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by Ben Best
Say's Law is the principle that supply constitutes demand. Or, in the words of economist Jean Baptiste Say, "...a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." (A TREATISE ON POLITICAL ECONOMY, Chapter 15).
J.B.Say (1767-1832) is the French economist who coined the word entrepreneur to describe an economic agent independent from the landlord, worker or even capitalist (since the entrepreneur may secure financing from others). Say wrote his TREATISE to counter the Mercantilist doctrine that money is the source of wealth. According to Say, goods buy goods, and money mediates the transaction: "It is not the abundance of money but the abundance of other products in general that facilitates sales." James Mill expanded on Say's argument in his book COMMERCE DEFENDED to counter the belief that underconsumption is the cause of economic recession — and to counter the belief that increased consumption is the remedy for recession. Say incorporated Mill's ideas in subsequent editions of his TREATISE. Say was emphatic that consumption destroys wealth and that only production creates wealth.
Thomas Malthus was the foremost classical economist who promoted the idea that underconsumption causes recession. Malthus blamed the wealthy for saving rather than spending. David Ricardo, in answering Malthus, invoked J.B.Say to write: "The shoemaker when he exchanges his shoes for bread has an effective demand for bread." Ricardo attributed post-war depression & unemployment to a mismatch of supply & demand, rather than to underconsumption.
Classical economics incorporated the ideas of Say, Mill and Ricardo rather than Malthus in its body of wisdom. These ideas were augmented by John Stewart Mill who emphasized the role of savings rather than consumption in wealth-creation when he said: "...to consume less than is produced, is saving; and that is the process by which capital is increased."
The beliefs of Malthus were revived during the Great Depression of the 1930s by John Maynard Keynes in his book THE GENERAL THEORY OF EMPLOYMENT, INTEREST AND MONEY (1936). It may not be much of an exaggeration to state that the GENERAL THEORY is little more than a protracted attack on Say's Law — a reversion to Malthus in claiming that underconsumption (low "aggregate demand") causes recession & unemployment — and the claim that government spending (financed by deficits, taxes or inflation) and subsidized consumer spending can compensate for "demand deficiencies". In his preface to the French edition of THE GENERAL THEORY Keynes refers to Say's Law as a "fallacy" and describes his own book as "a final break-away from the doctrines of J.-B. Say".
In the first section of Chapter 3 of his GENERAL THEORY, Keynes states Say's Law to be "supply creates its own demand" and he interprets Say's Law to mean "that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output". Both Keynes' statement and interpretation are erroneous. Say's Law states that a produced good represents demand for other goods, not for itself (as "its own" could imply). Say's Law does not equate supply & demand (Keynes' belief that Say's Law means that everything that is produced is sold), but makes supply a precondition for demand. Supply equals demand at the clearing price on a supply-demand curve (for particular goods and aggregates), but Keynes was wrong to equate supply/demand curves with Say's Law. Supply constitutes demand, but demand does not constitute supply — one cannot have the means to buy without first having something to sell. Supply of a good can constitute demand for other goods.
As Murray Rothbard put it, Keynes "possessed the tactical wit to dress up ancient statist and inflationist fallacies with modern, pseudoscientific jargon, making them appear to be the latest findings of economic science." Keynes' recommendations for government spending were music to the ears of politicians eager to expand the role of government, and to merchants eager to sell goods by any means. Keynesianism replaced what Keynes dismissed as "classical economics". And Keynes' misrepresentation of Say's Law as "supply creates its own demand" was accepted as if it were a quotation from J.B.Say.
Classical economists did not refer to the principle that "supply constitutes demand" as "Say's Law", but called it "the law of markets". The phrase "Say's Law" was probably coined by Fred Taylor, who wrote a widely used introductory textbook early in the 20th century (PRINCIPLES OF ECONOMICS, 1921). Although J.B.Say deserves credit for being the first word on the law of markets, he was neither the last word nor the most articulate exponent. Say's Law is not an obscure & insignificant economic tenent. I regard it as the most important issue in economics: how a society creates wealth.
This essay is an analysis of the idea that "supply constitutes demand", which I will call "Say's Law". It might seem appropriate to equate the phrase "Supply-side Economics" with Say's Law were it not for the fact that this phrase has been associated with a policy of cutting taxes (without cutting government spending) to stimulate the economy. This essay is less concerned with historical analysis of Say's Law and of "who said what" than with grasping essential principles. For a thorough scholarly analysis of Say's Law, including its exponents & detractors, I highly recommend SAY'S LAW AND THE KEYNESIAN REVOLUTION by Steven Kates — by far the best book on every aspect of Say's Law.
Knowledge of the laws of supply & demand from an Austrian perspective — and familiarity with The Austrian School of Economics — would be very helpful for understanding my analysis. I therefore encourage readers to read my review of MAN, ECONOMY AND STATE to the end of the second chapter before proceeding with this essay.
A useful tool for gaining economic understanding is to engage in thought-experiments that begin with analysis of isolated individuals ("Crusoe Economics"), then analyze a barter economy, then analyze a money economy, then analyze money & interest — and finally attempt to add all components of modern economy, including governments, international trade, currencies, technology, etc. I will start with this approach.
Because Say's Law is related to supply & demand — and because supply & demand are terms applied to the exchange of goods — the application of Say's Law to Crusoe Economics (where there is no exchange) might seem inappropriate. But supply & demand can be identified with production & consumption.
Robinson Crusoe on his deserted island produces a supply of fish & berries that he demands for consumption. How many berries and how many fish he produces will be a function of both his capacity for production and his desire for these goods. If production is difficult he may have to work hard just to produce enough to survive. If production is easy, diminishing marginal utility for extra fish & extra berries means reduced demand for these products — leaving him time to make clothes, build a shelter and enjoy leisure. Crusoe can produce without consuming, but he cannot consume without producing. That consumption requires production is true of any economy, but the fact is more glaringly obvious in a Crusoe economy. The emphasis on spending & consumption as a source of economic growth appears ludicrous in the context of Crusoe economics, which demonstrates why Crusoe economics is a useful "thought experiment".
Crusoe Economics also calls attention to a weakness of a simplistic interpretation of Say's Law: for Crusoe it is demand (his desire to consume) that motivates his production — and the marginal utility of his supply which diminishes his demand. ("Marginal utility" refers to the fact that the more we have of any good — bags of salt, for example — the less we value each additional unit. That is, each additional bag of salt give us less utility per bag). It would be simplistic to think that Crusoe could produce berries in abundance and yet continue to value them as much as he would value them if he were starving.
It is in a barter economy that the principle of Say's Law is most obvious. A potato farmer may grow some potatoes for personal consumption, but most of the potatoes she grows will be produced to exchange for other goods — clothing, furniture, medicine, etc. The supply of potatoes produced constitutes the farmer's demand for goods & services. The more potatoes she produces, the more other goods she can demand. "Demand" is not simple wanting. A starving person wants food, but can exercise no demand without producing something to offer in exchange (if there is no charity or coercion). In an exchange economy demand means purchasing power. In a barter economy, purchasing power means produced goods which are demanded by others. A person's supply, when demanded by others, constitutes that person's demand for the supply of others.
A barter economy also illustrates the same shortcomings of the simplistic interpretation of Say's Law seen in Crusoe Economics. If too many people devote themselves to the production of potatoes, the supply of potatoes will become very large and the marginal utility of potatoes will be very small. For an economy with overabundant potatoes, additional potatoes will have very little purchasing power. The supply of potatoes will still represent demand, but on a per-potato basis the demand is considerably weakened when the supply of potatoes is very large. Stated another way, when demand for potatoes is small, the demand (purchasing power) exerted by potatoes is also small.
Why would an economy produce an excess of potatoes or any other product? Goods produced (supply) have high purchasing power when those goods are in high demand (many people strongly wanting to consume them and existing supply is low). Production takes time. For agricultural products there typically are many months between planting and harvest. A farmer may need to decide between planting potatoes, cotton, soya beans, wheat or a number of other products. In part she will make the decision of what to plant on the basis of available equipment, soil & experience with crops — and in large part on the basis of expected profitability of the crop — how much the crop is in demand.
If there had been a major potato blight in a neighboring country potatoes may be very scarce (low supply) and the demand (price) of potatoes very high. This high demand may create an incentive for many farmers to plant potatoes. But at harvest time, the market might be glutted with potatoes — ie, so many potatoes have been produced & offered for sale because of the earlier prospects of high demand that farmers cannot even recover their costs of having grown them.
The desire to create supply that will have purchasing power motivates not only productive effort, but attention to correct forecasting. A potential producer who aspires to create supply which will have purchasing-power must pay attention not only to the potential demand by consumers, but to the potential supply of competitors.
Production cannot be blind. Supply only constitutes demand if the goods or services supplied are in demand. A supply of mudpies is not likely to constitute much demand. It is doubtful if any reasonable person would build a factory for mass production of mudpies with the thought of exchanging the mudpies for valuable goods & services. In the words of Dr. Murray Rothbard, "On the free market everyone earns according to his productive value in satisfying consumer desires."
Because the vast majority of production is for the purpose of exchange rather than personal consumption, every producer must be a forecaster — have a reasonable expectation that demand will be strong for the products he/she produces. Astute forecasting can lead to excellent profits whereas with poor forecasting it may not be possible to recover production costs. Luck can also be a factor. Exceptionally good weather may result in bountiful harvests for farmers, whereas exceptionally poor weather could lead to poor crops. It may be impossible to forecast weather with precision, but with years of experience producers learn to plan for tolerable extremes. In every area of production, the biggest profits go to those who successfully forecast and produce-for large demands that few others anticipate — especially including demand for new products that have never before been sold.
"The market reflects all the jobber knows about the conditions of the textile trade; all the banker knows about the money market; all that the best-informed president knows of his business, together with his knowledge of all other businesses; it sees the general condition of transportation in a way that the president of no single railroad can ever see... "
— Charles Dow
J.B.Say contended that the economics of a money economy are no different from the economics of a barter economy — that money is simply a vehicle for simplifying the exchange of goods (eliminating the problem of coincident wants). But a money economy is significantly different from a barter economy, not only because eliminating the problem of coincident wants is significant, but because money greatly increases the ability to forecast & calculate through the mechanism of prices. In a money economy the fact that overproduction of potatoes has occurred quickly becomes evident when the cost of producing potatoes exceeds the sale price of the potatoes produced.
Prices not only allow for calculation of the effectiveness of current production, prices play a significant role in forecasting future production. Current losses due to sales revenue inadequate to cover the costs of production for certain goods are a strong disincentive to continue producing large quantities of those goods in the future. Conversely, high prices — well above costs of production — can be charged when the produced supply is low relative to demand. Large profits from the production of certain goods represent powerful incentives for current producers to increase output of those goods and for new producers to become competitors — with the result that supply goes up and prices (and profits) go down.
Prices are thus an important signalling mechanism directing future production ("reproduction"). Karl Marx had no understanding of this process when he claimed, "Violent fluctuations in price ... cause interruptions, great collisions, or even catastrophes in the process of production" [DAS KAPITAL, Volume III]. The same fuzzy-headed analysis occurs in THE POVERTY OF PHILOSOPHY where Marx claimed that disproportionality of the price-allocation mechanism causes "overproduction and many other features of industrial anarchy". Marx dismissed Say's Law as "childish babble", "pitiful claptrap" & "a paltry evasion" — and he denied that production is the result of the desire to consume.
David Ricardo held that the value of goods is equal to the cost of producing those goods. Marx believed that all costs of production are ultimately reduceable to labor costs — a "labor theory of value". But if the value of goods consists entirely of the cost or labor that has gone into producing them, then mudpies acquire value through the labor required to make them. There would be no incentives to increase production efficiency — mudpies made through tedious, strenuous & time-consuming methods would be more valuable than mudpies made through simple & efficient methods.
Socialist economies have placed great stress on production, repeatedly setting "5-year plans" for increased output. But socialism not only lacks the incentives for production (profit motive), it results in the very misallocation of productive effort (overproduction/underproduction) that Marx mistakenly attributed to the "industrial anarchy" of capitalism. In his essay "Economic Calculation in the Socialist Commonwealth", Ludwig von Mises states that under socialism, "because no production-good will ever become the object of exchange, it will be impossible to determine its monetary value". Socialism therefore has no basis for rationally setting prices or allocating productive resources. Socialist bureaucrats make unfounded guesses about where a railroad should be built or the size of a factory for the production of tractors. In a free market, supply & demand result in prices that can be used for the calculations necessary to rationally allocate resources.
In classical economics, the controversy over Say's Law is closely associated with the concept of glut (overproduction). Some defenders of Say's Law originally denied that a glut of any good (such as potatoes) is possible — because the law of supply & demand dictates that there will always be a price at which a good will clear the market. At one point, J.B.Say himself tried to defend his law with the assertion that a supply of goods which is not in demand does not constitute "real" demand. Say also suggested that the overproduction of a single product is in reality an underproduction of all other products. Say ultimately acknowledged overproduction of specific goods by defining a glut as the condition existing when the cost of producing a specific product is greater than the purchasing power of the product.
John Maynard Keynes described unemployment as a glut of laborers and used this description as his refutation of Say's Law. Keynes asserted that Say's Law would lead to the prediction that a glut of labor could not exist, and Keynes claimed that the existence of unemployment is living proof of the invalidity of Say's Law. The Monetarist Milton Friedman responded with the argument that there is a "natural rate of unemployment" — challenging Keynes' assumption that full employment is a reasonable goal or that any level of unemployment necessarily constitutes a glut. Those who understand supply & demand realize that artificially low prices result in shortages and artificially high prices result in gluts. Unionism enforces (with legislative backing) wage-rates above the clearing price of labor — resulting in unemployment (labor glut). The image of shops full of goods too expensive for people to buy ignores the reality that shopkeepers cannot stay in business long under such conditions.
In general, a free market economy would rarely experience such gross misallocations of productive resources. By contrast, in government-dominated economies characterized by bureaucratic regulation, legislative & judicial disruptions and manipulation of fiat currencies by central banks — massive & sudden misallocations of resources resulting in a general glut is not only possible, but common.
General gluts are not the cause of recession, but are the effect of recession. When business activity slows in one or several large industries, sales drop and inventories of unsold goods accumulate. Manufacturing must be reduced to prevent further accumulation of unsold goods — leading to layoffs & unemployment. Unemployed workers do not create new goods or services which can translate into purchasing power — and the glut of unsold inventory continues and may spread to other industries until productive resources can be reallocated. Gluts are no more the cause of recession than are the reduced manufacturing or the unemployment associated with recession. Recessions are caused by conditions which have caused a gross misallocation of productive resources. For a detailed discussion of the ultimate cause of recessions, see my essay An Austrian Theory of Business Cycles.
When an economy is in recession (usually due to the actions of central bankers), unemployment and misallocation of resources results in the accumulation of inventories of products. Production is reduced and merchants reduce prices — even to the point of selling at a loss — in order to gain some value from the inventory. With consumers earning less purchasing power due to reduced production, demand for goods remains low as inventories are used and misallocated resources become redirected. Austrian economists say this deflation is a necessary healing process following the resource misallocations of the artificial boom, but Keynesians & Monetarists say that the deflation is economically harmful because it discourages spending (consumers will refrain from spending when they expect prices to fall further). "Printing money" to stop the deflation only erodes economic stability, does not increase wealth and may even lead to "stagflation".
Suddenly doubling all goods & services in an economy (everything else being equal) would not double the wealth of that economy. Doubling all goods & services would result in an aggregate glut, but the glut of some goods would be more severe than of others. Consumption of salt would probably not increase very much. Therefore, the doubled supply of salt would constitute a gross glut of salt (which follows from marginal utility theory). By contrast, doubling the supply of diamonds would probably increase the use of diamonds considerably (although marginal utility still applies).
As technological processes increase productivity, gluts of obsolete products (& products already being produced in sufficient amounts) send price signals to markets, shifting productive resources. The advent of the automobile resulted in gluts of buggy-whips & horse-drawn carriages. To continue the production of buggy-whips & carriages would be a gross misallocation of productive resources. The economy is best served by buggy-whip manufacturers going out of business and finding new ventures — and for their employees to find new work. Government programs intended to stimulate sales of inventories of salt, mudpies & buggy-whips — or any good or service — do more economic harm than good, by sustaining misallocation of resources.
Hundreds of years ago most of the productive energies of humans were directed toward the production of food. In the 19th and early 20th centuries fewer people were required to produce food and people increasingly worked in manufacturing. In the latter portion of the 20th century much of the working force was shifted from manufacture (steel, automobiles, etc.) to services. Production of software and technological capital goods has become the focus of an increasing portion of the work force — accelerating productivity & economic growth. As production of certain goods becomes increasingly efficient — requiring less labor and other costs per unit of good — declining profit margins in a free market direct productive resources to more profitable areas of endeavor.
Profit & loss signals guide economic progress in a free economy long before severe gluts can occur. Excessive inventories of buggy-whips, unutilized capacity for the manufacture of buggy-whips and unemployed workers from the buggy-whip industry are indicators that the market is in the process of reallocating resources — and are not an indication that the buggy-whip industry requires government subsidies.
Keynesianism holds that both consumer spending and government spending are the means to economic growth. Japan sought to use Keynesian deficit spending for economic recovery through the whole of the 1990s. Japan was left with the highest public debt in the world — and remained in recession while western economies experienced economic boom. Keynes' abysmal ignorance of the nature & causes of economic growth can be demonstrated by the following passage from the last section of Chapter 10 of his GENERAL THEORY:
"If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing. "
Spending theories are popular with statists who equate government spending for warfare, welfare, palaces & pyramids with economic stimulus. Pyramids have been out of favor for many millenia and palaces have been losing favor rapidly in recent centuries. Pyramids & palaces are built with demand based on expropriated wealth rather than demand based on the purchasing power of newly created goods & services. Although pyramids & palaces were built to gratify the egos of autocrats, some would argue these monuments have cultural value. But such monuments were usually built at high human & economic cost — and there is no way of comparing their value with what would have been created with the same resources freely deployed.
Warfare is a powerful narcotic for the egos of political leaders, whose personalities could easily be characterized as ego-addicts in constant need of enhancing their power & prestige. The idea that World War II was the economic stimulus ending the Great Depression was fortunately countered by the perception that the Vietnam War contributed greatly to the recessionary stagflation of the 1970s. Like government demand for consumer goods (pyramids & palaces), government demand for weapons & warfare redirects resources toward production of goods which do not enhance wealth — except for resisting wealth-destruction by terrorists or other governments. Warfare always results in a net destruction of world wealth. A strong case could be made for the idea that the economic boom period in the 1990s resulted from the "peace dividend" following the end of the cold war — and reduction in military spending. As political leaders learn to enhance their prestige by peace-making rather than war-making, there is hope that warfare too may be on the decline.
None of the above remarks are intended to deny that government has an important role to play in the maintenance of defense and the rule of law necessary for a civil/civilized society. But it is important to recognize that an institution that can simply take the money it needs (through taxation, inflation or borrowing collateralized by the ability to tax & inflate) has much less incentive & capacity for economic discipline when compared to businesses & individuals.
Politicians everywhere gratify their egos (and buy votes) by expropriating wealth from productive persons & organizations to disperse welfare & favors to unproductive persons & organizations. The number of the needy, the incompetent and otherwise unproductive elements of society can be greatly increased by the economic incentive of government money. Expropriating wealth from the most productive members of society deprives society of allowing that wealth to be utilized by those who are most able to contribute to economic growth and technical progress. And it undermines incentives for future wealth-creation by the victims. In the long run everyone is harmed — rich & poor — by the crippling of economic growth. A society that institutionalizes loving the poor & hating the rich through government programs that reward failure & punish success will be a poor society. Equal opportunity to succeed counts for little in a society that victimizes the successful. Love for the poor is best expressed by policies that encourage & empower them to become productive, and allows them to most benefit from the activities of successful producers.
A soldier spends taxpayer's money in the city where he is garrisoned — creating business for the local merchants. But if that soldier had remained a productive citizen, he would have spent money obtained from activities that contributed to society's aggregate supply of wealth. If he protects lives & property, he is contributing value to society by that means, rather than by the spending. "Cultural" subsidies benefit artists favored by bureaucrats and deprive taxpayers of the option of making different cultural choices. "Make-work" government projects may accomplish something productive, but only the market can make the best use of resources.
For people who believe that spending & consumption rather than savings & production are the source of economic growth, government spending is the ultimate economic stimulus. Money given to consumers in the form of tax rebates, tax cuts, welfare, etc. may not all be spent — some may be saved or used to pay debts. But governments can be "counted-upon" to spend, spend, spend ... If government spending was the key to economic growth, Japan would have boomed in the 1990s and socialist economies would have been economic miracles rather than basket cases.
In a January 1931 radio broadcast, John Maynard Keynes criticized thrift by saying, "Suppose we were to stop spending our incomes altogether and were to save the lot?... Why, everyone would be out of work... " But the real choice for use of earned income is not between spending or hoarding, as Keynes suggested, but between consuming or investing. Money employed in consumption sustains life & gives pleasure, but it does not lead to economic growth. Money employed for investment increases productive capacity, thereby increasing wealth available for consumption & investment in the future. Use of money for both consumption & investment leads to employment — but the latter reaps future benefits.
The quantity theory of money posits that the value of money is equal to the aggregate supply of goods & services in an economy. The value of money is the purchasing power of money, ie, aggregate supply of goods & services. Thus, the value of money could be called the aggregate clearing price for the aggregate supply & aggregate demand in an economy. A condition in which the aggregate clearing price is below the aggregate costs of production would be symptomatic of gross misallocations of resources in an economy — but such a condition is not theoretically impossible. Wars and the ending of wars (including cold wars) are often associated with massive reallocations of productive resources — and these reallocations can involve painful periods of readjustment. Artificial "bubbles" resulting from central banker manipulation of money & interest cause boom & bust misallocations.
J.B.Say regarded money as nothing but a means to facilitate barter. The aggregate supply of goods & services represents the wealth of society. If everyone woke up one morning to find every dollar replaced by one hundred dollars, no one would be wealthier or poorer because wages & prices had two additional zeroes. Nor would there be any change in either aggregate supply or aggregate demand.
The concept of "aggregate supply" to represent the wealth of society can be misleading. Most homeowners would sell their house if offered an outrageously high price for it. In that sense, nearly all existing homes are part of the aggregate supply. But in the normal course of events, homeowners are "slowly consuming" their houses by living in them and are not considering an immediate sale — although the thought of eventual or potential re-sale is usually in their minds. Similarly, most capitalists would sell their factories if offered a sufficiently high price, but are primarily focused on increasing the productivity of those factories and ensuring that the factories produce goods for which demand is high.
Money works magic in the minds of many economists — transforming simple relationships into complex conceptual nightmares. One monetary interpretation of Say's Law holds that the costs of production (paid for labor, land and capital goods) results in the incomes necessary for purchasing output. Carrying this argument further, critics of Say's Law express concern that all the income will not be spent — concern that some money will be saved or even hoarded. In this view, when consumers are worried about the future (lack "confidence") they are more inclined to save their money than to spend it — resulting in unsold inventory ("gluts"), manufacturing decline, unemployment and recession. But the consumer who is "confident" enough to save & invest actually benefits the economy more than the consumer who spends.
A monetary interpretation of Say's Law that stresses the spending potential of incomes generated by production is actually the opposite of Say's Law — interpreting spending & consumption as the engine of economic growth. Keynes' vision of economic activity as a circular flow of money between spenders & earners blinded him to the nature of wealth-creation, productive incentives, productivity increase and economic growth. The economic benefits of savings should not be justified on the grounds that investing is another form of spending. On the contrary, savings is the source of capital accumulation. Savers who earn interest or buy stock shares provide the means for others to have borrow or otherwise have access to capital to build productive resources. Capital & technological progress is the source of economic growth. Capital means plant, equipment, technology, research and employees to make more or better products at lower cost.
Mind-muddling theories are best dealt-with by a clear restatement of the basic principles underlying wealth-creation. What is wealth? Wealth is the aggregate value of supply (services & produced goods) available in a society. What gives value to that supply? The value of the supply is the desirability of that supply to the consumers. Even so-called non-materialist forms of wealth, such as health, knowledge, culture, love and liberty are difficult to obtain or maintain without the material foundations of adequate food, shelter, clothing and medical care. In a free society people produce valued supply in order to consume as well as to create wealth beyond immediate consumption. In the words of J.B.Say, "it is the aim of good government to stimulate production, of bad government to encourage consumption."
The silliness of the idea that consumer spending drives economic growth can be seen by imagining an economy in which 100% of the population is either a politician/bureaucrat or a welfare recipient. With no production of desirable goods & services, consumer spending would be useless. The more consumers are involved in the process of producing valuable goods & services, the more goods & services are available for consumers to buy.
Tax cuts provide capital & incentive for productive activity, but tax rebates intended to stimulate the economy through spending & consumption do not increase national wealth except by reducing the resources a government has to cause economic harm. Many politicians preferring tax rebates to tax cuts are like the hunter who eats his dog's tail before throwing the bone to the dog (who licks his master's hand in gratitude). Stimulating voter gratitude does more for a politician's stature than it does for the economy.
Consumers can only keep an economy from recession if they are employed in productive activity. If unemployment is low and those employed are producing useful goods & services, then an economy can remain healthy. High consumer spending is more an effect than a cause of the economic well-being associated with low unemployment. "Consumer confidence" is expected to be high if unemployment is low. Recession is not just a "national bad mood". Unemployed consumers who spend money received from government destroy (consume) wealth without producing wealth. Economic growth occurs only if "the consumer" is also "a producer".
A high Gross Domestic Product (GDP) is not necessarily a sign of high economic growth. GDP is a government-compiled statistic that equates economic activity primarily with government, business and consumer spending. Consumer spending is not two-thirds of the economy, it is two-thirds of spending. "The economy" is not defined by GDP, which excludes taxes, welfare & social security payments as well as stock & bond transactions. An economy with $2 trillion in exports and $2.1 trillion in imports would show only a negative $100 billion in GDP from trade. Equating spending with the economy quickly leads to the Keynesian fallacy that spending rather than saving is the key to economic growth — when, in fact, the opposite is true.
If the government employed most of the population to build pyramids and paid them with freshly printed money — or with money raised from sale of government bonds — a high GDP could be reported due to high government & consumer spending despite the fact that little of value was being produced in the economy. Nor does GDP give any indication of actual wealth. If 10% of a country's wealth was destroyed in a terrorist attack and 5% of the wealth was rebuilt, GDP would only record the 5% rebuild — giving no indication that net wealth had actually declined by 5%.
All income earners face a choice concerning how much of their income to spend and how much to save — ultimately a choice between savings & investment. In his GENERAL THEORY, Keynes argued that any aggregate attempt to save income would ultimately reduce aggregate income, what he called "the paradox of thrift". By this theory, weakened consumption results in reduced revenues to business, thereby reducing both the ability & the incentive of business to invest. But the aggregate income & wealth of a society are not increased by an exchange of money and consumption of goods. The increase in wealth of the merchants is exactly equal to the decrease in wealth of the consumers and the aggregate wealth of society is reduced by the value of the goods consumed (destroyed). Income invested rather than spent on consumer goods can buy producers goods which can be used to reduce the cost of producing existing goods or to produce new kinds of goods to further increase aggregate wealth.
The above should not be taken to mean that wholesalers, retailers and transporters create no value as compare to those who mine, manufacture or grow products. Distribution is an essential part of wealth, and innovations for efficiently reducing the costs of distribution increases well-being and is part of economic growth.
In a free economy (an economy not manipulated by central banks), when people save rather than spend, the increase in the supply of saved money reduces interest rates (interest is the price of money — increased supply and constant demand would mean lower price). This lower interest rate allows entrepreneurs (and consumers) to borrow money at lower cost. But when a central bank artificially lowers interest rates by creating new money there is less incentive to save. The central bank's actions are not only inflationary, they distort the economy by encouraging spending while discouraging saving.
Given the fact that the wealth of society increases by increasing the total desirable goods & services available — and by increasing the quantity & quality of productivity — why do so many people believe that spending & consumption increase wealth rather than savings & production? It is easy to blame Keynes & politicians, but in truth it is probably businesspeople who are most vulnerable to this illusion. Although businesspeople can hardly ignore the importance of cutting costs & improving production, their primary focus is on sales, sales, sales... As long as sales grow, it does not matter to them whether they have sold their products to productive or unproductive persons — nor where those persons got their money. In a barter economy, there is no recourse to exchanging real goods from money obtained from inflation or from issuance of government debt. Spending consumers mean sales & "prosperity" for the retailer. But the narrow perspective of the retailer does not reflect a deep understanding of how an economy grows.
Two hundred years ago the French economist Frederic Bastiat achieved prominence by stressing economic awareness of the unseen consequences of economic policies in addition to the seen consequences. Known as "the broken window fallacy", Bastiat described the economic narrow-mindedness of those who witness a window being broken and then praise the economic benefits of the employment of a glazier to replace the glass.
The glazier will buy more supplies, pay employees and spend the money earned — spreading the money through the economy. But as Bastiat pointed-out, the seen revenue to the glass industry has deprived unseen industries of revenue. The owner of the window would have preferred to spend the money on clothing, books, entertainment, dentistry, tools, toys for his children or savings/investments rather than be forced to spend it on window repair. The economy has been impoverished by the destruction of wealth in the amount of the window. If broken windows resulted in economic stimulus, it would be easy enough to stimulate an economy by breaking windows in homes & offices — and extending the benefit by destroying furniture & whole buildings. The broken window fallacy should illustrate not only that destruction is economically harmful, but that spending & consumption are not a source of economic growth.
Because the September 11, 2001 destruction of the World Trade Center happened during a time of recession — when there was a low "capacity utilization" — some economists invoked the broken window argument to suggest that the attack was economically beneficial because it would put idle resources to work. But idle resources are the result of misallocated productive capacity. One could as easily suggest that the idle munitions-producing factories following World War II were a sign that a new war was needed to get those factors working again. Even if resources that were idle on September 11 were relevant in the clean-up and rebuilding, those resources would have been of more benefit finding a way to become relevant to the productive needs of extant society than compensating for damage. It is the readjustment processes of recession — the bankrupcies & unemployment, etc. — that redirects misallocated idle resources to new employment in productive uses. Resources become idle because they were producing goods that were not in demand. The path to recovery is to retool productive capacities to produce goods that are in demand.
Crusoe on his island can spend his non-leisure time & resources (1) consuming (2) producing or (3) improving his productive tools. Crusoe's resources can be (1) consumed (2) invested in making tools or (3) lay idle. Time & resources spent on consuming diminish wealth. The time Crusoe spends on producing (gathering berries & fishing) increases his wealth, but the time he spends improving his tools (making baskets so he can gather more berries and making fishing nets so he can catch more fish) increase his wealth even more. Effort expended on making an ax reduces the long-term effort expended on obtaining wood for fire & shelter. Crusoe sacrifices time & resources he could spend producing in the investment of tool-making to increase his productivity. A short-term loss in production time results in a long-term gain in productivity. The principles illustrated by "Crusoe Economics" are true for any economy. Investment leading to increased productivity, not spending, is the source of economic growth. And investment is only possible when there is savings.
The claim that economic growth must come from consumers because consumers account for two-thirds of spending is a fallacy and a non sequitur. If Crusoe on his island spends two-thirds of his time obtaining & consuming food, and one-third of his time making nets for fishing and poles to shake coconuts from trees — it is clear which activity leads to increased productivity (economic growth). Consumption reduces the wealth of a society, production increases the wealth of a society and investment increases the productivity of a society. If Crusoe were forced to spend not two-thirds, but 100% of his time producing to consume — a subsistence, hand-to-mouth existence — Crusoe would never be in a position to improve his productivity.
Saved capital represents access to all factors of production — land, employees, buildings, machinery, time, etc. — necessary to produce goods & services. Investment to increase productivity means acquiring new technologies which empower workers — and training those workers. On a higher level, investment means spending money & resources to conduct research into technologies to increase productivity. Beyond the fact that production creates wealth and consumption destroys wealth is the fact that production of producer goods creates economic growth.
If someone has a goose that lays eggs, eating the eggs is more prudent than eating the goose. Excessive consumerism is the equivalent of eating the goose. Economic growth can occur if not all of the eggs are eaten, but are instead hatched and raised to increase the number of egg-laying geese. It is the buildings, equipment and capital stock of businesses that are the egg-laying geese of a market economy. Policies to "soak the rich" by taxing productive businesses & individuals not only destroy incentives for production, they erode the means for production — eroding economic growth if not causing recession, unemployment & general impoverishment.
Keynesian economists blame recessions on excessive savings (which Keynes called "hoarding" of money). Efforts by Keynesians to "stimulate the economy" through government spending or efforts to boost consumer spending can be seen to be counter-productive once it is understood that spending is not the source of economic growth. If government seeks to spend on investments, it must deprive businesses of money to do so — thereby guaranteeing an inferior allocation of resources (misallocation). Businesspeople who are the direct recipients of government money or the indirect recipients of government money given to consumers are wrong to equate their immediate benefit with general economic benefit.
Government "bailouts" of failed businesses subsidizes defective business practices, such as excessively risky investing or production of shoddy consumer goods — and provides incentives for those practices to continue. Government taxing of wealth-creators and high-earners punishes such people — not only creating disincentives to be more productive, but reducing their capital to be more productive.
Economic growth is increased wealth due to increased quality and/or quantity of production of valued products. Economic growth results from markets channeling resources into factors of production (and research to improve factors of production) which most satisfy consumer demand. Markets make the best resource-allocation decisions, not government. Therefore, the most important things government can do to stimulate an economy is to reduce spending, reduce taxation, reduce regulation and eliminate government control of money & interest-rates. Many things can impede economic growth — wars, high taxes, terrorism, oppressive business regulation, natural disasters, inflation, etc. But only investment, effort and innovation can consistently increase the factors of production and the productivity of the factors of production.
Efforts to bring economic growth to so-called underdeveloped countries often emphasize a need for education & technology. More commonly, however, these countries are ruled by expropriative dictatorships which are ready to plunder any wealth created. A productive society is a society in which private property is respected and contracts are honored. No individuals, rich or poor, can be expected to be productive under conditions in which they cannot own the products of their efforts. Productive individuals must not be victimized by thieves or taxes — and must not be hampered by regulation & licensing.
Productive individuals can be victimized by democracies as well as by dictatorships. When wealth is viewed as pre-existing & unchanging rather than created, struggle for wealth can degenerate into class warfare — a zero-sum game in which the players believe that the only way to increase wealth is to take it from others. A vision of an economy that does not include economic growth reduces to a fight over a larger share of "the pie". Class warfare, like all forms of warfare, ultimately destroys wealth for everyone: rich & poor — businesspeople, laborers and welfare-recipients. The idea that spending stimulates the economy provides a politically popular justification for expropriating wealth from business which produces it and for distributing it to the more numerous consumers (a larger voting block). But expropriating wealth from those who create it not only destroys the means & incentives for wealth-creating, it channels energies away from increasing productivity and toward finding ways to evade expropriation. The economy experiences a net loss.
Politicians who contrast policies that benefit business with policies that benefit "the people" fail to appreciate that it is business that provides productive employment and produced goods & services. "The people" are most benefitted when they can conduct business and/or be employed by business — and are harmed when money is expropriated from business which could have been used for hiring & increasing productivity. Pitting those who consume/destroy wealth against those who produce wealth hampers production of wealth and fosters destruction of wealth.
There are no limits to growth for either highly developed or underdeveloped countries. Exponential growth in technology can translate to exponential growth in any society that is not hampered by bandits (non-governmental or governmental), regulators or central bankers. By their manipulations of the money supply & interest rates central bankers have not only fostered economically destructive boom & bust cycles, but have created the poisonous illusion that "too much economic growth" is inflationary and unsustainable.
High population and few natural resources need not be barriers to economic growth, because human effort & enterprise are the ultimate resources. Hong Kong, Singapore and the Netherlands have limited resources and high population density, yet have thrived economically. In the period from 1960 to 1985 growth of per capita income in Japan, the United States and India was 5.8%, 2.1% and 1.5%, respectively. Japan had been a war-ravaged nation. The anti-capitalist bureaucratic policies in India did much to constrain potential growth. China showed a radical increase in economic growth by allowing private property and privatization of enterprises. With perhaps the freest economy in the world, Hong Kong's dense population created enormous economic growth on land that is hardly more than bare rock.
Understanding economic growth and how to facilitate it (or not hamper it) is the most important issue in economics. Improving the material condition of mankind results in everyone getting richer — rich, middle-class and poor. Charity for the needy, better education, better health, a clean environment, elimination of war & terror, advances in science & culture and time for more leisure activities are the fruits of economic growth & wealth creation.
(For more on the subject of economic growth without inflation see my essay An Austrian Theory of Business Cycles).
BOOKS:
SAY'S LAW: AN HISTORICAL ANALYSIS by Thomas Sowell (1972)
A REHABILITATION OF SAY'S LAW by W.H.Hutt (1974)
SAY'S LAW AND THE KEYNESIAN REVOLUTION by Steven Kates (1998)
Other essays discussing Say's Law which are available on the web are:
Say's Law and the Austrian Theory of the Business Cycle
Explains the relationship between production and demand; analyzes views of critics and supporters of Say's Law; describes the relevance of Say's Law to Austrian Business Cycle Theory.Say's Law and Supply Side Economics
A positive portrayal of Say's Law which includes a lot of material that is not relevant.