Say’s law fairy… “Build it and they will come.”
Paul Krugman, Dean Baker, Mark Thoma, (update: Jared Bernstein) and many others call for fiscal policy to boost employment and production. Their idea is to increase employment and labor’s power to bargain for better wages. The increased purchasing power of labor will resolve some problems with debt overhang too. There would be a snowball effect of output, employment and demand to return the economy back to full employment (implying an unemployment rate of about 5%).
I agree that a fiscal stimulus would create jobs and not crowd-out private production, but it would not get us back to the previous full employment. These economists are unknowingly guiding fiscal policy toward an illusion… “If you build it, they will come.”
Their view is another way to believe in the “Say’s law” fairy.
It’s like in the movie Field of Dreams, Ray is going broke and a friend tells him, “People will come, Ray, people will most definitely come.” … “They’ll pass over the money without even thinking about it.”
A reality check is coming for economists.
In 1803, Jean-Baptiste Say wrote…
“It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. … Thus the mere circumstance of creation of one product immediately opens a vent for other products.”
J-B Say’s message was that demand is increased by more production. If you were to tell J-B Say that low demand was the cause of low production and unemployment, he would not agree. He would have said that too many resources were being employed in some sectors of the economy and not enough in others. His explanation would imply structural unemployment. The economists above though do not see a problem with structural unemployment.
J-B Say would have also said that prices, wages and interest rates would adjust in order to return to full employment. Yet, there is rigidity in wages. As well, the interest rate is blocked by the zero lower bound. So therefore economists conclude that fiscal policy must be used.
However, a critical factor is not being understood. Effective demand has fallen and is blocking the economy from reaching full employment. A fiscal stimulus would be unable to overcome the lower effective demand limit.
Think of effective demand as the rim of a cup. The cup holds production in terms of utilizing labor and capital. As the economy recovers from a recession, the cup is filled with more production, more employment and more demand. Say’s law is in action only up to the rim of the cup, where production encounters the effective demand limit. If more labor and capital are utilized, the cup overflows… the result is inflation pressures, tighter monetary policy and a declining aggregate profit rate. The economy responds by contracting.
Problem… Currently the rim of the cup is below the level of full employment that we are accustomed to from decades past. In effect, the cup cannot now be filled back to the previous level of full employment.
Keynes drew the line in Chapter 3. The Principle of Effective Demand.
“Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.”
The effective demand vision of Keynes will become clear this business cycle. The effective demand limit has always been there stopping business cycles, but the cycles were seen to stop at expected levels of natural unemployment, not any demand limit. This time will be different though. It’s only been since 2009 that the effective demand limit fell. The economic cup has not experienced the lower rim yet. And since economists are guided by statistics, like a blind person using a cane, they cannot “see” the lower effective demand limit… yet.
The effective demand limit is determined by the percentage of national income received by labor (the primary consumers of finished goods and services). The effective demand principle is… The rate of employing labor and capital is limited by an effective rate of labor’s share of national income.
Moral of the story… No “Say’s law” fairy will raise the rim of the cup, if you keep filling the cup.
The entire Terrance Mann quote in Field of Dreams does put the horse back in front of the cart:
“They’ll pass over the money without even thinking about it;
for it is money they have and peace they lack.”
The error is thinking they have the money.
I think it was Delong that pointed out that Say modified his law by recognizing that money was also a commodity. If I remember correctly it was around 1820 when he came to that realization.
We live in interesting times.
It sounds like the argument is a matter of the chicken or the egg perspective. It also seems self evident that the ability to affect demand rests in the effective distribution of the means by which demand is put into effect. In effect, too many words only clouds the validity of the conclusion. All that needs be said was said last, “The effective demand limit is determined by the percentage of national income received by labor (the primary consumers of finished goods and services),” but would be more effecting to the readers if said first while all that preceded were left to explain why alternatives to the effective relationship between income, demand and production really have little affect on economic outcome.
I wonder, is “effective demand” the demand for labour as mediated through the employment/monetary (E/M) system?
For, short of death or extreme disability, the potential labour of a person is always “produced,” on a daily basis, and then either marketed, used outside of the market, or wasted in depressed idleness or sleep. In conditions of high unemployment (ie disengagement from the E/M system) that labour doesn’t disappear or get stored, it generally expresses itself in productive and counterproductive ways, but in much less efficient, less effective ways than in the E/M network.
You might compare it to how the human body behaves during starvation. As normal glucose levels are depleted starting at only three days, fatty tissues are accessed through ketones released from the liver in order to supply the glucose the brain needs to survive, and to spare the proteins of the muscle tissue.
In the economy this shows up as people working under the radar, or free, supporting other family members, picking up spare change as babysitters, dog walkers or newspaper carriers, or engaging in the high-effort, frustrating option of public assistance.
Why doesn’t the body use ketosis all the time? God knows we could use it these days, with so much body fat. Because ketosis is inefficient and biochemically hazardous, to say nothing of the halitosis, poor brain function and headaches. Map THAT onto the economy — notice the headaches?
An economy pushed into ketosis will survive, but inefficiency and poor brain function aren’t good on an ongoing basis, and ketosis is limited by the supply of fat.
Once stored fat is used up, protein is next on the chopping block. Muscle tissue is broken down and burned, an even less efficient and more biochemically messy process, and at this stage death due to kidney, liver or other organ failure, heart failure, or respiratory failure is not far away. The equivalent is burning the woodwork and interior walls to keep the house warm, a last ditch effort.
By my reckoning, America has used up quite a lot of her “fat,” that is, the resources the middle class had built up during the postwar generations. She has been in ketosis for at least fifteen years. She’s not too close to protein harvesting yet, but hints of it show up here and there, generally in the form of infrastructure neglect.
Now, dragging myself back to labour share, people need two things: sustenance, and activity. The two needs have in the past been coupled. They are coming uncoupled. Employers stand now as gatekeepers between activity and sustenance, pushing large segments of the population into ketosis. In fact, employers are relying on ketosis to support the unemployed people who in turn reduce the cost of employees allowed through the paid-activity gate. Labour share inside the gated economy is low because of the millions outside the gates.
Say was more astute than people seem to give him credit for. He kept thinking and developing his theory. He even saw the usefulness of fiscal policy to combat unemployment.
Changes in the interest rate keep Say’s law working when you include money in the equation. He never realized though there was a demand constraint sitting on top of his law. Keynes sensed it but never gave an equation for it.
These are the most interesting times in economics. We not only have the data, we have the crisis to learn new things, like the equation for effective demand. The story is not over yet though.
yet when you say, … “income, demand and production really have little effect on economic outcome.” … It’s that income distribution between labor and capital has an effect on the outcome, short-term and long-term.
I have had ketosis before when I did a fast. There’s a kind of sick euphoria with it. You make a really good analogy.
I think you misunderstood that statement which was a bit clumsily put to begin with. Or, maybe, I’m misunderstanding your reply.
Note that you’ve taken a piece of the sentence for which the preceding part changes its meaning a bit. “….while all that preceded were left to explain why alternatives to the effective relationship between income, demand and production really have little affect on economic outcome.” Meaning that the alternatives to your “effective demand” emphasis need to explain themselves in the face of your own well put explanation of your hypothesis. As noted, a bit clumsily stated by me, but done so so as to emphasize the difficulty in comprehending these issues when too many words get into play and, as a result, get in the way.
Ahhh… I get you now. It is good to feed back ideas and get clarification. “(They) need to explain themselves”… yes.
Thanks for clarifying…
Yes. That’s the point, but more importantly I wanted to stress that the heart of your own point, “The effective demand limit is determined by the percentage of national income received by labor (the primary consumers of finished goods and services),” should be stated first and foremost, e.g. “but would be more effecting to the readers if said first.”
Never leave the core of the hypothesis for last. Three quarters of any readership have probably stopped reading by that point. Say it first and then provide the logic.
Thanks… advice well received… ok hypothesis goes early in a post.
I almost made it a note at the end of the post.
those who want to learn about economics and politics ,,,,,ones who are crazy about the same and want to go for the same ………what you all need to do is just visit http://theindianeconomist.com/ and here you are…….go for it
Occasionally Ed posts an essay that is not too technical for me to understand. My standard metaphor for the what I think he is talking about — usually deployed to debunk the tax cuts for the “job makers” bunk — is to compare giving more money to the “job makers” to open new stores and factories when those already existing are being closed for lack of demand …
… to flooding an engine that already has too high a ratio of gas to air in the combustion chambers. Gas is supply and demand is the air that burns it. In economics both are made out of the same thing: money. You have to get the mixture just right for maximum power. I think that is what Ed is talking about.
Yes, Denis, good analogy. To take it farther, perhaps, you could see the gas and air as human labour and demand, and the engine as the organizational structure that mobilizes them for maximum power. Viewed that way, it seems that what we need for full employment is a bigger engine, a V-8 instead of the 4 cylinder we have at the moment.
However, our planet won’t support even the little Kia we have, too much longer. We need to support our people, but we don’t need to zoom around the race track at 100 MPH.
Ideally, we need to throttle back and reduce consumption and production and “froth,” while encouraging low impact activities like art, music, science, volunteerism, teaching and so on. The alternative leads to famines, wars, plagues and all the other rewards of thoughtless grasping.
“And since economists are guided by statistics, like a blind person using a cane, they cannot “see” the lower effective demand limit… yet.”
Effective demand would have been lower sooner, if consumers had not taken on huge amounts of debt to compensate for their stagnant wages.
The FED Funds Rate was being pushed lower and lower at each recession after 1980. And after each recession ended, that rate was not pushed back up to the pre recession high. This was the FED trying to increase economic activity.
Compare this to a novice pilot who notices that he is losing altitude and pulls back on the yoke in an attempt to regain some altitude. He notices that he is losing airspeed but his primary concern is to stop losing altitude. If he continues pulling the yoke back, the aircraft will stall, and fall out of the sky like a rock.
Many thanks Edward. I have two questions:
1. Could effective demand be increased by fiscal stimulus funneled into a direct jobs program like was done during the Great Depression,
2. How will hitting the effective demand limit manifest itself? Now we see stagnating median incomes, jobs growth barely ahead of population growth, etc. – will this get worse?
” Compare this to a novice pilot who notices that he is losing altitude and pulls back on the yoke……”
Here’s a cool economic model based on that analogy:
Fred brings up an interesting point that I’ve not yet seen an interesting review of. “Now we see stagnating median incomes, jobs growth barely ahead of population growth…”
Stagnating wages, little job growth; both said to be phenomenon that are two or three decades developing. What else has been occurring over that time period? Outsized compensation growth for the One Percent Club members. And at the same time the shifting of manufacturing to low wage, labor exploitative parts of the globe. The two processes, executive compensation and labor exploitation are likely closely linked.
Why does anyone expect the demand side of the equation improve until corrections are made to these processes? Bring back the factories so that we employ workers here in factories that can be better regulated. The resulting improvement in employment rate will help to adjust workers’ disposable income levels which will help to increase demand. It ain’t that complicated.
Another thought on the issue of Say’s law. J-B lived and hypothesized way back “in the day” as they say. What, has nothing changed that might have changed the factors playing upon the issue under discussion? What’s new? Lots of new things were being invented and put into production.
Such things had a waiting audience. Does anyone question that a steamboat would find anticipation for transporting goods? Do pack animals and wagons work better? The point is that Say could hardly be wrong,,,in his day. Forget the build it analogy. Try invent it and they will want it. It’s not quite the same today though Apple still knows how to wring a few extra drops out of an old cloth. Make it appear to be different and they will buy?
It’s not the addition of more product that counts. It is the understanding of what products have a waiting and willing customer base. It’s the old cliche about the better mouse trap. But there is a second half to the equation. Remember? The production has to take place within the same economic geographic area for it to add demand within that same area. Or at least the ability to express that demand, as in “I can afford to buy what it is that I demand.”
point #1… Effective demand could be increased by a direct jobs program, only if labor’s share of production is increased. Increasing labor share will raise the rim of the cup. If the jobs program does not raise labor’s share, it is just filling the cup, which is good in itself when the economy is sluggish.
point #2… As we get near the effective demand limit, the dynamics get interesting. Real GDP will slow down, but there is a response to increase investment. We are seeing that now. We will also see more money returning from abroad to be invested in the US. We are also seeing wage growth. The economy in 2014 will look like it is picking up steam… but let me give you an analogy.
Look at a 5 kilometer run… the runners pace themselves throughout the race. They run together. and then when they see the finish line in sight, they start to sprint in order to win. When they hit the finish line, they slow down.
The economy will act like that in 2014. The pace of the economy will pick up and the Fed will get worried about heating up too much.
At a certain point, profit rates fall, utilization of capital will fall, wages continue to rise, and then unemployment stops falling.
You will see winners and losers at the finish line. But the Fed has to be careful that the economy does not become overly destabilized in the rush of business competition. So monetary policy will need some control which it doesn’t have at the moment.
I expect the stock market to continue rising and have moments of slipping downward and building back up… Eventually it will fall.
At the moment I am seeing a recession somewhere in the 4th quarter 2014 to 3rd quarter 2015.
The key is to measure the distance to the finish line so that you can attack with all your energy at the right time and win.
Funny, I swear I had not seen those!
My point is that the Great Recession did not develop over the short term. And that the problems would have been more evident sooner if the FED has not been regularly lowering the FED Funds Rate from about 1980 to 2009.
Coincidently today I found this:
It is Jared Bernstein’s graph of the year.
It shows that between 1949 to 1979, 31% of the quarters had unemployment exceeding 5%. (Thirty years)
From 1980 to 2007, 64% of the quarters had unemployment exceeding 5%. This is more than double the quarters and was before the Great Recession. This would help explain why the FED never took interest rates back up to prior highs after each recession ended.
That is a very cool video of the plane…
John Maynard Keynes:
“Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment.”
The whole point of this observation is not that effective demand is an obstacle to full employment. The point is that aggregate demand (AD) is not equal to aggregate supply (AS) for all volumes of output. Keynes’ great insight was in realizing that AD decreases as a function of output and that AS increases as a function of output. Thus AD and AS intersect at precisely one point and that point is known as effective demand.
Keynes went on to argue that policymakers always have the ability to shift AD to the right through public works and expansionary monetary policy so that effective demand can be increased until full employment is achieved. As he says in Chapter 10:
” If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”
Evidently Paul Krugman, Dean Baker, Mark Thoma and Jared Bernstein understand Keynes much better than you do.
Wow. Edward you’ve managed to confuse me so much that I have to agree entirely with Mark.
Either he’s right that Krugman and friends understand Keynes much better than you do or I guess none of us except you seem to understand Keynes at all.
I didn’t quite understand: “The key is to measure the distance to the finish line so that you can attack with all your energy at the right time and win.”
Are you referring to the average investor trying to preserve or increase capital, or to the government trying to improve the situation & prevent effective demand from decreasing further during a new recession. Unfortunately, it seems unlikely the government–with a legislature in disarray–will do much that is helpful.
– See more at: http://angrybearblog.strategydemo.com/2013/12/says-law-fairy-build-it-and-they-will-come.html#comments
Some say that wherever AS and AD intersect is a point of full employment in that moment. Do AS and AD always cross at effective demand? I would say no.
Keynes defined a special crossing point of AS and AD. Normal crossing points are below full employment, but as output increases, there is a special crossing point of AS and AD that defines effective demand. It is the point where profit expectations decline. Say’s law would say that you only need to keep producing more or employing more factors in order to keep raising AD. But Keynes said no… there comes a point where more employment of labor and capital is resisted by firms due to falling expectations of profits.
My definition of effective demand agrees with Keynes’ in that there is a limit imposed by labor’s share of output upon utilization of labor and capital. I may not have the perfect equation yet, but past data shows that the economy will reach effective demand and then stop. There have been many ways that the economy reached effective demand, and in each different case, the result was the same, the utilization of labor and capital stops increasing.
The effective demand definition that I use says… if the composite utilization of labor and capital rises above an effective level of labor’s share of output, firms lose profits and contract. In essence, there isn’t enough relative labor share demand to support higher utilization of labor and capital for increased output.
If you have miners dig up money from the ground, you are increasing labor’s share and raising effective demand. But if you try to increase output by employing more labor and capital at the current rate of labor’s share, you simply crowd out profits of other firms.
A tighter labor market will increase labor share. Normally as labor share rises at full employment, effective demand begins to rise… but this is a signal that profit rates are declining as Keynes noted in his definition of effective demand. Thus, firms start to back off and desire to employ less labor and capital in an attempt to raise profits back up. The normal result is a contraction/recession.
Firms themselves are crowding each other out for profits at the effective demand limit. When real GDP is below the effective demand limit, firms do not crowd each other out. You will see in 2014 the competitive nature of firms to grab profit share.
Past data show that it is common for labor share or effective demand to rise before a contraction. So if a jobs stimulus program creates a tighter labor market when real GDP is close to the effective demand limit, a situation is created that simulates a normal beginning to a recession.
I had the average investor in mind when I wrote that.