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February 10, 2014

Say's Law of Markets, And Why Money and Wealth Are Not the Same Thing

Jean-Baptiste Say, an 18th-century economist and follower of Adam Smith, recognized one of the most fundamental laws in all economics: the entirely common-sense observation that consumption requires production. This axiom is called Say's Law of Markets.

However, this axiom is often mis-stated as "production creates its own demand". This is incorrect -- production is necessary for consumption to take place, but production anticipates demand, it does not cause it. Production is speculative in this sense. The simple act of producing some good or service does not, in and of itself, create demand for that good or service. (This is true even for basic commodities.)

What Say's Law really says is that production is the source of wealth. Market-driven production creates value and provides choice to consumers. Inventors and innovators bring new products to market, and as consumers are exposed to these new products, demand rises with the utility or desirability of these new products. New markets are opened by innovators who are able to tap into needs and wants that consumers didn't even know they had until a new product or service is offered.

This matters because many people (particularly Keynesians) tend to think of an economy in consumption-centric terms. This is the whole idea behind monetary stimulus: if people have more money to spend, they'll spend this money on goods and services, and the increased demand will invigorate production/supply. But this worldview comes into conflict with Say's Law, because it is on the production side that value is created and where innovation takes place.

Keynesians, especially those of the modern school, tend to use "money" and "wealth" interchangeably. Because they think of "wealth" in terms of consumption, they tie wealth directly to purchasing power: how many goods and services a consumer can buy. Ergo, more money equals more wealth because you can buy more stuff with more money.

This line of reasoning completely misunderstands what wealth really is. Wealth is only loosely connected to money, believe it or not. Wealth is a more complex notion, and is only partly measured by purchasing power.

So what is "wealth", really? (I could write a whole book on the difference between "wealth" and "money", but I'll try to boil it down.) Wealth is options. Wealth is choice. Wealth is variety. Wealth is agency - being able to do what you want to do when you want to do it. Wealth is surfeit - having more than the essentials of life. It is comfort, leisure, ease - or at least the agency and option (those words again) to avail oneself of leisure. Simply put, wealth is stored value that can be drawn down in various ways, only some of which involve the exchange of money for goods and services. And how is wealth created? Through production, because production must necessarily precede consumption.

Money correlates with wealth because money is a medium of exchange and a store of value. Rich people have a lot of money because they are wealthy, not the other way around. Wealth allows us to buy a bigger house or better car or nicer furniture. It pays for a nice dinner for two at an upscale restaurant. Note well: wealth buys these things, not money per se. Consumption is the draw-down of wealth, not the simple expenditure of money.

Money is the oil in the machine of an economy, but money is not in and of itself wealth. If I am stranded on a desert island with a thousand gold coins, I am just as poor as if I were a homeless vagrant living in an alleyway somewhere, because I cannot exchange my gold for things I want or need. It does not give me options or variety or comfort. My gold facilitates neither production nor consumption absent a market mechanism that makes use of it.

So: back to Say's Law of Markets. Wealth lies in production because it is production of goods and services which creates value. As a consumer, I have a vast array of choices in a free-market economy: I can buy an Apple iPad or a Samsung tablet; I can buy a Toyota car or a Ford truck; I can live in an apartment or a house (or a tent or a box over a subway grate). Consumption drains my wealth; production enhances it. I work at a job (production) to create wealth, and then expend that wealth buying goods and services. It's my choice as to what kind of balance I want to strike between production and consumption; if I want to increase my wealth, I must produce more value than I consume. This is as true for an entire economy as it is for an individual. (And "value" is the all-important word in that sentence. Producing goods of little to no value, or of negative value, will actually decrease net wealth due to the consumption of raw materials, time, and other inputs.)

Say's Law does not guarantee success on the production side, needless to say. If I decide to produce popsicle-stick models of the Eiffel Tower, or anchovy-flavored ice-cream, there may not be enough of a demand for those things to allow me to make a profit. Demand may not coalesce around a new product or service even if I invest a lot of money, time and energy into it; I may simply have miscalculated the latent demand. In such cases, my initiative will fail and I will need to try something else. This is Schumpeterian "creative destruction" at work, and it is how "failure" contributes to economic growth and dynamicism. Perhaps my next venture as a producer will succeed, and perhaps it will not, but I won't know until I try. (This is where the "risk vs reward" aspect of a market economy comes into play.)

But here's the key point: even a failed venture creates at least some value. Something new is brought into the world, something that did not exist before. The failed venture added some value to the market, even if that value was not enough to satisfy the need for profit (and may not even have offset the costs of the inputs). It is up to the producer to set a minimum bar for profitability. The criteria for "success" may vary, and may not be predicated on monetary profit -- the venture may be conducted for charitable reasons, or perhaps because the producer is already a billionaire and wants to spend his fortune doing something he likes regardless of profit. Ultimately, though, a productive venture must create value of some kind to be successful. In the case of the billionaire, we cannot call a loss-making enterprise "production" because wealth is being consumed rather than created.

Only the production of goods and services can actually create wealth, as opposed to the transfer of wealth, which is generally accomplished via government taxation. (And wealth-creation is by no means guaranteed or inevitable.) Money exists as a way to keep tabs on how much wealth exists, and to facilitate the movement of goods and services in the marketplace, but it does not in and of itself confer wealth.


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posted by Monty at 10:15 AM

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