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wanted to work to have a job. This was inconceivable in 1803 when Say first wrote what would eventually be called Say’s Law. It was inconceivable in 1936 when Keynes published his General Theory. And it is inconceivable today in the midst of the multitude of products we now take utterly for granted. Now if one said to a classical economist, what would people do if there were some unexpected economic crisis, they would have said that they would likely have hung onto their money while danger passed. This is not conjecture; that is exactly what they did say. If business confidence were low or economic conditions became highly uncertain, there would be a reluctance to part with money and so spending would diminish. Does this prove that demand deficiency causes recession. Of course not. It proves that in recession everyone becomes more cautious until the danger is seen to have passed. It may take one month, maybe three, perhaps in really bad times six months, but eventually optimism returns and the upturn begins. It may take years to return to prerecession conditions but unless things are made worse by inept government programs, - 5 - the healing processes of a market economy begin to gather force much sooner than modern theory typically gives it credit for. But to think that a refusal to spend during a crisis was evidence of demand deficiency – a general glut – was recognised as nonsensical. It was nothing other than a passing storm, and to know the difference was then a simple part of the general understanding of an economist. Today, it is only one economist in a hundred, if even that, who understands such things and keeps them firmly in mind. Demand is Constituted by Supply Let me now turn to the other way in which Say’s Law was expressed. That was to point out that demand is constituted by supply. Keynes’s mangled version was “supply creates its own demand”. To any classical economist, the word supply in this context meant “value adding production”. Even this, to modern ears, is barely enough so it is important to specify that value adding meant that the value of output must be greater than the value of the inputs that were used in its production. In a market economy, where production is for profit and producers who cannot cover costs disappear, it was good enough to just say supply because what else was there. Now, of course, there are no end of buyers who contribute nothing at all to the sum total of goods and services others would willingly pay the full cost of production to possess. But in the days before macro and massive increases in public spending, the ability to buy was dependent on one’s ability to sell. This is again a ground level view of the operation of an economy. Butchers would buy from brewers, brewers would buy from bakers, and bakers would buy from butchers. And where did they get the incomes to do all this buying. Brewers would sell to butchers, butchers would sell to bakers and bakers would sell to brewers. There was then embedded at the very core of understanding of an economy the necessary mutual accommodation in which each producer tailored their own production to the demands of others while they trimmed their own expenditures depending on how much they earned. If you build in on top of all of this an appreciation that wants are near enough infinite, the notion that a market economy will be run into the ground by demand deficiency is just about as nonsensical an idea as one can find. Causes of Recession This little apparatus gives you an idea of how the whole process might break down into the occasional recession. The Keynesian falsehood – absolute falsehood – that - 6 - classical economists assumed away the possibility of involuntary unemployment is still taught to this day. But quite obviously it was untrue as even the mildest recognition of the existence of the theory of the cycle would clearly show. The causes of recession were never demand deficiency – there is no such thing as a general glut. They said that and I say that. If you wish to know why economies enter recession, look elsewhere. And where to look was in the structure of demand relative to the structure of supply. We have our butchers, brewers and bakers selling to each other. I could be political and point out how a new tax on alcohol might affect production and sales or how new regulations in the meat industry could affect relative prices. But really, anything at all can happen to upset the relationship between purchase and sale. Mad cow disease, the return of prohibition, or wheat fields given over to ethanol production; each can have a major effect on production costs, relative prices and product demand. So too can positive new features in each market. Innovation and new products can upset established markets. Exchange rates can move and export demand can increase. And of course, there are the effects of monetary policy and the credit creation system that can have major distorting influences on every market. This is the classical theory of recession, structural maladjustments of one sort or another. It also makes it evident that recessions will be with us always. This is a theory that makes sense. You can see how the GFC started and built using this theory. Try explaining the downturn in 2008-09 using Keynesian economics. Keynesian theory, so far as explaining the onset of recessions is concerned, is shallow, utterly without penetration or insight. It is only because we have known nothing else for seventy years that we put up with it. But it cannot explain a thing. Say’s Law and Classical Policy But not only is Keynesian economics useless in explaining why the recession occurred, it is even less useful in trying to think through what ought to be done next. A Keynesian sees the problem as demand deficiency. There is no other scenario, nothing else is included in the reference frame. The policy solution is therefore some variant of instructions on how to raise aggregate demand, whether by lowering interest rates or raising public spending. Deficit finance is an intrinsic part of the Keynesian program. Starting from classical theory and Say’s Law, however, two matters are clear. The problem is not demand deficiency. And to get the economy moving again, the answer can only be found on the supply side of the economy. - 7 - The major aim of classical policy was to allow the market re-adjust. To raise employment it was first necessary to raise the level of value adding production. All of the emphasis would have been on the supply side. Moreover, because of Say’s Law, no economist before Keynes would have been unaware of the impossibility of spending-on-anything road to recovery. They would have understood it because they understood in their bones what Say’s Law meant. They would have understood that to produce goods and services whose production costs are greater than their value will slow the recovery process, not hasten it. It is now as clear as day that the massive expenditure programs carried out around the world as an attempt at an economic stimulus have not worked. They have not even remotely worked. The private sector in the United States has been virtually moribund. Meanwhile, the rate of unemployment rose beyond the highest level projected had there been no stimulus at all and has remained high and is expected to remain high well into the foreseeable future. Below is a chart dealing with the American economy which is pretty well self explanatory. The green line is the stimulus expenditure, the yellow bars are the unemployment rate and the dotted line shows the maximum rate of unemployment that President Obama said would have been reached had there been no stimulus. Source: Veronique de Rugy from National Review Online (24/vi/10) - 8 - The Demand for Goods and Services is Not the Demand for Labour The fact of the matter is that there is not a single stimulus program implemented after the commencement of the Global Financial Crisis that has actually worked. Not a single one has created employment. Not a single one has brought the rate of unemployment down. The two most prominent examples of such stimulus programs were the American and the British. The American, as the chart above has shown, has turned out to be useless. The British led to an equally abysmal result with the new government of the UK now in the process of bringing the British economy back into fiscal balance. Demand is constituted by value adding supply. Demand that is created through producing goods and services whose production costs are greater than the value of the output at the other end of the process create neither an increase in demand or an increase in employment. Once upon a time, to understand this was not quite second nature to an economist but was seen as one of the unintuitive conclusions that came with a proper understanding of economic theory. In the passage below, I am quoting Hayek directly, who is quoting a nineteenth century economist Leslie Stephen (now best remembered as the father of Virginia Wolf) who was himself repeating one of John Stuart Mill’s most celebrated economic conclusions first published in 1848, that the demand for commodities is not the demand for labour. And this is what Hayek wrote: |