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.