The Phaserl


Guessing the Future Without Say’s Law

by Alasdair Macleod, FinanceAndEconomics:

With Japanese and Eurozone interest rates becoming increasingly negative, and the Fed backing off from at least some of the planned increases in the Fed funds rate this year, economists are reassessing the interest rate outlook.

Economists lack consensus, with some expecting yet more easing, based on the apparent collapse in cross-border trade last year. The fact that the Bank of Japan and the European Central Bank see fit to pursue increasingly aggressive monetary reflation is taken as evidence of underlying difficulties faced in these key economies. And lingering doubts about the sustainability of China’s credit bubble point to a high risk of a credit-induced slump in the world’s growth engine.

Other economists, citing official US data and relying on the Fed’s statements, point out that unemployment levels have more than satisfied the Fed’s target, and that core inflation has picked up to the point where the Fed would be fully justified to increase interest rates over the course of this year, or risk overheating in 2017.

These two opposite camps conflict in their forecasts, but where they fundamentally differ is in expectations of future economic growth. Far from displaying the highest levels of macroeconomic discipline, their diversity of opinion should alert us that their forecasts may lack sound theoretical foundation. The purpose of reasoned theory is to reduce uncertainty, not promote it. And the explanation for most of the failures behind modern macroeconomic thinking is the substitution of market-based economics by economic planning.

The fact that today’s macroeconomics dismisses the laws of the markets, commonly referred to by economists as Say’s law, explains all. Subsequent errors confirm. The many errors are a vast subject, but they boil down to that one fateful step, and that is denying the universal truth of Say’s law.

Say’s law is about the division of labour. People earn money and make profits from deploying their individual skills in the production of goods and services for the benefit of others. Despite the best attempts of Marxism and Keynesianism along with all the other isms, attempts to override this reality have always failed. The failure is not adequately reflected in government statistics, which have evolved to the point where they actually conceal it. So when an economist talks of economic growth being above or below trend, he is talking about a measure that has no place in sound economic reasoning, and that is gross domestic product.


Gross domestic product in its current form is a relatively recent invention, dating from the 1930s. It was a gift to state-sponsored economists, needing a statistical justification for perfecting their theories of management of the economy. At last, here was a means of measuring the effects of economic policy, and therefore to adjust its future implementation based on evidence. The inconvenience of having to pander to markets had been dealt its final blow. Or so it was thought.

GDP comes in various guises, but for our purposes, we can define it as the total monetary value of recorded and eligible transactions between two points in time. It tells you nothing more. It does not tell you anything about the reasons for those transactions. It tells you nothing about the future. Economists, politicians and laymen who talk of economic growth miss this point entirely. What GDP does tell you, and only tells you, is how much money has been spent on new products included in the statistics. And, assuming there is no change in the allocation of total spending between qualifying and non-qualifying items, the limitation is simply the total earnings and profits of individuals and businesses applied to the purchase of those products. This is not to be confused with economic progress, which is an entirely different thing.

So ingrained is the belief that growth in GDP is a desirable objective, that it is akin to heresy to point out its utter meaninglessness. Assume for a moment that the GDP statistic captures all economic activity in a community, conventionally a nation state. Let us also assume that the quantity of money and credit is fixed, neither expanding nor contracting. And let us also assume that the trade balance is always zero. Therefore, all money earned, or made through profits, is spent or saved. Savings are deferred consumption, and through financial intermediaries, invested by businesses in capital goods and working capital. Logically therefore, the following must all be true:

All consumption is funded by income, whether it comes from salaries, entrepreneurial profits, income and profits on savings, or government benefits and subsidies.

All government spending must be financed by taxes or domestic savings. In other words, if the government increases its spending it must be at the expense of the non-government sectors. Therefore, an increase in government spending does not increase GDP.
Imports are paid for by exports.

Prices are free to reflect changes in demand for money, and changes in demand between different goods and services.

It is now be obvious that GDP cannot change from one period to the next. An economy under these conditions is free to evolve, respond to consumer and investment demands, to progress, all with zero “growth”. Therefore, growth in GDP can only be an increase in the quantity of money deployed, and it cannot be anything else.

This was broadly the situation when gold was money. Broadly, because there was also the cyclical effect of bank credit, which was formalised by the UK’s Bank Charter Act of 1844. At least it evened out over the cycle, and despite the ups and downs of bank credit, the British, European and American economies progressed, as consumers were offered and acquired improved goods throughout the industrial revolution, at least until the disruption of the First World War. This empirical example, which is fully explained by sound economic theory, confirms that the substantial leaps in economic progress at that time could not be quantified by GDP.

This is not to say that disruption in the rate of economic progress does not cause changes in GDP in a fiat currency environment. But the relationship between changes in GDP and true progress is not predictable and is wholly unsuited as an economic indicator.

Having established that GDP is simply a measure of the quantity of money spent on goods and services specified in the statistic, and nothing more, the basic goal of modern economists in a world of unlimited fiat currency is exposed as meaningless. This mistake is a source of considerable error, not only among policy-makers, but commentators as well.

The Fed has accepted this by default, because it does not target GDP. Instead, it operates a dual mandate of price inflation and unemployment, as proxy indications for advance warning of when monetary stimulus should be moderated. And here again, the use of these statistics is no substitute for a proper understanding of price formation and the forces that drive employment. So we shall look at these in turn.

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