The

VOL. 13 | NO. 4 | 3–28

QUARTERLY WINTER 2010
JOURNAL of
AUSTRIAN
ECONOMICS

WHY YOUR GRANDFATHER’S

ECONOMICS WAS BETTER THAN YOURS:
ON THE CATASTROPHIC DISAPPEARANCE
OF SAY’S LAW

STEVEN KATES
RMIT UNIVERSITY

Ludwig von Mises Lecture

Austrian Scholars Conference
Ludwig von Mises Institute
Auburn, Alabama
March 13, 2010

I t is a great honor for me to have been asked to present the Ludwig

von Mises lecture here at the Austrian Scholars Conference.
Let me begin with a story. When I came to select my list of
the ten most influential economists of the twentieth century in

I would like to thank Joe Salerno for his kind invitation to present the Ludwig von
Mises lecture for 2010, in this way giving me the opportunity to present these views
on the classical theory of the cycle and Say’s Law to a wider audience. I would also
like to thank my good friend, Peter Smith, who provided excellent and sympathetic
advice on an earlier draft of this paper.

3
4 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

an article published in the Canberra Times on December 1999, an

article which can still be found on the Societies for the History
of Economics website, the economist I chose as the most influ-
ential—not the best nor the greatest, mind you, but as the most
influential—was John Maynard Keynes. No one, I regret to say,
has had more influence than Keynes.
Then, second on my list, was Friedrich Hayek, placed there
because of his recognized relevance for the economies of Eastern
Europe that were then emerging from beneath the horrors of their
communist regimes.
But third was Ludwig von Mises, who might have just as easily
been second, about whom I wrote these words:

Ludwig von Mises took the fight up to the socialist dogmas of the early
twentieth century and showed on paper that no economy could ever
solve the problem of allocating resources without a price mechanism,
free markets and private property. Who doesn’t know it now? He knew
it eighty years ago.

Ludwig von Mises is an economist for whom I have had the

greatest imaginable regard which is why having been given this
opportunity to speak to you today means as much to me as it does.
And in beginning this address, I would like to mention something
that Mises and I have in common. He had been for twenty-four
years the economist for the Austrian Chamber of Commerce. Well,
as it happens, I had myself been, also for twenty-four years, the
economist for the Australian Chamber of Commerce.
And while to some extent this is mere coincidence, I believe
that for both of us, as the economic representative of the business
communities in both of our countries, even though more than
two generations apart, it was this experience that allowed us to
understand the workings of an economy with certain kinds of
insights that may generally not be appreciated by others.
But it was one aspect of my work that ended up having an
immensely large impact on my life, and that is the discovery of
Say’s Law for myself. It is because I reinvented this principle that I
believe I understand it so well.
And what happened was this. As part of the way in which the
Australian economy is managed, we have what was once known
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 5

as the National Wage Case. It is a court case in front of a panel of

industrial relations judges who at the time determined the level of
wages for something like ninety percent of the working population.
And as part of the union claim for higher wages, it was always
argued that increased incomes would be good for the economy
because it would increase demand. I would counter this by pointing
out how useless it would be for businesses to find their revenues
increased through first increasing their costs by an equivalent
amount. And then, a year after I had formulated this argument, I
came across the identical argument in a passage in an essay by John
Stuart Mill, published as long ago as 1844. This is what Mill wrote:

The utility of a large government expenditure, for the purpose of

encouraging industry, is no longer maintained.... It is no longer supposed
that you benefit the producer by taking his money, provided you give it
to him again in exchange for his goods. There is nothing which impresses
a person of reflection with a stronger sense of the shallowness of the
political reasonings of the last two centuries, than the general reception
so long given to a doctrine which, if it proves anything, proves … that the
man who steals money out of a shop, provided he expends it all again
at the same shop, is a benefactor to the tradesman whom he robs, and
that the same operation, repeated sufficiently often, would make the
tradesman’s fortune. (Mill, 1874 [1974])

Although it would be years before I would work this out, what

Mill wrote is based on a proper understanding of Say’s Law. High
levels of public spending do not encourage industry. Spending
does not of itself create growth and employment. You cannot make
an economy prosper through expenditure but only through value
adding production. Demand does not drive an economy forward,
nor does demand deficiency cause recessions.
It was this most fundamental of all economic propositions that
Keynes deliberately and willfully destroyed. Say’s Law has, for
all practical purposes, now disappeared from economic discourse
and policy. And until it returns, the ability for the economics
profession to provide sound and sensible advice during recession
will remain sharply constrained. But to understand what Say’s
Law means one must first understand the role Say’s Law played
in the Keynesian Revolution.
6 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

UNDERSTANDING THE KEYNESIAN REVOLUTION

The Keynesian Revolution, and therefore the origins of virtually
all macroeconomic theory today, can only be understood in relation
to Keynes’ coming across Malthus’ economic writings in 1932. In
particular, it was his reading of the Malthus side of the Malthus-
Ricardo correspondence, which had been unearthed in 1930 by
his close associate Piero Sraffa, that turned Keynes’ mind to the
possibility of demand deficiency as a cause of recession. Until that
time, economists had been near unanimous in arguing that insuf-
ficient demand as a cause of recession was fallacious.
There has been universal recognition amongst historians of
thought that something does happen in late 1932 to turn Keynes
in a new direction. Yet not one of the works devoted either to
understanding the nature of the Keynesian revolution nor to
examining the road between the Treatise on Money published in
1930 and the General Theory published in 1936, has suggested that
the reason for this change in direction occurs specifically because
Keynes was at that time updating his essay on Malthus.1 Indeed,
there is no reason given of any kind why at that particular
moment Keynes came to the conclusion that demand deficiency
was the missing link in the theory of the cycle. Yet it is as close to
a certainty as one can have in such reconstructions that Keynes
would never have written the General Theory as he did, focusing
on demand deficiency, had he not become deeply interested at
the end of 1932 in Malthus’ economic writings. It was Malthus,
of course, who had been the leading advocate in the nineteenth
century of demand deficiency as a cause of recession and of
increased levels of unproductive spending as the cure. Reading
Malthus’ letters to Ricardo, and then the text of Chapter VII of
Malthus’ Principles, ought to be recognized as the single most
important reason why Keynes was to write what he wrote in the
way he did.
Recognizing that this was the inspiration should make it easier
to understand what the intent of the General Theory was and to
understand the nature of the change in economic theory that occurs

1
Keynes was at the time completing the essay for inclusion in his Essays in Biography
which would be published the following year.
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 7

as a result. In the General Theory Keynes is very clear about what he

has learned from reading Malthus.

The idea that we can safely neglect the aggregate demand function is
fundamental to the Ricardian economics, which underlie what we have
been taught for more than a century. Malthus, indeed, had vehemently
opposed Ricardo’s doctrine that it was impossible for effective demand to
be deficient; but vainly. For, since Malthus was unable to explain clearly
(apart from an appeal to the facts of common observation) how and why
effective demand could be deficient or excessive, he failed to furnish an
alternative construction; and Ricardo conquered England as completely
as the Holy Inquisition conquered Spain. Not only was his theory
accepted by the city, by statesmen and by the academic world. But
controversy ceased; the other point of view completely disappeared; it
ceased to be discussed. The great puzzle of Effective Demand with which
Malthus had wrestled vanished from the economic literature. (Keynes,
1936, p. 32, emphasis added.)

It was the “great puzzle of Effective Demand” that Malthus had

been wrestling with which had disappeared and it was this that
Keynes was intent on restoring to economic theory.
Nor was Keynes wrong on the implications of Say’s Law to his
contemporaries. It was precisely this issue that is the dividing
line between pre-Keynesian economics and the economics that
has dominated theory ever since. Mainstream economists before
1936 had actively denied any role for aggregate demand in
understanding the business cycle. Although there had been some
attempts to overturn the law of markets, demand deficiency as an
explanation for recession was until then almost entirely the province
of cranks.2 The two most important diagrammatic innovations of
the 1930s were the IS-LM curves published by Hicks in 1937 and the
Keynesian cross diagram first published by Paul Samuelson in 1939
(see Schneider 2010). Both were developed in response to Keynes’
General Theory, and both feature in economics texts to this day.
The problem of recession as conceived in the General Theory was
that an economy, once it has passed a certain level of production,
will run out of demands for the goods and services it produces.

2
Keynes discussed a number of these in the General Theory, referring to them as his
“brave army of heretics” (Keynes, 1936, p. 371), a band of brothers that included
Bernard Mandeville, Malthus, Major Douglas, Silvio Gesell and J.A. Hobson.
8 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

This is not excess supply for individual goods and services, the
“particular glut” whose existence no one had ever denied, but
an actual excess supply of all goods taken together, that is, a
“general glut.” Keynes made the possibility of demand failure
the culminating point at the end of the introductory chapters of
the General Theory.

The celebrated optimism of traditional economic theory, which has led to

economists being looked upon as Candides, who, having left this world
for the cultivation of their gardens, teach that all is for the best in the best
of all possible worlds provided we will let well alone, is also to be traced,
I think, to their having neglected to take account of the drag on prosperity
which can be exercised by an insufficiency of effective demand. (Keynes,
1936, p. 33, bolding added)

The possibility of a failure of effective demand is the very point

behind the Keynesian-cross diagram, IS-LM curves or the AD-AS
relationship. It is taught to undergraduate economists worldwide,
and is embedded almost universally in our present policies
designed to pull economies out of recession. And while other
possible explanations for recession are now usually discussed as
well, demand failure remains the single most important concept
most economists are taught in relation to the causes of recession
and involuntary unemployment. It is the argument that recessions
can best be understood as occurring because of a fall in aggregate
demand that continues to mark economic theory to this day, along
with the implication that stimulating demand through deficit
spending is the optimal approach to take in dealing with recessions
when and where they occur.
Aggregate demand is intrinsic to the modern understanding of
the level of economic activity. The implication is that it is the level
of aggregate demand that is responsible for the level of output, the
rate of economic growth and the number of persons employed.
An insufficient level of aggregate demand is held generally
responsible for high levels of unemployment and it is almost
universally accepted that deficit financed public spending can
permanently raise the level of output and thereby lower the rate
of unemployment. There is an aggregate supply curve associated
with aggregate demand, but its principal role is the determination
of the rate of inflation. Production levels are not determined by
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 9

supply capabilities but by the willingness of individuals to buy

what has been produced with the incomes they have received.
Indeed, the issue went farther than this. Keynes argued that if
Say’s Law were valid, continuing and persistent unemployment
simply could not occur and this was unrecognized by classical
economists whom he was about to correct. As he wrote:

Say’s law, that the aggregate demand price of output as a whole

is equal to its aggregate supply price for all volumes of output, is
equivalent to the proposition that there is no obstacle to full employment.
If, however, this is not the true law relating the aggregate demand
and supply functions, there is a vitally important chapter of economic
theory which remains to be written and without which all discussions
concerning the volume of aggregate employment are futile. (Keynes,
1936, p. 26, emphasis added.)

For the vast majority of the economics profession even now, this
is the way in which Say’s Law and its implications are understood.
It is the very meaning of the Keynesian Revolution. Mises made
the same point in 1950:

Lord Keynes’s main contribution did not lie in the development of new
ideas but “in escaping from the old ones,” as he himself declared at the
end of the Preface to his “General Theory.” The Keynesians tell us that
his immortal achievement consists in the entire refutation of what has
come to be known as Say’s Law of Markets. The rejection of this law,
they declare, is the gist of all Keynes’s teachings; all other propositions of
his doctrine follow with logical necessity from this fundamental insight
and must collapse if the futility of his attack on Say’s Law can be demon-
strated. (Mises, 1950 [1980])

It is precisely here that we find the division between the

economics of the classics and virtually all modern economic theory,
especially of the mainstream variety. As was recognized at the
time, and as Mises clearly notes, Keynesian economics, that is all
of modern macroeconomics with its focus on aggregate demand,
must collapse if the attack on Say’s Law turns out to be wrong.
It is only to be regretted that Mises did not recognize how
singularly important it was to hammer home this point. He
treated Say’s Law as so obviously valid, beyond any possibility
of argument, that I suspect he found it impossible to understand
10 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

how anyone who called themselves an economist could accept

Keynesian theory. All he ever directly wrote on Say’s Law he
contained in a brief article in a collection of essays. But as for the
validity of Say’s Law, he could not have been more clear:

The exuberant epithets which these admirers have bestowed upon his
work cannot obscure the fact that Keynes did not refute Say’s Law. He
rejected it emotionally, but he did not advance a single tenable argument
to invalidate its rationale. (Mises, 1950 [1980])

Mises accepted Say’s Law as unquestionably valid, as part of the

“perennial laws” of economics. But because he found rejection of
Say’s Law inconceivable he did not do what he might otherwise
have done, which was to explain why it must remain an integral
part of the bedrock foundation of economic theory if that theory is
to provide us with the guidance needed when recessions and high
unemployment occur.

UNDERSTANDING SAY’S LAW—MALTHUS AND THE

“GENERAL GLUT” DEBATE
What is relevant about Say’s Law cannot be contained within a
single statement. Say’s Law, if it is to be understood in full, must be
understood as a series of related propositions which when taken
together constitute the basic ingredients of the classical theory of
the cycle. The most extraordinary of the many ironies that have
surrounded this issue since Keynes first pronounced on it in 1936
is that Say’s Law was the foundation stone within classical theory
for understanding why a cycle exists at all. Keynes’ argument was
that belief in Say’s Law meant that classical economists assumed
there was never at any stage an obstacle to full employment. The
reality is that Say’s Law was an integral part of the explanation of
why in fact unemployment actually occurred.
Keynes, in attacking “Say’s Law” in 1936 was not attacking some
one-sentence statement of principle. In attacking Say’s Law, he
was attacking the entire classical theory of the cycle. Unless this
is understood, it is impossible to understand in full exactly what
Keynes was able to do. The propositions associated with Say’s Law
need to be seen as the constituent elements of the classical theory
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 11

of the cycle and to understand why this was so, it is necessary to

enter into some of the early history of economic theory itself.
What became the classical theory of the cycle was formed during
what is now known as the “General Glut” debate that lasted from
the publication of Malthus’ Principles of Political Economy in 1820
through until John Stuart Mill published his own Principles of
Political Economy in 1848. Malthus was, in 1820, the single most
famous economist in the world. His 1798 publication, On Popu-
lation, had been an international sensation. As a result, when he
published his text on economic theory, it was not just another text
but a work that would instantly attract the widest attention.3
What in particular distinguished Malthus’ arguments from
virtually all other writings on economic issues at the time was his
belief that the recessions experienced by England at the end of the
Napoleonic Wars had been caused by oversaving and demand
deficiency. And so a debate was commenced across the whole of the
economics community of the time, with a raft of books on economic
theory published over the next few years in which much of the
argument centered on a discussion of what Malthus had written.
All agreed it was possible to have an excess supply of individual
goods and services. The question was whether there could be an
excess supply of all goods and services taken together.
Importantly, it was not a debate over whether recessions and
large-scale unemployment were possible. On this there was
obviously unanimity. The only question was whether recessions,
when they occurred, were the result of too much saving and too
little effective demand. That this could never be a realistic expla-
nation was ultimately accepted by the whole of the mainstream of
the economics community.
Moreover, during classical times there was no economic
principle known as “Say’s Law.” The term would not be coined
until the twentieth century or enter economic discourse until the
1920s (see Kates, 1998, pp. 148–149). There was Jean-Baptiste Say’s
théorie des débouchés, known in English as the “law of markets,”

3
As an interesting parallel, Keynes, too, was the most famous economist of his time
after having written his Economic Consequences of the Peace at the end of World War
I. It had also been a worldwide sensation in its time.
12 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

which stated that demand was constituted by supply. It was

the law of markets that was employed as part of the response
to Malthus’ views but as only one strand in a far more complex
series of counter arguments. It was a crucially important part of
the argument, but it was only one of the arguments in a longer
chain of reasoning. It was the entire set of counter arguments that
when taken together became the related propositions that formed
the classical theory of the cycle. Leaving Say’s Law in Keynes’
desiccated form of words—“supply creates its own demand”—
not only reverses the point that classical economists had tried to
make—that demand in real terms can only be derived through
the production of value adding goods and services—but ignores
every other related aspect that was central to an understanding
of the classical theory of the cycle.
By discrediting the crucially central idea that demand is formed
on the supply side of the economy, the related propositions that
had emerged from the debate over Malthus lost their coherence.
The publication of the General Theory caused the entire classical
perspective on the business cycle to disappear. The propositions
presented below are therefore intended to reassemble the arguments
that were at the core of pre-Keynesian business cycle theory and
need to be seen as the full meaning of Say’s Law as it emerged
during the General Glut debate.4 They are also put in a form so that
the entire argument can be seen as a full and complete response not
just to Keynes and the arguments of the General Theory, but also as
a reply to modern macroeconomics to the extent that it continues
to rely on demand deficiency to explain why recessions occur.

THE RELATED PROPOSITIONS OF SAY’S LAW

The related propositions that make up Say’s Law are discussed
below, along with concrete examples from the pre-Keynesian
literature to demonstrate their importance as integral components
of classical thought.

4
For historical accuracy I will note that these arguments had been first brought
together by James Mill in 1808 where he, too, specifically invoked the théorie
des debouches to explain why demand deficiency is a fallacious explanation for
recession. It is for this reason that in my view James Mill had been the first to
properly state “Say’s Law” (see Kates, 1998, pp. 24–29).
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 13

Proposition 1: Recessions are never due to demand deficiency. An economy

can never produce more than its members would be willing or able to buy. A
general glut (i.e. general overproduction) is impossible. Neither high levels of
saving nor the redirection of resources into higher levels of capital formation
cause recessions to occur.

This is the starting point for any understanding of the pre-

Keynesian theory of recession and Say’s Law. Four examples of
how this statement was an integral part of economic theory across
the entire classical period will help put the law of markets into its
proper context.
First Adam Smith. He specifically denies that there is any danger
from oversaving and that a community has anything to fear from
the saving of its more provident members. It was this argument
that Keynes specifically set out to deny.

What is annually saved is as regularly consumed as what is annually

spent, and nearly in the same time too; but it is consumed by a different
set of people. That portion of his revenue which a rich man annually
spends, is in most cases consumed by idle guests, and menial servants,
who leave nothing behind them in return for their consumption. That
portion which he annually saves, as for the sake of the profit it is imme-
diately employed as a capital, is consumed in the same manner, and
nearly in the same time too, but by a different set of people, by laborers,
manufacturers, and artificers, who reproduce with a profit the value of
their annual consumption. His revenue we shall suppose, is paid him in
money. Had he spent the whole, the food, clothing, and lodging, which
the whole could have purchased, would have been distributed among
the former set of people. By saving a part of it, as that part is for the sake
of profit immediately employed as capital either by himself or by some
other person, the food, clothing and lodging, which may be purchased
with it, are necessarily reserved for the latter. The consumption is the
same, but the consumers are different. (Smith, 1776 [1976], p. 359)

A second example is Alfred Marshall writing in a publication

co-authored with his wife, Mary Paley Marshall, in 1879. Here it is
made abundantly clear that deficient aggregate demand is not the
proper explanation for depression.

After every crisis, in every period of commercial depression, it is said that

supply is in excess of demand. Of course there may easily be an excessive
supply of some particular commodities; so much cloth and furniture and
cutlery may have been made that they cannot be sold at a remunerative
14 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

price. But something more than this is meant. For after a crisis the ware-
houses are overstocked with goods in almost every important trade;
scarcely any trade can continue undiminished production so as to afford
a good rate of profits to capital and a good rate of wages to labour. And
it is thought that this state of things is one of general over-production.
We shall however find that it really is nothing but a state of commercial
disorganisation. (Marshall and Marshall, 1879 [1881], p. 154)

And lest it be thought that this is the early Alfred Marshall

which was later subsumed by a different point of view, in a
section introduced into the fifth edition of the Principles in 1907
he emphatically made the point again. Note that problems on the
demand side are seen only to exacerbate a problem that has been
due to other causes.

It is true that in times of depression the disorganization of consumption

is a contributory cause to the continuance of the disorganization of
credit and of production. But a remedy is not to be got by a study of
consumption, as has been alleged by some hasty writers. (Marshall, 1907
[1961], p. 711n)

Finally, Friedrich Hayek. His 1931 article, “The ‘Paradox’ of

Saving,” is a full-scale discussion, more than 40 pages in length,
on the arguments of Catchings and Foster who during the 1920s
and 1930s had argued that over-saving was the cause of recessions.
Hayek’s opening paragraph is not only an attack on the belief that
excess saving is a cause of recession, but he also specifically refers
to the théorie des débouchés as providing the appropriate position.
And while Hayek had his own theory of the cycle, the article is
not in the least dependent on such views. It is nothing other than a
straightforward statement of the classical position. Hayek wrote:

The assertion that saving renders the purchasing power of the consumer
insufficient to take up the volume of current production although
made more often by members of the lay public than by professional
economists, is almost as old as the science of political economy itself.
The question of the utility of ‘unproductive’ expenditure was first raised
by the Mercantilists, who were thinking chiefly of luxury expenditure.
The idea recurs in those writings of Lauderdale and Malthus which gave
rise to the celebrated Théorie des Débouchés of James Mill and J.B. Say,
and in spite of many attempts to refute it, permeates the main doctrines
of socialist economics right up to Tugan-Baranovsky, Thorstein Veblen
and J.A. Hobson. But while in this way the idea has found a greater
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 15

popularity in quasi-scientific and propagandist literature than perhaps

any other economic doctrine hitherto, fortunately it has not succeeded
as yet in depriving saving of its general respectability. (Hayek, 1931, pp.
74–75, bolding added)

It is highly noteworthy that it was only five years later that

the General Theory would in fact do what Hayek had feared, and
“deprive saving of its general respectability.”5

Proposition 2: Demand is constituted by supply. Aggregate demand is not

independent of aggregate production but is identical with it. A community’s
purchasing power is constituted by its value added. Aggregate demand can only
increase when the value of the goods and services produced is greater than the
value of the inputs used up in the production process.

This proposition is a restatement of Jean-Baptiste Say’s

original théorie des debouches, wrongly characterized by Keynes as
“supply creates its own demand.” Moreover, the statement that
“demand is constituted by supply” may be the most important
concept in coming to grips with the classical theory of the cycle,
but because it is so foreign to modern macroeconomic thought,
it may also be the most difficult. Yet it was fully accepted by
pre-Keynesian economists.
Here is James Mill, in the first presentation of what would become
the classical theory of the cycle, explaining the significance of this
principle. He could not be more emphatic nor does he leave any
doubt about just how crucial he believes this principle to be.

No proposition however in political economy seems to be more certain

than this which I am going to announce, how paradoxical soever it may
at first sight appear; and if it is true, none undoubtedly can be deemed of
more importance. The production of commodities creates, and is the one
universal cause which creates a market for the commodities produced.
(Mill, 1808 [1966], p. 135)

5
The existence of this critique of Catchings and Foster may also help explain why
Hayek, having invested the time and effort in dealing with their arguments,
almost completely ignored Keynes’ attempt to achieve the same result. By the time
Keynes wrote, Hayek may well have found trying to explain the fallacies in such
reasoning completely stale. To have bothered responding to Keynes in the detail
required would have for him involved going over old ground.
16 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

Moving forward a century, the same concept is found in the

following passage from one of the most widely used economic texts
ever published, in which this principle is stated in very clear terms:

It is only because our exchanges are made through money that we have
any difficulty in perceiving that an increase in supply is (not “causes”) an
increase in demand…. An increase in the supply of cloth is an increase in
the demand for other things; and vice versa, an increase in the supply of
anything else may constitute a demand for cloth. What is divided among
the members of society is the goods and services produced to satisfy its
wants; and the same goods and services are both Supply and Demand.
(Clay, 1916, p. 242)

The notion of aggregate demand separate from aggregate supply

was foreign to pre-Keynesian economic thought. Aggregate
demand grows at the same rate and by the same amount as
aggregate supply, and will not grow unless supply has grown. It
is not, however, just any production that will lead to an increase
in aggregate demand. What creates demand is the production of
forms of output for which enough buyers can be found to cover
in aggregate the entire costs of production. Only if the goods and
services produced can be sold for more than was paid for the inputs
that went into their production can it be said with certainty that
value has been added during the production process. Conversely,
if the goods and services produced do not create more value than
is used up in the production process, there can be no increase in
aggregate demand because there has been no increase in aggregate
supply in any relevant sense.

Proposition 3: The process involved in purchase and sale is the conversion of

one’s own goods or services into money and then the re-conversion of the money
one has received back into other goods and services. There is no implication of a
barter economy. Money is intrinsic to the processes involved.

At the very core of the classical propositions surrounding Say’s

Law is an appreciation that money is infused with value only by
being received in exchange for value adding production. The process
is one that may be characterized in the formula C–M–C’ where the
set of goods or services in one’s own possession (C) is converted
into a different set of goods or services (C’) by the sale of what
one owns for money (M) and then the reconversion of the money
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 17

received into what one wishes to buy.6 Keynes had accused classical
economists of confusing a barter economy with the operation of a
money economy, but from the first statements on Say’s Law by Say
himself that had never been the case. Here is J.B. Say, in the fourth
edition of his Treatise,7 trying to explain the obvious.

Should a tradesman say, “I do not want other products for my woollens,

I want money,” there could be little difficulty in convincing him that his
customers could not pay him in money, without having first procured it
by the sale of some other commodities of their own. … You say, you only
want money; I say, you want other commodities, and not money…. To
say that sales are dull, owing to the scarcity of money, is to mistake the
means for the cause; an error that proceeds from the circumstance, that
almost all produce is in the first instance exchanged for money, before it
is ultimately converted into other produce. (Say, 1821, pp. 163–165)

But more importantly, the process lay in ensuring that those

who produced made sure that they created value in the process.
Demand was only constituted by the value added that arose from
the sale of goods or services to others. If output could not be sold
at prices that repaid the costs of production, then no value added
had occurred. That this frequently did take place provided the core
insight into the classical theory of the cycle. That demand was built
on productive activities was also pointed out by Mises, who was
explicitly following Say in making this point:

Commodities, says Say, are ultimately paid for not by money, but by
other commodities. Money is merely the commonly used medium
of exchange; it plays only an intermediary role. What the seller wants
ultimately to receive in exchange for the commodities sold is other
commodities. (Mises, 1950 [1980])

To understand demand being constituted by supply, it is

necessary to recognize that in a properly functioning economy,
purchases are effected with the revenue from the previous sale
of goods and services or with money borrowed from others who

6
This is the formula used by Marx to explain the classical mechanisms associated
with the law of markets but was used by him as a criticism.
7
It is the fourth edition that has been the one translated into English because that
was the latest edition available when Malthus published his Principles in 1820.
There would be a fifth edition in French that has not been translated.
18 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

have earned incomes by producing. For those who earned their

incomes from the sale of goods and services, the process is direct.
The creation of value and the sale of what had been produced
provided the income for the purchase of other goods and services.
For businesses investing borrowed funds, the purchases are effected
through the transfer of funds through a saving-investment process.
For governments, purchases are effected through revenues raised
through taxation of the incomes of those who had sold goods or
services to the market.

Proposition 4: Recessions are common and result in high levels of invol-

untary unemployment.

It really ought to be unnecessary to point out that this proposition

ought to be completely non-controversial. It really ought to have
been inconceivable to have suggested, as Keynes did in 1936, that
economists until then had had no explicit theory of involuntary
unemployment and recession. Yet one of the consequences of
the publication of the General Theory was the belief that classical
economists had no theories to account for recessions and invol-
untary unemployment. It is therefore necessary to make the explicit
statement that classical economists did indeed have such theories of
recession and they most assuredly did understand that involuntary
unemployment was a frequent feature of economic life. The theory
of the business cycle had been developing for over a century by that
stage, so that for Keynes to have stated of his fellow economists that
they had no theory of involuntary unemployment was absurd.
A compendium of all of the theories of the cycle is found in a
League of Nations publication by Gottfried Haberler, titled Pros-
perity and Depression whose first edition was published in 1937, the
year following the publication of the General Theory. The first words
of the preface ought to make it absolutely plain that recession and
unemployment were amongst the most important questions under
examination by the economics community of the world during the
1930s, and had been for generations:

This book has its origin in a resolution adopted by the Assembly of the
League of Nations in September 1930 by which it was decided that an
attempt should be made to co-ordinate the analytical work then being done
on the problem of the recurrence of periods of economic depression.
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 19

The literature concerning economic depressions and what is currently

and somewhat loosely described as the trade cycle is abundant…. It
is apparent from the persistence with which depressions occur, from
the gravity of their economic and social effects, and from the growing
consciousness of that gravity, that – however abundant the literature
on the subject, however elaborate and specious the theories – our
knowledge of the causes of depressions has not yet reached a stage at
which measures can be designed to avert them. (Haberler, 1937, p. iii)

That what ought to have been seen as absurdly improbable was

nevertheless accepted from the moment it was first published is
an issue that demands the attention of historians of ideas. Here we
merely note that Keynes’ statement, that economists before him
had no theories to explain recessions and unemployment, is false
as a moment’s reflection ought to have led anyone to recognize at
the time, just as it ought to be recognized today.

Proposition 5: Recessions are due to structural problems of one kind or another.

In particular, recessions occur where the structure of supply does not match the
structure of demand. Recessions occur when the pattern of demand is different
from the actual composition of output so that a significant proportion of the
goods and services put up for sale remains unsold.

For anyone basing their understanding of these issues on

Keynes’ writings, it is something of a surprise to discover that the
law of markets was at the very centre of the classical theory of the
recession and, in fact, provided the foundation for the theory of
the cycle as understood by classical economists. Because demand
was constituted by supply, cyclical activity was understood to be
the result of individuals and businesses producing what could
not be sold at prices which covered costs. Why this might happen
was the underlying issue, but that it frequently did happen, of this
no one had the slightest doubt. The more than one hundred year
classical literature on the nature and causes of the business cycle is
a testament to the recognition that pre-Keynesian economists gave
to unemployment and recession.
Torrens, writing in 1821 in a direct response to the arguments
presented by Malthus, makes the point as explicitly as it is possible
to make it. The classical theory of the cycle was built on these
very concepts. Demand is constituted by supply but only so long
as supply consists of what those with incomes to spend want to
20 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

buy. Keeping demand and supply properly proportioned was the

imperative, but once that had been achieved all went well. It was
when the proportions were not maintained that recessions would
occur. Torrens firstly notes that there is no possibility that supply
will ever outrun demand.

So long as the proportion is preserved, every article which the indus-

trious classes have the will and power to produce, will find a ready
and profitable vend. No conceivable increase of production can lead
to an overstocking of the market…. Increased production will create a
proportionally increased demand [sound familiar?] …. (Torrens, 1821
[1965], pp. 370–372)

What is particularly notable is that Torrens uses almost the very

words Keynes would use to summarize Say’s Law. “Increased
production will create a proportionately increased demand” is
the lineal ancestor of “supply creates its own demand.” Torrens is
invoking Say’s law of markets to show that demand deficiency is
never a problem. But he does not conclude from this that economies
cannot therefore go into recession or that there are no obstacles to
full employment. He instead uses this very principle to explain
why recessions occur. Following on from the above passage,
Torrens immediately sets out the consequences should something
happen to disturb the balance between the structure of production
and the structure of demand.

This happy and prosperous state of things is immediately interrupted

when the proportions in which commodities are produced are such as to
disturb the equality between effectual demand and supply…. Then gluts
and regorgements are experienced. (Torrens, 1821 [1965], pp. 370–372)

Torrens was not the first to make this point, but he made it very
well. A lack of proportion between supply and demand is the
cause of a descent into recession. The problems of recession are
due to structural problems in an economy, not because of a failure
of demand. And it required an understanding of the law of markets
to understand that recessions occur when what has been produced
does not coincide with what those with incomes want to buy.
In these passages, Torrens captured the theory that became
during the following century the common ground amongst the
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 21

economics community in discussing the business cycle. Recessions

and depressions were due to structural problems. Haberler, in his
Prosperity and Depression, provided a synopsis of the theory of the
cycle as it had been understood until then. In summarizing the
views of the economic profession of his time, he wrote:

An expansion or contraction may be interrupted on the one hand by

an accident…or it may on the other hand itself give rise to malad-
justments in the economic system…. Most cycle theorists have tried
to prove that the second type of restraining force is all-important.
(Haberler, 1937, p. 245)

This is Torrens once again. It is this maladjustment in the

structure of production, where demand and supply are out of
proportion with each other, that was the fundamental explanation
for recession. Demand deficiency played no part in the process
within orthodox theory.8
Where demand was crucial was in relation to the structure of
demand relative to supply, that is, in situations where what buyers
would have been willing to pay the full costs of production for did
not match what suppliers had actually put on the market. Starting
from the proposition that demand is constituted by properly
proportioned supply, recessions are caused by events that mislead
producers into producing goods and services that cannot be sold
at cost covering prices.

Proposition 6: Partial overproduction of individual goods and services

occurs continuously within economies and can lead to a general downturn in
an economy. The transmission mechanism is from a reduction in earnings in
some sectors of the economy where sales have been below expectations to a fall in
demand in other sectors and therefore to a wholesale downturn in activity.

Walter Bagehot, as editor of The Economist, wrote one of the

most influential nineteenth century works on the operation of the

8
There was, however, an under-consumptionist literature which argued that too
little demand from consumers was the systematic cause of economic recession.
This was at the time almost entirely the province of economic cranks, as Keynes’
reference to the “brave army of heretics” plainly shows. Hobson was seen as the
leading exponent of this view as both Keynes (Keynes, 1936, pp. 364–370) and
Haberler (1937, p. 115) make clear.
22 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

money market. As part of this work, he included a chapter on the

nature of the business cycle, in which he described the evolution
of a general downturn built out of a downturn in one part of the
economy. Given Keynes’ accusation that classical economists had
ignored monetary factors and their effects on economic activity,
it should not go unnoticed that the following is from Bagehot’s
Lombard Street which had as its subtitle, A Description of the Money
Market. What Bagehot wrote was this:

No single large industry can be depressed without injury to other

industries; still less can any great group of industries. Each industry
when prosperous buys and consumes the produce probably of most
(certainly of very many) other industries, and if industry A fail and is in
difficulty, industries B, and C, and D, which used to sell to it, will not be
able to sell that which they had produced in reliance on A’s demand, and
in future they will stand idle till industry A recovers, because in default
of A there will be no one to buy the commodities which they create.
(Bagehot, 1873, 121–122)

The essence of this process is the creation of an economic

downturn built upon the systematic failure of producers to sell what
they have produced in their own markets. This is not a description
of a Keynesian multiplier but a trail of purchase and sale between
different producers. It accepts that when the recovery comes there
may be different firms and industries in different proportions. But
the conception that lies behind it is that the pieces in the economy
must interlock as firms provide a market for each other with the
entire structure ultimately aimed at producing goods and services
for final home consumption.

Proposition 7: Monetary factors, most notably structural imbalances in the

market for credit, can also be and often are an important cause of recession.
Even where monetary instability has not been the originating cause of recession,
monetary factors will often deepen a recession brought on for other reasons.

It is because Keynes argued that classical economists thought only

in terms of real variables that such an obvious statement even needs
to be made. It was, in fact, the specific conclusion reached by Becker
and Baumol that ought to have put this issue to rest for all time,
and also have raised some questions about the foundations of the
Keynesian economic theory that had been built on the rejection of so
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 23

flimsy a straw man. Becker and Baumol could not have been more
explicit in dealing with this caricature of classical theory, which they
labeled “Say’s Identity.” In discussing what they term “the clearest
statement on the point”—Mill’s second essay in his Essays on Some
Unsettled Questions of Political Economy—they wrote:

It is all there and explicitly—Walras’ Law, Say’s Identity which Mill

points out holds only for a barter economy, the “utility of money” which
consists in permitting purchases to be made when convenient, the
possibility of (temporary) oversupply of commodities when money is in
excess demand, and Say’s Equality which makes this only a temporary
possibility. Indeed, in reading it one is led to wonder why so much of
the subsequent literature (this paper included) had to be written at all.
(Becker and Baumol, 1952, p. 374.)

Monetary factors can and do cause recession. It is stating nothing

but what ought to be obvious, that classical economists were fully
aware that monetary factors were often part of the process even
when not the initiating factor in causing recessions to occur.
The approach to economic policy becomes very different if one
begins from a classical perspective rather than from one built that
commences with demand deficiency. These different perspectives
are part of the matrix of ideas that were part of the structure of
understanding that existed under a theory of the cycle built on
classical foundations.

Proposition 8: Because recessions are not due to a failure of demand, practical

solutions to recession do not encompass increased levels of public spending.
While such expenditure may provide some limited benefit if spending is
concentrated on value adding goods and services, such expenditure is merely a
palliative rather than a cure.

The policy consequences of Keynesian theory have over the

years provided ample evidence that on this matter classical
economists were correct. There has been no instance of a
peacetime increase in public spending during recession that has
led to recovery. Reductions in taxation have a different effect on
economic outcomes, and can be consistent with classical principles
in generating economic growth. Increases in public spending,
however, are not. John Stuart Mill’s statement, found at the start of
this paper, is about as clear-cut as one could find.
24 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

The utility of a large government expenditure, for the purpose of

encouraging industry, is no longer maintained.... It is no longer supposed
that you benefit the producer by taking his money, provided you give it
to him again in exchange for his goods. (Mill, 1874 [1974])

The stimulus packages that have been associated with attempts to

revive economies internationally following the onset of the Global
Financial Crisis, especially in the US and UK, have been failures.
The absence of signs of success and the growing problems related to
the rising levels of public debt are indications that these Keynesian
policies did not work as their advocates suggested they would. The
outcomes of these stimulus packages ought to be recognized as the
major test of Keynesian theory and policy that they have been. Based
on this experience, the macroeconomics that is almost universally
taught should be recognized as of no theoretical or practical value.
Ridding economic theory of the aggregate demand curve should be
the single most important theoretical issue of our time.9
If public spending and deficit finance are recognized to have
failed, just as they failed in Japan during the 1990s and in the United
States during the Great Depression, support for Keynesian theory
and policy should erode and a search for an alternative theoretical
approach should commence. The proper place to begin such as
investigation is amongst the long-forgotten theories of the cycle,
which were discarded after the publication of the General Theory.
There should be a newfound recognition that perhaps, after all is
said and done, that so far as Say’s Law is concerned, Keynes was
wrong and the classical economists were right.

9
The downturn in activity, because the cycle is cyclical, will end at some stage with
an upturn. What is evident already, however, is that the spending programs which
have been introduced have not been factors in generating recovery. Indeed, not
only have they been of virtually no use in creating a net addition to employment
they have also coincided with deteriorations in economic conditions generally
that have been unexpected by those who introduced the stimulus programs. The
argument has been made that economic conditions would have been even worse
than they were had these programs not been introduced even though at the time
of their introduction, the expectation was that there would be a generally rapid
upturn in activity and the labor market. None of this has occurred, as anyone
looking at these programs from a classical perspective would have expected.
Steven Kates: Why Your Grandfather’s Economics Was Better than Yours… 25

MEN ERR IN THEIR PRODUCTIONS, THERE IS NO

DEFICIENCY OF DEMAND
It was Keynes himself who made it clear that the economics of the
General Theory was to be seen as a refutation of Say’s Law. Recessions,
he wrote, were caused by a deficiency of aggregate demand.
This was utterly contrary to mainstream classical thought.
Classical economists understood that economies are not driven
by demand but by value adding production, which is what they
referred to as “supply.” They understood perfectly well that raising
demand without an increase in the level of value adding output
cannot be an answer to recession and unemployment.
This was summarized by classical economists in various ways:
demand is constituted by supply, there is no such thing as a general
glut, overproduction is an impossibility. However, the most
remarkable short statement, not just on the nature of aggregate
demand but also on the related issue of how recessions occur, can be
found in Ricardo’s reply to Malthus in a personal letter written on
October 9, 1820. Ricardo was writing a few months after Malthus’
Principles had been published: “Men err in their productions, there
is no deficiency of demand.” (Ricardo, 1951–73, p. 277)
This is, first of all, a statement on the causes of recession: “men
err in their productions,” that is, there is some kind of market
disequilibrium which has occurred across the economy. And
beyond that, it is a statement of what does not cause recessions:
“there is no deficiency of demand.” Whatever might have caused
the recession, it is not due to a lack of demand. What is found in
Ricardo’s short statement is in summary form the entire classical
theory of recession with its explicit rejection of demand factors as
their cause. To understand what Say’s Law really means and why
it matters, this is what you need to know.
What if Ricardo’s short and to-the-point statement were at the
core of modern macroeconomics in the way it was at the core of the
classical theory of the cycle? Here there is no ambiguity of meaning,
none of the uncertainty that currently exists over what “supply
creates its own demand” does or does not mean. Ricardo’s brief
statement of classical principle means that when recessions occur,
they cannot be understood as a consequence of too little demand
but should be understood as some sort of derangement within the
26 The Quarterly Journal of Austrian Economics 13, No. 4 (2010)

market process. Were this understanding at the core of modern

macroeconomics, policy makers would have no excuse for the
levels of deficit spending that occurred after the commencement of
the Global Financial Crisis but would understand that far different
measures are needed to get markets and an economy back on track.
My book, Say’s Law and the Keynesian Revolution, which covers in
far more detail all that has been discussed in this paper, has as its
subtitle, How Macroeconomic Theory Lost Its Way. Macroeconomics
replaced the classical theory of the cycle in the 1930s and has been
Keynesian ever since. No metaphorical statement on the death of
Keynes or of Keynesian economics can be true so long as aggregate
demand maintains its presence at the core of macroeconomic theory
and policy. Macroeconomics, with its focus on aggregate demand,
has been systematically misleading economists since the 1930s.
Because of the near universal acceptance of Keynesian theory
within the mainstream, economists have repeatedly formulated
policies around the need to stimulate demand during periods of
high unemployment. Keynesian economics has, however, not had
a single peacetime success but has recorded many, many failures
to which one more can now be added. It is the very concept of
aggregate demand that must be removed from economic theory.
Its pervasive presence has caused a blackout curtain to fall across
the whole of macroeconomic theory making it all but impossible to
understand the underlying workings of an economy or to provide
useful advice when recessions occur.
The use of public spending and deficit finance to deal with
the Global Financial Crisis has been massive and worldwide.
This ought to be recognized as having been a decisive test of the
validity of Keynesian theory and policy. These policies have been
tried to their utmost limits in the United States and elsewhere and
should be recognized as having been an abject failure. A return to
an economic theory based around a proper understanding of Say’s
Law and the classical theory of the cycle should be the direction in
which economic theory now moves.

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