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Say’s Law and Keynesian Economics

February 24, 2011

It is reflected in Keynesian economics that the solution to a crisis is to expand aggregate demand. The economy is not producing at its maximum capacity; it is located inside its production possibilities frontier (PPF). Thus, the solution consists in the government making the economy take off again through fiscal spending or stimulus. This approach, which may sound as a common sense argument, has two serious problems. 1) The constraint imposed by Say’s Law and 2) the effects caused on the market structure.

If government tries to expand aggregate demand through in increase in taxes it is clear that what the government expands the private market contracts. The effects net each other. The government, then, usually tries to stimulate the economy through monetary expansion. But still, no aggregate demand can ultimately occur.

If we remove the monetary veil and think in terms of barter it becomes clear that the only way to increase demand is by increasing useful production. The useful aspect is central. If a person decides to produce filled holes he won’t be able to demand nothing in exchange; his product has no market value because it’s useless. Then, what to produce is not an unimportant aspect of increasing production. If we add money to this example what we get is a wealth transfer but not an increase in aggregate demand. If government pays these persons to dig holes and filled them back, then they will be able to use their income to increase their demand, but production has not gone up in the market. The increase in demand from these people is the other side of a decrease in the demand by others. This is a monetary illusion, not an increase in aggregate demand.

The well known example of digging holes and filling them back is picturesque and helps to illustrate the situation, but what governments usually try to do is to stimulate industrial production. This looks as more useful to the eye, but this is only the case if that production is profitable in economic terms. The fact that more people go to work does not mean their final product is profitable. The Keynesian dilemma can be visualized with the help of a PPF. Assume the economy can produce goods x and y and is located in point A and the consumers’ preferences are located in point E:

PPF

In a recession, when the economy is in point A, government tries to push the economy to the PPF. But it’s not the same if the economy goes in fact to point E or to somewhere else in the PPF. It is true that if there are unemployed factors of production the level of prices may not go up and there may not be inflation. But the real issue is not a change in the level of prices but on relative prices, something the Keynesian policy cannot avoid affecting. Because of this, if government tries to increase aggregate demand the economy will go to any point in the PPF except point E. The Keynesian policy gets into a non-exit road. If the economy is on the PPF but in a different point than E then some production activities are unprofitable (like the picturesque example of digging holes and filling them back). If government discontinues its stimulus then the economy goes back to point A (or even less if during the process capital goods have been consumed). We may “see” production going up, but in economic terms what is going on is capital consumption. Relative prices are important because the correct structure is unknown.

This role of relative prices is a much more protagonist problem in old classic economists and in Austrian Economics than in other approaches. Macroeconomic models that work with one representative good cannot deal with the problem of coordination in the market. If there is one good then the problem of relative prices goes away, but this is the particular problem that economics has to deal with. The one-good world does not simplify the problem at hand; it changes it into something else. Assumptions should fall into the problem, not outside the problem. Surely enough, the Keynesian recipe results in more production, a necessary but not a sufficient condition. Just increasing production does not imply the economy will go to point E.

In this short story Say’s Law plays a central role. Keynesian theory would not say that aggregate demand has decreased if the demand of microwaves has gone down but the demand of plasma TVs has gone up (in equal monetary amounts). But it does argue the aggregate demand goes down if the demand of microwaves goes down but people keep their money rather than buying plasma TVs. But if money is another good in the economy then the later example is nothing more than the demand of microwaves going down and the demand of money going up in the equal monetary amounts. There are no reasons, however, to assume that the demand for money is something different than the demand of any other good. Crises do not occur because aggregate demand suddenly goes down, but because there has been an accumulation of errors in the market usually by government interference with prices (i.e. interest rates). Keynesian economics does not prove Say’s Law to be wrong; it just wrongly specifies the problem. But, if there are no reasons to argue that the demand for money should be excluded from aggregate demand then Say’s Law holds and Keynesian theory does not. It seems then, than Keynesian stimulus consists more in an illusion that in a real solution. The study of sound money, then, has a trivial impact on how we understand the market process.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Image by nuttakit / FreeDigitalPhotos.net.

2 Comments

  1. Tim June 15, 2012 4:14 PM
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    "If we remove the monetary veil and think in terms of barter it becomes clear that the only way to increase demand is by increasing useful production."

    Why remove the monetary veil? Keynesians will agree that Say's Law is vindicated in barter economies…it's in *monetary economies* where Say's Law fails.

    • Ted Phalan June 18, 2012 1:08 PM
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      Perhaps it is better to let prices of those particular items that are in more or less demand adjust. This includes the price of money. The market will make these adjustments based on the demand for goods exhibited by holders of goods and holders of money. The Keynesian policy-makers would be flying blind if they tried to find the market rates that would clear various markets. Unfortunately, their goal is not necessarily to clear markets, but to manipulate markets for certain ends.