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Say’s Revenge

June 13th, 2009 by Jim May · 12 Comments · Business

This post was born as a huge comment to Myrhaf’s post here.

As Milton Friedman correctly wrote, inflation is always and everywhere a monetary phenomenon. By extension, therefore, so is deflation — which is why, contrary to mainstream economists, we are not in a truly deflationary period at present, insofar as there is no reduction in the supply of *money* that has happened over the last two years. Rather, it is demand destruction that has been happening, and that’s a horse of a different color.

The root of the confusion is ignorance of Say’s Law. Essentially, Say’s Law says that production of goods constitutes the demand for the other goods in an economy.

If I produce a widget that others in the market find desireable, I can trade it for the things they have that I want. The more desireable my widget is, the greater the value, and the greater the demand my production represents.

“Money” is not special as far as Say’s Law is concerned. Money is a particular commodity that, by virtue of certain characteristics — durability, high value (compactness), fungibility, divisibility etc. — serves as a store of value and as a medium of exchange, and is therefore chosen as common denominator of value.

Apart from that, prices are understood as the exchange ratio between the particular commodity designated as “money”, to all the other goods in the economy, are determined by supply and demand of *each* of the goods involved in a transaction.

Where things go off the rails, is that fiat money is an artificial commodity; that is, it has no innate utility, and extremely fluid supply. Wood, for example, has utility independently of its market value; if wood were sufficiently common, it would have no market value — it’s price would be “free” — but it nevertheless retains value as construction material, fuel for fires etc. All “real” commodities have utility, including gold; this is the root of gold bugs’ claims that gold can never drop to zero value.

According to Say’s Law, if I create widgets of a given utility, I am presenting increased demand to the market. If I make a lot of them, this has two effects, each the mirror image of the other.

The first is that my increased production, qua increased *demand*, pushes up prices of all other goods in the economy; to the extent that more goods are traded for my widgets, there are less goods available to be traded for other things in the market.

The second is that my increased *supply* of these widgets, drives my price down; my profit per widget is reduced.

However, the actual utility of each widget DOES NOT CHANGE. The $10 widget of today is the same as the newfangled $100 widget of last year. (This is not accounting for innovations that increase the utility, or decrease the cost, of the widgets). The net result is that all market participants are better off for having my widget, and this is the net increase in *genuine wealth* that I have brought about by means of producing items of genuine utility; that utility is what drove demand for my product.

Fiat currency, however, while it behaves the same in the market, has no utility (apart from the physical commodities involved in coins and bills) — and that is what makes it so dangerous as a store of value.

Normally, if someone produces something that has no utility or value, nobody will want it. It adds no wealth to the economy, and so there is no market for it. This is what the government is doing — producing something of no utility: dollars.

However, it has forced the issue via legal tender laws. By forcibly inserting this artificial commodity into contracts as money — as the denominator of value — the government attempts to repudiate and subvert Say’s Law.  Legal tender laws are an attempted substitute for utility.

Now, once that is done, fiat currency can and does work just fine as money (as a means of exchange, to be specific). To the extent that each one of us trades goods or services for dollars, those dollars do in fact stand for the value of these goods and serves, *so long as the market demand for them does not appreciably change between the point of acquisition and the point of spending. That is the problem with fiat currency, which the mainstream insists is a feature, not a bug: the government has the power to radically ramp up supply of its “good” by multiple orders of magnitude more speed than the rest of us can ramp up the supply of *our* actual goods in the economy!

This has multiple consequences.

The first one is confiscation, as detailed by Ayn Rand in “Egalitarianism and Inflation”. Imagine that gold was money, but that the government had the magical ability to suck it away from you, right out of your vault. Every year, there would be 4% or so of it gone. This is what inflation is doing; when the government boosts the money supply by 4%, it comes out ahead by the amount of the wealth “purchased” by that increased “demand”, while the value of the dollars that you have in your possession shrink by the same amount.

Note that the amount of value that you put into earning those dollars, however, did not change! You still put in 8 hours, or sold X amount of a good, to get it. The government has essentially stolen 4% of your created wealth. That is the function of fiat currency, the “back door” created by the legal tender laws.  All the supposed benefits of fiat inflation — in particular the reduction of dollar-denominated debt — is in fact the amelioration of debt and the artificial increase of market demand, at the expense of savers.

It should be noted that, since it is dollars that are being devalued, that those who are able to hold hard assets as hedges against inflation are NOT in fact coming out “ahead”.  If they saved in gold, for example, they have X ounces now, just as they did then. The price of those ounces went up, but so did the prices of whatever they can buy with those extra dollars they would realize from the sale.   This is how gold and hard assets protect wealth; they lack the “back door” of fiat currency, and are immune to confiscation by inflation. (The government has to use more overt and direct means in those cases).

The second one is just as bad; this is where Say’s Law avenges itself. This is why we are hearing all about “deflation” today, and why that is horribly wrong.

Remember that all the goods in the economy actually are goods — i.e. they are things with utility — except one: the fiat currency. The market does not acknowledge the difference (it is forbidden to do so); the fiat currency acts as an artificial commodity, as a demand factor just like all the other goods in the economy. This, however, is a subterfuge: the fiat currency, unlike all genuine goods, does not find its genesis in the creation of actual wealth. It does not, therefore, satisfy the conditions of Say’s Law. New fiat currency represents artificial demand; it masquerades as wealth, but in fact there is nothing there. The government does not create wealth when it creates money.

While market participants are legally forbidden from refusing fiat currency, they are nonetheless free to adjust to the supply changes.  Its only way to account for the loss of wealth is via inflation — i.e. by the transfer of wealth from holders of older dollars paid for by actual wealth creation, to those who hold “new” dollars created from nothing. This is the dilution that underlies inflation, and the source of the “false demand signal” that causes misallocation and misdirection of wealth in the economy.  This is why now, as in the Depression, we have the symptom which mainstream economists see as the problem: frozen wealth in the form of excess inventory of certain goods.

Now examine our current situation. What has been happening is that the bursting of the housing bubble has been destroying real wealth. Essentially, if you traded a net amount of real wealth for a house, then the value of that house dropped by half, you have lost half your net worth by misallocation — you paid too much, and half of that wealth is now “frozen” in the house (which retains its utility). Essentially, the false demand signals that came from earlier inflation by government, drove perceived value of houses far above their proper level, in regard to the actual value a house represents. Artificial demand, in the form of new dollars released by cheap credit, bid up the prices of houses, attracting a flood of both new and old dollars (which represented real wealth created by those who earned them) into the real estate market, by far the best performer at the time the new dollars entered the economy after 9/11.

When the bubble burst, while the amount of dollars around remained the same, the amount of real wealth dropped precipitously — frozen in the physical form of excess houses. Frozen wealth is essentially wealth whose utility is far less than its price — so nobody buys it; it presents no demand for any goods. This is demand destruction, the subtraction of the demand emanating from *real wealth*, from the economy.

Demand destruction is the root of the current recession; it represents the economy suddenly realizing that there is far less wealth — and therefore less real demand — than was previously thought. It is essentially a correction of the error induced by the false demand signal caused by the earlier creation of money by the government.

Because of Say’s Law, this destruction of real wealth translates into a reduction in real demand. This is why prices have not risen — and that is why mainstream economists are calling our current situation *deflationary*. Now remember that mainstream economics, unlike those of the Austrian school, do not distinguish between real wealth generation and the creation of fiat currency.

This failure is why people are applying the term “deflation” — a reduction in the money supply — to what is actually a reduction in real wealth. This is why individuals across the political “spectrum”, from Reason’s Steve Chapman and Glenn Reynolds to conservative and leftists economists alike — are calling for actual inflation — an increase in the money supply. They are blind to the fact that an increase in the money supply is not an increase in real wealth, and therefore is not an offset to what they are calling “deflation”.

This is why prices must rise, and why we are in for at least a decade of impoverishment — via 1970’s inflation at a minimum. They are essentially attempting to replace real demand (from real wealth production, now lost and/or frozen) with the artificial demand of new dollars. Since new dollars have no utility, the amount of real wealth in the entire economy will remain reduced — but the apparent market demand, augmented by the new dollars, will be higher than it should. This is what started the whole thing!

Do you see the insanity now, of the make-work projects and deliberate supply reductions of the New Deal?  Do you see why the only difference between then and now, is the presence of fiat currency — that we’ll see inflation instead of depression, but the net impoverishment across the whole economy will be the same?

More dollars chasing fewer goods (because of lowered production of goods and services following from the earlier demand destruction) will boost prices, suck more wealth from savers into consumption — which is more actual wealth destruction — eventually leaving us all much poorer.


A final addendum, in regards to the extent that government does not inflate, it can borrow, or raise taxes.

Borrowing only serves to delay the inflation, since the fund must be repaid, eventually — and the greater debt is an added incentive to inflate. It is worth noting that the German hyperinflation of 1923 arose because of the German government’s obligations to foreign governments under the Versailles Treaty; it simply printed marks to make payments.

Taxation speeds the impoverishment up, by direct confiscation.

The end results are the same.

12 Comments so far ↓

  • Myrhaf

    Great post, Jim. I know Richard Salsman has opposed Greenspan’s deflation in the past. I wonder what he is saying about the current economy.

  • Daniel Woelfel

    “It should be noted that, since it is dollars that are being devalued, that those who are able to hold hard assets as hedges against inflation are NOT in fact coming out ‘ahead’. If they saved in gold, for example, they have X ounces now, just as they did then. The price of those ounces went up, but so did the prices of whatever they can buy with those extra dollars they would realize from the sale. ”

    The lesson to be learned here it to get leveraged with futures and options. Spend $2000 on gold today, and you control about 2 ounces of gold. Deposit $2000 with an online broker like thinkorswim, and you can control about 32 ounces of gold.

    You could also short treasury security futures, since they are very sensitive to interest rates.

  • rob sama


    Daniel, you’re correct, assuming that there aren’t counterfeit shares floating around out there, introduced to the market by means of naked short selling. But since there are, I would be wary.

  • this is the samaBlog » Blog Archive » Say’s Law

    […] Jim May has written up an excellent analysis of our current economic situation, showing how we’re in an inflationary period, despite what popular economists say. Be sure to read the whole thing. […]

  • Rajesh Dhawan

    Excellent article, Jim. A much required explanation for a hugely misunderstood concept.

    Another destructive effect of Inflation is on the company inventories which is evident once the inflation is stopped or slows down. Inflation which encourages spending of cash to buy more inventory for sales fueled by excessive cash.

    Once the interest rates rise and the sales slowdown, it reveals widespread losses in form of unproductive inventory invetments.
    (source: Treatise of Capitalism, Reisman)

  • Jim May

    Rajesh: yes, that is what I was describing with the term “misallocation”. Currently, the big unproductive inventory weighing everything down right now is houses.

    I’m in Las Vegas now, and spent the weekend house-browsing…. the available bargains here are just shocking (especially by contrast of coming here from California). Were it for sale, I could probably buy the same house I bought here in 2001, for less than I paid in 2001.

  • John McVey


    You are implying that money is *only* the notes and coins in circulation, be they either proper banknotes and real gold coins or irredeemable Reserve notes and junk Treasury coins. That is debatable.

    When fractional reserve banking exists (I’m not looking for yet another argument about the virtues or otherwise of *that*) there is also what von Mises called “fiduciary media”, consisting of bank accounts out of which one can issue cheques or make direct transfers from without using notes and coins. The amount of fiduciary media can fall as a result of increases in reserve ratios or the destruction of deposits through bank failures, independently of changes in the base money supply. I argue that fiduciary media are part of the money supply – technically, that “M1” is the best conceptual measure of it.

    Equally debatable then is whether an increase in fiduciary media constitutes a type of inflation and a decrease a deflation. I’d argue that when government controls the base money and is giving support to banks et al then yes, they are. If no such government support existed then no, they wouldn’t be. Without government intervention there would be just the normal market forces in relation to credit and risk-management.

    We’ve had both increases in reserve ratios and spates of bank failures recently, so I don’t think recent prices history comes from destruction of demand for goods alone. This means the mainstream economists you cite are partly right on that score. That being said, your post was a good explanation of a real monetary phenomenon and which does warrant thorough consideration. Thank-you for that.


  • Daniel Woelfel

    “Daniel, you’re correct, assuming that there aren’t counterfeit shares floating around out there, introduced to the market by means of naked short selling. But since there are, I would be wary.”


    The futures market deals in contracts, not shares. It is impossible for there to be counterfeit contracts in the futures market. It takes two parties to make a contract, so for every seller there has to be a buyer.

    Investopedia has a good introduction to futures here:

  • Jim May

    John writes:

    “You are implying that money is *only* the notes and coins in circulation, be they either proper banknotes and real gold coins or irredeemable Reserve notes and junk Treasury coins. That is debatable.”

    I don’t see where I did that, but I do not consider the money supply as being restricted to physical currency. I here mean “money” as any and all things that exist as dollars, including time deposits etc. M3 is the closest approach to what I mean.

    The trick here is that money can exist and be created “inside the system” separate from the econopmy. The Fed could “give” every bank a trillion dollars today, and take it away tomorrow, and we would not experience price rises as a result.

    The problem is that I have several reasons to believe that the Fed will not be able to un-create that money.

    The first, is that it is being used to fill the holes on bank balance sheets — holes caused by the destruction of real wealth. When the bank forcloses a $300k mortgage on a house now worth only $150k, and nonetheless isn’t selling, the bank is out that $300k — $150k lost in a depreciating asset, and the other $150k frozen.

    The actual $300k in dollarsthat was originally lent, however, still exists — in the account of the original seller. Therefore, contrary to the mainstream view, those dollars were not lost — but real wealth WAS lost — or to be more precise, that additional $150k of “value” in the house was an illusion.

    That’s the point I made here: that the “deflation” we are seeing is a consequence of the fact that the loss in the house was of real wealth — that is, the house buyer traded $300k *earned* dollars, whether it was his own or a bank’s.

    This destruction of real wealth is what is dropping prices. Not “deflation”.

    Now here’s why I don’t believe that the Fed can or will retrieve those dollars: to the extent that the government is replacing those dollars lost in foreclosures — representing what was real wealth — with new dollars that represent nothing, they are necessarily increasing the money supply relative to the available goods.

    We don’t see the effect yet, because the loss of wealth in housing — and the ripple effects thereof, including the recession and the huge drop in available credit — is the dominant factor by far in the overall economy. Those big profits from house sales and home equity loans are gone.

    But nonetheless, in particular if you bank at Bank of America or at any of the failed banks over the last two years, some of those new dollars were the ones that were used to insure your checking account. So some of the new money is already leaking into the conomy now, and will not be retrieved.

    Eventually, once the economy adjusts to the demand destruction, by cutting inventories, shutting factories and closing stores, prices will rebalance to previous levels. Except now, there will be the false extra “demand” from the new money that has leaked into the economy to date — pursuing a supply of goods reduced to accomodate the recession.

    What happens next depends on how much of the new “inside” money has already escaped. IF a lot of it is out, the inflation will be big and sharp; if it leaks out more slowly, it will run longer. Either way, I do not expect to see much, if any, “soaking up” by the Fed, simply because that would be actual deflation — and so long as people insist on seeing deflation where there isn’t any, adding actual deflation to the mix — or ramming up interest rates in the Paul Volcker approach — just won’t be politically feasible.

    After all, it took a decade of this sort of thing before we were ready for Volcker. You won’t see it during an Obama term, that is for certain.

  • John McVey

    I thought you were implying it when you denied us having been in a deflationary period. I saw that you were decrying mainstream economist’s idiotic equation of inflation with price increases and deflation with price decreases, that you then excoriated them from claiming deflation because of actual price decreases, and then said that the real reason for price decreases was demand destruction.

    By extension I thought that by denying us having been in a deflationary period you were implying that fiduciary media weren’t part of the money supply and only notes and coins were. Notes and coins have indeed been in an inflationary mode for decades non-stop other than for a dip that offset the Y2K-related spike in demand for money, but fiduciary media have moved differently. I took what you opened with to mean that we “haven’t been in a deflationary period *at all* recently”, but if your real point was that “we were but aren’t any more, despite what the mainstream economists say” then I do apologise.


    Using economic terminology, in essence what you’re claiming has happened is that total money has still been increasing but its velocity has collapsed because the overall economic demand for money has increased via a convoluted game of musical chairs involving who owns what money and who’s doing what with it. That game was made possible by malinvestment becoming manifest (which is the destruction of real wealth as you write about) and government responses to this such as the disastrous mark-to-market edict (more destruction), FDIC payouts and bank bailouts (yet more destruction). Demand for money is high because the banks are holding on to the cash – they aren’t lending as high a proportion of these reserves as they use to because of concerns about asset prices and that damn edict. For that reason prices and quantities sold have fallen accordingly, which is your retail-level demand-destruction causing price-reductions, which via that damn edict turned into a vicious cycle that the Fed responded to by further jacking up the quantity of notes and coins.

    Additionally, since the vicious cycle may have abated, the exact nature of that game of musical chairs presents a coming problem because when velocity rises back to normal levels (ie as banks lend and people spend) it will also be accompanied by a catastrophic increase the money supply through falls in reserve ratios, unless the Fed claws back that increase in the money supply either by pulling a huge amount of notes and coins back out of use or mandating reserve ratios higher than they had previously been. You (and Laffer, and I) then doubt the Fed’s and current administration’s willingness or ability to do that. I’m just old enough to remember the anguish of the early 80’s, and I expect worse than that coming.

    I’m in perfect agreement with that as an explanation (and again, thank you for specifying it), leaving only the questions of what you meant by us not being in a deflationary period and in turn whether your claim about the money supply actually not decreasing is in fact true. According to the St Louis Fed, M1 had been flat or slightly down-trending since Nov 2004 and only increasing after Sep 2008 just as Laffer noted. That’s a nearly-four-year (just barely) deflationary period ending less than 12 months ago. I also apologise for how a quibble like that has turned into a considerable exposition.


  • Jim May

    JJM: that’s OK, I appreciate your comments; in my response I was able to fill in some additional details about how the new dollars are slowly leaking out already, and why I expect much more of it to follow.

    I remember back to the mid-70’s, and wondering when and if all those layoffs and monster mortgage rates would hit my family; fortunately, my parents were more than halfway through paying off a fixed-rate mortgage that began in 1966 (inflation actually ended up doing them a favor there), and my dad had just enough seniority at his factory job to make it to retirement in the mid 90’s.

    I have heard it said from a few sources that there was indeed a deflationary period during the period of 2004-2008 that you mention — but the CPI never reflected that. I’d be interested in knowing what M3 or my concept of “total dollars” was doing during that time. I suspect that in the same manner that demand destruction is masking inflation now, the growing real estate bubble and the consequent (false) “wealth effect” were masking the (tiny) deflation then.

    If I recall correctly, the Fed did actually try to bleed off excess dollars from the post 9/11 surge (the base interest rate was raised to 5% or so). That they did so at too slow a rate to matter indicates why I expect them not to retrieve this surge either. If they lacked the nads to do it when times were ostensibly good and with an unpopular sitting president, they surely won’t do it when times are bad and Obama is in the White House.

    Lastly, an additional point I’d like to bring up, is that ” a dollar is a dollar”; when new dollars commingle with old ones in trade, the dilution is a fait accompli, because once that happens, the dollars are now real wealth to someone (pending the subtraction from ALL dollars in circulation as a result of inflation.) This is a big reason why it’s hard to undo money supply increases. Suppose that the Fed gave you $1000 in new money, and you bought a bigscreen TV with it, putting it into circulation. Do you think the store is going to give that money up if the Fed came knocking? Who is supposed to give up their *earned* dollars in order to shrink the money supply? Once spent, the dollars have value, and retrieving them is outright theft of real wealth (of the TV in this case), by the exact same mechanism as with counterfeit money.

    The Fed could try to get it back from you, but that effectively makes it a loan. If you spent the money, now you have a debt of $1000 to the Fed which you can only pay from current or future earnings (wealth creation). This is why I don’t accept credit expansion as necessarily inflationary; the $1000 apparently bump in the supply is eventually drawn down by the repayment. The apparent demand created by the credit, is eventually matched by a drop thereof when you repay the loan.

    The only difference between this hypothetical Fed loan and a normal bank loan is that the bank normally makes loans out of real wealth (deposits) lent to it by others who have earned it. That’s not inflationary either. This even remains true to the extent that the bank borrows from the government, so long as the government dollars come out of theft (taxation) or from borrowing.

    But if the bank fall short and the government falls short (watch that bond market, and taxes!) and the Fed prints up the missing amount… it’s inflationary again. As I understand it, fractional reserve banking simply increases the risk of default, and therefore of the Fed creating dollars to shore up banks and/or replacing destroyed deposits after a collapse via the FDIC.

    In all cases, no matter how byzantine the path that the new dollars take or how long the delay before the new dollars circulate, or in what context they circulate, or how they fudge the numbers…. inflation can only come from the central bank. Changes in the price level from market factors (such as oil prices) is just ordinary supply and demand, and cannot be “inflationary”; inflation and deflation pertain solely to specific monetary causes of such effects.

    I just wish I’d bought up gold when I first began to suspect a repeating pattern in 2004, with the Iraq War and Medicare part D echoing Vietnam and the Great Society.

  • John McVey

    I forgot to add in why “Revenge of Say’s law” was an excellent title. The malinvestments lead to a destruction of ability to supply by the resources being largely directed to consumption instead of productive endeavours, with the bits that were direct to production being in the wrong fields (Heaven help the poor Chinese…). That destruction of ability to supply translates to a destruction in the ability to demand, hence the reference to the revenge of Say’s Law is the perfect summation of why real incomes are down. What converts it into also falling prices (the alleged deflation), though, is the sharp increase in demand for money leading to the sharp decrease in velocity.


    As to what’s coming, I think it will be bad, but not quite the “YIKES!” Laffer has in mind. A fair chunk of the new money was dished out via the TARP etc loans and equity purchases. When the banks pay the loans back they will do so in that money, which the Fed can just park. I don’t think that would require much in the way of nads, just people making a bit of noise about retaining Fed independence. Many banks have already indicated that they want to make repayment, too. Likewise when people spend money to buy corporate equity back from the government. If all that proceeds normally then for the most part what we’ll see is a magnified version of the Y2K spike/dip cycle, less what differences arise in the prices of the stocks traded.

    What concerns me more is the cash that was dished out as FDIC payments and the like. That was a direct issue of property and does not have matching liabilities – there is no non-theft means of permanently retiring the cash because there is no debt to take repayment on. This is where Fractional Reserve Banking comes into it. The pre-failure deposits were fiduciary media, which the failures plus FDIC payouts have converted to notes and coins. That’s a main element of that game of musical chairs. When the finance world returns to normal and reserve ratios fall back to recent historical norms, it is the cash from this source that’s going to be multiplied up by the gigadollar into more M1 and M3, via the FRB process, as people’s and banks’ respective demands for cash recede. I don’t know enough to put figures on how much and when.

    The only ways to make the cash flow one-way out of circulation is either far higher taxation or interest rates as you note, or more intervention by way of mandating higher reserve ratios. The govt can’t raises taxes or the Fed raise interest rates high enough without causing enormous revolt, so the third would be the least undesirable – but also the least likely because that would see the banks getting hammered for ‘withholding credit from needy borrowers’ and then made victims of a repeat of King Charles I’s raid on merchants’ deposits in the Tower of London in 1640. Thus, get ready for CPI increases PLUS higher taxation and interest rates.