What Does Say Say?

In Econ 101, we learned or were told something called Say's Law. What I assumed the main statement of Say's Law was that when a producer or supplier increases its production of output, demand for the good will increase no matter what. In other words, I interpreted a famous rephrase of Say's Law, "supply creates its own demand", as simply that as long as there is supply of a good, there will be demand for it. I thought of the law as a statement about only one certain good. But it turned out that not only was my short interpretation of Say's Law plain wrong, but also it assumes and claims interesting behavior regarding demand and supply in the economy. So, what does Jean-Baptiste Say say?

In 1803, he argued that a producer supplies a good to receive other goods he or she would like to consume in return. In his word :

It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products. (J. B. Say, 1803: pp.138–9)

An interpretation of the above paragraph is that, in short. when one wants to consumer more goods, he or she will produce more or increase the supply of goods he or she supplies. Once the supplier get money by selling its product, he or she now has to get rid of the money because, according to Say, the value of money decreases over time. Therefore, the supplier of X increases demand for Y by supplying more of X.

According to David Glasner on his blog post on Say's Law, Walras Law tells same story as Say's Law:

Walras’s Law says that the sum of all excess demands and excess supplies, evaluated at any given price vector, must identically equal zero. The existence of a budget constraint makes this true for each individual, and so, by the laws of arithmetic, it must be true for the entire economy. Essentially, this was a formalization of the logic of Say’s Law.

In other words, according to Walras's  Law and Say's Law, there will be no shortage of demand in the economy. Therefore, the economy will not experience cyclical unemployment caused by shortage of demand. Opposing views soon came from Malthus, J. C. L. de Sismondi  and later John Maynard Keynes in his famous the General Theory. Keynes argued the assumption made by Say, which says that the supplier of good X has to spend the money received by selling good X on other goods, such as good Y and good Z. Keynes wrote that the supplier doesn't necessarily spend all of the money received as revenue; in fact, in some condition, he or she may think saving that money under a mattress is more reasonable than spending it on some other goods. Basically, Keynes claimed that supply doesn't create its own demand. Moreover, Keynes was bold enough to reverse the statement to that demand creates its own supply. 

Also, Oskar Lange deduced that Walras's Law and Say's Law can be equivalent only in a barter economy, where goods are exchanged directly for other goods. In that case, there isn't intermediary like money, which can make Say's Law not necessarily true.

One implication of Say's Law, if we assume it implicitly holds in reality, if the monetary system can be engineered in a way that it can closely imitate a barter economy, a recession caused by inadequate aggregate demand could be avoided.

Edmund Phelps on the 80's High Unemployment Problem in Europe

In 2006, Edmund S. Phelps from Columbia was awarded the Nobel Prize "for his analysis of intertemporal tradeoffs in macroeconomic policy".  Phelps works have brought micro economics analysis in incentives of employers and employees to explain macro economic phenomena, unemployment and a natural rate of unemployment.

While studying his works, I was amused by his study on the 1980's Europe. During the first half of the decade, European countries experienced increasing unemployment rate.

His interest in the 80's Europe rests on a fact that there was no evidence of unexpected disinflation or deflation while unemployment rate was rising in the Europe. Rise in unemployment rate in Europe started when the most of the world experienced recession in the early 1980's. However, the unemployment rate in the Europe prevailed at the higher rate while unemployment in the US continuously decreased following a hike during the recession.

Then Phelps tried to solve this puzzle of high unemployment rate together with not so much deflation in Europe. First, he gave an argument on why this surge in the unemployment rate couldn't be explained by some fiscal tightening in Europe if it had one. He disproves fiscal austerity explanation for the unemployment rise by two parts. First, he just looks at the budget deficits of the leading countries in the area. He found that, in fact, there wasn't an evidence of fiscal tightening on the budget balance sheet. The following table shows that the following countries were having an easier fiscal policy than they had in 1980, when the unemployment wasn't high, during the first half of the 80s.  Moreover, he temporarily borrows a Keynesian hat and tries to see what Keynesian theory would say if there was indeed a fiscal tightening, and the the unemployed surge was caused by it. If there was a fiscal tightening during this period, decrease in the government spending or increase in tax would lower nominal interest rate according to IS-LM model "assuming that the supply of money is not permitted to change course in response." However, the empirical evidence doesn't support this Keynesian argument for high unemployment rate because the nominal interest rates in leading European countries except Denmark were higher during the period than they were in 1977.

Phelps further states:

"The evidence is all the more crucial when we reflect that, whatever the
cause, the resulting contraction of employment per se would tend to
slow the growth of nominal wages, thus to reduce the inflation premium
in nominal interest rates that borrowers are willing to pay, and hence,
other things equal, to lower interest rates. The rise of the average
European nominal interest rate is thus doubly hard to square with the
Keynesian fiscal hypothesis."

He finally gives some hope for Keynesian theory by offering a counterfactual argument that if there hadn't been fiscal tightening, the nominal interest rate, output and velocity of money would have been even higher. Therefore, according to Keynesian explanation, there was indeed fiscal tightening, that in fact lowered the nominal interest rate even though the nominal interest rate increased in absolute value. Therefore, Keynesian theory has no problem of telling the story of high unemployment in Europe. However, Phelps argues that in order for this Keynesian explanation to work, there has to be another contractionary shock other than fiscal tightening that raises the nominal interest rate while it contracts employment. If, according to him, there is not such another shock, a lone fiscal tightening would only lower the nominal interest rate in absolute term, but the nominal interest rate increased. To me, the interesting part of his argument is whether there could be a such contractionary shock that raises the nominal interest rate while contracts employment.

To explain this high unemployment period, Phelps proposed broader explanation for it which says that there was a change in the natural rate of unemployment. I will write about his explanation for rise in the natural rate of unemployment in a later post. To prepare my readers for that, I will end this post by quoting the conclusion of his paper (Phelps 1986, 509):

Our vision of the persistence of unemployment in Europe posits a
considerable degree of real wage stickiness, whether loosely imple-
mented through private understandings or enforced by public provisions
for indexation. If, to take the extreme case, the real wage of an employee
is a constant and if, as a consequence, the real cost savings (also
expressed in consumer goods) to the firm of laying off an employee,
which is the true cost of using the employee in production in view of any
benefits paid to the laid off, is likewise a constant, in the sense of having
been earlier predetermined for the course of his employment, a decline
in the real marginal-revenue productivity of labor as a result of devel-
opments such as a rise of markups, a real depreciation of the currency,
a fall of the real price of capital goods output, or a contraction of the
capital stock will cause some employees to be laid off. Further, unless
the real marginal productivity schedule is restored, laid-off workers will
remain laid off for the balance of their years as employees. In this extreme
case of real wage stickiness, it is only the entrance of new workers,
insofar as they can make deals for employment at reduced real wages in
view of the reduced marginal-revenue productivity of labor, that will
erode the average value of the real wage; but this statistical adjustment
will do nothing to put laid-off workers back to work. To the extent that
customer markets inhibit the rise of new firms to absorb the young while
contracts protect existing laid-off employees from being passed over for
recall in favor of hires of cheaper workers from the outside, new entrants
will end up bearing a share of the economy's unemployment-indeed an
increasing share as new entrants accumulate and the laid-off take the
places of retiring workers.

In the expectational sense, the equilibrium unemployment rate is thus
increased, and the natural rate with it. Yet their "long-run" values need
not have increased. (Also, it is not implied that the equilibrium rate
increased as much as the actual rate.)

An Attack on the Austrian Business Cycle Theory

In my most recent post, I briefly explained what the Austrian Business Theory is. In this post, I will try to make some arguments against the Austrian Business Cycle Theory. The theory, in short, says that when the central bank extends the bank credit at an artificially low interest rate, this credit feeds a boom in the production sector, And once businesses realize that the higher demand wasn't relative rather overall caused by an expansionary policy, they try to re-adjust their capital. This re-adjustment process is, according to the ABCT, a recession.

Now, let's try to argue against one of the main assumptions on which the ABCT built on.

The first assumption or definition that was taken to build the foundation of the theory by Ludwig Von Mises is the notion of a natural rate of interest. The natural rate of interest, a defined by Swedish economist Knut WIcksell, is the rate that would balance the amount of capital demanded by the borrowers and the amount of capital saved by the savers in the economy. In other words, it is a market equilibrium price for the capital. F.A.Hayek explains the notion in Prices and Production (1935):

“Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks."

The ABCT says that when the government or the central bank intervenes the market and controls the interest rate, the economy is distorted by this artificial interest rate.

However, the notion of the natural rate of interest could be attacked in a following way. This notion assumes that an equilibrium interest rate could be dictated by the market itself. If we want to see this natural rate of interest, we have to assume that savers and borrowers perfectly maximize the profit that can be made from the capital saved or borrowed. That perfect maximization, however, doesn't take a place in real world. When savers decide how much money to save for future, their decision depends on not only the prevailing interest rate but also how much money they have in their saving account or for how much time period they are saving etc. For the borrowers, they also don't react perfectly to the change in the interest rate. They might consider uncertainty in the economy or conditions on their borrowing. For these and many other factors that influence their saving and borrowing decisions, the definition of a natural rate of interest loses its assumption.

Therefore, from the very beginning of its story, which takes the notion of a natural rate of interest when it talks about how the central bank lowers the interest rate below a natural rate of interest, the Austrian explanation of business cycles is attacked by the other schools.

Meeting my own goal: A post on the Austrian Business Cycle Theory

Developed by Ludwig Von Mises and Friedrich Hayek, the Austrian Business Cycle Theory (ABCT) says that an artificially low interest rate, created by the government or a central bank, induces more investment in a production sector because investors now can find more money with an interest rate that is lower than a natural rate of interest. The artificially  low interest rate creates a production boom. Sooner or later, according to the theory, the investors realize the production is unsustainable and try to re-adjust the production and capital to other productions. At this moment, the economy is in a recessionary period.

When the interest rate is lower than a natural rate of interest, savers saves less and consumes more. At the same time, businesses borrow more money to invest in their projects. Businesses fail to see an increase in the demand for their products as an aggregate increase in the demand instead they think that the relative demand for their products has increased. To respond to the increase in the demand, businesses borrow more money and produce more. With a new cheaper money, investments that wouldn't have been done without an artificially low interest rate are made. These investments are called malinvestment by Austrian economists. When the businesses realize that this higher demand wasn't relative and the inflation is higher than they expected, they try to fix the mistake they made by changing the use of the capital and labor they have already obtained through the artificially low interest rate. Unfortunately, the process to make this adjustment takes some time because not all capital and labor can be used to produce a different product than the product they had been specified for. Therefore, this adjustment results in a period of unemployment and underemployment a.k.a a recession.

Moreover, the Austrian Business Cycle Theory explains one more thing that other business cycle theories don't explain. William J. Luther and Mark Cohen states this in their recent paper:

In particular, we have argued that the Austrian view is unique in suggesting that a monetary shock will distort the structure of production. An unexpected monetary expansion encourages early and late stage production relative to middle stage production. Hence, the Austrian theory claims that prices and production will increase in early and late stages relative to middle stages when the interest rate prevailing in the market falls below the natural rate.

In other words, the artificially low interest rate changes the structure of the production process.

According to the Austrians, the recent recession was the result of the Fed's low interest rate policy that followed 2001 recession.

Moreover, the theory has a implication on today's Fed's low interest policy. According to the Austrian Theory, the recession is a self-healing process of the economy after a boom and burst. Therefore, lowering the interest rate is seen as a problem by the Austrians. Here, WSJ covers some Austrian voices on the issue of the easy money policy in 2010:

Narayana Kocherlakota, president of the Minneapolis Fed, argued that a large part of today's unemployment problem is caused by issues the Fed can't solve, such as the mismatch between the skills of jobless workers and the skills that employers wanted.

The ABCT theory hasn't been prominent theory to explain the business cycles as others, such as Keynesian economics. Economists have done researches to study the empirical evidence of the theory, but most of them shows results against the ABCT explanation. (Here and here) But it is still important to look back at the ABCT theory and its ingredients to understand economy more and fix its errors, if there is, to solve the economics problems more successfully.