Say’s Law, Credit Expansion & the Business Cycle

By Russell Lamberti

Robert Blumen has an excellent post at titled “Say’s Law and the Permanent Recession” which we linked to last week. Blumen’s basic case is that the US economy has effectively been in a prolonged recession since around the turn of the century. This article is not about Blumen’s “permanent recession” thesis per se, but about the basic claims he makes regarding Say’s Law.

A commenter called ‘noah’ made some interesting comments on Blumen’s post which I thought were worth exploring further. Here are extracts of noah’s comment [my emphasis]:

“Aggregate demand is not only equal to, but identical to, aggregate supply. ”

Except that it’s not, really. It is absolutely true that Say’s Law is valid, and that every act of producing/supplying creates a corresponding ability to demand, and thus sustainable economic growth is supply-driven. But while all supply creates corresponding demand, not all demand is based in supply… some is based in credit. To say “money is only a temporary parking place for past production” isn’t quite accurate. Credit can act as money. (Counterfeit money can also act as money, and serve to boost demand.)

It may well be argued, what is credit but a promise of FUTURE supply/production? True, but merely a promise; there is no guarantee that all that promised future supply will ultimately materialize and generate income. In fact, today we are positively guaranteed it will NOT all materialize, not by a long shot, because for decades credit (and thus credit-based demand) has been expanding far out of proportion to the productive true wealth creation required to repay debt.

My ability to demand is based my ability to counterfeit, my ability to borrow, and my ability to produceWhile only the latter could be called “true demand,” that does not change the fact that I can demand,purchase and consume goods, services and assets well beyond my ability to produce. It makes sense to term that additional ability to purchase/consume as “phony demand.”

Hutt astutely distinguished between true purchasing-power and mere “money-spending power” (ala Keynes and Krugman). True purchasing-power is rooted ONLY in production, in accordance with Say’s Law: prior production (savings), current production (earnings), or future production (credit)It is NOT rooted in the printing press or the bottomless credit card, as is some portion of money-spending power. So we could say purchasing-power = true demand, and money-spending power = true demand + phony demand. 

The endogenous money creation of fractional-reserve lending ensures that demand can rise faster than supply (driving up prices)… until it can’t, as debt (especially the Ponzi debt of the financial sector) grows to unsustainable levels, as it did in the 1990s. The needed deleveraging has yet to occur.

The so-called Keynesian “demand shortfall” is nothing but a reflection of the fact that aggregate demand, along with debt, had previously grown to levels far too high to be supported by production-based incomes, and so now that demand must contract. So it is not just that some producers over-estimated demand for their output; some probably sold or even oversold all their prior output because the demand actually existed, but it was credit-driven (phony) demand rather than savings-driven (true) demand.”

There are a number of issues raised here, most good, some a little imprecise. The commenter makes some good observations about credit demand but Say’s fundamental premise still holds even in light of the credit/”phony demand” story.

Here’s why.

Firstly, Say’s Law, particularly in its fairly crude form of “supply creates its own demand”, does not explain business cycles/recessions on its own. As Professor Steve Kates pointed out recently [my emphasis],

There are two fundamental economic questions:

1) what is the basis for demand?

2) what causes recessions, or perhaps more accurately in this case, what does not cause recessions?

What Say, and Robinet, were explaining was the origins of demand, which they argue is based on previous sales. Demand is constituted by supply. What they wrote is an answer to the first question, but it is not an answer to the second.

The second question may be rephrased in this way: can there be such a thing as a general glut? This is a completely different question from the first, and the answer, as a consequence of the general glut debate, was that no, there is no such thing as a general glut, demand deficiency does not cause recessions. James Mill’s answer to this question was, in part, premised on Say’s answer to the first but were not an answer to the first. They are separate but related issues. Mill used Say’s discussion on the basis for demand to explain why a general glut was impossible.

It is because James Mill was the first, so far as I know, to answer the second question that I see him to have been the first to frame the classical statement on what is now called Say’s Law. *The General Theory*is about whether demand deficiency, a general glut, is possible. And when one finally accepts the classical answer to question 2, as FH may have done, then, but only then, the economic issues revolve around 1, which is what kind of supply will actually create demand.

Kates’ goes on to say that implicit in the classical formulation of the issue was the recognition that it was not any old supply that mattered, but useful, value-adding supply.

And then, in answering that question, we can ask ourselves whether the Keynesian notion that spending on anything at all will do the trick is a correct answer. To a classical economist, it need hardly be said, the idea that anyone would think non-value-adding production could create growth and employment is too ridiculous even to contemplate. Only a modern economist might think so, but to anyone from the classical tradition, the idea is still ridiculous.

Now, of course, the question of what kind of supply will actually create demand is indeed a fundamental question, and this is where noah rightly points out that supply responding to demand supported by fiduciary credit expansion by fractional banks is likely to prove misdirected. Misdirected supply quickly diminishes in its real economic value-add, thereby diminishing the value of the real demand it can support, ala Say’s Law.

You see, if only a crude quantitative understanding of Say’s Law holds, Austrian Business Cycle Theory doesn’t hold any water. It’s precisely because the quality and subjective value of supply is important that ABCT matters and is valid. Expecting misdirected production to support the same level of real demand as efficiently directed production is delusional, and basically Keynesian. It’s Keynesian because it would support the notion that as long as stimulus can be used to get industries expanding again to boom-time levels regardless of allocative efficiency or malinvestment considerations, real demand can be restored through wages and earnings, ushering in a virtuous circle of demand-supply-demand-supply and on and on.

I would therefore argue, in perhaps a surprising and ironic twist of economic history and theory, that Keynesianism requires a very simple, crude version of Say’s Law to hold true, a version that Keynesians attack in their criticisms of ABCT and classical theories! And I think Kates would agree with this as per his comment, “…we can ask ourselves whether the Keynesian notion that spending on anything at all will do the trick is a correct answer.

We’ve seen this before in another guise. The Marxists call it the labour theory of value, which is the idea that the act of production is objectively valuable in and of itself, seemingly regardless of what is produced and what value is derived from the person it is produced for. This is of course why the claim that Keynesianism is really just a glossy rehash of Marxism is a basically valid one.

It’s also why adherents of the classical and causal-realist traditions must be careful in their invoking of Say’s Law, because in its simplified form it can be construed as a labour theory of value. This is why Kates thinks this quote from David Ricardo in a letter to Malthus in 1820 offers the most clear statement of Say’s Law:

“Men err in their productions, there is no deficiency of demand.”

Back to the Blumen’s commenter. The second point to raise about demand is that noah’s view that credit-funded demand is an exchange of “future production” is simply not true. A traditional credit transaction is really a TRANSFER of existing supply-backed demand from a saver to a borrower. Whether the borrower can muster the productivity and earnings in the future to pay back the loan is a separate issue. The fact is that any transfer of real demand in a traditional loan transaction must be of demand validated out of prior productive value. This is fairly straightforward: I borrow your supply-backed demand and ‘use’ that demand as if it were my own. Demand is transferred from you to me. How that gets paid back is a secondary issue which does of course depend on my future productivity.

The story gets more interesting when we introduce bank credit expansion out of thin air. Now, noah correctly asserts that this raises ‘monetary demand’ and this leads to misdirected production and an inevitable bust. But does it increase REAL demand? The answer is no, and I think noah agrees here.

All credit expansion does is illegally and surreptitiously transfer demand away from some toward others. Those from whom demand is transferred away are either present or future ‘demanders’ who own real savings and income streams built on their productive value-add. Transferring some of their real purchasing power away from them creates a chaotic chain of events in an economy. The ensuing business cycle boom is really the start of the crisis, while the inevitable bust is the recovery process from the crisis.

With credit expansion, demand is effectively wrenched away from its supply origin and extended to unproductive borrowers such as consumers, government and favoured, malinvested industries. The pattern of demand is altered unsustainably. There are at least three harmful results that follow.

  1. The new pattern of redirected demand is unsustainable, causing suppliers to invest in lines of production for which demand will soon disappear (since it is being backed by poor or no productivity), resulting in wasted capital.
  2. Over-consumption occurs as the expansion of monetary liquidity temporarily creates illusory profits and incomes, resulting in under-investment (particularly in low capital maintenance). So we have 1) misdirected investment and 2) under-provisioning for the future.
  3. 1) and 2) mean real demand begins to fall because it is being created by supply of decreasing quality and value-add as the economy orients around sectors servicing misdirected, unsustainable (1), and excessive consumption (2).

The net result is that real demand is first transferred elsewhere in the economy, orientates toward consumption and away from investment (provisioning for the future), and then it falls (or rises by less than it would have in a healthy, progressing economy).

New demand was not created by the bank credit creation. The opposite is true. The end result of bank credit expansion is a reduction in real demand, which is another way of saying that it impoverishes the aggregate economy.

Say’s Law holds true, and while credit expansion can create the illusion of rising demand, it doesn’t raise actual demand. And because Say’s Law holds true (the qualitative, subjective value version of Say’s Law, that is) we will have recessions (mild, moderate or large) after credit expansions to the extent of the reduction in supply quality. The more supply is misdirected and oriented toward consumption now at the expense of making provision for consumption in the future, the more there will be a crisis and decline in real demand.

The Keynesians are therefore proximately correct. A recession is the result of a fall in aggregate demand. Yet once we understand why, it becomes obvious that the proposed Keynesian solution (viz. to continue impairing the quality of supply) is no solution at all but the very cause of the problem. It becomes clear that the obvious solution is to allow and aid the quickest possible restoration in the quality of supply – that means allowing factor markets to re-orientate as quickly as possible to adjust to meeting societies most pressing needs and re-couple demand with productivity by eradicating bank credit expansion out of thin air un-backed by real productive savings.