Floors vs Corridors: Just How Does the Fed Set Interest Rates?

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8 MIN READ - The Cautious Optimism Correspondent for Economic Affairs gets extremely eggheady with a peek behind the curtain at the Federal Reserve’s internal financial plumbing.

Corridor vs Floor Operating System Visual Aid

(Note: the following is by no means an endorsement of the Federal Reserve’s operating system or of the Fed itself)

Americans have recently been greeted by another headline that the Federal Reserve will hike its policy rate by yet another three-quarters of a percentage point to a “range of 3.0%-3.25%.”

Most people know this means interest rates on everything at their local bank or credit union—from mortgage loans to auto loans to credit cards—will go up too.

But how exactly does the Fed raise the interest rate that private banks charge, and how does it enforce its policy “Fed Funds” rate to keep it between 3.0% and 3.25%?

Does the Fed send out “interest rate police” to America’s 5,000 banks and force them daily to lend at whatever rate the Federal Open Market Committee demands?

Obviously that would mean the creation of a coercive police state at America’s banks and would be ugly, manpower-intensive, and expensive so the Fed utilizes a different mechanism using incentives known in monetary parlance as an operating system.

RESERVES

Central banks around the world generally employ either of two monetary policy operating systems: corridor systems and floor systems.

The majority of the world’s central banks use a corridor system. The United States is an exception in that it uses a floor system, although the USA also operated a corridor system until the Bernanke Fed converted to a floor system during the 2008 financial crisis.

A corridor system can be thought of as a “scarce reserves” system whereby the central bank makes a small amount of reserves available to the financial system and encourages banks to lend out nearly as many of those reserves as is legally allowed (traditionally 90%). A floor system can be thought of as a “plentiful reserves” system where the central bank overloads banks with reserves but limits the amount of reserves they lend.

And what exactly are reserves? 

Before 1914 they were gold coins, which fractionally backed the paper currency and deposit accounts of private banks.

The establishment of the Federal Reserve System in 1914 granted the central bank a monopoly on the issuance of “paper reserves”—Federal Reserve notes and commercial bank deposits at the Fed itself—although the Fed was still required to back its own paper reserves with gold by at least 40%. Therefore, the quantity of reserves the Fed could create was still limited.

Finally in 1971, when Richard Nixon severed the last remaining connection between the paper dollar and gold, reserves became “fiat.” There was no longer any limit on how many reserves the Fed could create which explains why the money supply has grown by 3,300% since 1971 while the price level has risen by 641%. Both would be impossible under a gold reserves standard.

And how do banks get reserves? They sell paper assets to the Fed—usually Treasury securities and recently also agency-backed mortgage securities—and receive an increase in their reserve balances at the central bank (hence the frequently employed term: “Federal Reserve asset purchases”).

CORRIDORS

At any given time some banks lend out all the reserves they legally can, injecting new checkbook money into the economy and expanding the money supply. However other banks may not find as many lending opportunities in their markets and hold onto idle—or what Fed officials call “excess”—reserves.

A bank that is “loaned up to the limit” may want to borrow excess reserves from another bank to lend more and increase its profits. The rate which borrowing banks pay excess reserves banks is known as the “Federal Funds rate,” the policy rate that the Fed controls.

Which leads us to the inner workings of operating systems.

As we stated before, Fed police don’t run out to every bank with guns and say “You’d better lend those excess reserves at 3.0% or else.” 

Instead the Fed uses incentives. And under a corridor operating system it uses two more “administrative” rates of its own to guide the Fed Funds interbank rate to its desired target. Those are: the Fed Discount rate and the Interest on Reserves rate (IOR).

(see above chart, left)

The Discount Rate is the rate which the Fed charges banks to borrow reserves from the Fed itself.

The Interest on Reserves rate is the rate which the Fed pays private banks to hold their reserves at the Fed instead of lending them out.

The two rates create a “corridor” which limits the upside and downside of what banks will charge one another in the Fed Funds market.

How do the two administrative rates define those limits?

At a slightly simplified level, if the Fed Funds rate is 3.25%, no borrowing bank will pay more than 3.25% to another bank for reserves because it knows it can always get reserves from the Fed for 3.25%. Why pay another bank 4% for reserves when you can get them from the Fed for 3.25%?

If the Interest on Reserves rate is 3.0%, no lending bank will accept less than 3.0% interest from a borrowing bank for use of its reserves. Why risk lending your reserves to another bank for 2.5% when the Fed will pay you 3.0% to do nothing?

The Fed also changes the quantity of reserves in the system through asset purchases or sales to affect the Fed Funds rate, but the Discount and IOR rate define the “corridor” itself.

FLOORS

Under an “ample” floor system the Fed floods the industry with lots (trillions of dollars) of reserves.

In 2008 the Fed was worried that panicking bank customers might rush to withdraw their cash in a classic Great Depression style bank run.

Since the industry was on a “scarce reserves” corridor system at the time such a spike in withdrawals could cause banks to run out of reserves and fail. 

Hence the Bernanke Fed went on a giant asset purchase spree and loaded the banks up with trillions of dollars in reserves to telegraph a message to the public: “Your bank has plenty of reserves now and can convert them to cash at any time. Between that and federal deposit insurance there’s no need to panic and pull your money out.”

However with trillions of dollars in reserves the banking system could easily create a major inflation if it loaned even a fraction of those new reserves out.

Hence the Fed adopted a “floor” operating system using a single administrative rate: the Interest of Excess Reserves (IOER) rate 

(see above chart, right).

The IOER rate is the rate the Fed pays banks to keep their excess reserves sequestered at the Fed instead of lending them out. And a bank will not lend its excess reserves to either the public or another bank for less since it knows it can always earn IOER interest from the Fed—at zero risk and zero maturity no less, the safest interest rate there is—safer than U.S. Treasuries.

Hence the IOER rate provides a “floor” which the Fed Funds rate cannot fall below.

To keep banks from buying other paper assets with their excess reserves the Fed pays an IOER rate slightly higher than that for competing short term securities like 1-month and 3-month Treasuries (see chart).

While the Bernanke Fed did want banks to lend reserves to support economic recovery, it always sought to limit the amount of lending using IOER to avoid a major inflation.

Fed apologists argue the Fed does not “control” the Fed Funds rate and that the Fed Funds market is a “free market” between banks, but with all these Fed administrative rates it’s clear that’s not really true. The Fed has a monopoly on reserves (some free market) and then it manipulates the Fed Funds market to achieve its target rate.

RETAIL RATES AND THE USA

Whatever rate banks pay for the use of reserves—be it the Fed Funds rate or the Fed Discount rate—they will not lend to the public for a lower rate than they paid since they would lose money. Hence the Fed Funds rate itself places a floor on retail interest rates in general.

When the Fed pushes the two corridor rates up, or pushes the floor rate up, and the Fed Funds market rate rises accordingly, retail rates that the public pays go up too.

And as the public sees rates rising on mortgages, auto loans, etc… they will tend to borrow less, slowing the rate of growth of the money supply or even contracting it (ie. price inflation slows or even reverses).

The Fed was not authorized by Congress to pay interest on reserves until 2008. So although it operated a corridor system for decades prior to the financial crisis, in practice it only employed one policy rate at that time: the Fed Discount rate which kept the Fed Funds rate from rising too high.

But there was no Interest on Reserves rate to prevent the Fed Funds rate from falling too low.

So what prevented the Fed Funds rate from falling to zero under the corridor system?

Scarcity of reserves. As mentioned before, the Fed alters the quantity of reserves too and scarce excess reserves available for borrowing kept the Fed Funds rate from falling too low due to simple supply and demand (low supply = higher price).

Hence in the Economics Correspondent’s opinion, the Fed was really operating a “ceiling system” before 2008 although monetary economists who know more than him might take issue with that characterization.

Finally, the Bernanke, Yellen, and even Powell Feds have seen the floor operating system fall under heavy criticism from Congress and the public, because a floor system requires the Fed to pay risk-free interest to banks on huge levels of reserves: trillions of dollars

As of the time of this writing banks are still holding $3.2 trillion in reserves, the remnants of the giant Covid pandemic asset-purchase campaign, and the IOR rate has just been lifted to about 3.15%.

That’s about $100 billion in risk-free annual interest payments the Fed is making to private banks, all for nothing, and politically that’s pretty indefensible.

Hence the Fed has been under pressure to sell off its assets and remove reserves from the system (aka. reduce its balance sheet), and it has been doing exactly that. Reserves have fallen rapidly from $4.2 trillion in December to $3.2 trillion in July.

And throughout the 2010’s decade the Fed repeatedly said the floor operating system was a crisis-only measure and that it would revert to a corridor system soon. However it has struggled to do so, particularly when falling reserve balances combined with reserves being set aside by foreign central banks (the so-called “Foreign Repo Pool”) and the U.S. Treasury (the “Treasury General Account”) led to a mini-interest rate crisis in September of 2019.

However when the Covid pandemic struck in March of 2020 the Fed scrapped any ambitions of quickly returning to a corridor system when it ballooned reserves again, affirming its floor system for at least several more years.

The Fed’s ability/prospects for returning to a corridor system in the post-Covid, post-inflation world remains an outstanding question.

ps. The Fed’s transition from a scarce reserves corridor system to a plentiful reserves floor system in 2008 can be seen quite clearly in a long-term chart of system reserves (see St. Louis Federal Reserve link).

https://fred.stlouisfed.org/series/TOTRESNS

Biden Proven Wrong on Inflation (Again): Oil Prices Are Down but CPI Hasn't Fallen

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West Texas Intermediate oil prices closed yesterday at $82.94, down 33% from the June 13th high of $123.68.

Three months ago the Biden administration blamed higher oil prices and ExxonMobil for 40-year record price inflation (see link).

http://www.cautiouseconomics.com/2022/06/government-budget05.html

Well now oil prices are down 33%, so according to Biden the national general price index should have fallen precipitously too. 

So the Cautious Optimism Correspondent for Economic Affairs would like to pose a question: 

Q. Are nationwide consumer prices down by even 1% since June? 

For that matter, the last time WTI oil traded at $82.94 was in January 2022. 

OK, we're back down to $82.94 again, so CPI should have fallen back to January levels (according to Biden).

Has anyone in CO Nation seen the general price level for all goods and services fall back to January 2022 levels? Please chime in if you have (or haven't).

Higher oil prices don't drive inflation.

“Inflation... ...trade unions don’t produce it, foreign sheiks don’t produce it, oil imports don’t produce it... ...what produces it is too much government spending and too much creation of money.”

-Milton Friedman

Keynes Would Oppose the Fed's Next Rate Hike

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From the Cautious Optimism Correspondent for Economic Affairs (and Other Egghead Stuff).

The late British economist John Maynard Keynes (1883-1946) would almost certainly not approve of this Wednesday’s anticipated Federal Reserve interest rate hike.

Keynes hated savers, blaming them for the world's economic ills because they wanted a "moderately high rate of interest" in return for the risk of investing their hard-earned money and forgoing immediate consumption. He called for…

"…the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital" (1936) 

...and an all-powerful central bank to push interest rates down as low as possible.

Regarding raising interest rates and possibly lowering business investment and employment, Keynes wrote in “The General Theory of Employment, Interest, and Money," his famous book which has wielded enormous influence over politicians, central bankers, and academics for more than 85 years:

"Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom."

So who is right? Should rates be forced down to rock bottom indefinitely to, as Keynes urged, "abolish slumps" and keep “us permanently in a quasi-boom?" 

Or should rates be hiked—or what free marketers would argue: simply allowed to rise on their own without being suppressed by central banks—to slow down the highest price inflation in 40 years, even at the risk of precipitating a more severe recession than we've seen in the two most recent quarters?

San Francisco Thieves Steal Police Catalytic Converters Right in Front of the Station

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Just another day in the Cautious Optimism Economics Correspondent's home which is the Revolutionary People's Republic of San Francisco. No doubt the thieves were caught but promptly released after they uttered the right pronouns.

"Thieves Steal SFPD’s Catalytic Converters Right in Front of the Station"

"A veteran officer at the SFPD was quoted as saying he doesn’t believe they will ever be recovered."

Read more at:

https://www.thedrive.com/news/thieves-steal-sfpds-catalytic-converters-right-in-front-of-the-station

CNBC/Bloomberg Also Don't Understand: High Oil Prices Don't Cause Inflation

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2 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff is listening to talking heads on CNBC and Bloomberg exclaim how "surprised" they are that reported headline August CPI was +8.3% year-over-year despite a 10% fall in gas prices in August.

If only they had bothered to read Milton Friedman or any economists of either the Monetarist or Austrian schools of economics, they'd already have understood that higher gas prices don't drive high inflation, and likewise falling gas prices don't drive lower inflation or deflation. 

Or, stated as a more general principle, "cost push" inflation—the theory that a higher price of one major commodity spilling over into other products that use that commodity as an input drives a general increase in all prices—doesn't exist.

Milton Friedman got it right over half a century ago when he stated:

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

He also criticized economists, most of them Keynesian and/or government-employed, who argued in the 1970's that higher energy prices were behind the 131% inflation that struck during the decade following the end of the Bretton-Woods international gold standard.

He was proven right as oil prices collapsed by a stunning 67% from November 1985 to July 1986, yet general prices actually rose by 0.5%.

And despite the stunning oil price collapse in 1986, the general price level remained 140% higher than when oil prices originally surged during the 1973 OPEC oil embargo.

Because, as Friedman never tired of repeating, the real reason prices rise is that money is being created too quickly by the central bank... period.

If gas prices fall, but the money supply remains constant, then consumers will have more money left after gas purchases to demand other products whose prices in turn rise and offset the falling price of gasoline. Hence falling gas prices don't lower the general price level which remains relatively constant.

If the Fed keeps expanding the money supply atop falling gas prices, consumers will have that much more money left to spend after gas purchases, pushing prices of other products up that much faster. The result: an increase in the general price level despite falling gas prices (to the shock of reporters on CNBC).

In other words, precisely what we are witnessing now: a year-over-year annualized increase of 8.3% for all prices, not just energy.

The Economics Correspondent wrote in more detail about the "rising gas prices cause high inflation" fallacy four months ago at:

http://www.cautiouseconomics.com/2022/05/inflation-currencies16.html

James J. Hill on America's Capital

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The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff considers James Jerome Hill to be arguably the greatest industrialist in American history. More details on Hill and his Great Northern Railway—the only Gilded Age transcontinental railroad to refuse federal government money and the only one never to go bankrupt—to come in a future article.

Addendum to Supply and Demand: The "Sick Chicken" Case of 1935

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3 MIN READ - A complimentary addendum from a previous column by the Cautious Optimism Correspondent for Economic Affairs (and other Egghead Stuff).

Last week the Economics Correspondent posted a comment that provoked so much reaction that it seemed a good idea to repost it as a full entry with added color.

The comment concerned Franklin Roosevelt’s National Industrial Recovery Act (NIRA) of 1933 which imposed price and wage controls throughout the United States and promptly reversed an economic recovery that had begun in the spring of that same year.

Leaving aside that the NIRA was one of FDR’s many harmful policies (this one extending the Great Depression by two years alone), it also has historical and political significance.

In 1935 the Supreme Court ruled 9-0 against most of the NIRA’s provisions—striking them down as unconstitutional—in the famous “Sick Chicken” case (details below). 

It was the Sick Chicken ruling that prompted FDR, in a fit of anger, to employ his famous “Supreme Court packing” strategy, although his attempts failed when Congress refused to pass his resolution.

Even the most reliably liberal activist justice Louis Brandeis told one of FDR’s aides "This is the end of this business of centralization, and I want you to go back and tell the president that we're not going to let this government centralize everything."

Considering today’s “conservatives” like John Roberts rule Obamacare as constitutional, such comments about centralization would get Brandeis, an otherwise lionized liberal, branded a white supremacist semi-fascist today.

(Never mind that economic fascism literally 𝘪𝘴 centralization of economic power with the state in the first place. Private property and profit motive still exist, but all production and investment decisions are made by the state, making it odd that the deregulating Trump was forever called “fascist” while Obama was not)

So without further ado, feel free to read the repost of a few brief comments on the NIRA, and try to remember the country this happened in was the United States of America.

====

The NIRA established over 400 legal codes that were forced on more than 2 million businesses, imposed artificially high government-fixed prices for tens of thousands of products, and criminalized any reduction of prices below state-mandated levels.

Just three egregious examples of FDR’s National Industrial Recovery Act (NIRA) pricing code enforcements:

1) In one of the famous NIRA cases of the 1930’s:

“A New Jersey tailor named Jack Magid was arrested and sent to jail for the ‘crime’ of pressing a suit of clothes for 35 cents rather than the NRA-inspired ‘Tailor's Code’ of 40 cents.” (Lawrence Reed, 1998)

See New York Times archived 1934 headline at:

https://www.nytimes.com/1934/04/21/archives/tailor-gets-30-days-for-cutting-prices-father-of-four-children.html

…and

2) “In Sidney Hillman’s garment industry the code authority employed enforcement police. They roamed through the garment district like storm troopers. They could enter a man’s factory, send him out, line up his employees, subject them to minute interrogation, take over his books on the instant… [they] went through the district at night, battering down doors with axes looking for men who were committing the crime of sewing together a pair of pants at night.” (John T. Flynn, 1944)

3) And in another famous NIRA enforcement challenge that went to the Supreme Court:

Schechter Poultry Corp. vs United States, or the so-called “Sick Chicken” case—government prosecutors indicted four Jewish chicken slaughterers on 60 counts of violating NIRA codes for mispricing poultry. In an exchange that the press rightfully mocked as ridiculous, government prosecutors argued to the court that:

“The poultry purchaser must come into the market and take all the chickens in a coop. He cannot go and select the choice chickens out of the coop.”

“If he does select the choice chickens out of the coop, as was the custom at one time, it brings down the prices in the sale of the lower-grade poultry, and the sales of the lower-grade poultry in turn bring down the prices of the higher grades.”

…and...

“His customer is not permitted to select the ones he wants. He must put his hand in the coop when he buys from the slaughterhouse and take the first chicken that comes to hand.”

The official “Sick Chicken” case transcript in its full absurdity is available at:

https://lonedissent.org/transcripts/pre-1955/a-l-a-schechter-poultry-corp-v-united-states

Wikipedia also has a good brief summary of the Sick Chicken case at:

https://en.wikipedia.org/wiki/A.L.A._Schechter_Poultry_Corp._v._United_States

A San Francisco Refugee Visits DeSantis Country

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This Florida activity seems strange and alien to San Franciscans

3 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff was privileged to visit CO World Headquarters over Labor Day weekend and meet up with highly esteemed CO operatives—namely, the Roving Correspondent for Affairs, the Correspondent for Thinly Researched Conspiracy Theories, and the COW* and CO themselves.

Aside from the usual subversive, anti-democratic exchanging of semi-fascist ideas—or so Joe Biden has told us—CO, the COW* and the Thinly Researched Conspiracy Theories Correspondent were gracious hosts, showing me and the Roving Affairs Correspondent around the area, taking us out on a friend’s boat, and soaking in the sun between political reform charter meetings.

As I was toured around the land of sun, sand, and palm trees I made a few observations about the free state community that is Boca Raton.

Having lived in San Francisco for over eighteen years, there were some customs and day-to-day goings-on that I didn’t recognize and needed time to adjust to.

For one, there were strange structures everywhere that looked like frames with big empty spaces inside, sometimes with people walking underneath wearing yellow plastic hats.

The other four CO Nation agents, all being Florida residents, informed me what I was witnessing is called home construction, an old bourgeoisie activity that has been all but criminalized in San Francisco for thirty-plus years. 

However, I proudly retorted that we have not only one, but two special activities of our own in the City by the Bay called 1) “banning all new housing construction,” and 2) “complaining about the housing affordability crisis.”

Note: The Economics Correspondent has written in greater detail on San Francisco’s self-inflicted housing crisis previously at:

http://www.cautiouseconomics.com/2021/11/short-bites-19.html

One evening we walked from a live band concert back to CO Headquarters through downtown Boca Raton’s geographical center: a large, grassy city block reserved as a public park. But as we skirted the grass something seemed to be missing. 

Visually, the park just didn’t look right.

As we crossed the next street it hit me like a bolt out of the blue: the park was completely void of homeless tent encampments and trash. 

It also smelled kind of nice.

I also felt a little strange—almost inadequate—that I hadn’t worked hard enough when traversing the sidewalk. You see, I got to walk in a straight line without even once dodging left or right to avoid piles of human poop or syringes gleaming in the streetlamp lights.

It was odd (but nice) being able to walk on a sidewalk with my head turned towards CO and the COW* and carry on a conversation without my eyes constantly surveying the next few feet of concrete as if negotiating a minefield.

I advised CO and the COW* that San Francisco’s Board of Supervisors would double their efforts with overtime to add, shall we say... special ornamentation to that park if they ever gained political power in Boca. The park might be green, but San Francisco politicians would add plenty of “color diversity” like yellow and blue nylon tents, and the ground and sidewalk would be adorned with the brown and silver of human feces and used needles. 

The surrounding downtown buildings were also full of shops and many restaurants that were still open at 10:30PM, a rarer and rarer sight where I come from. There was also no trash on the sidewalks or in the street gutters.

Two more things San Francisco needs to come over here and fix PDQ.

Oh, make that three things. There were so many white people patronizing the restaurants and San Francisco liberals simply can’t stand for that.

OK I did see an Asian couple eating ramen outdoors but I’ll take it upon myself to educate the Boca Raton City Council that Asian is the new “white adjacent” due to their high salaries, SAT scores, and achievement in general that frustrates the racism/victimization narrative. 

Unfortunately on a Saturday night City Hall was closed so I’ll have to educate them on their racism during my next visit.

We discussed many things political and CO Nation-related over a great steak which came from real grass-fed cows that emit methane flatulence—not locally grown, organic tofu fair-trade-awareness raising substitute.

All in all, I’m not sure I could adjust to life down here as the weather was not only hot and humid, but there was way more of this thing called freedom than I’m used to in the Bay Area. CO and the COW* also warned me I’d have to learn getting used to something called “free speech without getting your head bashed in by Antifa” and one final adjustment: figuring out how to survive zero state income taxes. 

Strange since I was told that tool of capitalist exploitation had been abolished worldwide since 1867 which coincidentally is the same year Karl Marx published Das Kapital, the proletarian treatise that San Francisco government adopted as its de facto legal code the very same year.

The list of remaining different and bizarre customs in this red state that I’ve been told is a bastion of DeSantis fascist bigotry is too long to provide in its entirety here, but I will close out on all the “Trump 2024” and “Let’s Go Brandon” signs and bumper stickers I saw everywhere. 

What was amazing wasn't so much the signs themselves but rather I don’t believe a single one of the BMW’s or Mercedes-Benzes adorning those bumper stickers had any windows smashed out in tolerant San Francisco fashion.

*Cautiously Optimistic Wife

Supply and Demand: Say's Law of Markets and Keynesian Economics (Part 2 of 2)

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10 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff apologizes for the length of his second and final post on Say’s Law and supply and demand. But the slightly complicated subject of Keynesian objections to Say’s Law can’t be divided into two installments without a sizable disruption, so one post it is.

Jean-Baptiste Say and John Maynard Keynes

In Part 1 we reviewed how French classical economist Jean-Baptiste Say’s (1767-1832) “Law of Markets” proved supply always precedes demand and how demand itself must always originate first from supply.

We also established the definition of demand in economics which, going back over 200 years to James Mill, is not simply “need” or “want.”

To go back and review Say’s Law’s insights on supply and demand you can read at:

http://www.cautiouseconomics.com/2022/08/macroeconomics-15.html

SUPPLY GLUTS

Say’s case that in market economies supply always precedes demand, and that demand grows from supply to begin with, was generally accepted by economists as correct for well over a century and still holds true today.

However Say integrated a few other tenets in his Law of Markets whose validity has not proven as durable in the economics profession.

Most controversially, Say is accused of arguing that an economy’s supply and demand are always in balance and that there are never overproductions or “gluts” of supply.

Only a few years after the publication of Say’s Treatise (1803) English economist Thomas Malthus was already challenging the “no supply glut” thesis. But Malthus was quickly outdebated by fellow Englishman David Ricardo and Say’s doctrines held up for another century.

However during the Great Depression Say’s Law met a more formidable critique from British economist John Maynard Keynes. The idea that supply gluts can’t exist has since subsequently fallen into doubt with many economists.

But first let’s start with what Say and Ricardo themselves actually described.

First, the perception that Say claimed supply gluts can never exist is largely untrue.

Say argued that an economy’s supply and demand tend to be equal but acknowledged sometimes they can temporarily fall out of equilibrium. He denied, however, that such imbalances arise from a general overproduction or overall insufficiency of demand but rather businessmen erring in their anticipation of consumer desires and making too many of certain wrong kinds of products (Treatise: Chapter 15, p. 135).

Ricardo actually spoke on the subject more succinctly than Say when he wrote:

“Men err in their production; there is no deficiency of demand."

-Letter to Thomas Malthus (1820)

Along those lines, Say also contended that a “general overproduction of everything” doesn’t cause recessions. As classical economist Steven Kates has summarized, Say’s Law states “You never, ever have a recession because of demand deficiency. A thousand other reasons, but never that.”

Instead Say advocated a more nuanced position on gluts: that recessions can occur when businessmen produce too much of one product and not enough of another. When losses expose the wrong kind of production, the process of realigning resources away from an errant production towards an undersupplied one will create unemployment, but once the misalignment is corrected growth can resume.

Finally, Say stressed such temporary imbalances in sectoral supply and demand resolve quickly via the market price system. Thus, so long as prices are allowed to adjust freely (a very important point we will come back to later), lower prices will clear inventories while signaling resource reassignment to other sectors exhibiting higher prices.

…which is just freshman level microeconomics today.

In a letter to Thomas Malthus Say asserted:

“If the quantity sent in the slightest degree exceeds the want, it is sufficient to alter the price considerably."

And in the Treatise itself Say wrote:

“When a product becomes less in demand… …All the stock on hand falls in price; the low price encourages the consumption, which soon absorbs the stock on hand.”

Now that we have cleared up Say’s more nuanced views about aggregate supply and temporary supply gluts, let’s look at Keynes.

KEYNES

During the Great Depression British economist John Maynard Keynes, puzzled by products and particularly labor markets clearing extremely slowly, concluded that Say’s Law—which he expressed as “supply creates its own demand”—was only correct only under special circumstances and that a more general theory was needed to explain business cycles.

Keynes proposed his own solution in his seminal book “The General Theory of Employment, Interest, and Money” (1936) where he differentiated Say’s Law from his own. 

Keynes’ conclusion? Markets failing to provide adequate demand causes depressions. Also, insufficient aggregate demand causes factories and businesses to run at partial capacity which in turn refuse to invest or hire idle workers, thus prolonging the slump.

Keynes’ proposed remedy? Both central bank cheap money and massive government deficit spending are needed to raise aggregate demand which in turn will clear the supply glut and quickly pull the economy out of its slump.

As Keynes himself wrote, if government were to borrow vast sums of money and…

“…the Treasury were to fill old bottles with banknotes [and] bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish… and leave it to private enterprise… to dig the notes up again… there need be no more unemployment and… …the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.” (General Theory, page 68)

Governments and politicians of course loved Keynes’ new theory and embraced it immediately, for it gave them academic and theoretical cover for what they love to do to this day: borrow and spend obscene amounts of money on anything they choose (usually buying votes).

Today’s Keynesian economists also consider the alleged refutation of Say’s Law to be Keynes’ greatest achievement and frequently cite the Great Depression as evidence that the free market has no built-in mechanism for clearing mass unemployment. 

Even Keynes’ critics agree that The General Theory is at its core an attack on Say’s Law. Steven Kates calls Keynes’ book “a book-length attempt to refute Say's Law.”

In fact, according to Keynes’ detractors, he necessarily *had* to disprove Say’s Law. For if he didn’t there would be no justification for central banks printing and governments spending trillions of dollars during recessions.

So after explaining the basics of Say’s Law and Keynes’ refutation, who is correct? Do markets for products and labor clear on their own? Or do entire economies get stuck with unsold goods and labor and need governments to spend more money to boost aggregate demand?

WHO IS RIGHT? MISSTATEMENTS

In the Economics Correspondent’s opinion Say’s Law remains valid, and both Keynes’ critiques and those employed by his followers are plagued by some errors. 

First of all, Keynes repeatedly stated Say’s Law as “supply creates its own demand” and proceeded to attack that premise. And to this day, both New Keynesian and Post Keynesian economists recite Say’s Law the same way. For example:

“Quite a few economists seemed utterly unaware that Say’s Law – the proposition that supply creates its own demand… …had been refuted three generations ago.”

-Paul Krugman: “Demand Creates its Own Supply,” New York Times (2015)

However Keynes’ version of Say’s Law is actually a misstatement, and he proceeded to criticize what is effectively a straw man: suggesting that one can produce anything and demand for that anything will magically appear.

For Say did not write that the production of apples creates a demand for apples itself. His original statement…

“A product is no sooner created than it, from that instant, affords a market for other products.”

…argued the production and sale of apples creates a demand *for other things* and in the amount that others value the apples. Note that Say specifically used the words “market for other products,” not “market for itself.”

Yet the Keynesian invention of “supply creates its own demand” rewrites Say’s Law with language that makes it sound ridiculous. And to this day, less-informed Keynesians (like Paul Krugman’s readers) believe that simply repeating a semi-absurd-sounding canon automatically refutes Say’s Law with no further discussion needed.

WHO IS RIGHT? SUPPLY GLUTS AND PRICE CONTROLS

Then there’s the central argument regarding macroeconomic supply gluts. 

Keynesians contend that the Great Depression, a slump where the job market required an unbelievable sixteen years to clear to full employment, proved that a market economy cannot clear supply gluts on its own without government spending to boost aggregate demand. In their eyes, *the* preeminent exhibit refuting Say’s Law is that Great Depression, a slump where massive inventories did in fact pile up, and labor took painfully long to clear.

But recall that Say argued it wasn’t overall supply gluts that cause recessions but rather overproduction in some sectors and underproduction in others. Furthermore Say asserted those sectors will realign and adjust quickly *when prices are allowed to adjust freely.* A market where prices aren’t allowed to adjust freely is an unfree market where governments interfere (i.e. price controls).

So were prices allowed to adjust during the Great Depression?

Only someone woefully uniformed on the Great Depression could make such an assertion. The 1930’s were the greatest experiment in government price controls—artificially forcing prices higher—in American history. The list of offenses is so great that the Correspondent only has room to discuss three of them here:

1) First there was wages.

One of Herbert Hoover’s first acts after the 1929 stock market crash was to pressure businessmen not to reduce nominal wages even as deflation lowered prices 30% due to bank failures and deflation. The result, in real terms, was a 40%+ pay raise for those workers lucky enough to still have a job.

In the middle of a major depression, paying 40%+ higher real wages left employers with only one real option: lay off workers. It’s no coincidence the unemployment rate was already 23.6% by 1932.

After Hoover was gone and businesses began lowering wages Franklin Roosevelt inserted minimum wage clauses that encroached even on factory worker salaries in his 1933 National Industrial Recovery Act. He then armed labor unions with new government powers via the 1935 Wagner Act.

Unsurprisingly, with wages pushed up above the market-clearing level the result was persistent unemployment—over 10% for more than a decade and above 15% for seven years—or what Keynesians would call a market “supply glut” of labor which they then argue proves Say’s Law is invalid.

The Economics Correspondent has written in greater detail on Hoover and FDR wage floor policy at:

http://www.cautiouseconomics.com/2018/01/the-great-depression-08.html

http://www.cautiouseconomics.com/2018/02/the-great-depression-09.html

2) In agriculture, the Hoover administration spent the equivalent of hundreds of billions of dollars in today’s money to purchase crops and lock them away in government warehouses to force up the price of food.

Again unsurprisingly, the artificial price floor resulted in huge stockpiles of unsold produce and livestock—another “supply glut”—which Keynesians also blame on a failure of Say’s Law.

The Correspondent has written about Hoover and FDR agricultural price floor policy at:

http://www.cautiouseconomics.com/2018/08/the-great-depression-12.html

3) Lastly, in terms of general products and services, FDR’s National Industrial Recovery Act (NIRA) forced business leaders to collude and artificially raise prices which, yet again, pushed them above the market clearing level and created supply gluts of unsold goods. The result was slowing of production, layoff of unneeded workers, and the very idling of factory capacity that Keynes argued was a free market phenomenon.

The NIRA went further by establishing over 400 legal codes that were forced on more than 2 million businesses, imposed artificially high government-fixed prices for tens of thousands of products, and criminalized any reduction of prices below state-mandated levels.

The list of distortive price-fixing and business practice codes during the 1930’s is also too enormous to fully provide here, but some of the most outrageous examples of NIRA cases can be found in the addendum section below. 

Either way it’s clear the U.S. economy under the Hoover and Roosevelt administrations was an entirely different world from the market economy Jean-Baptiste Say described in 1803.

So whenever you hear Keynesian economists argue “the free market” produced a supply glut during the Great Depression, remember that a key condition of Say’s Law is that prices and wages must be allowed to fall in response to a temporary sectoral insufficiency of demand, not politicians forcing prices up throughout the economy and artificially creating supply gluts as they did in 1930's, and which Keynesians then call a failure of the free market to provide adequate demand.

Or as Austrian economist Henry Hazlitt summarized in “The Failure of the New Economics,” his line-by-line refutation of Keynes’ General Theory:

“Keynes did not succeed in refuting Say's Law of Markets. His attempted refutation consisted merely in ignoring the qualifications that the classical economists themselves insisted on as an integral part of the doctrine.”
====
Addendum on the National Industrial Recovery Act:

Three egregious examples of FDR’s National Industrial Recovery Act (NIRA) pricing code enforcements:

1) In one of the famous NIRA cases of the 1930’s:

“A New Jersey tailor named Jack Magid was arrested and sent to jail for the ‘crime’ of pressing a suit of clothes for 35 cents rather than the NRA-inspired ‘Tailor's Code’ of 40 cents.” (Lawrence Reed, 1998)

…and

2) “In Sidney Hillman’s garment industry the code authority employed enforcement police. They roamed through the garment district like storm troopers. They could enter a man’s factory, send him out, line up his employees, subject them to minute interrogation, take over his books on the instant… [they] went through the district at night, battering down doors with axes looking for men who were committing the crime of sewing together a pair of pants at night.” (John T. Flynn, 1944)

3) And in another famous NIRA enforcement challenge that went to the Supreme Court:

Schechter Poultry Corp. vs United States, or the so-called “sick chicken” case—government prosecutors indicted four Jewish chicken slaughterers on 60 counts of violating NIRA codes for mispricing poultry. In an exchange that the press rightfully mocked as ridiculous, government prosecutors argued to the court that:

“The poultry purchaser must come into the market and take all the chickens in a coop. He cannot go and select the choice chickens out of the coop.”

“If he does select the choice chickens out of the coop, as was the custom at one time, it brings down the prices in the sale of the lower-grade poultry, and the sales of the lower-grade poultry in turn bring down the prices of the higher grades.”

…and...

“His customer is not permitted to select the ones he wants. He must put his hand in the coop when he buys from the slaughterhouse and take the first chicken that comes to hand.”

The official “sick chicken case” transcript in its full absurdity is available at:

https://lonedissent.org/transcripts/pre-1955/a-l-a-schechter-poultry-corp-v-united-states