In writing this diary I actually have been inspired by an excellent diary by gjohnsit and Krugman’s columns on Zombie Economics. Gjohnsit’s excellent diary (http://www.dailykos.com/...) had discussed a point raised by Don Patinkin (monetarist of the Chicago School) who had argued that a "lower standard of living is a good thing." I responded that this is an old argument in economics that keeps on being revived for clear political reasons, tracing its inception back to the wages-fund theory of the post-Ricardian period. Krugman’s columns specifically refer to Reaganomics and the idea that government intervention in the economy is always a bad thing (e.g., http://www.nytimes.com/..., http://www.chron.com/...).
However, upon consideration I believe that the term "zombie economics" is actually not a particularly good expression. Zombies imply a type of non-intentionality, at least in terms of how they appear in movies like "Night of the Living Dead" where the dead are coming out of their graves due to some bizarre viral, bacterial or meteorological event. That is, they are externally and accidentally caused and not due to the volition of others. Even in the case of the traditional less modern version of zombies where someone deliberately raises a zombie to frighten or terrify innocent people, this is a flawed analogy. In many senses, these economic ideas are different; they have strong policy and political implications and they are deliberately revived by those seeking to use them to create havoc for the vast majority of people, they are not there to terrify, they are there to do real damage. These ideas are not allowed to die as they have a very important function. Perhaps in some senses, they are more like Dracula in the Hammer movies who just keeps on being revived by evil people or even for an character in a real historical situation, they are like Rasputin, who simply despite being poisoned, stabbed, and thrown in a river refuses to die. Perhaps they are even like Frankenstein, where many dead things are cobbled together and then shot up with electricity to be brought to life.
In Krugman’s case, the problem is that he simply does not go back far enough in history of economic thought to find the genesis of these arguments; he is content to stop at Reaganomics, when their roots actually can be found in the classical and post-Ricardian period and then embodied within the long-period equilibrium model of neoclassical general equilibrium theory. This diary is meant to rectify some of this. I will concentrate on one argument (Say’s Law); sometime in the future, I will discuss the theory of wages.
In many senses the attack on Keynes and the resurrection of Say’s Law form the historical basis of much of modern right-wing and neoliberal attempts to justify income inequality as sound economic policy. For once, being an historian of economic thought actually has come in useful, I see these arguments as regurgitated arguments that have been updated to fit into modern discussions of theory and policy. While I have already covered some of this in older diaries and I’ve cited the diaries where appropriate, I have not really pulled things together tracing it through the neoclassical theory.
Before I begin, I want to put these historical economic ideas in context. James Mill (father of John Stuart and close friend of Jeremy Bentham whose ideas of lesser eligibility were used in the 1834 Poor Law Amendment as the criteria for Poor Relief), NW Senior served on the 1834 Poor Law Commission. JR McCulloch, James Mill, NW Senior and JS Mill were well known liberals (or Whigs) of the time advocating free-market or Laissez-Faire economic policies. This is the 19th century Liberal Argument. Keynes is also a Liberal (he was intensely distrustful of socialists like the Labour Party and loathed communists). We are looking at the transformation of economic policy amongst the Liberals. What we are seeing now with neoliberals and conservatives upholding Say’s Law now (after it has been demonstrated to be fallacious both theoretically and historically) is a shift on the part of economic Liberals back to the pre-Keynesian argumentation.
Say’s Law or Mill’s Law of Markets, General Gluts and Underconsumption Arguments:
Smith and pre-Say’s Law consolidation:
If we begin by looking at the writings of Adam Smith specifically on growth and the division of labour and effective demand, Smith notes that by far the greatest increases in the productive power of mankind is due to the division of labour (http://www.dailykos.com/...). However, it is quite evident that Smith links the extent of the division of labour to the limits of the extent of the market. That is, that technological innovation resulting from the division of labour, the extent of the division of labour itself, and economic growth is essentially dependent on the level of development of the market, specifically the effective demand of the various domestic classes (and international demand) for the goods and services produced by industry.
As such, Smith does not maintain that what is produced will be automatically consumed. The level of development of the economy will be constrained by the effectual demand of purchasers for goods and services. In order to deal with this, a theory of output discussing the demand of the various classes (Masters/Capitalists, Landlords, and Workers) becomes relevant as each class uses their income to purchase different commodities and uses their income differently; it is assumed that only masters, or capitalists, both consume final goods and invest, workers are assumed to spend all their wages, and landlords basically purchase luxury goods. Essentially, the demand of the various classes determines the level and composition of output. In his discussions of wages, we often see Smith supporting high wages for workers, this is due to two arguments, workers spend all their wages and their effective demand increases the demand for goods that they purchase. Smith’s ire was totally confined to the landlords who spent their money on luxury goods and who got a remuneration for the use of their privately owned land in production, he described them as people who reap what they haven’t sown. Smith does not make any claims with regards to general overproduction or underconsumption and does hold that at natural price levels, commodities would be sold covering the natural rates of wages, profits and rents (which implies that there is no general overproduction or underconsumption and that these will be solely market phenomena specific with regards to the production of certain commodities).
The value of general output is equal to the general remuneration of workers, landlords and capitalists:
PY = wL + (1+r) K + tT
PY = {wL + K} + {rK + tT}
In the classical theory {wnL + K) represents that part of output which is called necessary consumption, assuming that workers only obtain a subsistence wage, it is that part of output that is needed to replace the economy at the same level (you need to feed your workers and cover their reproduction and replace capital used up in the production process). {rK + tT} represent the surplus portion of the product that would be used for economic growth that if the product is sold at the natural price would go to capitalists as remuneration for investment and to landlords for use of the land. If workers are able to get a portion of the surplus product (as postulated by Smith and Ricardo during periods of economic growth) then the surplus portion of the wage over and above the amount needed for subsistence and reproduction is taken from that going to profits (as rent is normally negotiated in longer term contracts) and the surplus portion would be divided between ws, r and t and the value of output can be written as:
PY = wnL + K + wsL + rK + tT
If when commodities are taken to market, they are not sold at the natural price either because too much or too little has been produced and brought to market relative to the effectual demand, then one of the component parts of price will be paid at less/more (respectively) than the natural level, usually profits. This will lead to less being produced next production period and capital moving to another sector of production in search of higher profits. But this is only a specific market (relating to one sector) phenomenon and is not a general economic phenomenon. This is why people have argued that Smith has some sort of early version of Say’s Law.
The consolidation of Say’s Law
Say’s Law (http://www.dailykos.com/...) actually was added to economic theory by James Mill (1804) as Say’s arguments really did not sit within the classical economic doctrine (his arguments on distribution and price determination determined by supply and demand made him seem a bit of a crank as these were considered to affect only market prices rather than the natural prices).
Mill’s Law of Markets said that production created its own demand. In other words, whatever was produced would be sold at the natural price in which the costs would be covered and the profits realised, (while it was recognised that there would be temporary gluts and shortfalls of different commodities at various markets, it was seen that these would not affect the determination of the natural price levels). The introduction of this argument essentially eliminated the importance of a theory of output in mainstream economic arguments from that point onwards until Keynes and Kalecki introduced the theory of effective demand.
Malthus and General Gluts:
While there were dissenters to the doctrine (especially Malthus and Lauderdale), it became the dominant economic argument. Malthus’s comments are especially interesting only because Keynes finds them interesting (see Keynes’s Essays on Biography). Malthus argued that we can never be certain of realisation of the product at a price which covers the natural rates of wages, profits and rents. He articulated a crisis argument of general gluts or general overproduction or underconsumption where the level of effective demand provided by working people was insufficient to cover the goods produced. He maintained that it was the unproductive consumption of the landlords purchasing imported luxury goods that were purchased with the overproduced goods sold overseas that prevented underconsumption crises or that they would purchase the overproduced goods directly; hence he argued for high rents for the landlords to prevent general gluts (nothing like covering the needs of your really wealthy friends).
Savings and Investment and Implied Economic Policy
Say’s Law also has an additional meaning beside the idea that production creates its own demand. It is the idea that savings determines investment, that is, whatever savings exist will be invested in future production. Since economic growth is not constrained by effective demand, savings and investment become the only constraints upon economic growth. This is very important as it is this notion that gains increasing dominance and which is transferred from classical economic doctrine into neoclassical or marginalist economic theory that developed in the 1870s.
Why is this important? The idea that investment and hence future economic growth essentially derives from the savings of the rich means that we have an argument on which to justify high profits and low wages as it is these high profits that make the economy grow.
A small digression on Savings, Capital and determination of the rate of profits:
Again, we can look to James Mill as the father of these arguments. In the 2nd edition of Elements of Political Economy (1824), Mill adds a whole discussion on capital, where he described how difficult it is to increase the size of capital as compared to increasing the size of the labouring population (this is very relevant for the discussion of wages) as it requires abstention from consumption and savings rather than consumption which means possible decreases in the size of legacies for heir and risk. This is the first time that an argument discussing the genesis of capital has been articulated and it has been done to justify the right of capitalists to obtain profits. This is then developed into an argument called the abstinence theory of capital and profits by NW Senior, G Poulett-Scrope. This is then further developed into the Austrian version of capital theory linking the size of remuneration (r) to the length of time in which capital has been tied up in the production process and to the turnover of capital (see Wicksell, Bohm-Bawerk and Hayek).
A quick digression on wages and poverty:
Going back to James Mill again and wages, this difficulty of increasing the amount of capital for investment becomes an incredibly important consideration especially to the wages-fund authors (James Mill, JR McCulloch, NW Senior of 1834 Poor Law Amendment fame). In the early classical authors wages are taken as a given in the determination of the rate of profits and are determined by the notion of social subsistence and are essential to the reproduction of the working class as a whole (, for Smith on wages: http://www.dailykos.com/...
http://www.dailykos.com/...
http://www.dailykos.com/..., for Ricardo on wages: http://www.dailykos.com/...) . Employment and unemployment depend on the level of accumulation of capital which is used to employ the working class and the available technology. Poverty and unemployment are the fault of the economic system due to insufficient accumulation of capital to employ the available working population. In the wages fund theory (http://www.dailykos.com/...), wages are flexible and full employment of labour is assumed. In its static version, wages are determined by the relationship between the quantity of capital in relation to the quantity of labour to be employed. Dynamically, there are two ways to increase wages: 1) increase the quantity of capital which is used to employ it; and 2) decrease the size of the labouring population. Mill’s argument concerning the difficulty of increasing the amount of capital shifts the responsibility for poverty away from the economic system towards the poor and working classes that are lazy, dissolute and unable to control their own breeding. The fact that Malthus’s principle of population is incorporated into wage determination first inconsistently by Ricardo and then plays such a prominent role in wages-fund authors helps explain and justify the fact that worker’s wages are so low: according to Malthus, if workers’ wages are increased due to either social policy (like the Speenhamland amendments or raising wages), they will essentially breed so as to obliterate the increase and will remain poor; moreover, we have decreased the wealth of those that ensure economic growth to do so. Addressing income inequality essentially becomes a futile exercise that impoverishes all.
Say’s Law and Keynes:
Essentially, Say’s Law remained predominant in economic theory until the Keynesian revolution. What is the importance of Keynes’s and Kalecki’s theory of effective demand and why has it been under attack since it was written?
Keynes’s version of the theory of effective demand essentially reverses the causality from savings determining investment (and supply determining demand) to investment determining savings (and effective demand determining supply). In Keynes, it is the effective demand for commodities that determines the level and composition of output and the current employment of labour, expected effective demand determines investment, growth of employment and output, savings and economic growth. The importance of the notions of the marginal propensities to consume and to save is relevant in this discussion, as it is effective demand which drives the system; to increase growth, we need to increase effective demand, and specifically we need to increase the effective demand of those who primarily spend their income.
That is the basis of the theoretical justification for the social welfare state: it not only was meant to cover the most desperate. The effective demand of these people (who at the time really didn’t have much to spend) would provide the additional effective demand to enable further economic growth. Basic provision for the poor and higher incomes for the working classes means there is more effective demand for goods and services where there was little previously; this holds both statically and dynamically in the context of further economic growth. But it also means that the focus is taken off of the importance of high incomes for the extremely wealthy, investments that lead to economic growth (not short-term speculative investments) are contingent upon expected demand for goods and services, not the savings of the rich (increased wealth of the wealthiest). It is not savings that are important for economic growth, it is the investment that ensures economic growth that is what is important. Given that we can increase effective demand of those that primarily spend their incomes, then investments are directed towards those goods and services where there is expected demand and that will ensure high returns for investors. So, with economic growth, wages and profits can both increase together. The impoverishment of the poor and working class is not necessary to ensure economic growth, in fact, if their incomes rise, that is better for the economy as a whole to ensure economic growth.