print-edition icon Print edition | Economics briefAug 10th 2017

print-edition icon Print edition | Economics briefAug 10th 2017

Overcapacity and undercapacitySay’s law: supply creates its own demand
The third brief in our series looks at the reasoning that made Jean-Baptiste Say
famous
IN 1804 Jean-Baptiste Say enrolled in the National Conservatory of Arts and Crafts
in Paris to learn the principles of spinning cotton. The new student was 37 years
old, points out his biographer, Evert Schoorl, with a pregnant wife, four children
and a successful career in politics and letters trailing behind him. To resume his
studies, he had turned down two lucrative offers from France’s most powerful man,
Napoleon Bonaparte. The ruler would have paid him handsomely to write in support of
his policies. But rather than “deliver orations in favour of the usurper”, Say
decided instead to build a cotton mill, spinning yarn not policy.
Napoleon was right to value (and fear) Say’s pen. As a pamphleteer, editor, scholar
and adviser, he was a passionate advocate for free speech, trade and markets. He
had imbibed liberal principles from his heavily annotated copy of Adam Smith’s “The
Wealth Of Nations” and bolstered his patriotic credentials in battle against
Prussian invaders. (During breaks in the fighting, he discussed literature and
political economy with other learned volunteers “almost within cannonballs’
reach”.)
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His greatest work was “A Treatise on Political Economy”, a graceful exposition (and
extension) of Smith’s economic ideas. In Say’s time, as nowadays, the world economy
combined strong technological progress with fitful demand, spurts of innovation
with bouts of austerity. In France output of yarn grew by 125% from 1806 to 1808,
when Say was starting his factory. In Britain the Luddites broke stocking frames to
stop machines taking their jobs.
On the other hand, global demand was damaged by failed ventures in South America
and debilitated by the eventual downfall of Napoleon. In Britain government
spending was cut by 40% after the Battle of Waterloo in 1815. Some 300,000
discharged soldiers and sailors were forced to seek alternative employment.
The result was a tide of overcapacity, what Say’s contemporaries called a “general
glut”. Britain was accused of inundating foreign markets, from Italy to Brazil,
much as China is blamed for dumping products today. In 1818 a visitor to America
found “not a city, nor a town, in which the quantity of goods offered for sale is
not infinitely greater than the means of the buyers”. It was this “general
overstock of all the markets of the universe” that came to preoccupy Say and his
critics.
In trying to explain it, Say at first denied that a “general” glut could exist.
Some goods can be oversupplied, he conceded. But goods in general cannot. His
reasoning became known as Say’s law: “it is production which opens a demand for
products”, or, in a later, snappier formulation: supply creates its own demand.
This proposition, he admitted, has a “paradoxical complexion, which creates a
prejudice against it”. To the modern ear, it sounds like the foolhardy belief that
“if you build it, they will come”. Rick Perry, America’s energy secretary, was
ridiculed after a recent visit to a West Virginia coal plant for saying, “You put
the supply out there and the demand will follow.”
To grasp Say’s point requires two intellectual jumps. The first is to see past
money, which can obscure what is really going on in an economy. The second is to
jump from micro to macro, from a worm’s eye view of individual plants and specific
customers to a panoramic view of the economy as a whole.
Firms, like coal plants and cotton mills, sell their products for money. But in
order to obtain that money, their customers must themselves have previously sold
something of value. Thus, before they can become a source of demand, customers must
themselves have been a source of supply.
What most people sell is their labour, one of several “productive services” on
offer to entrepreneurs. By marshalling these productive forces, entrepreneurs can
create a new item of value, for which other equally valuable items can then be
exchanged. It is in this sense that production creates a market for other products.
In the course of making his merchandise, a producer will pay wages to his workers,
rent to his landlord, interest to his creditors, the bills of his suppliers and any
residual profits to himself. These payments will at least equal the amount the
entrepreneur can get for selling his product. The payments will therefore add as
much to spendable income as the recipients’ joint enterprise has added to supply.
That supply creates demand in this way may be easy enough to grasp. But in what
sense does supply create its “own” demand? The epigram seems to suggest that a coal
plant could buy its own coal—like a subsistence farmer eating the food he grows. In
fact, of course, most producers sell to, and buy from, someone else.
But what is true at the micro level is not true at the macro level. At the macro
level, there is no someone else. The economy is an integrated whole. What it
purchases and distributes among its members are the self-same goods and services
those members have jointly produced. At this level of aggregation, the economy is
in fact not that different from the subsistence farmer. What it produces, what it
earns, and what it buys is all the same, a “harvest” of goods and services, better
known as gross domestic product.
From head to foot
How then did Say explain the woes of his age, the stuffed warehouses, clogged ports
and choked markets? He understood that an economy might oversupply some
commodities, if not all. That could cause severe, if temporary, distress to anyone
involved in the hypertrophied industries. But he argued that for every good that is
too abundant, there must be another that is too scarce. The labour, capital and
other resources devoted to oversupplying one market must have been denied to
another more valuable channel of industry, leaving it under-resourced.
Subsequent economists have tried to make sense of Say’s law in the following way.
Imagine an economy that consists only of shoes and hats. The cobblers intend to
sell $100-worth of shoes in order to buy the equivalent amount of hats. The hatters
intend to sell wares worth $80 so as to spend the same sum at the cobbler’s. Each
plan is internally consistent (planned spending matches revenue). Added together,
they imply $180 of sales and an equal amount of purchases.
Sadly, the two plans are mutually inconsistent. In the shoe market the producers
plan to sell more than the consumers will buy. In the hat market the opposite is
the case. A journalist, attentive to the woes of the shoe industry, might bemoan
the economy’s egregious overcapacity and look askance at its $180 GDP target.
Cobblers, he would conclude, must grasp the nettle and cut production to $80.
The journalist might not notice that the hat market is also out of whack, in an
equal and opposite way. Hat-buyers plan to purchase $100 from producers who plan to
sell only $80. Unfortunately, this excess demand for hats cannot easily express
itself. If cobblers can only sell $80 of shoes, they will only be able to buy the
equivalent amount of hats. No one will see how many hats they would have bought had
their more ambitious sales plans been fulfilled. The economy will settle at a GDP
of $160, $20 below its potential.
Say believed a happier outcome was possible. In a free market, he thought, shoe
prices would quickly fall and hat prices rise. This would encourage shoe
consumption and hat production, even as it discouraged the consumption of hats and
production of shoes. As a result, both cobblers and hatters might sell $90 of their
good, allowing the economy to reach its $180 potential. In short: what the economy
required was a change in the mix of GDP, not a reduction in its level. Or as one
intellectual ally put it, “production is not excessive, but merely ill-assorted”.
Supply gives people the ability to buy the economy’s output. But what ensures their
willingness to do so? According to the logic of Say and his allies, people would
not bother to produce anything unless they intended to do something with the
proceeds. Why suffer the inconvenience of providing $100-worth of labour, unless
something of equal value was sought in return? Even if people chose to save not
consume the proceeds, Say was sure this saving would translate faithfully into
investment in new capital, like his own cotton factory. And that kind of
investment, Say knew all too well, was a voracious source of demand for men and
materials.
But what if the sought-after thing was $100 itself? What if people produced goods
to obtain money, not merely as a transactional device to be swiftly exchanged for
other things, but as a store of value, to be held indefinitely? A widespread
propensity to hoard money posed a problem for Say’s vision. It interrupted the
exchange of goods for goods on which his theory relied. Unlike the purchase of
newly created products, the accumulation of money provides no stimulus to
production (except perhaps the mining of precious metals under a gold or silver
standard). And if, as he had argued, an oversupply of some commodities is offset by
an undersupply of others, then by the same logic, an undersupply of money might
indeed entail an oversupply of everything else.
Say recognised this as a theoretical danger, but not a practical one. He did not
believe that anyone would hold money for long. Say’s own father had been bankrupted
by the collapse of assignats, paper money issued after the French Revolution. Far
from hoarding this depreciating asset, people were in such a rush to spend it, that
“one might have supposed it burnt the fingers it passed through.”
In principle, if people want to hold more money, a simple solution suggests itself:
print more. In today’s world, unlike Say’s, central banks can create more money (or
ease the terms on which it is obtainable) at their own discretion. This should
allow them to accommodate the desire to hoard money, while leaving enough left over
to buy whatever goods and services the economy is capable of producing. But in
practice, even this solution appears to have limits, judging by the disappointing
results of monetary expansions since the financial crisis of 2007-08.
Say it ain’t so
Today, many people scoff at Say’s law even before they have fully appreciated it.
That is a pity. He was wrong to say that economy-wide shortfalls of demand do not
happen. But he was right to suggest that they should not happen. Contrary to
popular belief, they serve no salutary economic purpose. There is instead something
perverse about an economy impoverished by lack of spending. It is like a
subsistence farmer leaving his field untilled and his belly unfilled, farming less
than he’d like even as he eats less than he’d choose. When Say’s law fails to hold,
workers lack jobs because firms lack customers, and firms lack customers because
workers lack jobs.
Say himself faced both a ruinous shortage of demand for his cotton and excess
demand for his treatise. The first edition sold out quickly; Napoleon blocked the
publication of a second. Eventually, Say was able to adapt, remixing his activities
as his own theory would prescribe. He quit his cotton mill in 1812, notes Mr
Schoorl. And within weeks of Napoleon’s exile in 1814, he printed a second edition
of his treatise (there would be six in all). In 1820 he began work once again at
the Conservatory in Paris—not this time as a student of spinning, but as France’s
first professor of economics, instructing students in the production, distribution
and consumption of wealth. He considered it a “new and beautiful science”. And, in
his hands, it was.