Many defenders of free markets, especially those interested in macroeconomics, are lambasted for defending a proposition known as Say’s Law, named after the famed 19th century Jean-Baptiste Say.

But there’s a big problem with dismissing Say’s Law. In this post, I will show why Say’s law is significant and why free market macroeconomists have good reason to support it.

A common misinterpretation of Say’s Law

Many people incorrectly summarize Say’s law with the phrase, “Supply creates its own demand.” Specifically in the context of macroeconomics, this would mean aggregate supply creates its own aggregate demand.

The implication: there is no such thing as an aggregate demand shortfall, and hence no such thing as recession caused by a decrease in market participants’ aggregate purchasing power.

This misinterpretation of the law prompted John Maynard Keynes to ridicule it in the early 20th century. It has been scorned by most macroeconomists ever since.

What Say’s Law really means

Say’s Law, however, does not say that supply creates its own demand, and it therefore does not say that there cannot be recessions caused by aggregate demand shortfalls. In fact, properly interpreted, Say’s Law provides perhaps the only way of understanding aggregate demand shortfalls!

Say developed his ideas in an exchange with other economic commenters, who were debating the possibility of a general glut, or oversupply of goods across the economy. (An oversupply of goods is, by definition, the same thing as a demand shortfall.)

Say made the point that postulating an oversupply of goods could not be an explanation in itself. Any oversupply of goods, he argued, was partly a function of the demand for other goods. If I am a shoemaker, my supply of shoes to the market is constitutive of my demand for goods other than shoes. This is a simple point—before one can consume goods, goods must be produced.

But this simple point has far-reaching implications.

Say’s Law, understood properly, says that the supply of good-X is a function of demand for goods-Y, where Y comprises goods that are not close substitutes for X.

Why interpreting Say’s law correctly actually matters

Why does this make a difference compared to Keynes’s interpretation of Say’s Law?

The answer is that Say’s Law is fundamentally about the coordinating role of markets. If I produce X goods to consume Y goods, then it must be the case that somewhere someone is producing Y goods to consume X goods. Markets enable producers and consumers to navigate the tradeoffs involved in this coordinating process. Call someone who produces X to consume Y an excess supplier of X, and an excess demander of Y.

In the aggregate, Say’s Law says that excess demand must equal excess supply, which must be zero.

How Say’s Law explains aggregate demand problems

But this seems to imply there can’t be recessions due to “goods piling up on the shelves.” Didn’t I claim this was not what Say’s Law said?

We can answer this by pointing to the excess demand for one particular good: money. There can be, and frequently is, an excess demand to hold money, which means people want to build up more cash balances than they currently have at the going purchasing power (price) of money. Especially in economies characterized by fiat money supplied by central banks, there is no price-profit mechanism at work in the money supply to undo this excess demand. Thus if individuals across the economy are trying to build up their cash balances, we can observe the typical associates of an aggregate demand shortfall-induced recession: falling sales, rising inventories, and rising unemployment.

Say’s Law thus shows us that aggregate demand problems, instead of being non-existent, have a very specific cause: an excess demand for money. Hence aggregate demand problems are monetary problems. If an economy is frequently characterized by aggregate demand shortfalls, we shouldn’t simply blame the “instability of capitalism.” That isn’t an explanation; it’s a black box.

Instead, we need to look at the institutions governing the supply of money. Frequent macroeconomic turbulence caused by changes in money demand imply that the monetary institutions in that economy are not good at coping with excess demands for money. This should impel us to explore whether those institutions are worth reforming.

Without Say’s Law, we wouldn’t know what the problem is, or where to look!

Photo Credit: Jean Baptiste Say, Public Domain, Ligação