What pumps up the economy

What pumps up the economy by Sauvik Chakraverti

Posted: Mon, Nov 3 2008. 11:55 PM IST

An understanding of Jean-Baptiste Say’s Law of Markets is essential in these turbulent times

To theoretical economists, the current turmoil in global financial markets is a battle between Keynesians and Austrians. Yet, I would prefer to go back in time to an older insight. This is Jean-Baptiste Say’s “Law of Markets”, which dates back to the early 19th century, long before either Keynes or any Austrian appeared on the scene. J-B Say was known as the Adam Smith of France. An understanding of his important law is essential in these turbulent times.

In a nutshell, Say’s law holds that the sale of X gives rise to the demand for all non-X. Thus, the Law of Markets makes a clear distinction between those who compete and those who do not. So, while the sale of X hurts those who compete with X, the same sale helps those who do not. For example, if I sell my bhel-puri, I have the means to demand everything else in the market— jeans, shoes, books, CDs...—everything except bhel-puri, which I obviously will not demand.

This Law of Markets was a pillar of classical liberalism. In the 19th century, in England, France or the US, you were not considered a political economist if you did not understand this law and its various serious implications. And it is precisely this law that the Keynesians mistaught as “supply creates its own demand”. But the supply of plasma TVs does not constitute the demand for plasma TVs! The very thought is nonsensical. Yet, a leading Keynesian, Prof. Joan Robinson, is on record saying that her mission in life was to disprove Say’s law. She taught Manmohan Singh.

There are important lessons in this for Indian industry. These leading businessmen of our country supported Keynesianism and economic autarky only because they did not correctly comprehend the Law of Markets. That is why they all waited hand-and-foot upon the finance minister and his “budget” for 60 years. To them, “supply creates its own demand” meant government deficits were the only way to pump up the economy. They applauded deficits. Demand to them was government demand, not consumer demand, which is “real” demand. They never served the consumer. They served the state.

Not only does Say’s law indicate that consumer demand is paramount, it has important implications for free international trade. We now see that when a Sony plasma TV or a Honda City sell, all our markets hum with catallactic energy. The seller of real estate gains. The bhel-puriwallah gains. Everyone gains when the energy in the market rises to fever pitch. The critical understanding that Say’s law can deliver for Indian industry is that they all stand to gain when foreign goods that do not directly compete with their products sell in our markets. So, more Kingfisher beer is likely to be sold if French cheeses sell in India. In those bleak days of protectionism and autarky, nothing sold. A Bajaj scooter came with a 10-year wait list. Amul Cheese was advertised as “The Taste of India”. There was no catallactic energy in our domestic markets. And Indian industry lost.

The Keynesians obscured all understanding of ‘sound money’. The central banker is their God

Let us now turn to what light Say’s law has to shine on the current housing bust in the US. I have taken a small liberty by representing the law as “the sale of X gives rise to the demand for all non-X”. The actual law goes deeper. What it really says is that “the production of X gives rise to the demand for all non-X”. The classical liberal understanding of markets was that anything produced is destined to be sold. If goods and labour are lying unsold, then prices must be lowered until markets clear. And this was the precise point: Markets Always Clear.

A classical liberal would, therefore, advise the US to allow housing prices to fall until all unsold stocks are sold. Note that the US government is doing the very opposite. By inflating the economy to the tune of $700 billion, it is attempting to keep up housing prices. It is preventing losses from being booked. It is, therefore, postponing the inevitable bust. And it is risking hyper-inflation during a recessionary stagflation. You cannot get it more wrong than this.

The mythology of the Keynesians holds that government spending through deficits has a “multiplier effect”. Nonsense. All that is multiplied is inflation, which is a hidden tax. According to the classicals, Say’s law contains a “natural multiplier”. So when an unsold house in the US is finally sold at a lower price, demand for all non-houses is automatically generated. Or when a labourer agrees to work at a lower wage, he immediately possesses the means to spend on all wage goods. This is a “real multiplier” based on real money. The Keynesians, of course, obscured all understanding of “sound money”. For them, fiat paper money is king. And the central banker is God. In the early 19th century, gold was the only money everyone knew, and the International Gold Standard was what all political economists called money.

The greatest tragedy that Keynesianism has wreaked upon the world is that it has caused a total loss of understanding of how markets actually work, an understanding at least 200 years old. Furthermore, the Keynesians exaggerated the role of the state. Classical liberals stood for “limited government”: a constitution that limited the government’s powers; and a parliament that limited its revenue. Thanks to the Keynesians we now have omnipotent government. No government is “limited” if it has unlimited powers to “create money”. Parliaments become meaningless then. Democracy becomes “pork-barrel politics”. Economic totalitarianism, and the consequent inflationism, are the twin evils Keynesians have bequeathed to the modern world. This is the long run Keynes laughed about.

Sauvik Chakraverti is an author and award-winning journalist. He blogs at www.sauvik-antidote.blogspot.com. Comments are welcome at theirview@livemint.com

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