Say’s Law, endogenous money, and the inablity for wages and prices to adjust

A Redditor asks for help responding to these issues:

During a recent discussion i was having the person brought up the following concepts. Can anyone who is well versed with austrian economics give me some feedback on these:

Say’s Law, endogenous money, the inablity for wages and prices to adjust, the limits of praxeology, and market clearing undermine the Austrian economics.

After reading that list, it sounds like your friend learned some big words but doesn’t have the foggiest clue what they mean.

To address Say’s law, first let us present the accepted definition from Wiki:

In Say’s language, “products are paid for with products” (1803: p. 153) or “a glut can take place only when there are too many means of production applied to one kind of product and not enough to another” (1803: p. 178-9). Explaining his point at length, he wrote that:

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)

He also wrote, that it is not the abundance of money but the abundance of other products in general that facilitates sales:

Money performs but a momentary function in this double exchange; and when the transaction is finally closed, it will always be found, that one kind of commodity has been exchanged for another.

Say’s law implies that there cannot be a general glut, so that a persistent state in which demand is generally less than productive capacity and high unemployment results, cannot exist. Keynesians therefore argued that the Great Depression demonstrated that Say’s law is incorrect. Keynes, in his General Theory, argued that a country could go into a recession because of “lack of aggregate demand”.

Basically Keynes entire economic theory is predicated on the assumption that Say’s law is not valid.  Keynes felt that sharply dropping interest rates could stimulate ‘”aggregate demand” and drive the economy out of a recession.

To refute this nonsense, one simply needs to look at our current economy.  Currently the government is responsible for 40% of GDP spending and the Fed has kept interest rates near zero for several years, yet the economy is still maintaining high unemployment rates.  Clearly Keynes theory is wrong.  Keynes dismissed the Austrian school’s explanation of the business cycle, which is capable of explaining not only the Great Depression, but also our current economic situation.  For a complete explanation of Austrian Business Cycle Theory, watch this video by Prof. Roger Garrison.  The Austrians state that wide spread unemployment in a depression is caused by the State artificially depressing interest rates, thereby distorting the structure of production.

Say’s law is most certainly valid and it fully supports the Austrian school’s brand of economics, while at the same time refuting Keynesianism.  I find it odd that your friend would mention an economic law that supports the Austrian school if he was attempting to refute the Austrian school.

Endogenous money theory says the quantity of deposits held by the non-bank sector ‘flexes’ up or down according to the aggregate preferences of non-banks.  This theory of money has no bearing on refuting the Austrian school’s position on money and credit, since most Austrian economists do not advocate fractional reserve banking policies and adhere to a 100% reserve gold standard.  Endogenous money theory isn’t even accepted by mainstream economists, let alone Austrian economists – and it proves nothing since it is simply a theory.

Wiki states:

This account [of endogenous money theory] runs entirely counter to the mainstream economic theory of money creation, which states that the quantity of broad money is a function of (a) the quantity of “high-powered money” or “government money” (notes, coins and bank reserves), and (b) the money multiplier. Endogenous money concludes that the money multiplier as a concept has no bearing on how lending and bank reserves interact in practice.

Clearly this concept is wrong, because we know from empirical experience that even tiny changes in the money multiplier by a central bank can have MASSIVE consequences on the macro-economy.  A failed theory to be sure.

The inability for wages and prices to adjust – again, clearly this is an assumption and not proof of a “fatal flaw” with Austrian economic theory.  Keynesians like to argue that while prices for goods are fairly fluid, wages tend to be sticky.  So if prices fall, wages will lag behind.  Supposedly this will drive up unemployment rates and is often used as an argument against the gold standard because the gold standard is inherently deflationary in nature.

What the Keynesians miss though, is that under a gold standard the supply of money is always ever so slightly increasing as new gold is mined or brought into the money supply by the melting of jewelry gold into money.  So if we know the money supply is basically constant, we can say that as prices for products fall due to increased efficiency of production, there is no reason why wages should have to fall if the price deflation is caused by an increase in production.

Consider the case of a workshop that has 10 men producing widgets.  At first they can only produce 100 widgets a day and sell them for $100 a widget on the open market.  But then they upgrade their workshop with new tools and now they can produce 1000 widgets a day, and sell them for $10 a widget.  Consumers get the product for cheaper, but the total revenue generated by the company, and hence the amount they can afford to pay their 10 employees, remains exactly the same.

If a particular market gets over-produced, whereby it costs a company more to produce a good than it sells for in the market, the least efficient firm in that market SHOULD go out of business.  This is an important market function and it should not be propped up by the State.  This means there is not enough demand for the product in question and consumers would prefer that scarce resources be directed into other ventures.

The limits of praxeology – by this I assume he means that praxeology does not generate mathematical models that can predict the future.  Ask him what models CAN predict the future with total accuracy.  If he is aware of one, ask him why he isn’t a billionaire.

Market clearing – again, this concept SUPPORTS the Austrian school.

Gary North writes:

Money is the most marketable commodity, said Ludwig von Mises in 1912 in The Theory of Money and Credit. Because of this, sellers of goods and services will eventually deal at some price. They cannot use all of their output. They need money to survive in a division-of-labor economy. They buy money by selling products. The markets will clear. The depression will end.

Keynes argued that this is not true. He said that there can be an economy in which falling prices do not clear the market. The economy can be in an equilibrium with unemployed resources.

In attempting to prove this point, opposed to the logic of economics after Adam Smith (“supply and demand”), he resorted to arguments proposed by a pair of crackpots. One was an engineer, C. H. Douglas. Douglas founded the Social Credit movement in the 1920′s. The other was Silvio Gesell, an obscure merchant, journalist, and farmer who had briefly served as the People’s Representative for Finances for the one-week Bavarian Soviet Republic in 1919.

Both men had a theory of exchange that required the state to inject fiat money into the economy in order to balance supply and demand. For them, money was not an outgrowth of voluntary exchange. It was and is a ministry of the state.

It did not occur to him that the banks immediately lend out the paid off loans. That is how they stay in business.Answering Major Douglas’s crackpottery is easy. I did it in 1993 in my book, Salvation Through Inflation. He was convinced that markets needed fiat money produced by the government in order to clear. He argued that when businesses repay loans after production, this destroys money. Then consumers cannot afford to buy the output. This was a distinction between finance credit and Real Credit. (Note: whenever you see the word Real capitalized, followed by a noun — also capitalized — be on the alert: a crackpot theory is close at hand.)

This error is found in most underconsumption theories. There is always a money bleed-off factor. Old money goes there to die, like the elephant burial grounds. The consumers cannot afford to buy.

North goes on to layout irrefutable proof that this concept of non-clearing markets is wrong.

  • Cyrusp

    “Clearly this concept is wrong, because we know
    from empirical experience that even tiny changes in the money multiplier
    by a central bank can have MASSIVE consequences on the macro-economy.
     A failed theory to be sure.”

    Base money (M0) in the USA exploded in 2008 – yet M3 has been falling for the last 3 years. So endogenous money theory is hardly a failed theory – in fact EMT cogently explains the debt deflation we have been experiencing.

    This article by Professor Steve Keen is an excellent explanation of how money really is created (since 1500AD anyway): http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

    “Endogenous money theory isn’t even accepted by mainstream economists”

    Judging by the absolute failure of mainstream economists to see this crisis coming that would actually be a compliment.

    • http://www.libertariannews.org/ Michael Suede

      Hey, idiot boy – see the phrase “MONEY MULTIPLIER”?

      See how everything you wrote has nothing to do with the money multiplier?

      See how the entire endogenous money theory revolves around the money multiplier?

      See how dumb you look now because you opened up your trap without understanding wtf you are talking about?

      • Cyrusp

        “See how everything you wrote has nothing to do with the money multiplier?”

        It has everything to do with the money multiplier. Please read the excellent article by Professor Steve Keen – he goes into a lot of detail on the money multiplier.

        • Cyrusp
        • http://www.libertariannews.org/ Michael Suede

          I did read it.

          Keen is flat out wrong about his assertions.  

          Frank Shostak explains:

          http://mises.org/daily/2504

          Further, Keen doesn’t take into consideration that the Fed is paying banks not to lend their excess reserves out.   

          http://articles.businessinsider.com/2011-08-17/news/29985897_1_banks-financial-crisis-short-term-interest-rates

          Given that the banks are making money without any risk because the Fed is paying them not to lend, and given that the banks are facing a massive derivatives crisis caused by the systemic implosion of Europe, it should become readily apparent why inflation is not rampaging out of control… yet.

          • Cyrusp

            Frank Shostak says:

            “It follows then that the so-called multiplier, or the expansion of
            credit out of “thin air” cannot emerge in its own right without the
            support from the central bank.”

            What the?? How can he ignore the empirical evidence that massive endogenous credit expansions have been happening since 1500 (long before the FED was created in 1913)? Even during the free banking period in the 1800s the amount of credit money dwarfed the physical gold supply.

            History strongly suggests that a free market would tend towards a credit money system rather than a hard gold standard – and other libertarians agree too:

            “What the Rothbardians want is for a bank to take your money and leave
            it untouched in a vault. But banks already offer this: they rent safe
            deposit boxes – not that many people use them, and those who do tend to
            put jewelry and other valuables in them.

            Instead of supporting a free market, the campaigners demand the
            criminalisation of fractional-reserve banking – they want to strip
            consumers of a choice over where they deposit their cash. This is a
            breathtakingly unlibertarian position for a bunch of supposed
            libertarians.

            In fact, fractional-reserve banking is just a result of market
            forces, going back to the bankers in of Genoa and Venice in the 12th
            century, who lend out their deposits.”

            http://www.samizdata.net/blog/archives/2011/07/the_libertarian_2.html

          • http://www.libertariannews.org/ Michael Suede

            History suggests that credit expansion at the hands of unscrupulous bankers has occurred since the dawn of banking.

            So yes, the historical record reflects periods of unbacked credit expansion throughout most of human recorded history.

            However, that does not make Shostak’s analysis invalid.

            If we assume your model is correct, then by default the banks are all breaking the law.  For the law says they can not lend without first having the reserves to do so.  

            This may very well be the case, but it is not how the law says the system should work – and in any case, it is an unstable system that will collapse on itself. As the ponzi pyramid grows larger, the system grows more unstable. We are witnessing the results of this as we speak.

          • Cyrusp

            “If we assume your model is correct, then by default the banks are all
            breaking the law.  For the law says they can not lend without first
            having the reserves to do so. ”

            Yet they do. All the evidence confirms that: “In the real world, banks extend credit, creating deposits in the process, and look for reserves later”.
            “it is an unstable system that will
            collapse on itself. As the ponzi pyramid grows larger, the system
            grows more unstable. We are witnessing the results of this as we speak.”

            I agree 100%. And when it’s a government/central bank sponsored ponzi scheme it can last for a long time.  But it eventually will collapse – I too think we’re in the starting phase of the collapse. I’ve got my gold (physical of course :) ).

          • Cyrusp

            “For the law says they can not lend without first having the reserves to do so.”

            Like Keen says, the laws are basically irrelevant:

            “Several Central Banks—including Australia’s RBA—completely abandoned
            the setting of reserve requirements. Others—such as America’s Federal
            Reserve—maintained them, but had such loopholes in them that they became
            basically irrelevant. Thus the US Federal Reserve sets a Required
            Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.”

  • Anonymous

    “Austrian economists … adhere to a 100% reserve gold standard.”

    Ehhhh… Austrian economists favor free market control of money. The free market will probably choose money that is a commodity or backed by a commodity, and since gold happens to have many properties that make it excel in this regard, it will likely be the most widely accepted form of money. If the government is to have control over money, Austrians point out it would be better to have a 100% reserve commodity-backed standard than to have what we have now.

    “it proves nothing since it is simply a theory.”

    This is not a criticism. Gravity and evolution are also just theories.

    “Endogenous money theory isn’t even accepted by mainstream economists”

    Austrian economics aren’t even accepted by mainstream economists.

    • http://www.libertariannews.org/ Michael Suede

      Austrian economists favor a 100% reserve banking system since they do not believe in legalized fraud.  But you are right that they don’t care what commodity the markets chose for a money.

      I’m not sure what points you are trying to make with the rest of your comments.

      • Anonymous

        Hayek, Selgin, and Salin were/are, to varying degrees and for varying reasons, okay with FRB. But I’m in agreement with those who say that it probably wouldn’t happen very often in a free market, whether or not the practice was generally regarded as fraudulent.

        And I’m not really trying to make a point. I’m just a fellow an-cap pointing out some glaring weak points in an otherwise good article. Calling something “a theory” isn’t good as a criticism. Austrian economics is just a set of theories. Pointing out that mainstream economists don’t support a theory is a poor appeal to authority. But this is an overall solid article.

        • http://www.libertariannews.org/ Michael Suede

          That’s why I supported each of those comments with additional content.