I’ve been absent for a little while, which is partly due to work, World Without End, and house guests, but one other thing that I’ve been doing lately is studying the Austrian School.  The Austrian School of economics is the libertarian’s school of choice because it advocates a complete laissez-faire approach to economics, idolatry of the market, and a rabid hatred of the Federal Reserve.  This is pure Ron Paul and Ayn Rand.

The reason I’ve been spending so much time on this subject is that I had sort of an email battle with a friend-of-a-friend at work whom I’ve never met.  We were fighting over the root cause of the financial crisis, and as you might suspect, me (Keynesian) and him (Austrian School) didn’t really agree.  I plan on posting our full exchange as soon as I get permission from the other party, but for now I wanted to touch on one of the many principles cited by Austrian School disciples, and supply-siders in general: Say’s Law.

In economics, Say’s Law or Say’s Law of Markets is a principle attributed to French businessman and economist Jean-Baptiste Say (1767-1832) stating that production, or supply, inherently creates demand for what is produced. An important implication of Say’s Law is that recessions do not occur because of inadequate demand or lack of money. According to Say’s Law, the production of goods provides the means to the producers to purchase what is produced, and hence, demand will grow as supply grows. For this reason, prosperity should be increased by stimulating production, not consumption. Another implication of Say’s Law is that the creation of more money simply results in inflation; more money demanding the same quantity of goods does not create an increase in real demand.

This has been brought up countless times in the past couple months by non-Keynesians against the stimulus.  They say something along the lines of this:

[B]ailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another…

First of all, there are issues with this type of theory when it comes hoarding and dishoarding.  Under Say’s law, an assumption must be made that the amount of people hoarding money in an economy balances out with the amount of people dishoarding (i.e. spending) money.  The mechanism for this is that any hoarding will result in an increase in loanable funds, which in turn causes an interest rate adjustment (making loans cheaper), and spurring investment.

Unfortunately, during a worldwide banking crisis, interest rate adjustments don’t exactly work the way they’re supposed to.  A corollary to all of this is that the velocity of money is not constant, or in other words, the amount of money being spent per year is not fixed, and typically drops substantially during a recession.  Therefore, since we have a bunch of resources sitting idle, why doesn’t the government increase spending to utilize the increase in idle resources?  There’s your stimulus.

This is not to say that we shouldn’t be concerned about any “crowding out” of private investment, but during a severe recession, the risk of that is very low.  Brad DeLong:

Could it happen that as the government starts its spending that the spending is, in Fama’s words, “funded by issuing more government debt…. The added debt absorbs savings that would otherwise go to private investment… [and] just move[s] resources from one use [private investment] to another [government purchases]…”? Yes, it can happen, When government deficit spending triggers a sharp rise in interest rates, that rise in interest rates will discourage and crowd-out private investment spending. But you have to have that rise in interest rates, and we don’t: the ten-year Treasury rate last Friday was 3.02% per year, down from 4.01% back before Obama’s election victory.

This is why the government should spend like crazy during a recession, and then eliminate budget deficits during boom periods.  Unfortunately, in the past 8 years we piled up a huge deficit fighting a disastrous war that had nothing to do with strategic American interests.

Heckuva job, Bush.

Tags: Austrian School, economics

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