Leithner Letter No. 64
16 April, 2005

When the profits of trade happen to be greater than ordinary, over-trading becomes a general error both among great and small dealers. They do not always send more money abroad than usual, but they buy upon credit, both at home and abroad, an unusual quantity of goods, which they send to some distant market in hopes that the returns will come in before the demand for payment. The demand comes before the returns, and they have nothing at hand with which they can either purchase money, or give solid security for borrowing.

Adam Smith
The Wealth of Nations (1776)

Historians fifty years from now may record that [John Meynard] Keynes’ greatest achievement was the liberation of Anglo-American economics from a tyrannical dogma. ... [Yet] the Keynesian attacks, though they appear to be directed against a variety of specific theories, all fall to the ground if the validity of Say’s Law is assumed.

Paul Sweezy
The New Economics (1947)

I believe (though I cannot prove) that the most crippling and dangerous kind of ignorance in the modern West is ignorance of economics, the way markets work and the ways non-market allocation mechanisms are doomed to fail. Such economic ignorance is toxic because it leads to insane politics and the empowerment of those whose rhetoric is [altruistic] but whose true agenda is coercive control.

What Do You Believe That You Cannot Prove?
(6 January 2005)

Who Wants To Be a Consumer?

To read general business and specialist trade publications, the daily newspaper and so on, and as Letter 63 observed, is occasionally to discern a valuable insight or nugget of information. Accumulating these perceptions, adding them to one’s own ideas and using justifiable principles to sift and subsume them into coherence will provide – over time and despite some misjudgments along the way – a firm basis for decision-making. Prominent investors seem to agree. The introduction to Benjamin Graham: The Memoirs of the Dean of Wall Street (McGraw-Hill, 1996, ISBN: 0070242690) states “Graham came to his convictions after long, searching and realistic meditations about history, garnered from extensive reading and daily immersion in the intricate values-testing of Wall Street.” Warren Buffett spends many hours reading a wide variety of publications and “massive quantities of financial statements.” According to Charles Munger, “both Warren and I learn more from the great business magazines than we do [from] anywhere else. ... And if you get into the mental habit of relating what you’re reading to the basic structure of the underlying ideas being demonstrated, you gradually accumulate some wisdom about investing. I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading” (see Janet Lowe, Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger, John Wiley & Sons, 2003, ISBN: 0471446912).

Yet few of the reports, articles, e-mail messages and other reading matter that typically clutter one’s desk should be taken seriously. Indeed, the vast bulk of stuff written these days – including monthly Newsletters to shareholders!–is better binned than read. In sharp contrast, a small number of old writings richly repay careful and repeated study. Mr Munger believes that “you learn economics better if you make Adam Smith your friend. That sounds funny, making friends among the eminent dead, but if you go through life making friends with the eminent dead who had the right ideas, I think it will work better in life. ...” The investor, then, must peruse widely, sift what is worth reading, study it carefully and apply its lessons to one’s investment operations.

If a sound business education in a Western country had to rely upon a single book (assuming that such an education can be derived from books, which is very doubtful), then Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations (1776) and Graham’s Security Analysis (1934) would be strong contenders. Perhaps the strongest candidate would be the King James Bible (1611). In sharp contrast and with few exceptions (such as Ludwig von Mises, Human Action: A Treatise on Economics, Fox & Wilkes, 1949, 1996, ISBN: 093073185), surprisingly little of what has been written since the Second World War builds significantly upon what was once known about commerce but has since been either denigrated or forgotten. (With that point in mind, it is good news that Henry Hazlitt’s classic, Economics in One Lesson (1946), is now available on-line from the Foundation for Economic Education.

To study finance, economics and investing from this point of view is to recognise that the “eminent dead” ably refuted some of the most important and perennial fallacies of their day. It is also to realise that, no matter how comprehensively they have been disproved, the same old myths constantly reappear in new and authoritative guises. Indeed, they are just as prevalent today (and infect influential people as much) as in Adam Smith’s day. Wise old passages can thus reveal more about the crazy world we inhabit than does the babble pervading today’s electronic and print media.

As an example, consider the boy who announced “I want to be a Consumer” in the British satirical magazine Punch (25 April 1934). “But what do you mean to be?” asked the kindly old Bishop as he sat the boy on his knee. “We must all choose a calling to help society’s plan. So what do you mean to be, my boy, when you grow to be a man?” “I want to be a Consumer,” earnestly replied the fresh-faced lad. “I’ve never had aims of a selfish sort. For that, I know, is wrong. I want to be a Consumer, Sir, and help the nation along. I want to be a Consumer and consume both night and day; for that’s the thing that’s needed most, I’ve heard Economists say. I won’t just be a Producer, like my friends Bobby and James and John; I want to be a Consumer, Sir, and help the world on.” “But what do you want to be?” the Bishop asked again. “For we all have to work, as must, I think, be plain. Are you thinking of studying medicine or taking a bar exam?” “Why, no!” exclaimed the lad as he helped himself to jam. “I want to be a Consumer and live in a useful way; for that’s the thing that’s need most, I’ve heard Economists say. There are too many people working and too many things are made. I want to be a Consumer, Sir, and help to further trade. I want to be a Consumer to do my duty well; for that’s the thing that’s need most, I’ve heard Economists tell.” And so the boy resolved, as he lit a cigar, to say: “I want to be a Consumer, Sir, and I want to begin today.”

In a manner that a schoolboy can readily understand, this passage illuminated a glaring deficiency of thought and action that prolonged and deepened the Great Depression – and which has infected mainstream thinking ever since (the best studies are Benjamin Anderson, Economics and the Public Welfare, Liberty Press, 1949, 1979, ISBN: 0913966681; Murray Rothbard, America’s Great Depression, Ludwig von Mises Institute, 1963, 2000, ISBN: 0945466056; Gene Smiley, Rethinking the Great Depression: A New View of Its Causes and Consequences, Ivan R Dee, 2002, ISBN: 1566634725; Jim Powell, FDR’s Folly: How Roosevelt and His New Deal Prolonged the Great Depression, Crown Forum, 2003, ISBN: 0761501657; Thomas DiLorenzo, How Capitalism Saved America, Crown Forum, 2004, ISBN: 0761525262; and various books and articles by Robert Higgs). As during the Depression, so too today: to policymakers, who have arrogated these decisions into their own hands, the really important thing is not production (which is somehow taken for granted) but consumption (which is allegedly prone to “deficiencies” of one type or another and must therefore be “stimulated”).

If consumers consume too few goods and services – that is to say, if they consume fewer than policymakers believe they should – then unemployment allegedly rises. And if unemployment rises beyond some threshold, growth is imperilled and the risk of recession rises; and if a recession is deep and long enough, then the spectre of the Great Depression – which, it is important to emphasise, interventionist policymakers did much to cause, deepen and prolong, and whose lessons they have not learnt – will return.

How, then, to combat recession and unemployment? How to ensure that a depression never recurs? Over the decades, the language of interventionism has altered greatly but the underlying thinking – and hence actual behaviour – has remained impervious to change. Accordingly, two policies are invariably invoked: a “monetary policy” that makes credit artificially cheap and a “fiscal policy” that encourages individuals and governments to overspend. Adroitly positioning the monetary and fiscal sails, and correctly anticipating changes of wind and weather, it is supposed that policymakers can steer the economic boat away from the rocks and towards its destination in a timely manner. More generally, says the mainstream, growth and prosperity are achieved by removing autonomy from individuals (i.e., forcing everybody into the same boat) and by concentrating authority over individuals into the hands of politicians (i.e., herding the benighted masses into steerage and ensconcing the anointed policymakers on the bridge).

Monetary and fiscal interventionism begets stability and prosperity because politicians say so; and they say so not least because since the 1930s all but a few economists have assured politicians that it is so. According to Mark Skousen, Paul Samuelson’s seminal text, Economics, “ranks with the most successful textbooks ever published in the field, including the works of Adam Smith, David Ricardo, John Stuart Mill and Alfred Marshall. Its [17] editions have sold over four million copies and have been translated into 41 languages.” It “has so dominated the college classrooms for two generations that when publishers look for new authors for a principles of economics text, they say that they are searching for the ‘next Samuelson.’” Accordingly, “for members of the economics profession, looking back at Samuelson’s text is like looking into a mirror that reflects many of our beliefs. If we are uncomfortable with some of what we see in that mirror, then we must also feel uncomfortable with the version of economics that was taught, and perhaps also uncomfortable with the impact that the teaching of economics may have had on the economy” (see The Perseverance of Paul Samuelson’s Economics).

Following closely the gist of Keynes’ General Theory of Employment, Interest and Money (1936), Samuelson’s first (1948) edition states that periodic “acute and chronic cycles” afflict private enterprise and that government has a responsibility to “alleviate” them. Government intervention into individuals’ commercial and financial affairs is thus a necessary condition of stability and prosperity. In particular, “the private economy is not unlike a machine without an effective steering wheel or governor ... [and policy] tries to introduce such a governor or thermostatic control device.” By the seventh edition (1967), Samuelson had dropped the “machine minus the steering wheel” metaphor but continued to emphasise that “a laissez-faire economy cannot guarantee that there will be ... full employment.” If it somehow managed to do so, then that would simply be a matter of “luck.”

In the text’s first edition, Skousen also notes, Samuelson was somewhat sceptical about central planning. “Our mixed free enterprise system, [despite] all its faults, has given the world a century of progress [that] an actual socialised order might find impossible to equal.” By the fifth edition (1961), however, this view had changed considerably. Although he expressed some reservations about statistics describing economic conditions in the Soviet Union, and whilst he acknowledged that it had expanded more slowly than Germany, Japan, Italy and France, Samuelson concluded that Western economists “seem to agree that [the USSR’s] recent growth rates have been considerably greater than [America’s].” The fifth through eleventh editions (1961-1980) included a graph showing that the “gap” between the American and Soviet economies was narrowing and possibly even disappearing. The twelfth edition declared that between 1928 and 1983 the Soviet economy grew at a remarkable rate of 4.9% per annum – more rapidly than its American, British, German and Japanese counterparts. In the thirteenth edition (1989) Samuelson and his co-author, William Nordhaus, culminated this theme. They declared “the Soviet economy is proof that, contrary to what many sceptics had earlier believed, a socialist command economy can function and even thrive.”

It was rather inconvenient that the Soviet Union and its satellites collapsed soon thereafter. But no matter: Western politicians’ confidence that they can use interventionist policies to steer Western command economies remains undimmed. Their fiscal policies (in practice, it does not matter whether the government is Blue or Red or Left or Right or Up or Down) encourage the government and individuals to spend more money. And their monetary policies (only impressionable people like finance journalists believe that central banks are independent entities) enable governments and individuals to spend money they do not otherwise possess

Interventionist fiscal and monetary policies have become very deeply entrenched in Australia. A recent biography of a prominent Australian politician provides a current example (see John Edwards, Curtin’s Gift: Reinterpreting Australia’s Greatest Prime Minister, Allen & Unwin, 2005, ISBN: 1865087041). Quoth the book’s review (The Australian, 5 March): “according to Edwards, Curtin saw World War II as an opportunity to create an Australian economy immune to the vagaries of inequitable and inefficient capitalism, with work for all. In the process of pursuing his goal he changed the way Australia was governed.” John Howard seems to be grateful. On 16 May 2004 he told Network Ten “there’s really one question to be asked. Does the public want a coalition led by me with the economy run by Peter Costello? Or a government led by Mark Latham and the economy run by Simon Crean? That’s the choice – the very, very stark choice. The Howard-Costello team – very good blend, run the economy extremely well. Very stable on defence and national security. Or the Latham-Crean team.” In Australia, it goes without saying, there is no “hands out of my pockets and stop meddling in my business” team.

That Australia became a much more regimented place during and after the Second World War is unarguable. Whether the policies of regimentation achieved what their proponents sought – and whether these policies’ unintended consequences outweighed their purported benefits – is another matter. But it does not matter because these policies are apparently non-negotiable. On 31 March The Australian Financial Review recalled that in 1975 the Commonwealth’s Treasurer, Jim Cairns, declared “the Labor government will never see ... resources remain unemployed because of a shortage of money. That battle was fought in this country 50 years ago and we are not going to fight it again.” His vow prompted one of the handful of liberals ever to sit in an Australian parliament, Bert Kelly, to ask “if printing money is a good solution, why not print more of the stuff and get rid of the unemployment problem altogether?” Cairns replied, “we might do precisely that.” (The policy ensued but its intended consequences, to put it mildly, did not.)

The rhetoric of the Liberal-National Coalition is different but its aggressively interventionist policies are virtual carbon copies of the ALP’s. Like all fiscal policies, the present incumbent’s encourage the government and individuals to spend more money. Accordingly, the Howard-Costello régime is the biggest spending and heaviest taxing since the 1940s. And its monetary policies enable governments and individuals to spend money they do not otherwise possess. At a press conference on 8 December 2003, after he released the Commonwealth’s Mid-Year Economic and Fiscal Outlook 2003-2004, Mr Costello stated “… if interest rates come down, people tend to borrow more. That is one of the reasons why you reduce interest rates, incidentally. You reduce interest rates so that people can buy more. It is considered stimulation for the economy. And nobody should be surprised that if interest rates are lower, people buy more; that is what the whole theory of monetary policy as stimulation is all about.”

Politicians have meddled so long and so extensively that few Australians realise – if, indeed, they ever stop to think about it – that there was a time when governments did not glorify expenditure and denigrate savings, prudence, thrift and retrenchment. And the “benefits” of monetary and fiscal policies (namely artificially cheap money and dependence upon the welfare-warfare state) have addled so many for so long a time that even when these policies’ manifest failings are brought to people’s attention they ignore them, rationalise them or indignantly refuse to regard them as failings. Hence no government policy in this country ever fails; it is simply (and deplorably) “underfunded.” Like some junkies and alcoholics, so too some debtors and dependants upon the welfare-warfare state: occasionally they recognise the pernicious effects of their self-induced craving – but often protest, in effect, that kicking their habit would be more painful than continued addiction (see Joel Miller, Bad Trip: How the War Against Drugs Is Destroying America, Nelson, 2004, ISBN: 0785261478 and Jeffrey Schaler, Addiction Is a Choice, Open Court, 1999, ISBN: 081269404X).

Inflation ≠ Prosperity

Adam Smith and Jean-Baptiste Say did not strive exclusively or even primarily to create a distinct body of economic knowledge. Their intent was practical, and in particular they sought to refute economic fallacies that protected certain élites and stifled most others’ living standards. Since time immemorial, whenever business conditions were poor people blamed one or the other (or both) of two evils. The first was a scarcity of money; and the second was general over-production (or under-consumption). If only money could be rendered more plentiful or if others’ production discouraged (or everybody’s consumption encouraged), then prosperity could be restored. Adam Smith, in a famous passage of The Wealth of Nations, was among the first to detonate the first myth. And Say’s Law is the classic refutation of the second.

“Upon every account,” said Smith, “the attention of government never was so unnecessarily employed as when directed to watch over the preservation or increase of the quantity of money in any country. ... No complaint, however, is more common than that of scarcity of money.” This passage is as timely as the new day’s rising sun. Early in 2000, the Reserve Bank of Australia increased the official cash rate, the rate on certain funds (i.e., excess reserves) lent among banks, by fifty basis points (i.e., from 5.0% to 5.5%). The RBA did so, according to the statement that accompanied its decision, partly because it detected incipient signs of inflation. And also in March of this year: the RBA increased the OCR from 5.25% to 5.50%.

On each occasion, a vociferous band of critics discounted the actual inflation, disputed the incipient inflation and contended that higher rates would harm businesses and consumers (particular those who are indebted up to their eyeballs). Money is already tight, protested these critics; and making it still tighter would cause consumption to moderate, growth to fall, unemployment to rise and otherwise impose inconvenient, unfair and intolerable burdens upon borrowers. The appropriate thing to do, says this pressure group (Debtors United for Inflation or DUI would be a good name for them), is to perish any further thought of rate rises – and, indeed, to decrease rates to a more “acceptable” level. Earlier this month, fearing that the RBA would increase the OCR to 5.75%, the DUI mobilised its forces and hastened to the megaphones (see, for example, “RBA Pressed Not to Raise Rates,” The Weekend Australian Financial Review 2-3 April 2005; “RBA Urged to Show Caution on Rates Rise” and “Another Rise Will ‘Wreak Havoc,’” The AFR 4 April; “Reserve Accused of Rates ‘Stuff-Up,’” The Australian 4 April; and “Businesses Irate at Idea of Rate Rise” and “It Could Break the Battlers,” The Australian 5 April).

The word “inflation” is almost invariably used by the RBa – and indeed by economists, politicians and market commentators and participants – to describe increases in the prices of raw materials, finished products and wages. Using this definition, the “headline” rate of inflation in Australia averaged roughly 2% per annum between January 1990 and December 1999, and has remained below or within the Bank’s target range of 2-3% since early 1996. The mainstream thus defines inflation in terms of its several possible consequences rather than its single and definitive cause. Inflation, in other words, rarely if ever refers to an increase in the supply of money. Attention is thereby distracted from monetary expansion – and the RBA’s sole responsibility for this expansion.

This is no matter of mere semantics. In Human Action, Ludwig von Mises noted “the semantic revolution which is one of the characteristic features of our day has also changed the traditional connotation of the terms inflation and deflation. What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates. This innovation is by no means harmless. It plays an important role in fomenting the popular tendencies toward inflationism.”

And so it has proved. Depending upon one’s definition of the money supply, inflation in Australia averaged closer to 6-7% during the 1990s and as much as 10% since 2000. As a result, in recent years the RBA’s quarterly economic statements read like the eyewitness accounts of the firebug who has joined the Rural Fire Brigade. These Statements have repeatedly – and accurately – noted that “inexpensive and freely available credit” has underpinned much economic activity in this country. They have catalogued behaviour, fuelled by loose credit, falling standards of consumer credit and rising asset prices, that in recent months has caused some activities to breach “capacity constraints” and “speed limits.” Clearly, then, when inflation is properly seen as an increase in the money supply, then it presently is and has long been much more pronounced than central bankers, politicians, economists and investors recognise.

But money and credit, like wine, noted Adam Smith, “must always be scarce with those who have neither wherewithal to buy it nor credit to borrow it. Those who have either will seldom be in either want of the money or of the wine which they have occasion for. This complaint, however, of the scarcity of money is not always confined to improvident spendthrifts. It is sometimes general through the whole mercantile town and the country in its neighbourhood. Over-trading is the common cause of it. Sober men, whose projects have been disproportioned to their capitals, are as likely to have neither wherewithal to buy money nor credit to borrow it, as prodigals whose expense has been disproportioned to their revenue. Before their projects can be brought to bear, their stock is gone, and their credit with it. They run about everywhere to borrow money, and everybody tells them that they have none to lend. ... When the profits of trade happen to be greater than ordinary, over-trading becomes a general error both among great and small dealers. They do not always send more money abroad than usual, but they buy upon credit, both at home and abroad, an unusual quantity of goods, which they send to some distant market in hopes that the returns will come in before the demand for payment. The demand comes before the returns, and they have nothing at hand with which they can either purchase money, or give solid security for borrowing.”

This conception of inflation has two important consequences. First, it helps to reconcile something that is otherwise difficult to comprehend: the co-existence in recent years of growing GDP and quiescent (by the standards of the 1970s) CPI. Inflation usually causes the prices paid by consumers to increase. But it need not always do so: if technological improvements or organisational efficiencies or good old-fashioned discipline exert a downward influence upon prices, but an increase in the money supply exerts an upward influence, then only a small overall increase of prices may occur. During times of high inflation (properly understood), in other words, wages and prices may increase modestly or not at all. According to Friedrich Hayek, Wilhelm Röpke and Murray Rothbard, precisely such a situation occurred in Europe and the U.S. during the Roaring Twenties. Second, this perspective indicates how central banks’ inflation produces demand for goods and services that is not supported by the current structure of production – and thereby exacerbates the business cycle.

The RBA’s and other central banks’ actions, in other words, roil rather than calm the economic waters. Interest reflects individuals’ time preferences; and the “natural” rate of interest indicates how much they are willing to forego consumption today in the expectation of greater consumption tomorrow. The greater (less) their willingness, the lower (higher) the natural rate. Yet the natural rate seldom prevails; and that which does (the “money” rate) is typically distorted by central banks. If the money rate is set lower than the natural rate, then the pace of credit creation quickens: seeing that it pays to borrow (i.e., the cost of credit is much less than what can be earned from the proceeds of credit) businesses will demand loans. Hence inflation often makes its presence felt in the market for loans. In recent years in Australia, Britain and the U.S., this has inflated the price of residential real estate. More generally, the structure of production will tilt towards more sophisticated (“lengthier”) processes.

When not upset by central banks, the structure of production at any particular time tends to be just long enough to exhaust the fund of savings generated by the natural rate. But the future is unknowable, entrepreneurial error is inevitable and a perfect match between the rate and the structure is unlikely. If the structure is too short relative to the rate, then there will exist unused capital available for deployment on more marginal projects; and if the structure is too long, then the available capital will be expended before production is completed. The situation under these latter circumstances resembles that of a builder who has oversized a set of foundations and discovers, once much of the structure has been raised, that there are insufficient bricks to complete it. To finish these projects, and reassured by the apparent boom, entrepreneurs must borrow more at subsidised market rates of interest. Sooner or later, however, either commercial banks (worried about the increasing pace and declining quality of credit) or the central bank (fearful of incipient or actual price increases) will halt the boom by intervening in the various markets for loans. The central bank will increase the short-term interest rates it controls, and commercial banks will impose higher rates and stiffer terms upon their loans. In this context it is significant that during the past several months central banks in Anglo-American countries have mouthed concern about “inflation.” Even more significantly, they forget to mention that their policies – and their policies alone – have created it.

Looking at inflation and interest rates from this perspective has two implications for investors. First, the relevant question to ask about prices and credit relates is not so much to their stability but to their integrity. Stability can and does mask distortions introduced by easy money. Investors would therefore do well to ask themselves: given governments’ aggressively interventionist policies, do prices of assets and rates of interest convey sensible information? Acting on them, would individuals make reasonable choices? Or would they undertake “malinvestments” that must be liquidated when the boom ends? It is a great pity that in recent years so many have obsessed about the Central Bank Esperanto of Alan Greenspan and Ian Mcfarlane, but nobody has recalled the sage words of the Weimar German central banker Hjalmar Schacht. (Next only to Gustav Stresemann, Schacht laboured harder than anybody to avert the financial and political crisis that he correctly foresaw would engulf his country. But his American, British and French counterparts did their utmost to thwart him.) In 1927, with the clouds of bust already forming, Schacht protested: “don’t give me a low rate. Give me a true rate; and then I shall know how to put my house in order.”

The second implication is that what is needed for a sound expansion of production is additional savings and capital goods – and not more credit and consumption. The boom apparent today in some parts of Australia is therefore partly illusory (see also Letter 60-61). To a significant extent, and more than in the past, Australians are subsisting on borrowed money; accordingly, they are also living on borrowed time. “Investment” encouraged by subsidised rates of interest can continue only so long as central and commercial banks make credit available at artificially low rates. It is this margin between the subsidised and the natural rate that misleads entrepreneurs and gives their investments the false appearance of profitability (see also Sean Corrigan’s excellent The Entrepreneur’s Guide to the Business Cycle). It also hoodwinks consumers and gives their shopping sprees the false appearance of sustainability. When the boom ends, it does not cause difficulties: it reveals difficulties that inhered all along in the policy of inflation. The defining feature of booms, then, is not that they are periods of good business; rather, they are irrationally exuberant times when capital is squandered on bad investments (see in particular James Grant, The Trouble With Prosperity: A Contrarian’s Tale of Boom, Bust, and Speculation, Times Books, 1998, ASIN: 0812929918).

Inflation, then, which in its modern guise can be created only by central banks, prevents and subverts – and neither creates nor maintains – prosperity. More than 200 years ago, Adam Smith grasped this truth far better than today’s interventionists. “It is not any scarcity of gold and silver, but ... the difficulty which [spendthrift] people find in borrowing, and which their creditors find in getting payment, that occasions the general complaint of the scarcity of money.”

What Say’s Law Says

Say’s Law, also referred to as Say’s law of markets (loi des debouches) or his theory of markets (théorie des debouches), is a bulwark of any defence of economic liberty. It appears in chapter 15 of A Treatise on Political Economy (1803) by Jean-Baptiste Say; and it shows that in voluntary exchange among buyers and sellers, consumption cannot exist without production. “A product is no sooner created, than it, from that instant, affords a market for other products.” You cannot get without the ability and the willingness to give. Temporally and logically, production precedes consumption; for that reason, in a commercial and technological sense the important thing is to produce. No exchange can occur unless each party to the trade has something to trade; and if they wish to consume more, then people must produce more.

Effective demand (as opposed to hypothetical desire) manifests itself in an ability to supply. My demand for a beachfront mansion is effective only if I am able to offer to you something that you are prepared to accept in exchange for the mansion. If I cannot, then my “demand” is mere wishful thinking. Clearly, my ability to produce is subject to myriad constraints such as my intelligence, diligence and capital. Equally clearly, my ability to register effective demand is also subject to a critical constraint – namely, others’ willingness to pay me what I want in exchange for what I produce. In sharp contrast, my general desire to consume is subject to far fewer constraints (namely my imagination and envy of those smug bastards who somehow manage to consume more than I do). Hence consumption will always take care of itself and can be taken safely for granted. It is, relative to production, trivial and unimportant.

Given Say’s Law, there is no such thing as a generalised excess supply (i.e., glut or surplus) of goods and services. There may be – and, given the inevitability and pervasiveness of entrepreneurial error described in Letter 58, always will be – an excess supply of particular goods; but the glut of goods A, B and C will always coincide with a shortage of goods X, Y and Z. Further, as long as nobody upsets the market mechanism then the laws of supply and demand will quickly adjust prices and thereby abolish the localised gluts and shortages. Only if politicians or some other malign non-market force thwart the adjustment of prices can gluts and shortages spread and persist.

It is important to emphasise that Say neither said nor implied that “supply creates its own demand.” He said nothing of the sort. Say does say that my production gives me the means to bid for your production. It gives me the opportunity to say: “I will sell to you amount X of Good 1 (which I have produced) in exchange for amount Y of Service 2 (which you produce).” But my production imposes no obligation upon you to accept the terms of my offer. Production per se does not create its own demand because in a free society you are free to decline my terms. Indeed, supply does not automatically create its own demand because you may not want what I am offering under any conditions (see also Letter 52 and the subjective conception of value). Every free-lance author and acquisitions editor knows this quite well. “I worked so hard for so long and gave up so much in order to write this manuscript!” wails the aspiring novelist. “So what? It’s utter drivel,” replies the publisher. “It’s unsaleable, we can’t use it and so we don’t want it at any price.” The author’s verbal demand for a publishing contract is clearly not the same as consummated and effective demand in the form of a signed contract. Only in this latter instance has supply created demand.

Says Law says that if markets are unfettered then prices will fluctuate such that they clear gluts. At some price – perhaps far lower than a producer hopes to receive – there will be a buyer for just about anything. A kindly neighbour, for example, might pay the writer a few dollars for his output. But she has not purchased the manuscript the writer had hoped to sell for a princely sum to a publisher: she has purchased scrap paper that she will use to scrawl notes and line her birdcage. The aspiring novelist thought that he was creating a masterpiece; but consumers do not agree and, as signalled by their actions in the marketplace, indicate that the writer has committed an entrepreneurial error. That his reward is much more paltry than his expectation is a signal that he must either write something that a buyer values as something more than scrap paper, or else find a more remunerative line of work. If a government “writers’ support program” offers the writer a price for his manuscript that is higher than the price his neighbour offered for the scrap paper, then the program subsidises – and thus encourages and underwrites – the production of drivel. This, in a nutshell, is why the arts, business and social science faculties of Australian universities are, by and large, feathered nests of mediocrity and cesspools of Bolshevism (for details, see Ludwig von Mises, The Anti-Capitalist Mentality, Libertarian Press, 1956, 1972, ISBN: 0910884293).

The critical insight, then, is not that production creates its own demand: it is that a lack of production creates no demand. He who produces little in exchange for which others will voluntary pay a high price registers feeble effective demand; and she who produces much of what commands a high price can register correspondingly greater effective demand. If you produce little or nothing you can, of course, register a bandit’s demand: you can, in other words, threaten to injure another person unless that person gives you something you want. Similarly, you can register a political demand: you can give a politician your vote on the understanding that in return the politician will force another person to surrender something that you want (the politician takes his cut before he forwards the loot to you). But if you produce little then in a voluntary exchange you can command little effective demand. A mere desire for a fancy car or a prestigious house does not create demand. Still less does hunger. Hunger may “incentivise” the hungry to supply goods and services that others are prepared to buy; but hunger per se creates no demand.

Keynes Versus Say

Why does it matter what Say said? It matters because John Meynard Keynes – probably the twentieth century’s most influential economist and the patron saint of contemporary interventionist monetary and fiscal policy – misstated Say’s Law. Keynes attacked and maintained that he had refuted something that Say never proposed. Steven Kates (Say’s Law and the Keynesian Revolution: How Macroeconomic Theory Lost Its Way, Edward Elgar, 1998, ISBN: 1858987482) calls Keynes’s General Theory “a book-length attempt to refute Say’s Law.” Second, in his attempt to refute it Keynes distorted Say’s Law. “Keynes was wrong in his interpretation of Say’s Law and, more importantly, he was wrong about its economic implications.” Third, it was upon this faulty foundation that Keynes erected the edifice of economic theory and policy that bears his name. According to Kates, “Keynes ... misunderstood and misrepresented Say’s Law. ... This is Keynes’s most enduring legacy and it is a legacy which has disfigured economic theory to this day.” Finally and most importantly, Say’s Law matters because if it is valid then The General Theory is invalid (see in particular Henry Hazlitt, The Failure of the “New Economics” – An Analysis of the Keynesian Fallacies, Foundation for Economic Education, 1959, 1994, ISBN: 157246024; Thomas Sowell, Say’s Law: An Historical Analysis , Princeton University Press, 1972, ISBN: 0691041660; William Hutt, The Keynesian Episode: A Reassessment, Liberty Press, 1979, ISBN: 0913966606; Say’s Law Is Back by Mark Skousen and Say’s Law For Our Time by Sean Corrigan).

For the purposes of this discussion, and when stripped of its many complexities, inconsistencies and absurdities, Keynesianism rests upon an assumption and a caveat. The assumption is that hands and minds are insufficient to produce wealth. It is not enough, in other words, simply to produce something that another person wants: the other person must have the money required to buy it. (The assumption, in other words, is that the seller should not have to reduce his asking price when he is unable to sell the quantity of output he has produced.) But this other person does not always – indeed, frequently does not – meet the seller’s terms. It is true that the buyer may not have sufficient money; but it is equally true that, like the publishing house and the aspiring novelist, the former simply does not value the good as highly as the seller. But to a Keynesian these considerations are immaterial: the solution to this problem of “insufficient demand” is not that producers conform to the subjective demands of consumers. Instead, it is the creation of money by the central bank (i.e., interventionist monetary policy) and its delivery (i.e., activist fiscal policy) to all those who might want to buy – or deserve to buy, but who have insufficient money to buy – so that they can buy on the seller’s terms.

The caveat is so rarely stated that one is tempted to think that contemporary Keynesians (whose numbers in the parliament, bureaucracy, mass media and financial markets, despite occasional protests to the contrary, are legion) have either forgotten it or never learnt it. It concerns people’s unwillingness or inability to buy at today’s prices. Let us say, for the sake of argument, a glut of a particular good occurs. But let us add the caveat (which Keynesians virtually never seem to add) that the glut exists under current conditions and hence at today’s prices. But unlike the mainstream, let us refer to Say’s Law and therefore expect that at tomorrow’s prices, i.e., if prices are allowed to fall sufficiently, then the glut will clear. At present prices, producers will reassess their position; and if these prices persist because they are not permitted to fall, then producers will tend to reduce their production.

In other words, we add the critical caveat that the persistence of glut (i.e., “oversupply” or “under-consumption”) presupposes the continuation of today’s prices. If so, then fewer goods will indeed be sold and lay-offs may well eventuate. But unlike Keynesians, let us refer to Say’s Law and, assuming that the market is free, expect that the glut will clear. If so, then tomorrow’s prices will be lower than today’s; that is to say, the costs of production can also fall to a level that will enable producers to supply the good at a price that consumers are prepared to pay. And if producers decide that it is not worth their while to supply this good at this price, then they can redeploy their capital and produce another good. In short, if governments refrain from meddling and prices are permitted to adjust, then neither any systematic retrenchment of employees nor reduction of the volume of output need occur. Quite the contrary: honest money and economic liberty enable prices to fall and production – and hence standards of living – to rise.

If men are unemployed or market conditions change such that they price themselves out of the market – that is to say, they demand wages that employers are unwilling to pay – then should they not respond to that change? Should they not, for example, offer their labour for less money? Before Keynes, most economists answered “yes.” But Keynes and his followers deplored this response. “Having regard to the large groups of incomes which are comparatively inflexible in terms of money,” he said in The General Theory, “it can only be an unjust person who would prefer a flexible wage policy to a flexible monetary policy, unless he can point to the advantages of the former which are not obtainable from the latter.”

Keynes asked for the advantages of laissez-faire in the labour market over an interventionist (i.e., inflationist) monetary policy, and Gary North in his excellent article entitled “Demand? What With?” and dated 9 August 2003 happily obliges. “All right, here are a few. How about this advantage: the freedom to make an offer and the freedom to decline one? How about this advantage: living in a society in which politicians don’t legislate price floors and therefore decree that some resources – particularly human beings – will be permanently unemployed? How about this advantage: an economy in which a legislated monopoly, the central bank, can’t debase the monetary unit so as to favour special-interest groups – above all, commercial bankers?”

In sharp contrast to Keynes, Say’s Law implies that downturns and recessions are caused not by any “failure” or “deficiency” of demand. Rather, they are the results of derangements of the interrelation among producers and consumers. Revisionist histories of the Great Depression (and much other logic and evidence) show that this interference typically favours producers and penalises consumers, and identify governments as the primary corrupters of markets. The business cycle eventually turns downwards because governments’ fiscal and monetary policies inevitably transmit false (in the sense that they do not conform to consumers’ wishes and preferences) signals into markets. As a result – and unlike the situation in an unfettered market, where their miscalculations are isolated and episodic – large numbers of producers commit “clusters of error.” They egregiously misjudge the quantity and the quality of the goods and services that consumers wish to buy. Under these conditions, where prices do not properly adjust to economic reality, persistent and widespread shortages of some goods appear and inventories of others accumulate. Clearly, only if the prices of goods, services and labour are free to adjust such that they can quickly correspond to changes of consumers’ preferences can production be reconfigured to new conditions.

In Steven Kates’s words, “classical theory explained recessions by showing how errors in production might arise during cyclical upturns which would cause some goods to remain unsold at cost-covering prices.” The classical model (i.e., that school of thought that is not homogenous or completely internally-consistent, and which developed after Adam Smith and before the marginalist revolution of the 1870s) was a “high-sophisticated theory of recession and unemployment.” Alas, during and since the 1930s Keynes and his followers buried it – and, it seems, erased most people’s memory of it.

Who Wants You To Be a Consumer?

John Meynard Keynes is the most influential economist of the twentieth century. And The General Theory of Employment, Interest and Money is probably the single most influential economics book of that century. But Keynes’s renown does not stem from his contributions to economics. As Henry Hazlitt concluded, “I have been unable to find in [The General Theory] a single important doctrine that is both true and original. What is original in the book is not true; and what is true is not original. In fact, even much that is fallacious in the book is not original, but can be found in a score of previous writers.”

Keynes was influential because he told politicians precisely what they wanted to hear: namely, that they were a sine qua non of economic stability and prosperity. That they are clearly not – indeed, that their actions invariably foment volatility and mishaps – seems to trouble few people. Keynes anointed politicians as stimulants of consumption and as guardians of employment; he clothed their hypocrisy and robbery in the garb of civic virtue; and above all he commanded them to do what politicians always strive to do: spend, spend and spend.

Keynesianism thrives within governments. Without any hint of shame, politicians say that spending is a good thing. Indeed, they boast about the money they have spent and propose to spend, and chant that government expenditure is a necessary condition of prosperity. Keynesianism also pervades print and broadcast media in the sense that reporters (probably unknowingly) interpret the news in a crudely Keynesian fashion. They babble about national income, national growth, the national labour force and other aggregate concepts, as well as the government statistics that measure them. Reporters and economists alike obsess about measures of consumer expenditure and confidence because they falsely regard high and rising measurements as causes of prosperity. If expenditure and confidence rise, then they rejoice; and if they stagnate or fall, then they worry – and demand that the government “stimulate” expenditure.

Keynes is probably the most prominent of a long line of cranks who have contended that inflation and consumption beget opulence (see also The Misesian Case Against Keynes by Hans-Hermann Hoppe). Keynes differs from his predecessors only in the sense that he used the arcane methods of mathematical economics to obscure his embrace of these long-refuted contentions. Despite Adam Smith’s and Jean-Baptiste Say’s and Henry Hazlitt’s and many others’ refutations, and despite Keynes’s eclipse in most departments of economics, these fallacies persist.

Keynesian economics is the economics par excellence of the welfare-warfare state. This is because Keynesian economists seem to applaud any and all government expenditure. It hardly matters whether the spending consists of subsidies to businesses or consumers, guns and butter, or pyramids and windmills: by definition, and regardless of how wasteful and destructive they are, these expenditures – any expenditures – swell GDP. Further, and as Joseph Salerno points out, Keynesian economics is the economics of fascism. In the preface to the first German edition of The General Theory, published after Hitler’s establishment of a totalitarian dictatorship, Keynes wrote approvingly that “the theory ... that is the goal of the following book can be much more easily applied to the conditions of a totalitarian state than [it can] under the conditions of free competition and a considerable degree of laissez-faire.”

So who wants to be a consumer? People who obsess about today, ignore the future and succumb to the deceptive attractions of crackpot economists. And who wants you to be a consumer? Politicians who live for the next election, eagerly grasp Keynes’ fallacies – and use them to drain your pockets and restrict your liberty. “The ideas of economists and political philosophers, both when they are right and when they are wrong,” said Keynes, “are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.” That much, if very little else, Keynes got dead right.

Chris Leithner


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