Say's Law of Markets: Classical and Neoclassical versions

Teaching macroeconomics, and having to deal, as always with the confusion generated by all manuals (to a great extent Keynes' fault for using the term classical for everybody that came before him) between the old classical political economy tradition and the marginalist (or neoclassical, other misnomer, this one Veblen's fault) school.

Not all classical authors accepted Say's Law, to which Keynes' Principle of Effective Demand (PED) was contrasted, but all neoclassical authors do accept it (last week the Societies for the History of Economics, aka SHOE, had a very confusing discussion on Say's Law, in which this simple fact got completely lost by a few debaters). Marx certainly was critical of Say's Law.

Ricardo in chapter XXI of his Principles famously says:

"M. Say has, however, most satisfactorily shewn, that there is no amount of capital which may not be employed in a country, because demand is only limited by production. No man produces, but with a view to consume or sell, and he never sells, but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person. It is not to be supposed that he should, for any length of time, be ill-informed of the commodities which he can most advantageously produce, to attain the object which he has in view, namely, the possession of other goods; and, therefore, it is not probable that he will continually produce a commodity for which there is no demand."

The Ricardian notion is relatively simple. It suggests that the objective of production is consumption (what Marx would call later the "simplest form of the circulation of commodities," or simple exchange, where commodities are produced for exchange for commodities, with money being just an intermediary, C-M-C'). Further, Ricardo suggests that nobody would continue to produce something for which there is no demand over the long run. Yes there might be mistakes and excess production, but over time producers learn from their mistakes. In this simple story if a capitalist saves, it is by definition because he intends to invest and be able to produce more in the future. Think of the corn model; the corn not consumed, for wages (for the reproduction of the system), goes by definition into expanded reproduction.

The Ricardian model has no adjusting mechanism between investment and savings, which are by definition one and the same. Also, there is no guarantee that the system fully utilizes labor resources, or that the system would be at full employment. The rate of interest was regulated by the rate of profit, and adjusted to its level in the long run, but it did not adjust savings and investment.

This is, in fact, the main difference between the old classical version of Say's Law when compared to the marginalist or neoclassical one. In the neoclassical version the rate of interest (the natural rate of interest indeed) becomes the adjusting mechanism in what is often referred to as the Loanable Funds Theory (LFT) of the Rate of Interest (for a simple discussion of Wicksell's version of the LFT go here). Now an excess supply of funds (savings) for investment would be eliminated by the tendency of the monetary rate of interest to equilibrate with the natural rate, guaranteeing that investment is at the level of full employment savings. Investment can deviate from the equilibrium level of savings only in the short run, and neoclassical theory (including Wicksell of course; a few in the SHOE discussion seemed confused about this) would accept Say's Law in this new version in the long run. Note that in order for a rate of interest to lead to increasing investment demand, it must be the case that labor is fully utilized, and firms decide to substitute labor for capital. In the marginalist version Say's Law implies full employment in the labor market.

Keynes' Principle of Effective Demand, by suggesting that savings were simply a residual (income not spent), famously argued that, instead of supply creating its own demand, it was autonomous spending decisions (which Keynes associated with investment) generated income and, hence, made the supply effective. It was the variations of the level of income that made the adjustment of savings to investment possible, and there was no guarantee that autonomous spending would provide for the full utilization of resources.

For a thorough analysis of Keynes' PED, this book remains in my view one of the best around.