In my preceding post Say’s Law: Context, Criticism and Keynes’s Refutation - Part 1, I provided some context for understanding Say’s law. For those of you who havn’t read this post, it’s a good idea to give it a quick read. It will set you up really nicely for this one.
*5 mins later*
Okay, so I’m assuming you did as I suggested, you astute and fabulous reader of my blog! Pat yourself on the back and begin to read the text below.
In today's post, I will talk about the criticisms and questions raised regarding Say’s law by economists before Keynes and then by Keynes himself.
Criticism of Say’s law (before Keynes)
While most people think that Keynes was the first to refute Say’s law, this isn’t accurate. Leading economists challenged Say’s law over 100 years before Keynes. Keynes was the first however to develop a detailed counter-model of economic theory that was able to not only refute Say’s law, but also offer an explanation for the prolonged depression of the 1930s and suggest a way out of it. For now, let’s talk about some of the objections made vis-a-vis Say’s law in the pre-Keynesian era.
1. General “gluts” (overproduction) were observed
Thomas Malthus (1766 - 1834) observed general gluts. He saw widespread unemployment and goods lying unsold following the Napoleonic wars (1803-1815). There did not appear to be any excess demand in certain pockets of the economy to balance out the extra supply in others. The glut appeared to be widespread and chronic. This was in direct contract to Say’s law.
Infact, Malthus encouraged the state to spend in order to create jobs (Keynesian remedy) so that demand could be raised to meet the excess supply. This again is diametrically opposite to what Say believed. He thought that prices would automatically adjust to bring demand in balance with supply.
John Stuart Mill (1806 - 1873) also accepted the occurrence of general gluts. He said that during such gluts there was excess supply of all non-monetary commodities (Say believed that this would not happen), while there was an excess demand for money (this would cause “hoarding”).
2. Money could be “hoarded”
Say considered money to be just a medium of exchange for goods. He did not believe that it would be demanded as a store of value and thus did not believe that there was any reason to hoard money. John Stuart Mill on the other hand, believed that people would tend to “hoard” money when there was a lack of “commercial confidence”. In such a situation, there would be an excess supply of all goods (a glut) and an excess demand for money.
Thus, even before John Maynard Keynes (1883 - 1946), Say’s law had its share of detractors.
The Great Depression and Keynes’s Refutation
But it was the Great Depression of the 1930s that presented the biggest challenge to Say’s law. Production dropped, prices plummeted and unemployment soared (to 25-33% of the labour force) in the US and in Europe. This situation continued for most of the decade. There were no automatic forces (price or others) moving economies towards full employment. There was a general, economy-wide deficiency of demand for goods and services and it was not correcting. Say’s law was not working.
It was during this time (in 1936) that Keynes’s The General Theory of Employment, Interest and Money was published. It rejected Say’s law. Keynes argued that an economy could go into recession due to a lack of aggregate demand and that there were no natural, automatic forces (even in a competitive market) that would push an economy towards full employment.
To explain why a situation of deficient demand would arise, he explained why people would “hoard” money.
In A History of Economic Thought, 1967, William J. Barber explains Keynes’s thinking rather well.
Barber writes:
“Keynes's assault on the Say's Law tradition centred on this analysis of money. He set about the task by reversing the perspective from which money was viewed. Whereas neoclassical writers looked first at money in motion - i.e. when spent - Keynes chose to analyse money as it was held. The primary question to be answered was: how and for what reasons is the community induced to hold the stock of money that exists at a given moment? Obviously the community required some minimum stock of money to lubricate the wheels of commerce and to provide a reserve against contingencies. These motives for holding money were thoroughly compatible with neo-classical thinking. But Keynes insisted that there was also another reason for holding cash - the speculative motive for liquidity. This concept was essential to the opening of space for the analytical innovations of the General Theory.”
What is the speculative motive for holding money?
It is based on the inverse relationship between interest rates and interest bearing, capital assets. For e.g. lets assume that the face value of a bond is Rs. 100 and it pays a coupon of 5% (Rs. 5) annually. If the interest rate on comparable bonds rises to 10%, the value of this bond will fall to Rs. 50, exposing the bondholder to huge capital losses. In cases when interest rates are low and there is high probability of them moving up, it would be prudent to hold cash as a hedge against the risk of capital loss. In such circumstances, hoarding becomes sensible.
Barber goes on:
“When this consideration was taken into account, money could no longer be interpreted exclusively as a medium of exchange. Instead it also performed an important function as a store of value. This insight undercut the line of reasoning upon which Say's Law had rested. Hoarding could no longer be ruled out by assumption, nor treated as an irrational activity. Once this link in the neo-classical analytical chain had been broken, confidence in the self-adjusting properties of the economy to a full-employment level of equilibrium could no longer be sustained. On the contrary, an underemployed economy might tend to get stuck at a level of income well below its potential if part of its income stream leaked into the build-up of idle hoards.”
By giving a plausible explanation of why people would hoard money, Keynes demonstrated how spending (demand) could be less that output (supply) and lead to a general glut/ recession.
He also argued that this lack of aggregate demand would become a vicious cycle, and that ultimately intervention in the form of government spending would be needed to stimulate the level of aggregate demand and move the economy towards full employment.
The majority view among economists is that the Great Depression ended with World War II, which led to a spike in government spending and drastically reduced unemployment.
So, is Say’s Law Valid today?
In a strict sense, it is clear that Say’s law does not hold true in modern economies (we don’t have barter economies where everything is produced for exchange) where money can be held as a store of value and spending can easily be less than production.
That said, many Classicals contend that Say’s law wasn’t intended to be interpreted in the strict sense that we encounter it today. The truncated, absolutist form in which we study Say’s law in school/college is the doing of the many economists who came after Say and tried to interpret his work.
The fact that production creates incomes sufficient enough to buy back the products produced is true. These incomes are generally spent on consumption and investment; and a stable equilibrium cannot exist unless output = spending.
Interpreted in this way, without making any absolute statements, Say’s law’s basic principles make sense.
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