produces only because of, and to the extent of, his demand for other goods. (Sometimes this doctrine was supported by demonstrating that supply equals demand ex post.) [James Mill.]

(5) A higher rate of savings will cause a higher rate of subsequent growth in aggregate output [James Mill and Adam Smith].

(6) Disequilibrium in the economy can exist only because the internal proportions of output differ from consumer’s preferred mix—not because output is excessive in the aggregate” [Say, Ricardo, Torrens, James Mill] (Sowell 1994: 39–41).
So this is Say’s law, according to the Classical economists.

First, it is perfectly possible that supply equals demand ex ante, which is asserted in proposition (1) and in the first statement in (4) (if one ignores the qualification “since each individual produces only because of, and to the extent of, his demand for other goods,” which does not follow at all), but to assert that it will always hold ex post is a non sequitur, without demonstrating the truth of propositions (2), (3), (5), and (6).

Unfortunately, these propositions cannot be held to be true.

Let’s start with proposition (2). Under conditions of uncertainty, money has utility (see my previous post “The Utility of Money in Post Keynesianism”, which I will use in what follows). It is deeply flawed to regard money only as a “neutral veil” that overcomes the inconveniences of direct barter. Such an idea is associated with the “neutral money axiom” (Davidson 2002: 19). In reality, people really do choose to hold money in and of itself as (1) a store of value and (2) a way of dealing with future uncertainty. Thus there is a precautionary motive for holding money, in addition to the transactions motive. Say’s law of markets requires neutral money or the idea that money only has a medium of exchange role. As Paul Davidson has argued,
“[in] an uncertain world, the possession of money and other nonproducible liquid assets provides utility by protecting the holder from fear of being unable to meet future liabilities” (Davidson 2003: 236).
The neoclassicals thought that only producible goods and services can provide utility. But money can have utility on its own account. So can liquid financial assets. The neoclassical view was that money has no utility, but only exchange value. The Austrian view also seems to be that money has no utility except for what can be obtained in exchange for it. The idea that money has no utility in itself is part of the three fundamental neoclassical axioms that Keynes rejected. The following three fundamental axioms are the basis of neoclassical economics and of Say’s law:
(1) the neutral money axiom (i.e., holding money by itself provides no utility),
(2) the gross substitution axiom, and
(3) the ergodic axiom.
If one assumes these false axioms, then one will believe that the “aggregate demand function is the same as the aggregate supply function” (Davidson 2002: 43). Post Keynesian economics requires the rejection of these axioms. In a fundamentally uncertain world, you have the problem of facing a possible lack of liquidity in the future (i.e., lack of money). This is why many people like to hold onto money, and precisely why money has utility – and in fact often has a great deal of utility.

Moreover, Keynes in the General Theory made the fundamental point that fiat money and even commodity money have special properties:
“… money has, both in the long and the short period, a zero, or at any rate a very small, elasticity of production, so far as the power of private enterprise is concerned, as distinct from the monetary authority;—elasticity of production meaning, in this context, the response of the quantity of labour applied to producing it to a rise in the quantity of labour which a unit of it will command. Money, that is to say, cannot be readily produced;—labour cannot be turned on at will by entrepreneurs to produce money in increasing quantities as its price rises in terms of the wage-unit. In the case of an inconvertible managed currency this condition is strictly satisfied. But in the case of a gold-standard currency it is also approximately so, in the sense that the maximum proportional addition to the quantity of labour which can be thus employed is very small, except indeed in a country of which gold-mining is the major industry.
Now, in the case of assets having an elasticity of production, the reason why we assumed their own-rate of interest to decline was because we assumed the stock of them to increase as the result of a higher rate of output. In the case of money, however—postponing, for the moment, our consideration of the effects of reducing the wage-unit or of a deliberate increase in its supply by the monetary authority—the supply is fixed. Thus the characteristic that money cannot be readily produced by labour gives at once some prima facie presumption for the view that its own-rate of interest will be relatively reluctant to fall; whereas if money could be grown like a crop or manufactured like a motor-car, depressions would be avoided or mitigated because, if the price of other assets was tending to fall in terms of money, more labour would be diverted into the production of money;—as we see to be the case in gold-mining countries, though for the world as a whole the maximum diversion in this way is almost negligible” (Keynes 1936: 230–231).
Money has a zero or very small elasticity of production. This means that a rise in demand for money and a rising “price” for money (i.e., an increase in its purchasing power) will not lead to businesses “producing” money by hiring workers.

The property of zero or very small elasticity of production also applies to liquid financial assets. If consumers decide to buy less producible commodities and increase their holding of money or ownership of financial assets, unemployment will result in some sectors as demand for commodities declines. The price of financial assets will rise and it is possible that the price of money could also rise. But private businesses cannot hire the unemployed to “produce” or “manufacture” more money or financial assets to exploit profit opportunities in the high-price liquid assets (Davidson 2010: 255–256).

In classical and neoclassical economics, however, money is held to be a commodity (e.g., gold, silver or some other type of commodity). If the demand for commodity money rises, neoclassical theory says it can be “produced” like any other commodity by hiring unemployed workers. But this idea is utterly false in a world where the commodity money consists of rare metals like gold or silver, and certainly false in the modern world of fiat money.

The second special property of money and liquid financial assets is that they have zero or near zero elasticity of substitution:
“The second differentia of money is that it has an elasticity of substitution equal, or nearly equal, to zero which means that as the exchange value of money rises there is no tendency to substitute some other factor for it;—except, perhaps, to some trifling extent, where the money-commodity is also used in manufacture or the arts. This follows from the peculiarity of money that its utility is solely derived from its exchange-value, so that the two rise and fall pari passu, with the result that as the exchange value of money rises there is no motive or tendency, as in the case of rent-factors, to substitute some other factor for it.
Thus, not only is it impossible to turn more labour on to producing money when its labour-price rises, but money is a bottomless sink for purchasing power, when the demand for it increases, since there is no value for it at which demand is diverted—as in the case of other rent-factors—so as to slop over into a demand for other things” (Keynes 1936: 231).

“money has (or may have) zero (or negligible) elasticities both of production and of substitution” (Keynes 1936: 234).
Financial assets are not gross substitutes for commodities. The neoclassical gross substitution axiom is wrong. In both a commodity money and fiat money world, savings are held in the form of money and non-producible financial assets. An increase in demand for money and non-producible financial assets and rising prices of such liquid assets will not spill over into a demand for relatively cheaper commodities, because the elasticity of substitution of money and liquid assets is zero or near zero (Davidson 2010: 256–257; Davidson 2002: 44–45; see also Hahn 1977: 31). Even if wages and prices were perfectly flexible, there could still be “leakages” in aggregate supply in the form of speculation on financial asset markets which would be “non-employment inducing demand” (Davidson 2010: 257; Hahn 1977: 37).

Thus a shortfall in aggregate demand is possible.

Moreover, there are other obvious leakages from the aggregate income arising from production that result in insufficient aggregate demand. There is no necessary reason why all the income will be spent on commodities in a particular time period, or even at all. Savings and changes in the rate of saving may happen.

Sowell’s proposition (3) above is also unacceptable. Classical advocates of Say’s law argued that saving would result in reasonably quick consumption or investment, but that simply does not follow. Money savings can become idle balances (“hoards,” in the terminology of Keynes). But even idle balances of money are not the only cause of a shortfall in demand. We can list the various “leakages” from aggregate income as described above, as well as some other ones, as follows:
(1) People desire to hold money as a hedge against future uncertainty (the “precautionary motive,” in Keynes’ theory), and since expectations are subjective such holdings can vary. In depressions or recessions, people may choose to hold more of their money as cash. In underdeveloped and pre-modern economies, hoarding can take the form of holding money physically outside of banks as cash or coin (Gootzeit 2003: 182). In the Great Depression, the rise in the hoarding of money was a significant factor, as it probably was in pre-1914 downturns in the business cycle (Wicker 1996: 144).

(2) As we have seen, even when people hold money either as individuals or as savings in financial institutions, not all the money will be invested in production of producible commodities (= goods and services). Money can be used to speculate on asset prices. New savings or a rise in savings can be diverted to purchasing of financial assets (or real assets) with the money used to buy such assets then flowing to other speculators, who buy new financial assets or hold money idle in the process of using it in further speculation on assets. Thus there is a “speculative demand” for money that can rise or fall.

(3) In modern economies where savings are held in demand deposits and saving accounts in banks, money is invested by banks themselves. But even here investment by banks will be subject to subjective expectations under uncertainty. In recessions or depressions when expectations are low, banks may simply choose to keep their depositors’ money as excess reserves or use it to buy financial assets on secondary markets. Thus even modern banks can “hoard” by reducing investment and leaving money in idle balances (at central banks or held in reserve for speculation on financial assets).

(4) Money income can be spent on imports causing a trade deficit, which in pre-fiat money days could result in a contraction of the money supply and deflationary pressures.

(5) A government might levy taxes and a run budget surplus without re-injecting that money back into the economy (and effectively destroying it).
Once propositions (2) and (3) of Say’s law above are shown to be false, propositions (4) and (5) collapse completely, and the idea that supply equals demand ex post cannot be possible.

For all these reasons, aggregate demand failures can cause recessions, whenever aggregate demand falls short of supply. Equilibrium will not result and is not necessarily a condition of free markets. Say’s law is a myth.


APPENDIX 1: SAY ADVOCATED PUBLIC WORKS

In his discussion of the introduction of labour saving machines, Say recognised that this would create short term unemployment, and in a footnote actually advocated public works spending by government:
“Without having recourse to local or temporary restrictions on the use of new methods or machinery which are invasions of the property of the inventors or fabricators a benevolent administration ran make prevision for the employment of supplanted or inactive labour in the construction of works of public utility at the public expense as of canals, roads, churches or the like …” (Say 1832: 87).
This must come as an embarrassing shock to Austrians who so frequently cite Say’s work with approval.

APPENDIX 2: RESERVATION DEMAND DOES NOT RESCUE SAY’S LAW

Reservation demand is defined as a type of demand in which producers or sellers of commodities hold their commodities off the market and refuse to sell them, because they expect higher prices in the future.

Reservation demand was never invoked by J. B. Say or other classical economists in defence of Say’s law, but one modern libertarian defence of Say’s law appears to use this concept.

As J. T. Salerno notes,
Rothbard (1993, pp. 350–56, 662–67) was the first to analyze the demand for money in terms of its exchange demand and reservation demand components. In 1913, Herbert J. Davenport … also clearly identified these two partial demands for money but ultimately failed to integrate them into an overall theory of the demand for money” (Salerno 2006: 40, n, 4).
Rothbard sets out the types of reservation demand in relation to commodities:
“The sources of a reservation demand by the seller are two: (a) anticipation of later sale at a higher price; this is the speculative factor analyzed above; and (b) direct use of the good by the seller. This second factor is not often applicable to producers’ goods, since the seller produced the producers’ good for sale and is usually not immediately prepared to use it directly in further production. In some cases, however, this alternative of direct use for further production does exist. For example, a producer of crude oil may sell it or, if the money price falls below a certain minimum, may use it in his own plant to produce gasoline. In the case of consumers’ goods, which we are treating here, direct use may also be feasible, particularly in the case of a sale of an old consumers’ good previously used directly by the seller—such as an old house, painting, etc. However, with the great development of specialization in the money economy, these cases become infrequent” (Rothbard 2004 [1962]: 253).
Rothbard (2004 [1962]: 755ff.) treats money as a commodity and analyses the supply and demand for it “in terms of the total demand-stock analysis” he had used in Chapter 2 of Man, Economy, and State, and this obviously has relevance to Say’s law, and is indeed applied to it in Hoppe, Hulsmann, and Block (1998: 40).

To see how the concept of reservation demand is applied to money we can turn to Rothbard’s Man, Economy, and State: A Treatise on Economic Principles (1962):
“When a seller keeps his stock instead of selling it, what is the source of his reservation demand for the good? We have seen that the quantity of a good reserved at any point is the quantity of stock that the seller refuses to sell at the given price. The sources of a reservation demand by the seller are two: (a) anticipation of later sale at a higher price; this is the speculative factor analyzed above; and (b) direct use of the good by the seller. This second factor is not often applicable to producers’ goods, since the seller produced the producers’ good for sale and is usually not immediately prepared to use it directly in further production” (Rothbard 2004: 253).
So, in relation to commodities, Rothbard’s definition is in line with the generally accepted definition. But there is absolutely no necessary reason at all why (1) the value of commodities not sold due to reservation demand would equal (2) the total value of unsold commodities in a given period. Many commodities will remain on the shelves simply because they were not sold.

Moreover, Rothbard treats money as a commodity since he is an advocate of the gold standard. When we come to money, Rothbard also uses the concept of reservation demand:
“The total demand for money on the market consists of two parts: the exchange demand for money (by sellers of all other goods that wish to purchase money) and the reservation demand for money (the demand for money to hold by those who already hold it)” (Rothbard 2004: 759).

“More important, because more volatile, in the total demand for money on the market is the reservation demand to hold money. This is everyone’s post-income demand. After everyone has acquired his income, he must decide, as we have seen, between the allocation of his money assets in three directions: consumption spending, investment spending, and addition to his cash balance (‘net hoarding’). Furthermore, he has the additional choice of subtraction from his cash balance (‘net dishoarding’). How much he decides to retain in his cash balance is uniquely determined by the marginal utility of money in his cash balance on his value scale. … We have now to look at the remaining good: money in the cash balance, its utility and demand. Before discussing the sources of the demand for a cash balance, however, we may determine the shape of the reservation (or ‘cash balance’) demand curve for money” (Rothbard 2004: 759).
Rothbard’s reference to everyone acquiring “his income” can presumably refer to total factor payments from production (aggregate supply). Rothbard now defines “reservation demand” for money as the money flowing into cash balances (net hoarding).

It is here that libertarians might jump on Rothbard’s analysis to argue that Say’s law can be saved from collapse by applying the concept of reservation demand to money.

But what can the expression “reservation demand” mean when applied to money? When applied to commodities, it means that commodities are held off the market by sellers in expectation of higher prices in the future. Logically, then, reservation demand for money would be holding money in expectation of a higher price for money in the future in terms of its purchasing power. That is, a higher price for money can only mean a rise in money’s purchasing power, whether through general price deflation or falls in the prices of a commodity or commodities one wishes to purchase. Rothbard’s other comments support this:
“an expectation of a rise in the … [purchasing power of money] in the near future will tend to raise the demand-for-money schedule as people decide to “hoard” (add money to their cash balance) in expectation of a future rise in the exchange-value of a unit of their money. The result will be a present rise in the [purchasing power of money]” (Rothbard 2004: 768).
But Rothbard’s definition of “reservation demand” as all net money added to and held in cash balances (“net hoarding”) includes forms of idle money that cannot legitimately be called “reservation demand.” Rothbard has changed the meaning of “reservation demand” in a sleight of hand.

At most, “reservation demand” for money can only describe one subcategory of Keynes’ speculative demand for money: that category that involves holding money in expectation of general price deflation or price falls in one or other commodities.

Speculative demand for money includes many other categories, including holding money to buy assets expected to rise in price in the future.

And even if one chooses to make “reservation demand” for money in its only proper sense equal to its value as inserted into aggregate supply, this still leaves other idle money balances not spent on consumption or investment in capital goods.

A revised version of Say’s law according to the libertarian defence can be given here:
Aggregate supply (AS) = total factor payments + value of money held in reservation demand
equals
Aggregate demand (AD) = consumption + investment on capital goods + value of commodities and money in reserve demand.
This still does not save Say’s law. Although the value of all commodities held by “reservation demand” equals the value of such commodities included in total factor payments, there will still be the value of commodities not purchased by consumption or investment on capital goods in AD left over.

As for AD, the value of total factor payments will be divided into these three categories when spent in aggregate demand:
(1) consumption payments;
(2) investment on capital goods;
(3) money held by reservation demand (a speculative demand for money);

But money from total factor payments can also be diverted into

(4) money held idle by precautionary motive (money held because of uncertain future);
(5) money held for other speculative demands;
(6) money held idle in financial market transactions.
Although money held in (3) will by definition equal money held in reservation demand in aggregate supply, there is still the likelihood that money will be held idle by the precautionary motive (4), other speculative demands (5), and in financial market transactions (6).

Rothbard’s sleight of hand is to lump (3), (4), (5), and (6) into one category he called reservation or ‘cash balance’ demand.

This can be used to then argue that Say’s law holds because the category “cash balance demand” is by definition equal to that value in aggregate supply when it is inserted into AS.

But this trick will not save Say’s law. In (3), (4), (5), and (6), money will be idle and not spent on aggregate supply. Without total factor payments going to purchase commodities or to capital goods investment, aggregate demand failures can occur.

I also note that Hoppe, Hulsmann, Block, in response to Selgin and White (1996), have also used the concept of reservation demand in discussing Say’s law and in arguing against the existence of fiduciary media:
“[Selgin and White] have overlooked Say’s law: all goods (property) are bought with other goods, no one can demand anything without supplying something else, and no one can demand or supply more of anything unless he demands or supplies less of something else. But this is here not the case whenever a fiduciary note is supplied and demanded. The increased demand for money is satisfied without the demander demanding, and without the supplier supplying, less of anything else. Through the issue and sale of fiduciary media, wishes are accommodated, not effective demand. Property is appropriated (effectively demanded) without supplying other property in exchange. Hence, this is not a market exchange which is governed by Say’s law – but an act of undue appropriation” (Hoppe, Hulsmann, Block 1998: 40).
One obvious consequence of such a view is that Say’s law can only hold in a world without fiduciary media, fractional reserve banking and fiat money! For Say’s law to work in the way postulated here there must only be commodity money and no fractional reserve banking or fiduciary media. We don’t live in such a world, so Say’s law does not hold.


BIBLIOGRAPHY

Baumol, W. J. 1977. “Say’s (at Least) Eight Laws, or What Say and James Mill May Really Have Meant,” Economica n.s. 44.174: 145–161.

Baumol, W. J. 1999. “Retrospectives: Say’s Law,” Journal of Economic Perspectives 13.1: 195–204.

Becker, G., and W. Baumol, 1952. “The Classical Monetary Theory,” Economica 19.4: 355–376.

Davidson, P. 2002. Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham.

Davidson, P. 2010. “Keynes’ Revolutionary and ‘Serious’ Monetary Theory,” in R. W. Dimand, R. A. Mundell, and A. Vercelli (eds), Keynes’s General Theory after Seventy Years, Palgrave Macmillan, Basingstoke, England and New York. 241–267.

Gootzeit, M. 2003. “Savings, Hoarding and Say’s Law,” in S. Kates (ed.), Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, Edward Elgar Pub, Cheltenham; Northampton, Mass. 168–186.

Hahn, F. H. 1977. “Keynesian Economics and General Equilibrium Theory: Reflections on Some Current Debates,” in G. C. Harcourt (ed.), The Microeconomic Foundations of Macroeconomics, Macmillan, London. 25–40.

Hollander, S. 2005. Review of Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, History of Political Economy 37.2: 382–385.

Hoppe, H.-H., Hulsmann, G. and W. Block, 1998. “Against Fiduciary Media,” Quarterly Journal of Austrian Economics 1.1: 19–50.

Kates, S. (ed.), 2003. Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, Edward Elgar Pub, Cheltenham ; Northampton, Mass.

Keen, S. 2001. Debunking Economics: The Naked Emperor of the Social Sciences, Zed Books, London and New York.

Keynes, J. M. 1936. The General Theory of Employment, Interest, and Money, Macmillan, London.

Lange, O. 1942. “Say’s Law: A Restatement and Criticism,” in O. Lange, F. McIntyre and T. O. Matema (eds), Studies in Mathematical Economics and Econometrics: In Memory of Henry Schultz, University of Chicago Press, Chicago. 49–68.

Mises, L. 2005 [1950], “Lord Keynes and Say’s Law,” Mises Daily, April 25, 2005, http://mises.org/daily/1803

Murphy, R. P. 2006. Study Guide to Man, Economy, and State: A Treatise on Economic Principles, with Power and Market: Government and the Economy, Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. N. 2004 [1962]. Man, Economy, and State: A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, Ala.

Say, J. B. 1816. Catechism of Political Economy, or, Familiar conversations on the manner in which wealth is produced, distributed, and consumed in society (trans. J. Richter), Sherwood, Neely, and Jones, London.

Say, J. B. 1832. A Treatise on Political Economy; or, The Production, Distribution, and Consumption of Wealth (4th edn; trans. C. R. Princep and C. C. Bibble), Grigg & Elliott, Philadelphia.

Salerno, J. T. 2006. “A Simple Model of the Theory of Money Prices,” Quarterly Journal of Austrian Economics 9.4: 39–55.

Selgin, G. A., and L. H. White, 1996. “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians!,” Review of Austrian Economics 9.2: 83–107.

Sowell, T. 1972. Say’s Law: An Historical Analysis, Princeton University Press, Princeton, N.J.

Sowell, T. 1994. Classical Economics Reconsidered, Princeton University Press, Princeton, N.J.

Smith, A. 1811. An Inquiry into the Nature and Causes of the Wealth of Nations (11 edn; vol. 1), Oliver D. Cooke, Hartford.

Visser, H. 2002. “Neutrality of Money,” in B. Snowdon and H. R. Vane (eds), An Encyclopedia of Macroeconomics, Edward Elgar Publishing, Cheltenham. 526–532.

Wicker, E. 1996. The Banking Panics of the Great Depression, Cambridge University Press, Cambridge and New York.

60 comments:

  1. And still You are wrong. "General glut" may appear only in monetary terms. When people stop eating at restaurants they buy more burgers and brown bags are booming, when the drop huge gas-guzzlers, more small vehicles are sold, holidays abroad vs domestic, etc.

    And hoarding? Isn't the demand for money a form of demand??? :)))

    The Keynes analysis fall short of explaining the reasons of hoarding and lack of "animal spirit", that is: uncertainty. But the extreme liqudity preference (hoarding) must not last long, because very soon the irresistible business opportunities will show up (lower prices), hence the demand will rise.

    Underconsumption theory was not invented by Keyens by the way:

    http://en.wikipedia.org/wiki/Underconsumption

    ReplyDelete
  2. The Keynes analysis fall short of explaining the reasons of hoarding and lack of "animal spirit", that is: uncertainty.

    Actually, Keynes understood well the distinction between risk and uncertainty: risk can be quantified, uncertainty simply cannot be quantified.

    Keynes placed uncertainty at the heart of economic analysis. See the work of the Post Keynesian economist Paul Davidson:

    http://econ.bus.utk.edu/RISK%20AND%20UNCERTAINTY%20IN%20ECONOMICSBy%20Paul%20Davidson.pdf

    ReplyDelete
  3. Lord Keynes, I dared you to refute Say's law, and you come up with this hodgepodge of pseudo-economic goggledegook??? You gotta be kidding. Keynes claimed to have refuted Say's law with essentially the same kind of utter nonsense, and because Keynes' entire General Theory depended upon rebutting Say's law, Keynes' entire General Theory flopped.

    So, let me make it simple for you, and see if you can respond in your own words without reference to any of you other nonsensical blogs, nor to any other authority. If you can't do that, just say so.

    JB SAY; In order for people to consume, they must produce, because without production there can be nothing to consume, and without production, people would have nothing (no money) to spend on consumption."

    JM KEYNES: No, government can create and spend money, which will allow people to consume without producing.

    SAY: Um, what will they consume?

    KEYNES: They will consume bread, because the State, by its ability to print money, can turn stones into bread.

    SAY: Huh???

    Netterville: Ok, Lord K. the second, explain to the people how the State performs the necessary miracle that refutes Say's law?

    ReplyDelete
  4. Ned Netterville,

    Thanks for your comments.

    In order for people to consume, they must produce, because without production there can be nothing to consume, and without production, people would have nothing (no money) to spend on consumption

    That people need to engage in production before consumption is true.

    In other words, that consumption must have prior production (at home or overseas) is true. What doesn’t follow is that supply (total factor payments from production) will equal consumption or investment. Aggregate demand failures can occur.

    Your statement here is incorrect:

    without production, people would have nothing (no money) to spend on consumption.

    Without production, people would have no commodities for consumption. They might still have money.

    But money is not wealth. Money is a unit of account and medium of exchange (also a store of value): but as a unit of account and medium of exchange it is a thing that facilitates exchange and production. The money itself is NOT wealth.

    In a recession, deficit spending is a way of mobilizing idle resources like labour for production. The production (= wealth creation) is facilitated by money as wages or payment for other commodities.

    See my most recent post.

    Regards and thanks again,
    LK

    ReplyDelete
  5. Anyone who wants to know why Lord Keynes makes no sense and why his attack on Say's Law is way way off the mark, check out my discussion with him out here

    http://blog.mises.org/14205/krugman-and-says-law/

    ReplyDelete
  6. Bala,

    Thanks for your comments and contribution.

    I have refuted the idea that "reservation demand" can save Say's law in Appendix 2 above.

    ReplyDelete
  7. Lord Keynes,

    Your so-called refutation above depends completely on the fundamentally flawed concept of "idle money". Since there is no such thing as "idle money", you still do not make any sense.

    ReplyDelete
  8. Just to add another point, your attempt to accuse Rothbard of sleight of hand is extremely incorrect. Frankly, it is you Keynesians who are using sleight of hand when you try to ignore speculation. If you are talking "short-term", you need to include speculative demand for cash in the cash balance. Anything else is plain wrong.

    Further, it is wrong to talk of the value of unsold stock as anything other than "reservation demand" because it remains in inventory ONLY because the seller was not willing to sell it at a price that the customer was ready to pay. That price in turn ought to have been lower than the price the seller was quoting in the first place for otherwise, the good would have been sold.

    By not selling at a lower price, the seller is expressing a preference for a higher price and is holding out for a higher price (maybe even what he is quoting now) at a later point in time. So, even that is reservation demand.

    So, you are still wrong.

    ReplyDelete
  9. . Since there is no such thing as "idle money", you still do not make any sense.

    Idle money = money not used in purchasing of commodities or capital good investment in whatever period you want to use to argue that Say's law works.

    It is a *very* clear and important concept that exists in the real world.

    If you are talking "short-term", you need to include speculative demand for cash in the cash balance. Anything else is plain wrong.

    All money in the "cash balance" as used in Rothbard's argument cannot be considered as "reserve demand".
    It is an obvious and dishonest change in the meaning of "reserve demand".

    Further, it is wrong to talk of the value of unsold stock as anything other than "reservation demand" because it remains in inventory ONLY because the seller was not willing to sell it at a price that the customer was ready to pay etc

    Your error is to assume that there *would* a buyer even if the seller had lowered the price.
    There is no necessary reason why consumers will buy at all if they derive no utility from the product. Lowering the price won't help.

    ReplyDelete
  10. reservation (or reserve) price is the biggest price a buyer is going to pay for a good or service; or; the smallest price at which a seller is going to sell a good or service

    It is irrelevant whether buyers might pay a
    "reservation (or reserve) price" when they don't wish to purchase anything in the first place, because of, say, the precautionary demand for money.

    ReplyDelete
  11. " Your error is to assume that there *would* a buyer even if the seller had lowered the price. "

    The alternative to this is that the good is of no value to all buyers and the seller has made a wrong assessment.

    " Idle money = money not used in purchasing of commodities or capital good investment in whatever period you want to use to argue that Say's law works.

    It is a *very* clear and important concept that exists in the real world. "

    Only if you assume that money itself is not a good produced and exchanged on the market. Money held in cash balance and not used to purchase consumption or investment goods serves the purpose of being prepared for uncertainty.

    In addition, especially for the "worst" case of what you call "idle" money, money in a safe, it serves a very important economic function - that of reducing the stock of money available for exchange When that happens, the purchasing power of every other unit of money in circulation improves. Thus, it cannot, by any stretch of the imagination, be called idle.

    So you are wrong again.

    " All money in the "cash balance" as used in Rothbard's argument cannot be considered as "reserve demand".
    It is an obvious and dishonest change in the meaning of "reserve demand". "

    And this is just smear. Why is it dishonest? I could hold cash for short term expected requirements, emergencies or on a speculation that I could get more for it in the future than I can now. The last bit, especially is nothing more than holding off an exchange in expectation of a better "price" in the future. If that is not reservation demand, what is?

    So you still make no sense.

    ReplyDelete
  12. money itself is not a good produced and exchanged on the market.

    Correct. Money is *not* a produced commodity anymore. Therefore all such analysis does not apply to the real world.

    Money held in cash balance and not used to purchase consumption or investment goods serves the purpose of being prepared for uncertainty.

    Some of it is. And congratulations!
    You have just described J. M. Keynes' precautionary demand for money!!
    So you agree with Keynes here??


    In addition, especially for the "worst" case of what you call "idle" money, money in a safe, it serves a very important economic function - that of reducing the stock of money available for exchange When that happens, the purchasing power of every other unit of money in circulation improves. Thus, it cannot, by any stretch of the imagination, be called idle.

    You are must have price deflation for that to happen, for "every every other unit of money in circulation improves."

    Deflation does not increase production - REAL wealth creation.

    Therefore money held that produces price deflation is IDLE.

    ReplyDelete
  13. " You have just described J. M. Keynes' precautionary demand for money!!
    So you agree with Keynes here?? "

    How does it matter? Explain it first before I say anything.

    " You are must have price deflation for that to happen, for "every every other unit of money in circulation improves." "

    Deflation is a decrease in the supply of money. If people hoard their money or concert their monetary gold into ornamental gold, deflation has already happened. It is the fall in price that you should be referring to but insist on using the term deflation fairly dishonestly.

    And when deflation happens, ceteris paribus, prices will have to fall relative to what they would have been in the absence of deflation because the Total Stock curve moves leftward.

    " Deflation does not increase production - REAL wealth creation. "

    Deflation may not increase production, but the consequent improvement in the purchasing power of money in the hands of people makes it possible for people to save more and this savings can genuinely enable a lengthening of the structure of production as well as enable the production of more or new goods and services than earlier. In either case, real wealth creation is the consequence.

    " Therefore money held that produces price deflation is IDLE. "

    Therefore, there is NO money that is ever "idle". Money that is held and produces steady price decrease (I am rejecting your use of the term price deflation) makes a higher standard of living possible to mankind.

    ReplyDelete
  14. " Correct. Money is *not* a produced commodity anymore. Therefore all such analysis does not apply to the real world. "

    Wrong. The correct interpretation, as I told you on the other thread, is that what is today being treated as if it were money is not money in the first place. The problems of today are because of this debauching of money.

    ReplyDelete
  15. Deflation is a decrease in the supply of money etc etc

    I am well aware of the archaic Austrian use of the words "deflation" and "inflation" in their 19th century senses.
    That is why I said *price deflation*.
    It is ONLY *price deflation* that leads to the rise in money's purchasing power.
    You could easily have a significant amount of people holding money idle, although no price deflation results, only shortfalls in aggregate demand.

    Deflation may not increase production, but the consequent improvement in the purchasing power of money in the hands of people makes it possible for people to save more and this savings can genuinely enable a lengthening of the structure of production as well as enable the production of more or new goods and services than earlier. In either case, real wealth creation is the consequence.

    Deflation also has devastating effects.
    Debt contracts are fixed by law.
    Deferred purchasing is encouraged. Debt deflationary spirals can erupt. Debtors and creditors go bankrupt. Producers are penalized.
    This is what caused the severity and length of the contractionary period of the Great Depression.

    ReplyDelete
  16. " It is ONLY *price deflation* that leads to the rise in money's purchasing power. "

    Wrong. A rise in the purchasing power of money and a fall in the prices of goods are just 2 sides of the same coin. One does not and cannot cause the other. It is deflation that causes a fall in prices of goods.

    " Deflation also has devastating effects. "

    Pathetic argument.

    " Debt contracts are fixed by law. "

    So? Debtors ought to pay back their loans, ought they not?

    " Deferred purchasing is encouraged. "

    That's called "saving" in common parlance. I do understand that you Keynesians hate savings and want to do whatever you can to drive consumption.

    " Debt deflationary spirals can erupt. "

    Serious and damaging debt deflationary spirals happen only because in a prior inflationary period, massive credit expansion (typically possible only through a fractional reserve banking system) resulted in unwise loans being made to a lot of people.

    That apart, on a free market where money production is also in private hands, even price deflation will be under control. If the price of the monetary commodity goes beyond a certain level (there will always be such a level), it will become profitable for producers of the monetary commodity to churn out more of it and send it into circulation. This will automatically serve as a check on the rising price of the monetary commodity.

    " Debtors and creditors go bankrupt. "

    Debtors and creditors who make wrong decisions, even though they may have been wrongly guided by distorted interest rate signals that may have been someone else's fault, deserve to go bankrupt, if that is indeed the penalty the market would hand them. That's normal failure in business.

    " Producers are penalized. "

    for wrong decisions. That sounds OK. In fact, preventing the penalising is what leads to the problem of moral hazard.

    " This is what caused the severity and length of the contractionary period of the Great Depression. "

    Nonsense. The severity and length of the Great Depression was caused by faulty monetary, fiscal and trade policies. (Smoot-Hawley is one example. Gold confiscation was another. Public works were a third.). You also find it convenient to ignore the role of expansionary monetary policy in creating huge malinvestment between 1922 and 1929.

    You have swallowed too much Keynesian poppycock for you to make any sense. Read Rothbard's "America's Great Depression" to get the lowdown on the GD.

    ReplyDelete
  17. A rise in the purchasing power of money and a fall in the prices of goods are just 2 sides of the same coin. One does not and cannot cause the other.

    They are indeed related.
    However, you forget that price falls can come about by expansion of output and productivity increases. This isn't related to money supply.

    So? Debtors ought to pay back their loans, ought they not?

    Severe debt deflationary environments mean they can't and won't.
    This causes bankruptcy to BOTH debtors and creditors.

    Nonsense. The severity and length of the Great Depression was caused by faulty monetary, fiscal and trade policies etc

    Mistaken monetary policy was one factor, as Friedman argues. Smoot-Hawley had a role, but it clearly wasn't the only major factor.
    Debt deflation, bank runs, and a deflationary spiral were clearly *very* important factors as well.

    .Read Rothbard's "America's Great Depression" to get the lowdown on the GD

    Already have. Rothbard's book is unconvincing

    ReplyDelete
  18. " They are indeed related. "

    I am sorry if I wasn't clear the last time around, but PPM is the reciprocal of the price of the goods that money buys. If 1 house is 100 ounces of gold, the House Price of Gold 1/100. The House Price of Gold IS the purchasing power of God were it to be the money commodity.

    So,your statement above betrays your lack of understanding of this basic point.

    " but it clearly wasn't the only major factor. "

    Mindless assertion that carries no value in this argument.

    " Debt deflation, bank runs, and a deflationary spiral were clearly *very* important factors as well "

    Bank runs, debt deflation and the deflationary spiral were all consequences of the prior malinvestment (the one that happened from 1922-29). They are aspects of the depression. They are not the causes. We call it a depression because it was a period characterised by bank runs, debt deflation and the over-blown fears of a deflationary spiral.

    On a similar line, do you call a high body temperature the cause of a fever? It is the fever itself.

    You seem to have your "cause" and "effect" all mixed up (in true Keynesian style).

    " Already have. Rothbard's book is unconvincing "

    Yup!! I can understand how difficult it must be for those who have swallowed Keynesian poppycock for a number of years and are heavily invested in it to find it convincing. Further, the very fact that such people usually do not accept the validity of the Austrian Theory of the Business Cycle (with no valid arguments for the same) explains why AGD is unconvincing.

    ReplyDelete
  19. Bank runs, debt deflation and the deflationary spiral were all consequences of the prior malinvestment (the one that happened from 1922-29). They are aspects of the depression. They are not the causes.

    They were not fundamental causes of the initial downturn: they were fundamental causes of the spiral from 1929-1933, and reasons for the depth and duration of the contraction.

    Further, the very fact that such people usually do not accept the validity of the Austrian Theory of the Business Cycle

    The belief that Hayek's business cycle theory explains the Great Depression is refuted easily:

    ABCT takes account of the real capital goods sector, takes up Wicksell’s natural theory of the interest rate and Mises’ theories on money. ABCT postulates malinvestments in the capital goods sector.
    In the Great Depression, it was excessive debt to businesses and individuals who used this debt to bid up asset prices, causing a bubble. When this crashed, excessive private debt led to debt deflation and financial crisis, and an unregulated banking system collapsed in bank runs and failures, causing a money supply contraction and demand failure.
    Whatever distortion in the capital goods sector was minor compared to these factors.
    A very similar thing happened in 2000-2008: excessive debt to businesses and individuals in a system of ineffective financial regulation. People used this debt to bid up property prices, allowing yet more consumption via debt, and then the bubble collapsed, setting off a financial crisis and demand contraction.

    ABCT with its ridiculous obsession with malinvestments in the real capital goods sector is NOT an even remotely relevant explanation of this.

    ReplyDelete
  20. Let’s see if ABCT *predicted* the Great Recession.
    Here is J. G. Hulsmann explaining ABCT in 2001:

    “ABCT claims that injections of new quantities of money into the credit market can reduce the rate of interest below its equilibrium level; with the new money, entrepreneurs make additional investments in higher-order production stages, bidding laborers away from other branches of industry. This new course of action is entirely unsustainable, … It cannot be sustained. Sooner or later the market participants will discover that the available resources do not suffice to complete all ongoing investment projects. The moment of this discovery of past errors is the "crisis"; it entails rising unemployment and other forms of reallocation of resources, jeopardizing previous plans, destroying communities and firms”
    Hulsmann, J. G. 2001. “Garrisonian Macroeconomics,” Quarterly Journal of Austrian Economics, 4.3: p. 36-37.

    You think this is an explanation of the 2007-2008 crisis? What happened in the 2000s was excessive private debt to consumers who bought houses and then went further into debt to finance consumption.
    The crisis was NOT caused by malinvestments in “higher-order production stages”. That is laughably false.

    ReplyDelete
  21. " What happened in the 2000s was excessive private debt to consumers who bought houses and then went further into debt to finance consumption. "

    What is laughably false is your implicit statement that a house is a consumption good. Your lack a sound theory of capital (once again due to swallowing too much Keynesian poppycock) is showing.

    If I buy a house at a price of $300,000 and the house is expected to last 30 years, ONLY $10,000 of it is a consumption good in any 1 year period. The remainder is a capital good. Banks loaned money based on their appraisal of the capital value (not to be mixed up with the concept of subjective value) of the house BEFORE any consumption happened. Hence, the loans were made against and for capital goods and not for consumption goods.

    So much for your explanation.

    ReplyDelete
  22. " ABCT with its ridiculous obsession with malinvestments in the real capital goods sector is NOT an even remotely relevant explanation of this. "

    And Keynesianism with its complete lack of a proper theory of capital is a cruel joke on the science of economics. Your use of the phrase "real capital goods sector" betrays your vacuity.

    ReplyDelete
  23. Your use of the phrase "real capital goods sector" betrays your vacuity.

    I see. In what way?
    Here is the definition of ABCT by an Austrian scholar:

    ABCT is unique in including real capital goods among its elements in a manner which does not assume away their essential heterogeneity. Austrian treatment of capital goods owes much to Bohm-Bawerk’s structure of production analysis and the notion of capital complementarity. The theory demonstrates the connection between this structure of capital and monetary policy by way of Wicksell’s natural rate of interest theory and Mises's integration of money into general economic theory Batemarco, R. J. 1998. “Austrian Business Cycle Theory,” in P. J. Boettke (ed.), The Elgar Companion to Austrian Economics, Elgar, Cheltenham, UK. p. 216.

    ReplyDelete
  24. I said:
    consumers who bought houses and then went further into debt to finance consumption.

    You say:
    What is laughably false is your implicit statement that a house is a consumption good.

    My reference to "consumption" above refers to consumer goods(TVs, DVDs, clothes etc).

    Even if you consider houses as capital goods or partly capital goods, what was going on was not malinvestment in higher-order production stages.

    ReplyDelete
  25. " My reference to "consumption" above refers to consumer goods(TVs, DVDs, clothes etc). "

    Lack of a theory of capital once again. A TV is not a consumption good. A TV delivers satisfaction over a fairly long life-time. If a TV lasts 10 years and costs $200, in year 0, i.e., at the time of purchase, it is a pure capital good (though of the first order). In year 1 of use, $20's worth is a consumption good and $180's worth is a capital good.

    A similar treatment would apply to DVD's and clothes.

    This is the proper treatment of durable goods. So, you are still wrong.

    ReplyDelete
  26. " Even if you consider houses as capital goods or partly capital goods, what was going on was not malinvestment in higher-order production stages. "

    You mean to say that home builders did not invest substantially in capital goods necessary for meeting the surge in the demand for houses? Do you mean to say that manufacturers of raw materials did not invest heavily in increasing capacity?

    I guess all those homes just appeared magically out of thin air just as all the money that financed it did.

    ReplyDelete
  27. " I see. In what way? "

    In the way that you are completely unable to see durable goods as capital goods? That you see televisions and DVD players as consumption goods in an economic sense? That you forget that praxeology goes all the way upto the actual delivery of the satisfaction that the individual receives from consumption?

    Vacuity in the sense that you have no theory of capital?

    ReplyDelete
  28. That you see televisions and DVD players as consumption goods in an economic sense?

    I see. You believe that TVs and DVD players when purchased by ordinary private people for private home use (and not by a business to provide a service) are capital goods only?? That they are NEVER consumer goods?

    Where does Mises or Rothbard say that a TV when purchased by a private consumer is a capital good?

    ReplyDelete
  29. Capital goods, then, are products which are not produced for immediate consumption; rather, they are objects that are used to produce other goods and services .... Manufacturing companies also use capital goods .... capital goods are sometimes referred to as producers’ goods or means of production. An important distinction should also be made between capital goods and consumer goods, which are products directly purchased by consumers for personal or household use.
    http://en.wikipedia.org/wiki/Capital_good

    So when a private consumer purchased a TV or DVD player for home use (from, say, refinancing their mortgage in the 2000s), they were purchasing a capital good?

    Thanks

    ReplyDelete
  30. " So when a private consumer purchased a TV or DVD player for home use (from, say, refinancing their mortgage in the 2000s), they were purchasing a capital good? "

    Firstly, I was just using the example to show that you have no clue about the nature of durable goods or that you have any theory of capital at all. Secondly, out here where I live (that's India), I can sell my car or TV or DVD player on a 2nd hand market, though the price is not likely to be anything comparable to that of a new one. Thirdly, the TV or the DVD player are not exactly present goods in a praxeological sense. They do not deliver their satisfaction at an instant but spread out over a period of time. So, they are not pure consumption goods. Fourthly, a television or a DVD player "can" serve as a capital good because I can rent them out just the way i may rent out my house. Finally, ALL capital goods get consumed. Even if I buy a machine for the purpose of applying it in a process that churns out final consumption goods, they are "consumed" proportionately in every time period.

    The essential difference I am trying to show is that a television or a DVD player is not completely a "present good". There is a little bit of a "future good" in that too.

    That apart, your claim that the cause of the bubble was that people borrowed for such consumption goods is completely laughable and flies in the face of facts.

    Further, what they did with the money that they got on a top up mortgage is irrelevant. The crucial issue was that the money was received as a top-up mortgage. That means that the loans were made on a capital (at least partially) good like a house.

    The key point in all this is your denial of the role of malinvestment in the home building sector to make possible the massive bubble in housing.

    Did all those houses apprar out of thin air the way the Fed and the FRB system magically create money out of nothing?

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  31. " I see. You believe that TVs and DVD players when purchased by ordinary private people for private home use (and not by a business to provide a service) are capital goods only?? That they are NEVER consumer goods? "

    Not exactly. I am just trying to show that they are not pure consumption goods on account of their durability.

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  32. All this in any case takes away from the primary point which is that your attack on Say's Law stands completely discredited on the mises.org thread.

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  33. Take a further case. I buy a house on a mortgage. I then take a top-up loan, use it to buy televisions, furniture, etc and then rent the house out as a "fully furnished house". Is the TV then a cspital good? I am just saying that not all TV purchases are "consumption".

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  34. What about all those people manufacturing indoor swimming pools and granite kitchen counters? Were they or weren't they malinvestments?

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  35. Fourthly, a television or a DVD player "can" serve as a capital good because I can rent them out just the way i may rent out my house.

    Yes, I know that. That point is that people buying commodities through excessive private debt are NOT using them as pure capital goods.

    The key point in all this is your denial of the role of malinvestment in the home building sector to make possible the massive bubble in housing

    I don't *deny* it at all. However, it is only one factor, and regarding ABCT it still does not provide a fundamental explanation of the 2000s bubble and 2008 financial crisis. For that, you need to look at excessive private debt, asset bubbles, poorly regulated financial systems, financial innovation, and Hyman Minsky's financial instability model.

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  36. What about all those people manufacturing indoor swimming pools and granite kitchen counters? Were they or weren't they malinvestments?

    They are not the malinvestments postulated by ABCT.

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  37. " and regarding ABCT it still does not provide a fundamental explanation of the 2000s bubble and 2008 financial crisis. "

    Do you understand ABCT? I am asking this because if you did, you would't make this statement and this one.

    " They are not the malinvestments postulated by ABCT "

    ABCT does not help one identify where the malinvestments will be. It only says that there will be widespread malinvestment.

    I am still waiting for your refutation of ABCT. Until now, I am seeing just isolated random assertions without a whiff of an argument.

    Finally, your last comment about the context of Keynes' remark does not address my objections to your claim of having refuted Say's Law. So, as it stands between us, Say's Law holds - in the long as well as short run.

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  38. On Minsky, his FIH and your claims of their magical predictive powers, here's some food for thought.

    http://mises.org/daily/2787

    " For that, you need to look at excessive private debt, asset bubbles "

    What causes these? Are these just a product of complex modern capitalism? Why do you Keynesians fail to think?

    " poorly regulated financial systems "

    Ha! Ha! Ha! As usual, when government intervention causes a problem, all you Keynesians rush out of your foxholes to scream that the solution is more government intervention. Your joke never stops.... Thanks for the laughs.

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  39. Just a particular sentence from the article I mentioned.

    "We thus conclude that Minsky's Financial Instability Hypothesis doesn't prove that the capitalistic system is inherently unstable. The instability that Minsky has identified has nothing to do with capitalism, per se, but rather with the institution (the central bank) that prevents the efficient functioning of capitalism." - Frank Shoshtak

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  40. Thanks for your comments.

    ABCT does not help one identify where the malinvestments will be. It only says that there will be widespread malinvestment.

    Unfortunately it does: in the capital goods sector where output will shifted to the more remote future.

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  41. " Unfortunately it does: in the capital goods sector where output will shifted to the more remote future. "

    Have you read "Prices & Production" by Hayek? He explains very clearly the difference between the lengthening of the structure of production when genuine savings are injected into the production system and that which happens when fiduciary media are created and injected into the production system. The effect is clearly not what you have stated.

    Hayek clearly states that when genuine savings are invested, the lengthening proceeds towards remoter stages while when fiduciary media are injected, the lengthening (through additional capital investment) proceeds in favour of the stages where the injection happens. If the latter happens to be at the consumer goods production stage, then more malinvestments would be headed in that direction.

    So, the way I interpret Hayek, more of the malinvestment happens closer to the point of injection and less down the line. So I find no sense in your statement "more remote future".

    At the very best, the only sense in which you may be right is to restate your statement as "When credit is injected into the production of consumption goods, malinvestment happens not just in that level but also in the production of 1st, 2nd, 3rd, etc. orders of producers' goods as well."

    So, if fiduciary media are injected into housing, ABCT would predict that at the very least, malinvestments would happen in various industries linked closely with the housing sector. Since various industries are linked with one another almost inextricably, a credit injection of sufficiently large proportion can lead to fairly large malinvestment across the board.

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  42. In fact, taking this a further step forward, even this surge in investment in producers' goods industries linked to the bubble industry (the injection point of fiduciary media) would not be a problem if the bubble could be sustained by non-stop injection credit into the system of production.

    The problem is that it is not possible to keep injecting credit in the production system through the creation of fiduciary media. There will come a stage when interest rates will have to go up and a large number of firms which either started or expanded under the earlier artificially low interest rate regime find conditions unsuitable for profitable operations and hence shut down. There are 2 reasons for this. Firstly, interest costs rise and financial projections go haywire. Secondly, people have not made any real savings to pick up all the consumption goods churned out by the vastly expanded production system.

    The rash of business failures that occurs at this stage is the depression/recession.

    The main point of ABCT is not predicting particular industries where the malinvestment happens but explaining the process by which massive credit expansion through massive creation of fiduciary media creates an unsustainable boom that inevitably ends in the bust.

    So your random and arbitrary statements actually do not even scratch the surface of ABCT, leave alone refute it.

    Incidentally, I am still waiting for your refutation of ABCT.

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  43. Why ABCT does not explain the housing bubble and financial crisis of 2008:

    http://socialdemocracy21stcentury.blogspot.com/2010/10/austrian-business-cycle-theory-its.html

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  44. Thanks. That just leaves a very important question. Is a house a pure consumption good? I think that sort of settles it.

    In any case, this does not constitute a refutation of ABCT in general. It is only a claim that ABCT did not predict the current crisis.

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  45. In fact, your post does not even touch upon the essence of ABCT - That credit expansion through creation of fiduciary media CAUSES the business cycle.

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  46. In any case, this does not constitute a refutation of ABCT in general

    LOL.. if you read it, will see it's not meant to. It shows how ABCT cannot explain the 2008 crisis. My actual critique will come later.

    **In this post I will analyse what appears to me to be most important form of ABCT: the form postulating distortions in the capital goods sector ... and how this simply cannot be invoked as a serious or fundamental explanation of the US housing boom in the 2000s and financial crisis of 2008.**

    Thanks

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  47. I have a simple answer - Home flipping makes homes a first order capital good.

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  48. Let's see if I can understand something...

    I may think that, in today's real world, Say's law may not hold true because money is now longer a commodity. But this still leaves the question open if Say's law holds in a commodity-backed money world.

    One of the big issues most Keynesians bring about when discussing is "deflation" (I refer to the current meaning of deflation, what Lord Keynes called *price deflation* in this post). They will point out the disastrous consequences of deflation. Lord Keynes said:

    "Deflation also has devastating effects.

    (1) Debt contracts are fixed by law.
    (2) Deferred purchasing is encouraged.
    (3) Debt deflationary spirals can erupt.
    (4) Debtors and creditors go bankrupt.
    (5) Producers are penalized."

    (1) is clearly a legal issue. I can (and possibly should) not be that way. Furthermore, those contracts can have varying forms, and could address the "deflationary" issue.

    Then, is nothing inherently wrong with (2). As long as the market can adapt to the new purchasing scheme, it would work quite fine.

    (3). This may happen as the deflation was not expected at all by the economic agents. This goes for (4) and (5) as well.

    So I think the main issue is that most of the "fear of deflation" actually seems to exist because the real issue is "fear of *unexpected* deflation". I just can't see how the market (the economic agents) won't be able to handle it, as we can currently handle inflation (when it happens in an smooth and expected way).

    What do you think about this Lord Keynes? Do you think that, even when the economic agents know deflation is the rule, it will still hold its "devastating effects"? I just can't see how "aggregate demand" problem could arise with a commodity-backed money and a little bit of deflation.

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  49. Anonymous,

    Even in a world of commodity money, Say's law still does not work, because of shifting liquidity preferences, changing idle money and subjective expectations in the process of investment.

    And the issue is not just unexpected deflation: it is also financial crises, banking panics, and debt deflation. If the market can "handle" unexpected deflation properly (along with these other things), then the Great Depression would not have happened, nor would the 1899s US downturn with high involuntary unemployment lasting nearly a decade have happened either.

    Nor would Australia's devastating 1890s depression have happened. And the list goes
    on ...

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  50. "Even in a world of commodity money, Say's law still does not work, because of shifting liquidity preferences, changing idle money and subjective expectations in the process of investment."

    May I come as an idiot, but what exactly do you refer when saying that Say's law still does not work? Are you referring to Say’s Equality, to Say’s Identity, or both of them?

    I think that the law is pretty poor as such, because it's based on undefinable terms (significant amount of time, brief periods of disequilibrium, equilibrating forces that must soon bring the two together). It's the impossibility of properly defining that time periods that renders the law null and void.

    I may argue that equilibrating forces always exist (at least, in the long run) but it's pretty possible for an economy (unhampered or not) to fall into a recession and/or high unemployment period.

    And I made a big mistake in my previous comment. What I meant to say is that the market can be (at least, theoretically) pretty good at handling *expected price deflation*, not *unexpected price deflation*. What I can't see is how unexpected price deflation might occur in a free market causing all the coordination problems we already know.

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  51. Are you referring to Say’s Equality, to Say’s Identity, or both of them?

    Both. They are both false propositions, as I argue above.

    In particular, Say’s Identity - the idea that "no one ever wants to hold money for any significant amount of time, so that, as a result, every offer (supply) of a quantity of goods automatically constitutes a demand for a bundle of some other items of equal market value" (Baumol 1977: 146) - is perfectly absurd.

    "What I meant to say is that the market can be (at least, theoretically) pretty good at handling *expected price deflation*, not *unexpected price deflation*"

    Yes, there is some evidence that expected deflation may not be as bad as severe unexpected deflation when an asset bubble bursts in an eocnomy with excessive private debt.

    Deflation was severe but expected in 1920-1921, but, as I have argued elsewhere, there was no huge asset bubble in 1920, financial crisis, mass bank runs or excessive private debt:

    http://socialdemocracy21stcentury.blogspot.com/2010/10/us-recession-of-19201921-some.html

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  52. Just read you article, I found it very interesting, thanks. I found that most of my views, ideas and doubts were already stated by "Edward", to whom you said:

    "Edward,

    Thanks for your comment. You make some intelligent points I agree with, on the Fed's role, deflation, and debt deflation. I did reply on the Krugman in Wonderland blog."

    Could you please send me the URL of the post you commented in "Krugman in Wonderland" blog?

    All this reading is shaking my Austrian foundations!

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  53. For the discussion on the 1920-1921 recession:

    http://krugman-in-wonderland.blogspot.com/2010/10/austerity-bogey.html

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  54. "All this reading is shaking my Austrian foundations!"

    Well, I do in fact think there are some intelligent ideas in Austrian economics, particularly in the work of Ludwig Lachmann.

    My thoughts on Austrian economics are here:

    http://socialdemocracy21stcentury.blogspot.com/2010/12/different-types-of-austrian-economics.html

    Also, the early Austrians were by no means hostile to all government intervention:

    http://socialdemocracy21stcentury.blogspot.com/2010/10/friedrich-von-wieser-and-eugen-von.html

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  55. Well, also Mises, the non-interventionist, had helped set some economic policies while working as an economic advisor in Austria.

    While I may not be against government intervention in a theoretical way, I'm very distrustful and skeptic about government action. That's why, among similar alternatives, I would naturally choose the more free market oriented, mostly because of Occam's razor. Also, I prefer the impersonality of the "invisible hand" against the personalism and purposeful action of the visible hand of the government.

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  56. Hi LK,

    I'm aware this is an old post, but I'd just like to point out something Brad Delong discovered: Say did not believe in Say's Law!

    That's right. After the panic of 1829, he conceded that there could be a general glut, and JSM came to the conclusion that there wasn't a general glut, if you included money as a commodity.

    http://delong.typepad.com/sdj/2011/04/hoisted-from-the-archives-macroeconomics-is-not-hard.html?asset_id=6a00e551f080038834014e88231f4b970d

    The classical economists were Keynesians.

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  57. TMMblog,

    Very interesting link and a good point.

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  58. "The money itself is NOT wealth."
    actually one of the functions of money apart from being the medium of exchange is also a store of wealth. this function is what keynesians and most other schools of economics forget.

    Says laws works in the long-term and that is all that matters. just as is inflation in a boom, there must be deflation in a bust.
    "And the issue is not just unexpected deflation: it is also financial crises, banking panics, and debt deflation."
    to have no deflation requires that growth must be organic (like 1%) and no mistakes have been made. I agree with keynes that irrational behavoir does exist as well as easy credit giving wrong signals. my main point is that the markets will punish everyone accordingly. I agree with some keynesians analysis but not one of their solutions.

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  59. "actually one of the functions of money apart from being the medium of exchange is also a store of wealth. this function is what keynesians and most other schools of economics forget.

    That is a ludicrous statement. Keynesians forget that money has a store of value function?? You have no idea what you're talking about.

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  60. I think this discussions about Say's law really don't add anything to a better understanding of the economic system.

    Most of the time I'd say that Say's law is something impossible to disprove, but that depends on how you define it. For example, every time I encounter a criticism of it, I find it to be a particular market disequilibrium, being, in all cases, a disequilibrium in the market for money. This way, we can state that Say's law still holds.

    An opponent of the law will say that it doesn't hold, because there can still be demand left over by the increased demand for money (or liquidity preference). As Lord Keynes said:

    "This still does not save Say’s law. Although the value of all commodities held by “reservation demand” equals the value of such commodities included in total factor payments, there will still be the value of commodities not purchased by consumption or investment on capital goods in AD left over."

    This is a strange way to put it, since that part of "AD left over" is the supply of money reduced (most commonly referred to increase in demand for money). In fact, those individuals who preferred to keep more money in their cash balances decided to do it because they value it higher than the then-present goods at the then-present market value.

    Lord Keynes then goes on to argue:

    "But this trick will not save Say’s law. In (3), (4), (5), and (6), money will be idle and not spent on aggregate supply. Without total factor payments going to purchase commodities or to capital goods investment, aggregate demand failures can occur."

    Sure. Aggregate demand failures can occur, since in any given period there can be money not spent on consumption nor investment. But I still can't see how it invalidates Say's law. Note that, even that I consider that the equality still holds, aggregate demand failures can happen anytime.

    So I would strip away of content to the Say's law. I'd rather say that the main difference between Keynesians and not Keynesians is whether the free market provides any way of equilibrating savings (including hoarding, the way of saving most attacked by Keynes) and consumption/investment. That way we can focus on market mechanisms and their efficiency towards producing the desired output instead of focusing in commodities unsold, bankruptcies and underemployment, which are the results of the former.

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