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US Economy Demand Deficiency is Not the Problem and Keynesianism is Not the Solution

Economics / Economic Theory Oct 04, 2010 - 03:34 AM GMT

By: Gerard_Jackson


Best Financial Markets Analysis ArticleIn trying to explain the state of the American economy the commentariat is still blaming the lack of consumer demand. But as the classical economists always pointed out when presented with this fallacy, consumption is never a problem but production is.

(Although I have made use of classical economists numerous times, drawing attention their correct views on production and consumption, I should make it clear that classical economists were far from being in agreement on every important point of theory, especially where value, prices and costs entered the discussion.)

When it came to Say's law of markets the classical economist adhered to the rule that production is the sole source of demand. Unfortunately they vulgarised "Say's Law" in two ways. They bypassed Say's stress on the necessity for price adjustment and they also ignored his keen insight that costs and prices were out of kilter during a depression because entrepreneurs had excessively bid up costs: a clear case of a general failure of entrepreneurial forecasting.

Regrettably Say neglected to seek out the reason why a cluster of entrepreneurial failure should suddenly emerge and why it tended to be concentrated in the higher stages of production. It has always puzzled me how economists who claim to have read both Say and the British classical economists could overlook how the latter managed to truncate Say's law of markets. Mill exemplified this failure to fully capture the essence of Say's insights with his statement that

[a]ll sellers are inevitably and ex vi termini buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply: everybody would be able to buy twice as much, became every one would have twice as much to offer in exchange. It is probable, indeed, that there would now be a superfluity of certain things. (John Stuart Mill, Principles of Political Economy, Vol. II, University of Toronto Press 1965, pp. 271-72.)

There would be nothing "probable" about it all, as Say might observe. B. M. Anderson noted that should we

double the supply of commodities in every market, and if we did, we should not clear the markets of the double supply in every market. If we doubled the supply in the salt market, for example, we should have an appalling glut of salt. The great increases would come in the items where demand is elastic. We should change very radically the proportions in which we produced commodities. (B. M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, LibertyPress, 1979, p. 392.)

In other words, production must take place in its proper proportions. In today's jargon: equilibrium must be maintained. The point is not that these economists failed to note the phenomenon of disproportionalities -- far from it -- but that they failed to note the role that the simultaneous and large-scale entrepreneurial failure played in this process. Most of them did, however, recognise the boom-bust cycle as being a monetary phenomenon that was related to the rate of interest.

(Dr Steven Kates' view that Mill carried on the early classical explanation of the trade cycle is erroneous. [Kates, Says Law and the Keynesian Revolution: How Macroeconomic Theory Lost its Way, Edward Elgar, 1998.] It was very clear by the 1840s that Mill had completely departed from the monetary account of booms and depressions, if he ever subscribed to it, that is. In his Principles of Economics he denied that money had anything to do with "commercial crises which he blamed on "a spirit of speculation".¹ [Ibid. p. 542].)

Without a doubt, the American Marxist economist Paul Sweezey was spot on when he wrote: "...the Keynesian attacks, though they appear to be directed against a variety of specific theories, all fall to the ground if the validity of Say's Law is assumed." Now a Krugman would snort: "So What? Everyone knows Keynes refuted Says Law." But the fact is he did no such thing. What he did was to construct a straw man by deliberately misstating the law so that he could easily refute his version of it. He then tried to support his conclusion with a truncated passage from Mill. But it is clear from the writings of these economists that they never defined Say's Law as "supply creates its own demand". They fully understood the importance of equilibrium, despite their failures on the entrepreneurial front.

The key to avoiding a glut in one good, which amounts to a shortage elsewhere, is equilibrium or producing goods in their proportions as demanded by consumers. The classical view that demand springs from production which in turn must be in equilibrium to avoid gluts and depressions brings us not to the American economy in 2010 but to its condition in the 1930s, with which many are now drawing a comparison. The classical economists, including Marx, knew that depressions always started in the producer goods industries and then worked their way down to the point of consumption. Most economists in the 1930s, e.g., Dr Benjamin M. Anderson and Joseph Stagg Lawrence, also knew where depressions first made themselves felt. While others of the time were arguing that holding up consumer spending was necessary to restore prosperity, Lawrence pointed out that consumption was being maintained and that it was the producer goods industries that were contracting.

Focusing on consumption gives rise to the purchasing power of wages fallacy doctrine which state that maintaining money wage rates will prevent a fall in production. The tragic consequences of this misbegotten doctrine were an expansion in withheld capacity which greatly deepened unemployment and reduced output further. John Oakwood in which he strongly attacked this fallacy (EE Barron's, EE 29 June 1931). He made the vital distinction between wages and purchasing power, stressing that purchasing power is the ability to produce goods for exchange against other goods and services. These exchanges take the form of values. Where the wage exceeds the value of the workers' services unemployment rises and idle capacity emerges. What did the Hoover government do?

It tried to keep money wages up as prices fell. This meant that real wage rates rose as the money value of labour services fell, causing the demand for labour to fall. The Australian experience during the Great Depression actually refutes the Keynesian orthodoxy on government spending and employment. Even though Australian governments cut spending unemployment began to steadily fall from 1932 onwards. The reason is made clear by the following charts. The first one shows productivity picking up in 1932 and second chart shows that unemployment began to fall at almost the same time. Rising productivity was allowed to reduce the cost of labour relative to the value of its marginal product which in turn made it more profitable to hire . The opposite happened in the US with tragic results, some of which are still with us in the form of the Obama administration's mad spending binge.

Therefore price fixing by the Hoover/Roosevelt governments prevented the necessary readjustments from taking place and so kept the economy depressed for ten years. If they had allowed costs and wage rates to readjustment, as happened during the 1920-21 depression, capacity would not, as Professor Hutt put it, have been withheld. William Röpke² put it very well when he said: "The reestablishment of equilibrium creates purchasing power." So the lesson of history along with yesterday's wisdom tells us that the last thing that must be done is to try and pump up consumption. Let market forces liquidate the maladjustments and allow prices and costs, including wages, to readjust to the proper proportions between production and consumption, which in turn should be dictated by consumer preferences, not by the Fed.

None of this is to say there is nothing positive that Obama can do to accelerate the recovery process -- there is. for starters, he could abandon his statist economic policies.

¹ One could call Mill's explanation of the boom-bust cycle an "irrational exuberance" theory, though he did slip credit expansion in through the back door. Irrespective of one might call it his theory is a far cry from the currency school's far more accurate monetary explanation of booms and busts. Unfortunately, by the late forties even Colonel Torrens had moved in the direction of Mill, such, in my opinion, was the latter's influence. (I should add that the apparent failure of Peel's 1844 Banking Act probably played a role in Torrens' change of direction.) Given the historical facts I am thoroughly mystified as to how Kates could conclude that Mill's theory was in keeping with the currency school's monetary theory.

² Kates states that "Wilhelm Röpke's 1936 Crises and Cycles was the last major work in English on the business cycle that was in no way influenced by Keynesianism. This is not strictly accurate. Frederick C. Mills Prices in Recession and Recovery that was published in October 1936 by the National Bureau of Economic Research. Then there was the remarkable Banking and the Business Cycle by C. A. Phillips, T. F. McManus and R. W. Nelson, published by Macmillan and Company in 1937. Both these books provide invaluable insights into the Great Depression and the nature of the business cycle.

Kates discussion of Röpke's theory of booms and busts was particularly disappointing. (Ibid. pp. 114-121.) Although he is correct in noting that Röpke's theory "stretches back through time... to the theories of Say and Ricardo" he neglected to mention that Röpke arrived at his theory through von Mises' work which was built on the work of the currency school and Wicksell's insights. It is truly strange that in the section titled Say's Law in the classical Theory of the Business Cycle he ignores the seminal work done by Mises and Hayek in this area while including Haberler and Lavington.

By Gerard Jackson

Gerard Jackson is Brookes' economics editor.

Copyright © 2010 Gerard Jackson

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