Why Consumer Led Recoveries Can Be Bad For Economies

By: Gerard_Jackson

There is genuine bafflement among orthodox economists (at least in private) about the forces that burst bubbles and bring economies to their knees. Whenever a slowdown emerges the inevitable impulse to call for rate cuts make itself felt. I have even had economists tell me that America's post-WWII boom vindicates the Keynesian vote, forgetting — perhaps they don't know — that Keynesians predicted something like 6-8 million unemployed because of the massive drop in government spending once the war was over. In fact, for the fiscal years 1944 to 1947 government spending dropped by $56 billion, a fall of 59 per cent! The result was a boom in employment that completely refuted Keynesianism.

Nevertheless, Keynesians were able to turn reality on its head and claim that the boom vindicated Keynes. This pinpoints the important fact that that statistics generally prove nothing in themselves. Statistics need to be interpreted, which means that one needs a theory. It follows that applying the wrong theory will very likely render a wrong answer, particularly if the statistics are incomplete.

Economists who always argue for a consumption-led recovery genuinely believe that consumer spending accounts for about two-third of total economic activity. They are gravely mistaken. Their error is to omit spending on intermediary goods, those goods that pass through the capital structure, which in turn consists of incredibly complex stages of production. This omission is defended on the curious grounds of double counting. To be blunt, it's ridiculous account for fixed investments, i.e., durable goods, while ignoring ‘non-durable' capital goods merely because they are unfinished .

What these economists do not realise is that these particular goods are also savings. If spending on these goods were to contract then living standards would fall. Therefore, only when we take into account intermediary spending does a true picture of actual gross spending emerge. Once this is done consumption as a proportion of total spending drops to 30 per cent or so. This completely changes the perspective on economic recovery. By taking into account total spending we will find that recoveries were not led by consumption at all. In fact, I would bet that spending by manufacturing was the leading indicator. But as I have pointed out, national accounting methods omit this vital factor. (Fortunately the American Bureau of Economic Analysis is now taking into account much of the spending between firms. At least this is an excellent step in the right direction).

Let us assume, as our baffled commentators do, consumption will increase economic activity. Now What would this really mean for an economy? Let us take the US economy as an our example. In case anyone has forgotten, producers direct production and investment not only in response to changes in demand but also anticipated changes. It ought to be clear that if consumption were to lead recovery the effect would be to direct resources from the higher stages of production to the lower stages, those closest to the point of consumption. The term for this is capital consumption.

In English so plain that even a post-Keynesian can understand it, stimulating the economy by continually promoting consumer spending will, at the very best, retard economic growth or, at worst, even shorten the capital structure and hence eventually lower living standards. This is because consumer spending would alter the price structure in away that would make it more profitable to increase production and investment in the lower stages of production at the expense of the higher stages. The result would be an eventual downward pressure on wage rates.

Moreover, the effect of artificially lowering rates before all of the boom-created “imbalances” have been eliminated will, if the stimulus is successful, only pile more malinvestments on top of the surviving ones which will then have to be liquidated at a later date. If the malinvestments/imbalances are particularly severe and price margins remain compressed then interest rate cuts might prove ineffectual in the short-term. As I have pointed out more than once, artificially cutting rates is what brought about the boom-bust situation in the first place.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

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