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Wednesday, August 25, 2010

Say's Law of Markets, Part II: Say's Law of Markets

So far we have discovered that, stripped of at least some of its mystique, "money" is simply the term used to describe the medium by means of which producers and consumers exchange the present value of marketable goods and services. Thus, this thing we call money is not really valuable in and of itself. Money only acquires a derived value due to the private property interest that the maker or issuer of the money has in the present value of the existing or future marketable goods and services from which the money is derived.

Say's Law of Markets

We can therefore say that we do not, strictly speaking, make our purchases with "money." Rather, we make our purchases of what others produce with what we ourselves produce by means of our labor, capital, or land. While this is clearly solidly grounded in the natural law philosophy of Aristotle (albeit with a few, easily corrected diversions along the way), it was, perhaps, most clearly expressed by Jean-Baptiste Say, a late 18th, early 19th century French political economist as his "Law of Markets."

Say was obviously not the first to state what has become known as Say's Law. Say does appear to have been the first to explain his "law" in terms that could be easily grasped . . . although subsequent economists, adhering to the incomplete definition of money and credit tied to existing accumulations of savings, have managed to misunderstand it egregiously. This has been accomplished by taking Say's Law in its truncated summarization: production equals income, therefore, supply generates its own demand, and demand, its own supply.

This usual statement of Say's Law raises more questions than it answers. We need to take Say's Law in its more complete formulation, as explained by Say to the Reverend Thomas Malthus in refutation of the latter's theories of inevitable insufficiency:
All those who, since Adam Smith, have turned their attention to Political Economy, agree that in reality we do not buy articles of consumption with money, the circulating medium with which we pay for them. We must in the first instance have bought this money itself by the sale of our produce.

To a proprietor of a mine, the silver money is a produce with which he buys what he has occasion for. To all those through whose hands this silver afterwards passes, it is only the price of the produce which they themselves have raised by means of their property in land, their capitals, or their industry. In selling them they in the first place exchange them for money, and afterwards they exchange the money for articles of consumption. It is therefore really and absolutely with their produce that they make their purchases: therefore it is impossible for them to purchase any articles whatever, to a greater amount than those they have produced, either by themselves or through the means of their capital or their land.

From these premises I have drawn a conclusion which appears to me evident, but the consequences of which appear to have alarmed you. I had said — As no one can purchase the produce of another except with his own produce, as the amount for which we can buy is equal to that which we can produce, the more we can produce the more we can purchase. From whence proceeds this other conclusion, which you refuse to admit — That if certain commodities do not sell, it is because others are not produced, and that it is the raising produce alone which opens a market for the sale of produce.

I know that this proposition has a paradoxical complexion, which creates a prejudice against it. I know that one has much greater reason to expect to be supported by vulgar prejudices, when one asserts that the cause of too much produce is because all the world is employed in raising it. — That instead of continually producing, one ought to multiply barren consumptions, and expend the old capital instead of accumulating new. This doctrine has, indeed, probability on its side; it can be supported by arguments, facts may be interpreted in its favor. But, Sir, when Copernicus and Galileo taught, for the first time, that the sun, although we see it rise every morning in the east, magnificently pass over our heads at noon, and precipitate itself towards the west in the evening, still does not move from its place, they had also universal prejudice against them, the opinions of the Ancients, and the evidence of the senses. Ought they on that account to relinquish those demonstrations which were produced by a sound judgment? I should do you an injustice to doubt your answer.

Besides, when I assert that produce opens a vent for produce; that the means of industry, whatever they may be, left to themselves, always incline themselves to those articles which are the most necessary to nations, and that these necessary articles create at the same time fresh populations, and fresh enjoyments for those populations, all probability is not against me. (Jean-Baptiste Say, Letters to Malthus. London: Sherwood, Neely, and Jones, 1821, 2-3.)
Or, to summarize to the point of near-incomprehensibility, "because production equals income, supply generates its own demand, and demand, its own supply."

Understanding Say's Law

Obviously, this explanation of Say's Law is utterly baffling to anyone who is convinced that only existing accumulations of savings can be used to finance new capital formation. From the point of view that takes the "slavery of past savings" as a given, Say's Law posits an impossible solution to the problem of an economic downturn. If, as the "slaves of savings" assume, existing accumulations of unconsumed production are the sole source of money — and thus accumulations of money (savings) — then the act of saving is restricted to those who are free (at least in part) from the necessity of consuming all that they produce simply to exist in a manner befitting the demands of human dignity.

The assumption of past savings thereby leads to the conclusion that ownership of the means of production must be concentrated, either in the hands of a private elite, or the State. This dovetails very neatly into the belief that only the State has the ability to "create" money by issuing what amounts to official purchase orders backed by the State's power to confiscate wealth in the future, whether directly by taxation, or indirectly through inflation. This is incorrect, as we will see when we look at the real bills doctrine, an application of Say's Law.

Say's Law and the "Invisible Hand"

One flaw — omission, rather — that we do find in Say's extended explanation of the Law of Markets is that he assumed as a given that if someone wants to produce a marketable good or service, this can be done equally well by means of labor, capital, or land. This, however, is a significant departure from the analysis of Adam Smith. This is incorrect on two counts. One, Adam Smith assumed as a given that human labor was and would remain the predominant factor of production. Thus (as we shall see), ownership of the means of production was a matter of indifference to Smith. Two, Say did not acknowledge that there might be barriers preventing someone from owning capital or land — a significant lacuna at a time when capital was taking over as the predominant factor of production.

In consequence, economic growth and development were slowed to a rate far below what should have been the case in an economy with an advancing technology and a frontier (the New World) open to colonization and exploitation. Despite the rising recognition and respect for personal sovereignty and individual human dignity that were creating a new political environment freed from the distortions of individualism and collectivism, erroneous ideas of money and credit ensured that, however well in theory personal sovereignty and human dignity might be recognized and respected, economic (and thus political) practice ensured a very different reality. Without effective access to the means of acquiring and possessing the means of production, most people would remain dependent on the rich for their subsistence. Disruptions in civil society were bound to — and did — become increasingly frequent and more violent as time went on, culminating in the French Revolution, which resulted in the formation of the modern Nation-State.

The Primacy of Labor Dethroned

Still, regardless of how productive capital might become and how it was financed, as long as the primary input to production was human labor, things could not be distorted too much. Until capital was able to take over the bulk of the production of marketable goods and services, it didn't matter how much wealth someone owned, or how inordinate his or her desires.

As long as labor was the predominant means of production, the rich could only satisfy their wants and needs by purchasing the labor of those who did not own capital. This made the poor dependent on the rich, true, but it also forced the rich to trade some of their wealth for the productions of the poor. As Adam Smith was to point out in his study of moral philosophy, The Theory of Moral Sentiments (1759),
The rich only select from the heap what is most precious and agreeable. They consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose from the labours of all the thousands whom they employ, by the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species. (Adam Smith, "Of the Effect of Utility upon the Sentiment of Approbation," The Theory of Moral Sentiments. Part IV, Chapter I, §10.)
This is Adam Smith's "invisible hand" argument. He reiterated it in The Wealth of Nations (1776), although, perhaps, not as clearly as in Moral Sentiments. Smith did, however, insert a version of Say's Law of Markets:
But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. (Adam Smith, "Of Restraints upon the Importation from Foreign Countries of Such Goods as can be Produced at Home," An Inquiry into the Nature and Causes of the Wealth of Nations. Book IV, Chapter II, §9.)
We see, then, that the invisible hand is a combination of two essential parts: the self-interest of the rich (or whoever is in the process of realizing effective demand) and the distribution mechanism provided by human labor. The labor of the poor serves to distribute the wealth of the rich evenly throughout society in order to satisfy the self-interested demands, wants, and needs of the wealthy:
Luxury is ever in proportion to the inequality of fortunes. If the riches of a state are equally divided there will be no luxury; for it is founded merely on the conveniences acquired by the labour of others. (Charles de Secondat, Baron de Montesquieu, The Spirit of Laws. Book VII, Chapter 1.)
Taken together, the quotes from The Wealth of Nations and The Theory of Moral Sentiments point out Adam Smith's essential flaw in assuming that the invisible hand will correct and guide the market toward a maximization of justice, respect for human dignity, and acknowledgement of personal sovereignty for anybody but the rich. That flaw is found in the premise that human labor is the sole or primary means by which people gain access to the distribution of the goods of this world. Obviously, Adam Smith and others simply assumed that when the rich have an economic want or need (a "demand" in economic terms), others will supply their labor in order to produce the desired good or service to satisfy that demand.

Say's Law v. Malthusian Doctrine

Perhaps not coincidentally, the Reverend Thomas Malthus published his discredited Essay on Population in 1798, the year following the "Last Invasion of England" and the suspension of convertibility of Bank of England notes into gold. By 1821, when Say's Letters to Malthus were translated and published in English, Malthusian doctrine had become (as Joseph Schumpeter put it) established as "economic orthodoxy" despite its obvious flaws. Malthusian doctrines, however, combined with the seemingly unshakeable fixation on existing accumulations of savings as the sole source of financing for new capital formation, had a disastrous effect on acceptance of the fact that ordinary people could and should have the opportunity to participate in the economic process, both as consumers and as producers by means of their labor as well as ownership of the means of production.

Malthus' theories received a solid trouncing by economists such as John Weyland. Weyland's thesis was that the rate of population growth is determined by the state of economic development, not (as Malthus presumed) the other way around. This has been substantiated by subsequent events and supported by such diverse authorities as Jane Jacobs (Jane Jacobs, The Economy of Cities. New York: Vintage Books, 1970, 118-119.) and R. Buckminster Fuller. (R. Buckminster Fuller, Utopia or Oblivion: The Prospects for Humanity. New York: Bantam Books, 1969, 200-201.)

In other words, the more advanced a society becomes, the lower its reproductive rate; lowering the rate of reproduction does not advance a society: "population has a natural tendency to keep within the powers of the soil to afford it subsistence in every gradation through which society passes." (John Weyland, The Principles of Population and Production as They are Affected by the Progress of Society; with a View to Moral and Political Consequences. London: Baldwin, Cradoc, and Joy, 1816, 107.) Nevertheless, as Schumpeter noted,
The teaching of Malthus' Essay became firmly entrenched in the system of the economic orthodoxy of the time in spite of the fact that it should have been, and in a sense was, recognized as fundamentally untenable or worthless by 1803 and that further reasons for so considering it were speedily forthcoming. It became the "right" view on population, just as free trade had become the "right" policy, which only ignorance or obliquity could possibly fail to accept — part and parcel of the set of eternal truth that had been observed once for all. Objectors might be lectured, if they were worthy of the effort, but they could not be taken seriously. No wonder that some people, utterly disgusted at this intolerable presumption which had so little to back it began to loathe this "science of economics" quite independently of class or party considerations — a feeling that has been an important factor in that science's fate ever after. (Schumpeter, History of Economic Analysis. New York: Oxford University Press, 1954, 581-582.)
The Malthusian idea that there could be such a thing as excess people is, even from the crudest and most materialistic approach, utter nonsense. Even a rational materialist would say that unemployed people are a wasted resource, not a drain on society, regardless of their value as human beings. Nevertheless, Malthus's theories allowed the rich to assume that the misery and degradation of the working classes was their own fault for refusing to limit their numbers. Malthusian theory gave the rich a necessary salve to their consciences, and helped justify concentrated ownership of the means of production. People continued to believe — falsely — that if people were poor, it was because 1) they lacked the discipline to save and thereby accumulate the necessary financial capital to purchase productive assets, and 2) they were incapable of restraining themselves from breeding up to and beyond their own ability to support themselves.

There was, however, a slight problem with these assumptions. The predicted shortages didn't seem to be making their scheduled appearance. The new technologies that came in with the Industrial Revolution were producing marketable goods and services in such huge quantities that the problem was finding enough buyers with disposable income to purchase the tremendous amount of output, not a surplus of demand emanating from Malthus's Imaginary Multitudes. Supply and demand were becoming increasingly out of balance, but not because there was not enough to go around. On the contrary, the world was facing the paradox of people starving in the midst of plenty, even overabundance. What was going on?

We find the answer in Say's Law of Markets, stated most simply as "production = income." Once we think about this simple equation, we realize the truth of it. Every time a "production" (i.e., a good or service) is sold, it represents income for the seller. The raw materials or supplies used by the seller to produce a good or service also resulted in income for the producer of the raw materials or seller of the supplies, and so on, down the line. Thus, everything that is sold in the aggregate generates the aggregate demand to purchase it. We can therefore expand Say's Law of Markets by saying that "supply generates its own demand, and demand its own supply."

As we have seen, however, there was still a serious question remaining. That is, under the past savings assumption, except in extraordinary circumstances ownership of all new productive technology goes to the people who are able to cut consumption and save: the rich. How, then, are people without capital supposed to acquire ownership of capital if their income from labor is already insufficient to provide a living income, much less savings in sufficient amount to purchase capital?