This Time It Is Not Different: Walter Bagehot and the Persistent Concerns of Financial Macroeconomics: Aggregate Demand and Aggregate Supply: Say's Law

At the beginning of economics, back at the very start of the nineteenth century, Jean-Baptiste Say (1803) wrote that the idea of a “general glut”—of economy-wide “overproduction” and consequent mass unemployment—was incoherent. Nobody, Say argued, would ever produce anything beyond what they expected to use themselves unless they planned to sell it, and nobody would sell anything unless they expected to use the money they earned in order to buy something else.

Thus, “by a metaphysical necessity”, as John Stuart Mill put it back in 1829, there can be no imbalance between the aggregate value of planned production-for-sale, the aggregate value of planned sales, and the aggregate value of planned purchases. This is what would become “Say’s Law”.

Say pointed out that producers could certainly guess wrong about what consumers wanted—and thus produce an excess of washing machines when what consumers really wanted were more yoga lessons. But, Say argued, that would produce a clear market signal in the form of an excess demand for and high profits in making commodities short supply and an excess supply of and losses in making commodities in surplus. The market system had the incentive and the power to quickly iron out such imbalances. The fact remained that planned spending had to equal planned production. And, in reply to those who claimed that general depression could be produced if the economy’s money supply was too low, Say said that producers could and would always give credit:

to say that sales are dull, owing to the scarcity of money, is to mistake the means for the cause.... Should the increase of traffic require more money to facilitate it, the want is easily supplied... merchants know well enough how to find substitutes for the product serving as the medium of exchange or money...

Thomas Robert Malthus thought at the start of the 1820s that there was something wrong with Say’s argument. Malthus believed that he could see the excess supply, but not the corresponding excess demand:

[W]e hear of glutted markets, falling prices, and cotton goods selling at Kamschatka lower than the costs of production. It may be said, perhaps, that the cotton trade happens to be glutted; and it is a tenet of [Say’s and Ricardo’s] new doctrine on profits and demand that if one trade be overstocked with capital it is a certain sign that some other trade is understocked. But where, I would ask, is there any considerable trade that is confessedly under-stocked, and where high profits have been long pleading in vain for additional capital? The [Napoleonic] war has now been at an end above four years; and though the removal of capital generally occasions some partial loss, yet it is seldom long in taking place, if it be tempted to remove by great demand and high profits...

But Malthus did not have a coherent view of what was wrong with Say’s basic argument. Malthus tended to see what we would call cyclical unemployment as, rather, an aspect of his other Malthusian concerns about the causes of poverty—and thus as something, like the rest of poverty, best addressed through long-run reform measures to strengthen monarchy, patriarchy, and religion.

The proper answer to Say was given by John Stuart Mill in a piece he wrote in 182911 but did not publish until 1844:

[T]here cannot be an excess of all other commodities, and an excess of money.... But those who have... affirmed that there was an excess of all commodities, never pretended that money was one of these commodities.... [P]ersons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute.... When this happens to one single commodity, there is said to be a superabundance of that commodity; and if that be a proper expression, there would seem to be in the nature of the case no particular impropriety in saying that there is a superabundance of all or most commodities, when all or most of them are in this same predicament...

What has the potential to break Say’s Law—the equality of expected production and incomes on the one hand and planned spending on the other “by metaphysical necessity” as Mill put it—is, Mill said, that people do not just buy currently-produced goods and services with their incomes, they also buy money—or, more generally, financial assets. The easiest way for a wealth holder to build up his or her holdings of financial assets is for him or her not to spend the financial assets he or she already owns: to attempt to cut planned spending below expected income. But while each individual can cut planned spending below expected income, an economy as a whole cannot cut its actual spending below its actual income, because what is one economic agent’s income can come from nowhere but some other economic agent’s spending.