Jean Baptist Say (1767
- 1832)ECON 272
The Classical School: Say's Law, Economic Growth, Crowding Out
The three main characters of the Classical School: Adam Smith, David Ricardo, and J. B. Say.
Adam Smith’s book An Inquiry Into the Nature and Causes of the Wealth of Nations is the most famous publication from this school (published in 1776).
Overall assumptions or basic ideas:
productivity is the key to the wealth of nations (not spending or aggregate demand),
markets are self correcting,
markets will achieve full employment if left alone (equilibrium means full employment in the modern day version of the Classical model),
the long run is the relevant time period to judge outcomes of markets.
Four cornerstones:
1. Say’s Law: Supply or productivity must take place before demand takes place -- but why? (see J.B. Say, 1803, A Treatise on Political Economy)
Jean Baptist Say (1767
- 1832)
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, A Treatise on Political Economy).
Say argued against claims that business was suffering because people did not have enough money and more money should be printed. Say argued that the power to purchase could only be increased by more production. So Say's Law is used against those who want to give an economy a boost via unproductive consumption. Consumption destroys wealth, in contrast to production which is the source of economic growth, according to Say's Law. Production must be guided by wants, however, to prevent the creation of goods for which there is little demand.
But wants and demand are two different things. Wants drive all of our behavior -- but we do not demand anything unless we have the means to obtain it. Production provides that means!
What Say's Law is NOT:
It is not saying "build it and they will come" or in other words -- we must
produce something first before someone can buy it. That is NOT what he is
saying. He is also NOT saying that producing something and then marketing
it will create a demand for it. Marketing does not create a demand if
people do not have the means to buy!!!
In the equilibrium version – all supply will be bought up as long as prices are flexible. Remember, an economist can agree with Say's law without agreeing with the "equilibrium" version of the law.
2. Flexible Wages and Prices: The market will always clear in the long run so we will have full employment. Any unemployment above that level is voluntary unemployment. This is only true if wages are flexible. We will also not have excess supply or demand in the economy as long as prices are flexible. Therefore wage and price controls will only create problems in the economy.
Voluntary Unemployment:
Graphs:
Government Deficits and Crowding Out
Total federal spending as a share of the total economy (measured by national income) - growing from 3% of the economic pie prior to the New Deal, to over 45% of today's economy (and growing!).
Our old friend: The Debt Clock
As with any debt - we need to look at the debt compared to the pie: so if we use GDP as our pie measure, how big is the debt compared to GDP?
Congressional Budget Office (CBO) - Government Debt held by the Public - Historical - Federal Debt Held by the Public
Country comparisons: http://stats.oecd.org/Index.aspx?QueryId=36382
Why Worry about Deficits and the Debt?
1. passing the debt burden to future generations (is this moral?)
Future Taxes: deficit spending today and interest payments mean that future generations will pay more of their tax dollars to the government's creditors and less for other things. Remember, when the government spends - the private sector can't.
2. Opportunity cost -- when someone lends money to the government (buys a treasury bond), they are moving resources from the private sector to the government sector. So there is an opportunity cost as to the use of those resources. Will the government be as "productive" with the resources as the private sector would be? That is the question. This is often the political debate we see in Washington, D. C.-
3. Crowding out -- government borrowing reduces private spending by raising interest rates (theory regarding why a large government debt, or prolonged deficit spending, is anti-productive).
CROWDING OUT
1. There is an opportunity cost to the revenue being used by the government. When people buy a government bond instead of a corporate bond, for example -- there's less private investment. Therefore - private investment is essentially "crowded out" by government borrowing.
But there's more:
2. Crowding out can come because of a change in interest rates:
The savings/investment model (interest rates): This is a theory that originated in Classical economics. So let's look at their assumptions, etc.
Now back to the classical school:
S = f ( r ) and I = f ( r ) – these are important assumptions of the model. Flexible interest rates guarantee that S=I in the long run.
Assumptions: Savings and Investment are both functions of the interest rate.
The loanable funds market:
Savings = supply of loanable funds.
Investment = demand for loanable funds.
GRAPH
When G > T (the government deficit spends and goes into debt). It enters the loanable funds market and bids for investment funds. This increase in the demand for loanable funds drives interest rates up and this “crowds out” some private investment (demand for funds by private investment goes down because of the higher cost of borrowing). So why anti productive? Private investment is productive investment (in capital goods). Government spending is mainly on "consumer goods" (non productive spending). The government has moved resources from the productive to the unproductive sector of the economy.
Counter: Infrastructure argument.
Counter again: Private firms can produce infrastructure and there's no guarantee that the government will spend money on infrastructure.
4. Equation of Exchange or the Quantity Theory of Money:
MV=PQ (assumed to be true by definition).
M =
V= inverse of the demand for money
P=
Q=
If V and Q are held constant, then there is a proportional and direct relationship between M and P. Money is not wealth for an economy. REAL productivity is wealth.
Policy Conclusions of the Classical School:
Laissez Faire-
Balanced Budget-
Low government regulation (no wage and price controls)-
Low taxes-
Basically, government should stay out of the economy. The economy is self-correcting in the long run. Government only makes things worse.
So in Today's World
The Classical Economists would not like the "fiscal stimulus" - saying that it doesn't increase real productivity growth. Also wouldn't like monetary policy for the same reason.
Plus: the large deficits are crowding out private investment -- at least in the sense that resources are being funneled via the government vs. via private entrepreneurs. Without the trial and error process of the market -- there is no way of knowing if the resources used by the government are really going to create jobs and create "real" growth -- most likely, they do the opposite.
They would probably argue, hold the rules steady and let the entrepreneurs increase economic growth and job creation.