World GDP versus Total Value of Financial Asset Market Exchanges

Here are two important statistics:

(1) World GDP (2007):
US $65.61 trillion

(2) Global annual value of major financial asset market transactions (2007):
US $900 trillion*

* This includes foreign exchange turnover and stock market trading (excluding bonds and other over-the-counter transactions).

What is significant about this?

The significance is that global GDP is dwarfed by the value of major financial asset market transactions. A vast amount of spending that occurs every year is on secondary financial markets, including markets where foreign exchange, stocks, and shares are sold.

I assume that some of this $900 trillion involves foreign exchange transactions for international trade and so on (that is, for purchases of goods and services), but it is estimated that over 90% of foreign exchange transactions are speculative. At any rate, the total value of world trade (merchandise exports plus commercial services) was about $16.9 trillion in 2007, but not all of this required foreign exchange transactions (e.g., trade between nations in the Eurozone involves countries using the same currency, the Euro). Moreover, given that over-the-counter transactions and bond trading is excluded from the estimate above, it is obviously an underestimate of the real global aggregate value of such trading.

Any economic theory that ignores this type of spending and its sector of the economy (i.e., the secondary financial asset markets) is deeply flawed and liable to be missing something fundamental about modern market economies. In any one year, money can get sucked into this world of financial asset market transactions and essentially trapped there for a significant period of time as it is used to buy and sell assets over and over again.

Spending on the secondary financial asset markets is essentially a type of transaction that does not induce employment in the way that spending on final goods and services does. Most financial assets are non-reproducible, in the sense that businesses do not hire a significant number of workers or factor inputs when demand for these assets rises (Davidson 2002: 44), for they already exist in vast quantities in many different countries.

This type of spending is also a fundamental reason why Say’s law is one of the most ridiculous ideas ever formulated by economists.

The late Frank H. Hahn pointed out why:

“there are ... resting places for saving other than reproducible assets [i.e., final goods and services – LK]. In our model this is money. But land, as Keynes to his credit understood, would have just the same consequences and so would Old Masters. It is therefore not money which is required to do away with a Say’s Law-like proposition that the supply of labour is the demand for goods produced by labour. Any non-reproducible asset will do. When Say’s law is correctly formulated for an economy with non-reproducible goods it does not yield the conclusions to be found in textbooks. As I have already noted Keynes was fully aware of this and that is why he devoted so much space to the theory of choice amongst alternative stores of value.” (Hahn 1977: 31).

As individuals become richer and richer, the less likely it is that their income will be spent on final goods and services. That is to say, the wealthy have a lower marginal propensity to consume than poor classes of people.

So what do the rich and ultra-rich mostly spend their money on? The answer is: mostly assets on secondary financial markets (either directly or, more likely, indirectly via financial institutions). This is why there is no necessary reason for Say’s law to hold true in any modern capitalist economy.

The stupidity of the assumptions behind Say’s law goes right back to Jean Baptiste Say (1767–1832) himself:

“Every producer [= capitalist] asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product; for we do not consume money, and it is not sought after in ordinary cases to conceal it: thus, when a producer desires to exchange his product for money, he may be considered as already asking for the merchandise which he proposes to buy with this money. It is thus that the producers, though they have all of them the air of demanding money for their goods, do in reality demand merchandise for their merchandise.” (Say 1816: 103–105).

When you believe (like Say) that capitalists only ever spend their money on goods and services (whether consumption goods or factor inputs for further production), it is a recipe for disastrous economic theory.

UPDATE
It occurs to me that I should have mentioned another source of non-employment inducing demand: spending on real assets with low or relatively low elasticities of production (e.g., gold).

As one moves to real assets with moderate to high elasticities of production, the story is different, of course.

Furthermore, one might reply with the question: why is it that during asset bubbles, economies tend to have booms? But the booms associated with asset bubbles tend to be driven by the modern financial system and its creation of credit to fuel asset bubbles, consumption and investment, with a positive wealth effect amongst owners of the assets whose price is rising (either more consumption out of income or credit). Capitalists are caught up in the boom via their optimistic expectations.

If in a recession demand to hold money increases and demand to hold non-reproducible financial assets also rises (by using money to buy them), we have in the latter case exactly what can be called non-employment inducing demand.

BIBLIOGRAPHY
Davidson, P. 2002. Financial Markets, Money, and the Real World. Edward Elgar, Cheltenham.

Hahn, F. H. 1977. “Keynesian Economics and General Equilibrium Theory: Reflections on Some Current Debates,” in G. C. Harcourt (ed.), The Microeconomic Foundations of Macroeconomics Macmillan, London. 25–40.

Say, J. B. 1816. Catechism of Political Economy, or, Familiar conversations on the manner in which wealth is produced, distributed, and consumed in society (trans. J. Richter). Sherwood, Neely, and Jones, London.

A Note on Prices and Say’s Law

In neoclassical theory, the equilibrium price is the price in a particular commodity market that equates the demand for that commodity with the supply, so that the market is cleared. It can be understood as a market-clearing price.

By contrast, in Classical economics, the equilibrium price (or natural price) is derived from costs of production (wages, other factor inputs, rent, and profits). That is, factor inputs are capital goods (where the return is profit), labour (the return is wages), land (rent) or raw materials (cost of purchase).

Now let us turn to how later Classical economists defined or formulated Say’s law, according to Thomas Sowell (1994: 39–41):

“(1) The total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output [an idea in James Mill].

(2) There is no loss of purchasing power anywhere in the economy. People save only to the extent of their desire to invest and do not hold money beyond their transactions need during the current period [James Mill and Adam Smith].

(3) Investment is only an internal transfer, not a net reduction, of aggregate demand. The same amount that could have been spent by the thrifty consumer will be spent by the capitalists and/or the workers in the investment goods sector [John Stuart Mill].

(4) In real terms, supply equals demand ex ante [= “before the event”], since each individual produces only because of, and to the extent of, his demand for other goods. (Sometimes this doctrine was supported by demonstrating that supply equals demand ex post.) [James Mill.]

(5) A higher rate of savings will cause a higher rate of subsequent growth in aggregate output [James Mill and Adam Smith].

(6) Disequilibrium in the economy can exist only because the internal proportions of output differ from consumer’s preferred mix—not because output is excessive in the aggregate” [Say, Ricardo, Torrens, James Mill] (Sowell 1994: 39–41).

I have pointed out before that many modern studies have concluded that it was the Classical economists Adam Smith and James Mill who had a major role in developing Say’s law, in terms of the propositions listed above, not necessarily Jean-Baptiste Say himself.

Indeed Thweatt (1979: 92–93) and Baumol (2003: 46) conclude that Adam Smith was in fact the father of Say’s law in Classical economics, and that James Mill was the first to express it properly in 1808.

What is the significance of this?

It is as follows: propositions (1) and (4) above seem to me to show the influence of the Classical price theory: the notion that the equilibrium price (or natural price) is derived from costs of production, and indeed that prices are normally or generally equal to the costs of production.

For how else it is possible to argue, as in proposition (1), that the “total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output”? If this is supposed to mean the total factor payments received before the sale of a given volume (or value) of output, there is a problem.

That Say’s law does think in terms of Classical equilibrium price is confirmed by the way that sectoral imbalances are allowed and explained by the theory:

“There could be, Say argued, a temporary glut of some commodities, but this would result from the fact that market equilibrium had not been attained. Some prices would be too low and others too high, relative to their respective long-run equilibrium prices or costs of production. In this case, there would be a glut of those commodities whose prices were too high and simultaneously a shortage of those commodities whose prices were too low. The gluts and shortages would exactly cancel out in the aggregate.” (Hunt and Lautzenheiser 2011: 137).

But already before we get to other critiques of Say’s law, it is vulnerable to the observation that this is not how prices are formed in the real world: in many markets for newly produced goods and services, especially in industrial markets, prices are administered or set by corporations and businesses, according to normal production costs plus a profit markup. Because of the profit markup, there is some degree of stability of profits that results from price administration (Gu and Lee 2012: 461). Stable profits in turn allow stable margins for internal financing of investment (Melmiès 2012).

But once the profit markup is factored into real world prices, the Classical price theory falls apart: prices in the real world are seldom the Classical equilibrium prices derived from costs of production, but the prices for many commodities exceed the costs of production. In the aggregate, the sale price of the aggregate supply of commodities will be well above the costs of production, and so the idea that the “total factor payments received for producing a given volume ... of output are necessarily sufficient to purchase that volume ... of output” before actual purchase is false. It is also false to say that in “real terms, supply equals demand ex ante [= before the event],” if by this one means that aggregate costs of production including wages or purchases of factor inputs will equal the aggregate cost of the output when purchased. The latter – the aggregate cost of the output when purchased – will exceed the total factor payments before sale.

Of course, if one wants to define Say’s law as the idea that the income from aggregate sales plus factor payments is sufficient to purchase that output in a given period, perhaps one can evade this criticism, but the point is there seems to be ambiguity about how Say’s law is defined.

Are total factor payments received for producing a given volume of output defined as ex ante or ex post payments, i.e., before or after the actual sales of those products?


BIBLIOGRAPHY

Baumol, W. J. 2003. “Retrospectives: Say’s Law,” in S. Kates (ed.), Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, Edward Elgar Pub, Cheltenham; Northampton, Mass. 39–49.

Gu, G. C. and F. S. Lee. 2012. “Prices and Pricing,” in J. E. King, The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 456–463.

Hunt E. K. and Mark Lautzenheiser. 2011. History of Economic Thought: A Critical Perspective (3rd edn.). M.E. Sharpe, Armonk, N.Y.

Melmiès, J. 2012. “Price Rigidity,” in J. E. King, The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 452–456.

Mill, James. 1808. Commerce Defended. An Answer to the Arguments by which Mr. Spence, Mr. Cobbett, and Others, have Attempted to Prove that Commerce is not a Source of National Wealth. C. and R. Baldwin, London.

Sowell, T. 1994. Classical Economics Reconsidered. Princeton University Press, Princeton, N.J.

Thweatt, W. O. 1979. “Early Formulators of Say’s Law,” Quarterly Review of Economics and Business 19: 79–96.

Jean Baptiste Say on Failures of Aggregate Demand

In modern formulations of Say’s law (or the “law of markets”), there are two main variants of it, as follows:

(1) Say’s Identity
According to Baumol (1977: 146), this

“is the assertion that no one ever wants to hold money for any significant amount of time, so that, as a result, every offer (supply) of a quantity of goods automatically constitutes a demand for a bundle of some other items of equal market value.”

(2) Say’s Equality
Again, according to Baumol (1977: 146), Say’s Equality

“admits the possibility of (brief) periods of disequilibrium during which the total demand for goods may fall short of the total supply, but maintains that there exist reliable equilibrating forces that must soon bring the two together.

Say’s Identity requires that no failures of aggregate demand can occur, as money is not held for significant periods of time and factor payments from aggregate supply are spent in aggregate demand (either in consumption or investment). Thus in particular commodity markets there might be excess supply, but overall there is “zero value of the sum of excess demands” (Kates 2003: 45). It appears that James Mill and John Ramsay McCulloch both used Say’s Identity and Say’s Equality in their writings (Blaug 1996: 150).

There is a question here about whether Jean Baptiste Say ever expressed his “law of markets” as Say’s Identity. This is complicated by the fact that there was more than one edition of his Treatise on Political Economy. The second edition of the Treatise on Political Economy was published in 1814 and has a revised version of Say’s law (Baumol 1977: 147), while in the first edition the law of markets is not nearly so complete. It was only in the second edition of the Treatise on Political Economy (1814) that Say’s discussion is identifiable as a “form of a type of Say’s equality, i.e., supply and demand are always equated by a rapid and powerful equilibration mechanism” (Baumol 1977: 159). Indeed, Jean Baptiste Say even criticised Ricardo for using a version of the law of markets we would recognise as Say’s Identity (Blaug 1996: 150). The second version of the law of markets – Say’s Equality – is obviously a far weaker version of it, for it admits the possibility of short term failures of aggregate demand, even if a long run inequality between aggregate supply and demand is denied.

A relevant passage by Jean Baptiste Say on this issue occurs in one of his letters to Malthus:

“Mr. Ricardo insists that, notwithstanding taxes and other charges, there is always as much industry as capital employed; and that all capital saved is always employed, because the interest is not suffered to be lost. On the contrary, many savings are not invested, when it is difficult to find employment for them, and many which are employed are dissipated in ill-calculated undertakings. Besides, Mr. Ricardo is completely refuted not only by what happened to us in 1813, when the errors of Government ruined all commerce, and when the interest of money fell very low, for want of good opportunities of employing it; but by our present circumstances, when capitals are quietly sleeping in the coffers of their proprietors. The bank of France alone possesses 223 millions of specie in its chests, more than double the amount of its notes in circulation, and six times what it would be prudent to reserve for the ordinary course of its payments.” (Say 1821: 49; it was also published in New Monthly Magazine, Volume 14 [1820, October 1], p. 368ff.).

What we have here is:

(1) a recognition that money savings will not necessarily be invested in capital goods and that an aggregate demand failure has occurred;

(2) “many savings are not invested,” a rudimentary insight not far removed from Keynes’s theory of liquidity preference.

All that needed to be added was an analysis of the role of demand for money used in speculation on secondary financial asset markets for liquid assets as a store of value and subjective expectations in the investment decision.

BIBLIOGRAPHY
Baumol, W. J. 1977. “Say’s (at Least) Eight Laws, or What Say and James Mill May Really Have Meant,” Economica n.s. 44.174: 145–161.

Blaug, M. 1996. Economic Theory in Retrospect (5th edn). Cambridge University Press, Cambridge.

Kates, S. (ed.), 2003. Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle. Edward Elgar Pub, Cheltenham ; Northampton, Mass.

Say, J. B. 1821. Letters to Mr. Malthus: On Several Subjects of Political Economy, and on the Cause of the General Stagnation of Commerce. To Which is added A Catechism of Political Economy. Sherwood, Neely, and Jones, London.