Say's Law and
Supply Side Economics

There was a series on PBS about the Great Depression some years ago. Remarkably, there were no actual economists interviewed about the causes of the Depression. Instead, pseudo-authorities, like Gore Vidal, and ordinary people from the time were asked what the problem was. They repeated phrases about "overproduction and underconsumption." Like Herbert Hoover and Franklin Roosevelt themselves, they thought that people simply did not have enough money to buy the output of industry [1]. In a sense that was true, but the program that such a theory evidently called for, raising wages and protecting jobs, which would presumably give people the extra money needed to buy all industrial production, had disastrous results:  Unemployment hovered around 20% for a decade, despite all the bells and whistles of the New Deal. Vidal said that Roosevelt "saved capitalism," but the New Deal did not revive the economy or substantially lower unemployment. Most people are aware of this -- otherwise the Depression after 1933 would not still have been the Depression -- but acknowledging its implications is avoided [2].

Even today, economics is often still thought of in "underconsumptionist" terms -- not often by economists but frequently in politics and in public debate -- and the Los Angeles Times still prints articles to the effect that the basic problem of economics is "how to achieve sufficient demand to absorb available production" [3]. In fact, public policies including everything from protective tariffs and "fair trade" to unionism and the minimum wage are based on this principle. These kinds of ideas in the post-World War II world are usually identified with John Maynard Keynes. A biographer of Keynes, Robert Skidelsky, says that Keynes's "aim was simply to ensure a level of aggregate demand sufficient to enable market-clearing real wages to be established without price inflation" [4].

But Hoover, Roosevelt, and Keynes had it all backwards. The proper economic principle is called "Say's Law," for Jean Baptiste Say (1767-1832), that "supply creates demand." This means that "overproduction" in a free economy is actually impossible. This happens to have been the topic of the doctoral dissertation of the great economist Thomas Sowell, now available as Say's Law, An Historical Analysis [Princeton University Press, 1972] [5].

Why Say's Law is correct is evident from one simple consideration:  if inventory doesn't sell, then prices will be cut until it does. Or, if a manufacturer wants to sell to a mass market, he knows that he can't wait until everyone can afford something expensive; he knows that he has to market his product at a low enough price that it will begin to sell [6]. In more technical economic terms, if the supply function increases (from "supply, a" to "supply, b" in the chart below), which means that it becomes possible to produce a greater quantity of goods for a given price, then, if the demand function does not also increase, a greater quantity of goods will end up being sold anyway as prices fall to a market clearing level (from "price, a" to "price, b" in the chart). Say's Law may also mean that the demand function will increase also, but it is not necessary to get into that part just to see how the basic price mechanism works (and, indeed, if demand increases, prices might not fall). A greater quantity of demand will result from an increased supply function even if no other factors are involved -- as long as prices are allowed to fall (in Germany now, businesses are fined for cutting prices). When industrial production increases and more goods become available, some old goods will go unsold as money moves over to the new goods, and prices will have to fall right across the board. That is called "deflation," and it is what happened in the United States from the end of the Civil War until 1896, while the United States grew into the largest economy in the world [cf. "Money as Value"]. Money became more valuable, and wages continued to buy as much as was desired of total production (the Edsels, of course, don't sell, except for bankruptcy liquidation) [7].

A visitor to the United States from the Soviet Union in the 80's was shown an American supermarket -- in stark contrast to the empty shelves in Soviet stores -- and he remarked that it was well stocked but that people could not afford to buy the goods. Almost anyone can see the fallacy in his viewpoint:  a store that couldn't sell its goods would quickly go bankrupt. Many do all the time. But although this is obvious on a microeconomic scale, people lose track of it on a macroeconomic scale:  they imagine that industry could just produce a bunch of stuff that people would actually want but that would just sit there. No industry would be left in that case.

Several questions occur. Question #1:  Why hasn't there been any deflation since World War II, even though the U.S. economy has grown vastly since then? Deflation will only happen if the money supply does not grow fast enough as production increases. Prices will remain stable or even increase (inflation) if the money supply grows as fast or faster than production [cf. "Money as Value"]. Under the gold standard, what happened to the money supply depended on the supply of gold. As gold from California slowly ran out, there was deflation; but, after 1897, gold strikes in the Yukon and South Africa created a mild inflation until World War I. Now that nations are no longer on the gold standard, governments can increase the money supply and even create permanent inflation just by printing money. Indeed, most people today, including reporters, businessmen, politicians, and even many economists, unaware of monetary history, think that a growing economy somehow actually causes inflation.

When I was in high school, an American history textbook had a diagram of the "wage and price spiral." Workers would press for higher wages. Then businesses would raise prices. Then workers would press for even higher wages. This was supposed to explain how inflation happened. However, there is a very simple reason why this isn't correct:  If the money supply does not increase, the "wage and price spiral" runs out of money. If a business raises prices to offset wage increases, less of its production will be sold. If enough is sold that revenue actually increases, as desired, this will have two effects:  (1) people are getting less for their money from this business, which decreases the value going to consumers; and (2) money is drawn from elsewhere in the economy, which means that there is less money left to buy the production of other businesses. Somebody gets the short end of the stick. Somebody has to cut prices.

Question #2:  If a business must cut prices to sell its inventory, will it not also cut wages to preserve its profit margin, meaning that the growing value of deflating wages will simply be offset by wage cuts? Wages will indeed fall with prices in a deflation, but falling nominal wages in the post Civil War era actually meant rising real wages:  Wages did not fall as fast as the prices of goods. If the value of wages simply fell equally with the value of production, then cutting prices to move inventory would be ineffective -- no new products, like cars or radios, could ever be introduced into an economy, since the purchasing power would not be there to buy them. Why real wages would rise as nominal wages fell may be understood in terms of another simple consideration:  expanded production will always mean expanded demand for labor. Drawing off labor to produce new goods bids up the value of labor, which would offset the downward tendency of deflation.

All the great labor strife of the 1870's, 80's, and 90's -- the Great Railroad Strike & Riot of 1877, the Haymarket Riot (1886), the Homestead Strike (1892), and the horrific Pullman Strike (1894) -- followed from the understandable perception that wages were falling, as nominal wages actually were being cut, even while real wages in fact were rising. At the time, who was going to believe that wages, even while being cut, were in fact rising? This would require a level of economic sophistication that even today, in public discourse, is usually lacking. Once the post-gold strike inflation ended the cuts and so the perception, labor strife diminished greatly. Unionism would not achieve great victories until given special monopoly legal privileges ("collective bargaining rights," etc.) in 1932 & 1935, as part of the Hoover and New Deal policies to drive up wages.

Artificially raising wages, on the other hand, or maintaining nominal wage levels during a deflation, as with Hoover and Roosevelt, only manages to produce unemployment [cf. "Historical Statistics and Analysis"]. Wages that are not allowed to naturally seek a market clearing level produce the same results as any other kind of price fixing scheme:  when wages (prices) are too low, a shortage results; and when wages (prices) are too high, a surplus results. A surplus in the labor market is called "unemployment." Hoover and Roosevelt thus engineered, not greater demand and prosperity, but greater unemployment and unparalleled Depression.

Question #3:  When the labor market is left to determine wages, what guarantee do we have that the wages will buy anything? Another way to understand the answer is to note that what wages will buy depends on the value of money, while the value of money depends on the transactions the money supply must cover, i.e. the output of the economy [cf. "Money as Value"]. What wages will buy thus depends on what the economy produces, and Say's Law means that the value of money will rise to a market clearing level, that is, until production may be purchased by the money held by consumers.

When Henry Ford raised his daily wage from $2.34 to $5 in 1914 (also cutting the working day from 9 to 8 hours -- U.S. Steel still had a 12 hour working day as late as 1922), and ultimately to $6 a day in 1922, it was because he thought that nominal wages would have to rise to make it possible for his workers to buy Model T Fords. But unless everyone similarly more than doubled wages, which they didn't, this cannot explain how Ford created a mass market for Model T's outside of his own workers. He did that by cutting the price of the car:  Originally offered at $850 in 1908, the price of the Model T was cut to $600 in 1912, to $550 by 1914, and ultimately down to $300 by 1922 (about $4500 in 1995 dollars -- still cheaper than most cars), when he was selling more than a million a year. Ford knew why cutting prices worked, and one of the reasons he raised wages too was to attract and retain loyal workers; but Ford was confused about the economic role of wages, thinking that nominal wages needed to rise, since later he advised Herbert Hoover to prevent wages from falling during the deflation of the early Depression [as in the quote above], with disastrous consequences. In the mild inflation of 1914, it is reasonable that Ford's wages would have risen in such a productive industry, but this should not be have been confused with the real engine of wealth for most people:  Falling real prices. Ford's understanding, which was the opposite of Say's Law, may be called "demand side" economics, just as Say's Law itself may be called "supply side" economics.

"Supply side" economics is now associated with Arthur Laffer and his advice in the late 70's that the highest tax rates should be cut, which would free up private capital and produce economic growth, which then would result in higher tax revenues. Although cutting tax rates produced the "seven fat years" from 1982-89, and tax receipts actually did increase, this advice is now commonly disparaged as "tax cuts for the rich" and falsely blamed for growing federal budget deficits in the '80's [8]. The thinking seems to be that the profits of business should either be given directly to workers through pay raises or be taken by the government to be given to workers indirectly. Producing greater profits is thought of as useless and immoral.

However, if Say's Law is correct, life improves through greater production, not through higher nominal wages. Greater production requires greater capitalization -- money invested in machinery and training -- and the capital for that must come out of profits. Greater production, in turn, means greater productivity -- that fewer workers are needed to produce the previous quantity of goods. But, Question #4:  If employers must cut prices in the deflation of a growing economy but cannot cut wages to the same degree, what is going to restore their profit margin? The answer is greater productivity. If the workers with higher real wages produce proportionally more for those wages, then the balance of revenue and expenses will be restored. The employer therefore must have had a sufficient profit margin in the first place to absorb both the blow of declining prices against rising real wages and to be able to invest in sufficiently greater productivity to offset the new level of wages. In the long run, this means that lower paying, labor intensive work gets replaced by higher paying, capital intensive work.

If we think in terms of the labor freed up by greater productivity, as fewer workers can produce the same output, it is then clear that this can be put to the production of more of the old products, if desired, or new products, as we have seen:  the cars, radios, refrigerators, washing machines, TV's, calculators, pacemakers, VCR's, computers, snowmobiles, and all the other features of modern wealth. But just as profits and capital are still foolishly attacked in the press and in politics, the process by which labor is made available for new production is also attacked:  "corporate downsizing," even when all it does is get rid of useless, bloated management, is attacked for its cruel effects on workers. The effects may indeed be cruel on an individual level, but without that process, 90% of human beings would still be subsistent peasants, which is far crueler than any industrial layoffs. Certainly, the ancient Egyptians would have been horrified to learn that less than 2% of the population would later be needed to produce all of a large country's food [cf. "Historical Statistics and Analysis"]. What is everyone else to do? It would not have helped to tell them that most people would be producing things that they could not have even imagined -- just as no science fiction writers of the 1950's imagined pocket calculators or personal computers.

Question #5:  If investment in greater productivity frees up labor, will that not produce a higher level of unemployment that would drive down wages? Indeed, unless the capital exists and is invested to create the new production that would need the free labor. Even if there is a lag in hiring that would drive down wages, so that increases in productivity would initially mean increases in profits for businesses that "downsized" their labor force, as new businesses bid up labor again and produce new goods, the prices of all goods would then have to fall, if necessary, until the market cleared. Employers with windfall profit margins from downsizing would lose their higher profits to the interaction between deflationary price cutting and the wages bid up by the labor market. The effect of productivity freeing up labor is then precisely the same, seen from a different direction, as the effect of expanded production driving down prices:  falling nominal prices and rising real wages will meet at the point where production will equal consumption.

The paradox of Say's Law is thus that capital, the "supply side," is the only real means of improving the human condition -- both the capital to create new production and the capital to create greater productivity -- while "social" spending or regulation to artificially promote demand through high wages, the "demand side," can easily produce, or perpetuate, widespread poverty and misery. Thus the Soviet Union reproduced the economic poverty as well as the political privilege of a mediaeval state, even as Herbert Hoover and Franklin Roosevelt, with glowing rhetoric about the common man, lodged the wealthiest nation in history in a full decade of unprecedented unemployment. The mythology of the New Deal and the Keynesian rejection of Say's Law still distort American politics and economics.

How Say's Law works can be examined with some simple graphs. At left is a hypothetical "equillibrium" condition where production equals consumption, i.e. wages equal prices. The quantity of money mediates the exchange between wages and prices. There is also an equivalence between labor and production, since the quantity of production derives from the quantity of labor. This chart and the subsequent ones presuppose market-clearing wages, i.e. full employment (which should be no more than 2% unemployment). If wages are too high and do not clear the market, then there is substantial unemployment and both production and consumption are concentrated in the employed workforce. At right we can see what happens if the quantity of production increases, ceteris paribus (all other things being equal). Here the money supply still matches the quantity of labor, so wages remain the same. However, if the quantity of production is going to sell, for the same quantity of money, then prices must fall. This was the deflation characteristic of late 19th Century America. Also, note that for the increased production to come from the same quantity of labor, productivity must increase, i.e. labor produces more goods for the same effort.

This case represents the bottom line, the touchstone and paradigm, in all considerations of economic growth and progress. Life improves by increased production, and constant labor can increase production by increased productivity. If the money supply remains the same, then nominal wages will remain the same, but for the increased production to sell, prices must fall. If businesses kept prices the same, despite increased productivity, then some goods would not sell, and the increased productivity would be wasted (or, at least, remaindered). But prices can be cut, with costs and profits remaining the same, and the increased production can then sell. The real value of money (and the real value of wages) thus rises, since the money covers more transactions. Everything else is just a variation of this, mainly because of independent variation in the money supply.

The increase in production shown is slightly less than the actual increase in the Gross National Product of the United States from 1921 to 1928 (Harding-Coolidge), which was 49%. This still compares most favorably with the increase in the GNP during subsequent periods of strong growth, from 1961 to 1968 (Kennedy-Johnson), 38%, and from 1982 to 1989 (Reagan), 29%. Why the rate of economic growth should have slowed over time is explained by the restrictions that have been put on business and capital, for purposes contrary to Say's Law.

One characteristic of the Twenties, however, was stable prices. The chart at right shows what happens if the quantity of money increases along with production, which is what happened in the Twenties, thanks to Benjamin Strong. Now prices remain stable, but the extra quantity of money must be absorbed by the same quantity of labor:  So wages rise. This is actually what happened during the Twenties, though the labor force also increased in size, so wages would not have risen quite as much as the idealized case shown. If wages did not rise, then not all of production would be sold, and somebody would go bankrupt with unsold inventory -- though the consumption of labor itself would be unchanged. At the same time, however, the money that could have gone to the wages that could have moved the extra inventory would have to be just sitting someplace, perhaps in a bankvault.

What if people poured into the country and production didn't change? This could hardly happen unless the addition to the population remained unemployed. However, if somehow the addition to the population was aborbed into the workforce, and if production did not change, then two things would have to happen:  (1) wages would fall, and (2) productivity would have to fall also. Thus, the same quantity of production would be produced by more labor and would be distributed among the larger population. Wealth per worker would decrease, and technology would have to decline, as production becomes more labor intensive rather than capital intensive. This situation could not occur unless the technology were somehow declining, despite growth in population, OR if we had some sort of collapse in the existing economy and money supply, relative to stable population. That is actually what happened in the Great Depression, when the collapse of credit and the failure of banks sharply deflated the money supply and when production declined both because of business failure and because many businesses deliberately scaled back production (through layoffs and slowdowns). Since much of the workforce became unemployed (28% at its worst), the distribution of remaining production would be disproportionately concentrated with the remaining employed workers. If we had the same sort of situation, but the money supply is maintained through money creation, we would still have the same decline in wealth, but prices would rise rather than wages fall. This was the early situation in post-Communist Russia, where the economy continued, overall, to collapse, but the money supply, at first, expanded continually. When the expansion in the Russian money supply was brought, somewhat, under control, wages still declined in relation to production, since real wealth, production, still declined, whether massive inflation occurred or not.

If production keeps up with the growth in the labor force, and the money supply keeps up also, then prices and wages would not change at all -- we would simply have a kind of expansion of the equillibrium state. This is somewhat unrealistic, since productivity does increase over time with technological innovation. So, in general, production is going to increase faster that the quantity of labor, and real wages are most likely to increase, unless there is some collapse in the money supply or the economy.

In the days of central banking -- which means today -- when money can be created by fiat, the money supply is no longer liable to experience any kind of collapse. Instead, we have the opposite, as at right, where the growth in the money supply outpaces the growth of both the labor force and production. This means that both prices and wages will expand:  a general inflation. This has been the case in the United States ever since World War II. This is the easiest policy politically, since wages will appear to rise whatever is happening to the economy. People may be irritated that prices rise also, and they may even realize that the real value of their savings is being lost, but these are both more remote considerations than a stagnant or declining paycheck and are unlikely to become hot political issues.

Thus, again, once Say's Law is understood, it is obvious that growth in production takes care of demand, as long as wages are allowed to maintain market-clearing levels. What happens to the money supply is secondary, though it helps to avoid falling wages, since people are not going to like that, whether it really makes any difference or not (and it will increase the value of debt). Price deflation is acceptable as long as wages do not also fall, but that is a tough target to hit. Growth in productivity, not just growth in production, is ultimately what makes life better and increases wealth for everyone.

Political Economy

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Copyright (c) 1996, 1997, 1998, 1999, 2000, 2002, 2003, 2004, 2005, 2006, 2007 Kelley L. Ross, Ph.D. All Rights Reserved

Say's Law and Supply Side Economics, Note 0

The great Arab historian Ibn Khaldûn (1332-1406) clearly anticipated the Laffer Curve. While most of his political enemies regarded Ronald Reagan as an ignorant fool, Reagan actually majored in economics in college and long remembered Ibn Khaldûn's wisdom. Supply Side economics was nothing new to him.

It is thus of some interest to quote the full explanation than Ibn Khaldûn gives for his assertion:

It should be known that at the beginning of a dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.

The reason for this is that when the dynasty follows the ways of Islam, it imposes only such taxes as are stipulated by the religious law, such as charity taxes, the land tax, and the poll tax. These have fixed limits that cannot be exceeded.

When the dynasty follows the ways of group feeling and (political) superiority, it necessarily has at first a desert attitude, as has been mentioned before. The desert attitude requires kindness, reverence, humility, respect for the property of other people, and disinclination to appropriate it, except in rare instances. Therefore, the individual imposts and assessments, which together constitute the tax revenue, are low. When tax assessments and imposts upon the subjects are low, the latter have the energy and desire to do things. Cultural enterprises grow and increase, because the low taxes bring satisfaction. When cultural enterprises grow, the number of individual imposts and asssessments mounts. In consequence, the tax revenue, which is the sum total of (the individual assassments), increases.

When the dynasty continues in power and their rulers follow each other in succession, they become sophisticated. The Bedouin attitude and simplicity lose their significance, and the Bedouin qualities of moderation and restraint disappear. Royal authority with its tyranny and sedentary culture that stimulates sophistication, make their appearance. The people of the dynasty then acquire qualities of character related to cleverness. Their customs and needs become more varied because of the prosperity and luxury in which they are immersed. As a result, the individual imposts and assessments upon the subjects, agricultural labourers, farmers, and all the other taxpayers, increase. Every individual impost and assessment is greatly increased, in order to obtain a higher tax revenue. Customs duties are placed upon articles of commerce and (levied) at the city gates. Then, gradual increases in the amounts of the assessments succeed each other regularly, in correspondence with the gradual increase in the luxury customs and many needs of the dynasty and the spending required in connection with them. Eventually, the taxes will weigh heavily upon the subjects and overburden them. Heavy taxes become an obligation and tradition, because the increases took place gradually, and no one knows specifically who increases them or levied them. They lie upon the subjects like an obligation and tradition.

The assessments increase beyond the limits of equity. The result is that the interest of the subjects in cultural enterprises disappears, since when they compare expenditures and taxes with their income and gain and see the little profit they make, they lose all hope. Therefore, many of them refrain from all cultural activity. The result is that the total tax revenue goes down, as individual assessments go down. Often, when the decrease is noticed, the amounts of individual imposts are increased. This is considered a means of compensating for the decrease. Finally, individual imposts and assessments reach their limit. It would be no avail to increase them further. The costs of all cultural enterprise are now too high, the taxes are too heavy, and the profits anticipated fail to materialize. Finally, civilization is destroyed, because the incentive for cultural activity is gone. It is the dynasty that suffers from the situation, because it profits from cultural activity.

If one understands this, he will realize that the strongest incentive for cultural activity is to lower as much as possible the amounts of individual imposts levied upon persons capable of undertaking cultural enterprises. In this manner, such persons will be psychologically disposed to undertake them, because they can be confident of making a profit from them. ['Abd-ar-Rah.mân Abû Zayd ibn Khaldûn, The Muqaddimah, An Introduction to History, Franz Rosenthal translation, abridged and edited by N.J. Dawood, Bollingen Series, Princeton University Press, 1967, pp.230-231]

While Ibn Khaldûn was writing about the cycle of dynastic governments with which he was familiar in Mediaeval North Africa and Spain, the same dynamic applies to democracies, where politicians seek to obtain votes by bestowing benefits from the public purse. Indeed, the motive to abandon productive "cultural" activities will be stronger in a democracy, since it quickly becomes apparent that profit can be obtained more easily from political activity than from economic production, when economic activity itself is burdened with increasing taxes, mandates, and regulations. This dynamic is explored by modern Public Choice economics. Thus, the productive are despised (as the greedy and grasping) and burdened, while the unproductive are celebrated (as noble victims or disinterested public or cultural servants) and supported.

It is especially noteworthy that Ibn Khaldûn identified the period of low taxes as one in which the "ways of group feeling" predominate. These days, collectivist ideologies of "group feeling," like communitarianism, support the idea that the productive have a duty to support the unproductive, promoting a regime of high taxes and high vilification against the productive themselves. But, as noted elsewhere, a welfare regime of the rent-seeking and unproductive promotes a kind of malignant individualism that is impossible under laissez-faire capitalism. The political benefits bestowed on the unproductive are rights which require no agreement or good will from others, and which can be demanded without civility or consideration. Ibn Khaldûn's wisdom thus is conformable with this greater insight, that true community attends low taxes and respect for the property of others, not the high taxes and confiscations of a regime of parasites, whether dynastic or democratic.

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Say's Law and Supply Side Economics, Note 1

It may seem strange to lump Herbert Hoover and Franklin Roosevelt together. The conventional wisdom is that Hoover was a supporter of laissez-faire capitalism whose inactivity let corrupt business practices drive the country into the Depression, while Roosevelt reformed the economy and therefore pulled the country out of the Depression. Neither impression is true. Hoover was a Teddy Roosevelt "Progressive" who believed in activist government. Federal spending increased faster during Hoover's four years than during the first seven years of the New Deal. Hoover promoted high wages for workers and high prices for farmers. Twice, in 1920 as chief of the wartime Food Relief Administration and then after he became President in 1929, Hoover wrecked the American agricultural export market by using the power of the federal government to drive up agricultural prices. That was supposed to be good for farmers, but it simply destroyed their foreign markets. Hoover then destroyed almost all export markets by signing the Smoot-Hawley Tariff in 1930, even though he was warned in a petition from 1000 economists not to do it. Within a year American trade had fallen more than 50% and unemployment had jumped from 6% to 17%. Later Roosevelt said that farmers didn't need an export market anyway! (For the details of this, see The Farm Fiasco, by James Bovard, ICS Press, San Francisco, 1991.)

Although it is Roosevelt who is famous for pro-labor legislation, especially the National Labor Relations Act of 1935 and the Fair Labor Practices Act of 1938, pro-union legislation began with the Norris-LaGuardia Act of 1932, under Hoover, which exempted labor unions from antitrust law, freed them from any responsibility for violence that their members might engage in, and granted additional privileges. It is no wonder that Calvin Coolidge said of Hoover:  "That man has offered me unsolicited advice for six years, all of it bad." Occasionally Hoover is credited with having "anticipated" many of Roosevelt's New Deal policies. The irony is that the New Deal policies did not work (if their purpose was to end the Depression, rather than just expand the power of government or open the way for socialism); and if Hoover "anticipated" Roosevelt's policies, this means that the Depression was perpetuated when Roosevelt continued and expanded the very devices by which it was created in the first place. Indeed, there were limits to what Hoover was willing to do:  he did not believe the federal government should make direct payments to private individuals or seize unconstitutional powers to completely control finance, business, and commerce. Roosevelt had no such scruples, though even what he did now looks modest compared to the powers that the Federal Government has since usurped.

The mythology and bad economics that attend our understanding of Roosevelt was reinforced in one of the Century episodes run by ABC News, as part of a series looking back on events of the 20th Century. On Thursday 8 April 1999, ABC ran an episode on Roosevelt. They explained his election victory in 1936 as the result of his alliance with labor unions, which is probably in part true, but then it explained his alliance with the labor unions as the result of a new understanding that "workers are consumers also," so that wage raises would enable them to buy more, stimulate the economy, end the Depression, etc. Since the economy actually became worse after Roosevelt's reelection, ABC said that Roosevelt wasn't even as interested any more in ending the Depression but in creating a "different kind of society" where there was less of a gap between rich and poor. Unfortunately, instead it made for a kind of a society where unionized employees were a lot better off than the continuing unemployed. But all of this treatment by ABC was a tissue of falsehoods. A program of driving up wages was not something that suddenly occurred to FDR in 1936, it had been the constant policy, not just of FDR, but of Herbert Hoover before him, as can be seen merely in the quotes given above. ABC seemed to only interview "experts" who reinforced the mythology, like a labor historian, rather than any economist who could explode their treatment and expose the continuity of policy from Hoover to Roosevelt. The whole episode was, indeed, merely the continuation of New Deal, Democratic Party propaganda. The kind of thing that is all too typical of Network News (as discussed in Bernard Goldberg's recent book Bias -- though still stoutly denied by the figures who, styling themselves "objective," continually repeat the leftist line).

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Say's Law and Supply Side Economics, Note 2

It is common and indeed conventional knowledge that only World War II ended the Depression. It is also generally understood why the War did that, with millions of men drafted into the armed forces and the government borrowing and spending mountains of money on war production. What is less often acknowledged is that the New Deal as such thus failed to end to the Depression. Nor is it generally understood why the Depression did not return in 1946, after the military was demobilized and war production ended. By all rights, nothing should have been any different from 1939. But the Depression did not return. Despite demobilization and the end of war production, unemployment in 1946 was 3.9% and in 1947 3.9%.

On 5 June 2004, the day Ronald Reagan died, there was a report on CNN about the Normandy landings (whose 60th anniversary would be the following day) and about the impact of World War II on subsequent history. The reporter said that the War ended the Depression with the draft and by "putting money in workers' pockets" -- and that things have continued much the same ever since. The reporter, however, failed to reason through that with the end of the War the draft ended and that during the War it was both the case that wages were frozen and that war production was not of consumer goods to be bought by those workers. Civilian housing, automobiles, and tires were not even produced during the war. People had to just either save their money or buy War Bonds with it. After the War, the money was then worth less because of inflation. So his explanation didn't add up.

So why didn't the Depression return in 1946? Because wages were frozen even while the money supply was inflated with the war spending. This drove down real wages, the opposite of the consistent policy of Hoover and Roosevelt for a decade to drive up wages. In 1946, wages were low enough to clear the employment market. If employers could then hire workers at a market wage, and produce consumer goods, business could get back to normal. It did.

The first post-War recession was in 1949. In the fourth quarter of 1949 unemployment peaked at 7.0%. President Truman was urged to do something, but he actually said, "The kind of government action that would be called for in a serious economic emergency would not be appropriate now" [Richard K. Vedder and Lowell E. Gallaway, Out of Work, Unemployment and Government in Twentieth-Century America, Holmes & Meier, 1993, p.185]. By the second quarter of 1950, unemployment was already back down to 5.6%.

This is an instructive history for the Marxist view that capitalism only saves itself through militarism. Such a thesis is refuted by the economy of 1946 and by the economy of 1950 (let alone by the economy of 1921). Economically, Cold War government did not begin until 25 June 1950, when North Korea invaded South Korea. This effected the return of the draft and renewed military spending. If the economy had really been in trouble, some might have thought that welcome, but the economy was already recovering from the recession of 1949, nothing of the sort explains the prosperity of 1946-1949, and military spending, of course, does not produce the consumer goods characteristic of the economy of the 1950's.

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Say's Law and Supply Side Economics, Note 3

Los Angeles Times, Commentary, "Wanted: Alternative Thinkers for a Change," Robert Theobald, Monday, April 8, 1996.

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Say's Law and Supply Side Economics, Note 4

In The Road From Serfdom:  The Economic and Political Consequences of the End of Communism, Viking Penguin, 1996.

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Say's Law and Supply Side Economics, Note 5

One might have expected Jacques Barzun's formidable From Dawn to Decadence, 500 Years of Western Cultural Life, 1500 to the Present [HarperCollinsPublishers, 2000] to devote some mention to Say, especially when his preference for figures in his native France is noted. But what we get instead is tribute to a "forgotten pioneer" of economics, Simonde de Sismondi (1773-1842). And what was Sismondi's singular contribution and insight?

Why did the seemingly beneficial production of goods by machinery bring on "poverty in the midst of plenty"? The answer was:  free competition keeps wages low, free enterprise makes for overproduction, which leads to recurrent "crises" -- shutdowns or failures entailing unemployment and starvation.

His detailed criticism of the new society includes the observation that it splits labor from capital and makes them enemies, with the power all on one side. The idea of their "bargaining" over wages is absurd. Tyrant and victim describes the relation, yet without cruel intent of the one or knowledge by the other of who his oppressor is. Again, with overproduction the capitalist must seek foreign markets and preciptiate national wars, while at home a class struggle goes on without end...[pp.456-457]

Barzun apparently considers these proto-Marxist confusions and canards to be a great discovery, anticipating Marx in the year of his birth (1818). Indeed, Sismondi coined the term "proletariat." No wonder Say is overlooked -- he failed to notice that overproduction was endemic in capitalism! Sismondi even anticipates Lenin's Imperialism with the idea that overproduction must be diverted to foreign markets (all those wealthy colonials in Africa, India, etc.), with war following behind (since so much British trade and investment went to the United States, there must have been some terrible wars over it).

It is sad to still find something like this in a distinguished historian in the year 2000. The simple ideas that wages depend on the labor market, where workers "bargain" by changing jobs or, heaven forbid, going into business for themselves (something strong discouraged, apparently, in modern France), and "overproduction" sells when prices fall to a market clearing level, still hasn't gotten through to people like Barzun, despite the failure of command economies and the stagnation of the Euro-socialist ones (apparently what Barzun prefers). Not a lot of starvation in laissez-faire Hong Kong there, Jacques. Or, for that matter, in Victorian England (just in preindustrial and mono-agricultural Ireland). Note the statement on increasing wages in 19th century Britain by Paul Kennedy in the epigraph above.

1818 may, indeed, have been a bad year for Sismondi to publish, since there was a post-War recession in Britain and the economy had not yet taken off in the way that would distinguish it for the rest of the century. Many people writing during the Great Depression, of course, thought it proved that America was finished and that the Soviet model was the hope of the 20th century. Barzun, in effect, has not noticed the results of post-1818 Britain, post-1945 America, or the real fruits of the Soviet Russian economy. While Kennedy himself, writing in 1987, believed that the Soviet economy was the second largest in the world (and had been for decades), this turned out to be fraudulent. In 2003, the Russian economy, for all the size and population of the country, was only the 18th largest in the world, behind that of little Taiwan and Argentina [cf. The Economist Pocket World in Figures, 2003 Edition, p.24]. Kennedy's own thesis of the relative decline of Great Powers, well illustrated by Russia in the 19th century (falling from the largest economy in the world to fourth), and believed by him to likely be applicable to the United States in the 1980's, only applied to 20th century Russia, again, instead.

But if Jacques Barzun is still parroting "underconsumptionist" economics, it is not suprising that the indoctrinated, politically correct, economic and historical illiterates of American colleges and universities should still be operating as an orphaned Fifth Column for the Soviet Union. A popular book like Barzun's represents a distinct disservice to the future.

An interesting contrast to Barzun's treatment of Sismondi is in Thomas Sowell's recent On Classical Economics [Yale, 2006]. Sowell has an entire chapter on Sismondi, actually titled "Sismondi: A Neglected Pioneer" [pp.104-128]. Sowell's appreciation of Sismondi, of course, is not the gushing enthusiasms of Barzun. Sowell credits him, as a critic of Say's Law, with scoring real points against defenders like Say and Ricardo, introducing concepts (the theory of equilibrium income, the development of growth model equations, etc., see pp.125-126) that were valuable advances but then, because Sismondi was forgotten, had to be rediscovered all over again later. This did not mean that Sismondi was right about Say's Law or right in his proto-Marxist principles. Indeed, among Sismondi's suggestions were "guaranteed wages and employment" [p.121]. If any notion in political economy has been taken seriously and been applied with vigor, it is this, especially in places like France. The result, however, as in the Great Depression, has been high unemployment and low growth. Not what Sismondi, or anyone implementing these policies, would have expected. Yet, as Sowell points out and Barzun doesn't, Sismondi expected that most of the problems with an economy would be due to government intervention:

"The development of nations proceeds naturally in all directions; it is scarcely never prudent to obstruct it, but it is no less dangerous to hasten it..."

Contrary to interpretations in the literature [Barzun's?], it was not inherent defects of the capitalist economy but the deliberate policies of contemporary governments which Sismondi regarded as the primary cause of glutted markets....

...but he was by no means a dirigiste:  "By allowing the greatest freedom to capital, it will go where profits call, and these profits are the indication of national needs" [pp.115-116]

Thus, Sismondi was much less a sort of proto-Marxist critic of Say's Law as a kind of Keynsian, and one whose arguments rested at least as much on the weaknesses of Ricardian economics as on any mistakes of his own.

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Say's Law and Supply Side Economics, Note 6

The simplest and most abstract explanation of Say's Law is the principle that the value of production always equals the value of income. The income it produces is ultimately the income that exists to purchase it. What goes around, comes around. Thus, if the production is increased, income is necessarily increased.

While this principle is appealing in its simplicity, it does not obviously explain how one gets from production to the income that buys it. Nor does it obviously answer the objection that there clearly was something fearfully wrong with the "comes around" part during the Great Depression. Indeed. What the principle cannot explain of itself is the case where the labor market pushes a large body of unemployed out of the income loop. If that happens through an artificial manipulation, to drive up wages, because of a theoretical belief in prosperity through high wages rather than low prices, then the production/income loop cannot operate. And if increased production and productivity require capital spending, but capital spending all but stops (as it did in the Depression) because of uncertainty, political attacks, and hostile government policy, then the engine of increased wealth is stopped dead.

Thus, the best explanation of Say's Law is how the price mechanism works with increased production. You make something; it doesn't sell; so you cut the price. If your product is actually appealing, you will get down to the price where it will sell; and if your operation is efficient and productive enough, you will be able to cover your costs.

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Say's Law and Supply Side Economics, Note 7

There is also an extended discussion of Say's Law in Sowell's On Classical Economics [Yale, 2006]. However, many passages make it clear that the "general glut" critics of Say's Law were aware that falling prices would clear the market. Their point was that the market clearing prices might not cover the production costs, leaving the producer with a loss and possibly with bankruptcy. This is succinctly expressed in "an anonymous monograph of 1821, probably written by Samuel Bailey" quoted by Sowell:

Nobody denied, that a new product will always, or almost always, find a market:  The question is, at what price? whether a profitable market? whether its production and sale will bring in what were before the usual average profits of stock or less? [p.141]

This, however, strikes me as a very different issue from other conclusions drawn by the "general glut" critics, for Sowell also says:

Underconsumptionists such as Sismondi and Malthus saw the problem as inadequate aggregate demand to sustain the existing level of aggregate output and employment. [p.166]

"Inadequate demand" (still the issue with Keynes) and profitability are different problems. If we attempt to inflate demand by driving up wages, as Sismondi recommended and Hoover and Roosevelt practiced, we do not increase profitability -- au contraire -- we simply drive down employment. Meanwhile, businesses, with rising wages, can only maintain any profit margin they have by laying off employees (forbidden by Sismondi and modern France) or increasing productivity (with capital investment).

But that is the trick behind the whole thing. Production can never be increased without increases in productivity, in the first place so that some labor can be freed up from the necessity of producing what is already being produced. When market clearing prices fall below the level of recovering costs, the difference in the long run can only be made up for with increased producivity. If politics then drives up wages also, businesses must (1) increase productivity even more, and (2) avoid new hires. French unemployment, after all, is not the result of people being fired (which is illegal) but of new workers not being hired in the first place.

As it happens, the "general glut" theorists held that falling prices would fail to cover costs because they postulated constant technology, i.e. productivity would not increase. In this they were logically correct, given that postulate, but historically wrong -- with special irony since one good difference between people like Sismondi and the Ricardians was the developoment of a dynamic rather than a static analysis of economics. In a dynamic economy, technology changes and productivity grows. And in retrospect, the point seems moot. That is because "underconsumptionists" at the level of policy rarely worry about the profitability of businesses. Those under Marxist influence, all too many, don't care whether businesses are profitable or not. All that the modern underconsumptionists worry about is driving up demand. They think that will take care of everything else, perhaps even the profitability of business. And that is the bad news. Driving up demand pulls up unemployment but does nothing for productivity or production. That requires capital, and capital may require tax cuts. Not surprisingly, the underconsumptionists tend to hate tax cuts, don't like capital, and believe that capital and profits should be taxed away in order to stimulate demand by way of government largesse (which, coincidentally, may also get the responsible politicians reelected). This then produces the "perfect storm" of unemployment and stagnation, as in the Depression or modern France.

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Say's Law and Supply Side Economics, Note 8

See discussion in Thomas Sowell, "The Reagan Administration," The Vision of the Anointed, BasicBooks, 1995, pp. 82-85

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Say's Law and Supply Side Economics, Note 9

In December 1930, when unemployment had jumped up to 14.4% (from 6.1% as recently as October), 352 banks failed. The Federal Reserve, which had been created to back up the banks in a credit collapse, providing cash to prevent the banks from default if there was a run, decided not to do the job it was created to do. The first banks to fold were small ones in the Midwest. The larger Eastern banks that dominated Federal Reserve decision making may not have considered them important enough to care about or strong enough to merit survival anyway. Banking laws often prevented branch banking (this survived in Texas, for instance, until the 1980's), and this helped create many small, vulnerable banks. The general collapse, however, created a momentum that spread. The Bank of United States was based in New York and was allowed to fail, even though it took down many New York small businesses with it. It had half a million depositors and was the largest bank in American history to break. That many depositors were Jewish may have worked against the Bank, when establishment Anglo bankers were less embarrassed by anti-Semitism than they might have been later. If finance was under control of the Jews, as anti-Semites like Henry Ford believed, the failure of this bank would be hard to explain. Of the 25,000 banks in the United States in 1929, only 12,000 were open in early 1933. This was devastating for the economy, let alone for the individual fortunes of families and businesses. As the banks collapsed, this cut the money supply by almost a third, since banking deposits multiply the money supply -- "demand" deposits, upon which checks can be written, are used as money by the depositor, while the banks use the original money for loans. If the loans default, and the deposit in lost in the bank's collapse, the money supply abruptly contracts. This created an almost unprecedented deflation, in which the value of taxes and all debts suddenly was much greater, imposed upon individuals and businesses whose income was itself collapsing. Since government revenues were falling, Congress and President Hoover thought that raising taxes was a good idea -- still the first instinct of politicians during a recession. Meanwhile, Federal Reserve monetary policy was based on the impression that inflation, of all things, was a problem -- an impression created by the high values of the Stock Market before the Crash, and by a flow of gold into the United States from Europe. This misdiagnosis was never corrected in any way that made much difference, and the price levels of 1929 did not return until after 1942.

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