Understanding Say's Law; S. Horwitz

THEFREEMAN IDEAS ON LIBERTY Understanding Say's Law of Markets by Steven Horwitz O ne of the problems in the world of ideas, particularly in the social sciences, is that the insight behind old ideas can get lost as new ideas crowd the intellectual landscape. Often, the historian of ideas has the thankless task of reminding his colleagues that what they think some long-dead writer said is not, in fact, what he was talking about at all. Such misunderstandings are frequently more than just simple errors; they can have profound effects on our theories of the social world, our interpretations of history, and our proposals for policy. In economics, one can find numerous examples of this phenomenon. My task here is to explore one of them: the wayin which Say's Law of Markets (named for the great Classical economist Jean-Baptiste Say) has been fundamentally misunderstood by economic theorists and laypersons alike, and to explore some of the consequences of this misunderstanding.

W. H. Hutt once referred to Say's Law as "the most fundamental 'economic law' in all economic theory."l In its crude and colloquial form, Say's Law is frequently understood as "supply creates its own demand," as if the simple act of supplying some good or service on the market was sufficient to call forth demand for that product. It is certainly true that producers can undertake expenses, such as advertising, to persuade people to purchase Dr. Horwitz is Eggleston Associate Professor of Economics at St. Lawrence University in Canton, New York. 4 a good they have already chosen to supply, but that is not the same thing as saying that an act of supply necessarilycreates demand for the good in question. This understanding of the law is obviously nonsensical as numerous business and product failures can attest to. If Say's Law were true in this colloquial sense, then we could all get very rich just by pro ducing whatever we wanted.

In a somewhat more sophisticated under standing, one which John Maynard Keynes appeared to pin on the Classical economists, Say's Law is supposed to be saying that the aggregate supply of goods and services and the aggregate demand for goods and services will always be equal. In addition, Say was supposed to have been saying that this equal ity would occur at a point where all resources are fully employed. Thus, on this view, the Classical economists supposedly believed that markets always reached this full-employment equilibrium. In one sense this is trivially true. If we compare the actual (ex post) quantities of goods bought (demanded) and sold (sup plied) they will always be equal. Whatever is sold by one person is bought by another. Presumably, however, Keynes thought the Classical economists meant something else, perhaps more along the lines of "market economies will never create general gluts or shortages because the income generated by sales will always be sufficient to purchase the quantity of goods available to buy." There is a strong sense in which this is true, but by itself UNDERSTANDING SAY'S LAW OF MARKETS 5 it does not assure that full employment will take place because obvious examples of significant unemployment and unsold goods can easily be pointed to. And, in fact, this is what critics of Say's Law have done. By pointing to the various recessions and de pressions that market economies have ex perienced, they claim to show that Say's Law was at the very least naive, and probably downright wrong.

What Say Said If we want to get a more accurate under standing of Say's Law, perhaps we should consult what Say himself had to say about his supposed law. In the passage where he gets at the insight behind the notion that supply creates its own demand, Say writes: "it is production which opens a demand for prod ucts.... Thus the mere circumstance of the creation of one product immediately opens a vent for other products."2 Put another way, Say was making the claim that production is the source of demand. One's ability to de mand goods and services from others derives from the income produced by one's own acts of production. Wealth is created by produc~ tion not by consumption. My ability to de mand food, clothing, and shelter derives from the productivity of my labor or my nonlabor assets. The higher (lower) that productivity, the higher (lower) is my power to demand. In his excellent book on Say's Law, Hutt states this as: "All power to demand is derived from production and supply.... The process of supplying-i.e., the production and appro priate pricing of services or assets for replace ment or growth-keeps the flow of demands flowing steadily or expanding."3 Later, Hutt was to be somewhat more precise with his definition: "the demand for any commodity is a function of the supply of noncompeting commodities.,,4 The addition of the modifier "noncompeting" is important. If I sell my services as a computer technician, it is pre sumed that my resulting demands will be for goods and for services other than those of a computer technician (or something similar).

The goods or services competing with those that I sell can alwaysbe obtained by applying my labor directly, so I am unlikely to demand them. The demand for my services as a computer technician is a result of the supply ing activities of everyone but computer tech nicians. This way of viewing Say's Law gets at the interconnections between the various sectors of a market economy. In particular, it makes sense of the claim that "the employment of all is the employment of each." As each worker finds employment, he or she is able to turn around and demand goods and services from all other noncompeting suppliers, creating the opportunity for their employment. From this perspective, Say's Law has nothing to do with an equilibrium between aggregate supply and aggregate demand, but rather it describes the process by which supplies in general are turned into demands in general. It is always the level of production which determines the ability to demand.

Production Must Come First This process can be seen in the differences between small, poor, rural towns and wealth ier suburban areas. In the small town, the fact that less value is being produced by residents means that their ability to demand goods and services is correspondingly limited. As a re sult, the selection of products, the number and diversity of sellers, and the degree of specialization among producers is quite lim ited. By contrast, in the wealthier suburb, there is an amazing array of products, with a large number of diverse sellers all offering very specialized goods. Perhaps most impor tant is that in the wealthier area, there is a greater degree of competition, as the market can support multiple sellers of particular goods given the level of wealth being gener ated by producers. Say points out that this explains why a seller will likely get more business as one among a large number of competitors in a big city than the sole seller of an item in the more sparsely populated coun tryside.s The key to understanding Say's Law of Markets is that it is production that must come first. Demand, or consumption, follows from the production of wealth.

To a degree, Say's Law is just an extension 6 THE FREEMAN • JANUARY 1997 of Adam Smith's insight that "the division of labor is limited by the extent of the market.,,6 Smith's point was that the degree of special ization that one would see in a given market depended upon how much demand there was for the specialized product. Thus, small towns rarely have ethnic restaurants beyond the very popular Chinese and Italian, nor do they have radio stations that specialize in very narrow musical formats (oldies from the 1970s only, for example). Larger, wealthier communities can support this degree of spe cialization because there is sufficient demand, deriving from a larger population and a larger degree of wealth being produced. It is in this sense that production (supply) is the source of demand. Because all movements between supplying and demanding have to take place through the medium of money, it is somewhat over simplified to say that production is the source of demand. Actually demanding products requires the possession of money, which in turn requires a previous act of supply. We sell assets or labor services for money, which we then use to demand. Money is an intermedi ate good that enables us to buy the things we ultimately desire. However, we have to be careful to remember that what enables us to purchase is not the possession of money, per ~e, but the possession of productive assets that can fetch a "money's worth" on the market.

When we sell that asset (or our labor services) we receive wealth in the form of money. As we spend that money, we demand from the wealth our production created. However, be cause we do not spend all of our wealth that we temporarily store as money, but choose to continue to hold some of it in the monetary form, the demand for current goods and services will not precisely match the value of what has been produced, as some money remains in the producers' possession. Thus it looks as though, given the existence and use of money, Say's Law, even rightly understood, leaves open the possibility that aggregate demand is insufficient to purchase what has been supplied. However, if the monetary wealth is stored in the form of bank-created money, such as a checking account (but not Federal Reserve Notes), then that withheld consumption power willbe transferred to those who borrow money from the bank that created it. The money I leave sitting in my checking account is the basis for my bank's ability to lend to others. The power to consume that I choose not to utilize by leaving my production generated wealth as money is transferred to the borrower. When she spends her loan, her addition to aggregate demand fills in for the "missing" consumption demand resulting from my decision to hold money. There is, therefore, no excessor deficiencyin aggregate demand, as long as the banking system is free to perform this process of turning the saving of depositors into the spending of borrowers.

Say's Law of Markets cannot be fully appre ciated unless one understands the working of the banking system and its role in intertem poral coordination. 7 All Markets Are Money Markets Because all market exchanges are of goods or services for money, all markets are money markets, and the only way there can be an excess supply or demand for goods is if there is an opposite excess supply or demand for money. Take the more obvious case of a glut of goods, such as one might find in a recession. Say's Law, properly understood, suggests that the explanation for an excess supply of goods is an excess demand for money. Goods are going unsold because buyers cannot get their hands on the money they need to buy them despite being potentially productive suppliers of labor. Conversely, a general shortage, or excess demand for goods, can only arise if there is an excess supply of the thing goods trade against, which can only be money.

Recessions and inflations are, therefore, fun damentally monetary phenomena, as Say's Law points us in the direction of looking at what is going on in the production of money to explain the breakdown of the translation process of production into demand. Unlike Keynesian critics of Say's Law of Markets who saw deficient aggregate demand resulting from various forms of market failure as causing economic downturns, we have UNDERSTANDING SAY'S LAW OF MARKETS 7 argued that a more accurate understanding of Say's Law suggests that there is no inherent flaw in the market that leads to deficient aggregate demand, nor is the existence of real-world recessions a refutation of the Law. Rather, once we understand the role of money in making possible the translation of our productive powers of supply into the ability to demand from other producers, we can see that the root of macroeconomic disorder is most likely monetary, as too much or too little money will undermine that trans lation process. Despite having been dismissed in the onslaught of the Keynesian revolution, Say's Law, when properly understood both in its original meaning and its relationship to the banking system, remains a powerful insight into the operations of a market economy. 0 1. W. H. Hutt, A Rehabilitation of Say's Law (Athens, Ohio: Ohio University Press, 1975), p. 3.

2. J. B. Say, A Treatise on Political Economy (New York: Augustus M. Kelley, 1971), pp. 133, 134-35. 3. Hutt,op. cit., p. 27. 4. W. H. Hutt, The Keynesian Episode (Indianapolis, Ind.: Liberty Press, 1979), p. 160. 5. Say, op. cit., p. 137. 6. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (Chicago: University of Chicago Press, 1976), p. 21ft'. 7. On the relationship between the banking system and Say's Law, see George Selgin, The Theory of Free Banking (Totowa, N.J.: Rowman and Littlefield, 1988); Larry J. Sechrest, Free Banking: Theory, History and a Laissez-Faire Model (Westport, Conn.: Quorum, 1993); and Steven Horwitz, "Capital Theory, Inflation, and Deflation: The Austrians and Monetary Disequi librium Theory Compared," Journal of the History of Economic Thought 18:2 (Fall 1996). ~-------------------------------------~ THENEWJOURNALONLIBERTY T he INDEPENDENT REVIEW is the new, quarterly, journal devoted to the political economy of liberty. Transcending the all too-common politicization and superficiality in contemporary scholar ship and policy debate, The INDEPENDENT REVIEW is superbly written, provocative, wide-ranging, and based on solid scholarship.

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