Classical Economics, the Great Depression, and Say’s Law

Today, capitalism is on the ropes.  Thomas Piketty, Robert Gordon, Adair Turner, and Larry Summers have lamented the end of growth leading to a new age of “secular stagnation”.  Is capitalism a spent force?  In its current form of crony capitalism, where government favors the wealthy, powerful, and connected above the industrious and productive, we can say yes.  This is not capitalism of the definition, but a perversion of capitalism.  The reason that Piketty et al. arguments have gained attention is because our economic system no longer promotes capitalism. The entrepreneurial spirit that founded our country exists no less today. Indeed that spirit is innate to every human, as economic liberty is synonymous with individual liberty. All humans desire liberty with the same fervor as they desire air to breathe. 

Since the Great Depression, the economics profession has devolved in its understanding of basic economic principles. This began with a misinterpretation of the causes of the GD.  Conventional wisdom blamed the GD on an unexplained failure of capitalism and the solution was government intervention to correct capitalism’s defects.  Had the Federal reserve, a semi-government institution, only flooded the economy with liquidity, the GD could have been prevented—says one school of thought.  Today, Bernanke’s liquidity flood, in response to the 2008 financial crisis, is the missed mythical solution to the GD put in practice. (The result thus far is unsustainable debt, stagnated growth, income inequality, reduced standard of living, high unemployment, negative interest rates, distorted markets, the collapse of nation states, and voter revolt against the establishment.)  In reality, the GD was a fiscal event that began with the tariff legislation enacted by Smoot-Hawley—a global tax hike that piled goods behind international walls and required liquidation—and continued with Hoover’s massive tax increase in 1932, a dollar devaluation in 1933, and FDR’s decade of harmful socialist policy.  The solution was to undo the negative tariff fiscal policy that caused the initial market correction.  Instead, government reaction created new bad policy and layered it upon previous bad policy.  This put the “great” in an otherwise periodic economic contraction.  Classical economists of the time deserve blame for not recognizing what was happening around them and providing a solution.  This created an economic vacuum filled by the Keynesian economic model of government intervention to stimulate aggregate demand—from which we still suffer today.  

The result of this faulty interpretation was the abandonment of Say’s Law. Say’s Law states that all goods are ultimately paid for with other goods. Not supply creates its own demand, as dismissively defined by Keynes.  Say argued:

the encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we see that production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.’”  [A Treatise on Political Economy I.XV.20] 

For this reason, the classical model only considers the producer when arranging economic policy. This is supply-side vs. demand-side economics, or classical economics vs. Keynesianism. Demand-side Keynesianism dominates academia, government, finance, and media to the complete exclusion of classical economics. By analogy, consider the Copernican vs. Ptolemaic models for describing the path of planets. If the model is wrong–Ptolemy assumed the sun revolved around the earth–then the assumptions derived from the model will be wrong. This will hold true despite any elegant mathematical equations or terms created to justify and explain the model. Keynesianism demand-side is the Ptolemaic model of economics. 

In the most basic economy we would find two producers exchanging their product, the excess of their needs, with each other. As we add the concept of money, financial intermediaries, other economic producers, and international trade to arrive at the complex, technological economic system that exists today, we still find at its core, economic actors producing to exchange the excess of their needs with each other. When considering the producer, government must construct an economic foundation to encourage and promote efficient production and exchange. The first requirement is a stable unit of account. Inflation or deflation requires a risk premium added to the terms of trade making the exchange less efficient. The second requirement is low taxes and regulation that encourage economic production and capital formation. 

The economic environment we find ourselves in is another of the world’s periodic detours down the wrong path. The solution is both simple and complex. A revival of basic economic understanding requires the rejection of destructive, errant economic thought and policy, from which the world continues to needlessly suffer.

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