by Jerry O’Driscoll
This post follows on my earlier one, “It’s All About Say’s Law.”
Say’s Law of Markets answered the fears of under-consumption as the spreading industrial revolution brought forth an ever more bountiful supply of goods. The law’s logic is that production creates the income that is the source of the demand for goods.
In the General Theory, J. M. Keynes recast Say’s Law as the proposition that “the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output.” That formulation would be foreign, if not incomprehensible, to any economist who had ever subscribed to Say’s Law. That law negates the concept of “output as a whole”
The classical economists typically articulated propositions in terms of long-run comparative statics (Ricardo being the prime example). But all (even Ricardo) also analyzed short-run dynamic processes. In modern parlance, excess demand in some markets and excess supply in other markets were entirely consistent with Say’s Law. And that included inter-temporal demand and supply.
Even in situations of disequilibrium (to use modern phraseology), long-run propositions are a discipline on analysis. They point in the direction toward which markets are moving. By contrast, propositions about transitional effects, like the Paradox of Thrift, cannot be generalized. They are not true in the long run. When some economists enunciate them as permanent truths, they become dangerous nonsense that misleads policy makers and confuses the public.
Consider the current economic situation. A financial crisis has been brought on by, first positive, and then negative monetary shocks. In the short run, individuals are increasing their demand for money (velocity is declining), and are simultaneously increasing their long-run, desired savings to a more normal rate. These effects combine to place downward pressure on nominal demand in many markets.
But the decline in nominal demand is not evenly spread across all markets. If demand is to be stimulated consistent with the new consumption/savings equilibrium, it would need to be supplied in the precise proportions that correspond to the new pattern of demand across markets (including inter-temporal markets). The information requirements to accomplish that task are nothing short of what would be required for comprehensive economic planning of the economy. Moreover, Public Choice tells us that stimulus will always be applied according to political, not economic, criteria.
If nominal demand is falling at uneven rates, then relative prices are changing. The same self-regulating forces are at work as described in microeconomics. Resources are being re-allocated across markets even as this is being written. A macroeconomic model with one good (output), one price, one interest rate, one wage rate, etc. is incapable of capturing those forces. The rationale for stimulus makes sense only in terms of such models and not in terms of how market economies actually work.