Spending Does Not Drive the Economy, Part 2

I posted a few weeks ago some thoughts on how spending does not drive the economy. My point is not that spending is unimportant to the economy, but rather that lack of spending is not the core problem. For before you can spend, you need to have something to spend.

Therefore, attempts to re-start the economy by encouraging spending are addressing the symptom, not the problem. If we want to address the problem — and see spending revive — we need to realize that production precedes and enables consumption. Thus, any stimulus package needs to focus on removing obstacles to production (usually taxes and excessive regulation), rather than stimulating consumption.

This point is made very well in the book Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Reading that book is actually what sparked my first post on spending and the economy. To flesh things out a bit more, here is one of the most helpful (and extended) quotes from that book on spending and the economy, which I’ve broken up a bit through some brief summary statements.

(By the way, if you are aware of the “paradox of thrift,” the seeds to a large part of the answer are in this quote. If I get the chance, I’ll post more thoughts on the paradox of thrift down the road.)

Behind every government “stimulus” effort—whether it’s Barack Obama’s massive infrastructure programs or George W. Bush’s checks to every American, is the belief that consumer spending drives the economy.

There is one sense in which we can say “spending drives the economy”:

There is a Kernel of truth in this otherwise illogical view [note: I’m not always a fan of the tone in this book; for example, I wouldn’t call the other view “illigocial,” although I do believe it is wrong]. Consumer spending does drive the economy in the sense that every firm decides on what it will produce, with what methods, and in what quantities, in light of what it anticipates consumer demand to be. Businesses don’t survive unless they create what the consuming public wants. So consumers drive the economy in the sense that their wishes are what motivate the production decisions of producers.

But that is not what is usually meant:

But “consumer spending drives the economy” is often taken to mean that wealth is generated by the mere fact of our spending—and this belief is provably false.

Whenever a recession threatens to hit, Americans are urged to rush out and empty their wallets to get the economy back on track. But what is supposed to happen next, when the following day Americans have no more money to spend? That’s left unexplained. Saving is especially condemned, even though it’s obviously the prudent and sensible thing to do during a recession. A penny saved, we’re told, is a penny diverted from immediate spending—it’s actually said to be a drag on the economy. It was this fallacy on which the “stimulus package” of 2008 (and so many other … programs like it) was based.

The spending-is-good-for-the-economy fallacy grows partly out of our use of Gross Domestic Product as a measure of economic health. GDP sums up the dollar value of all final goods and services sold in a country in a given year. It thereby leaves out all the higher and intermediate stages of production that take place on the way to producing final consumer goods, since these processes are the ingredients of final good, but not final goods in themselves. But this higher-stage production is the bulk of the economy, and leaving it out gives a distorted picture of the percentage of overall economy that consumer spending amounts to.

Consumption is the act of using things up; a nation does not become wealthy by using things up:

Even without examining the statistics on which this idea is based—its proponents claim that consumption spending is over 70 percent of the economy—it should be obvious that something isn’t quite right about it. Consumption is the act of using things up.  How did any country ever become rich simply by using things up? Before things can be used up, they need to be produced. Production, in fact, is what makes consumption possible in the first place, because it gives us the means with which we can acquire to goods we want. to consume more, we first have to produce something ourselves.

The power to consume comes from having produced:

Where does a consumer shopping at a retail store get the purchasing power that allows him to make his purchase and consume in the first place? He gets the money he spends from contributing to some previous production process. He earns a paycheck by playing a role in producing something people want.

Production implies the willingness to spend:

John Stuart Mill already refuted the fallacy that consumer spending drove the economy nearly two centuries ago. “What a country wants to make it richer is never consumption, but production,” he wrote. “Where there is the latter, we may be sure that there is no want [lack] of the former. To produce, implies that the producer desires to consume; why else should he give himself useless labor? He may not wish to consume what he himself produces, but his motive for producing and selling is the desire to buy. Therefore, if the producers generally produce and sell more and more, they certainly also buy more and more.” [emphasis mine]

Stimulating consumption apart from production is what created the problem and thus is not the answer:

And as Austrian business cycle theory shows, the last thing we should want to do during an economic downturn is to give an artificial stimulus to consumption.  The downturn itself is caused by an increase in consumption simultaneously with an (incompatible) increase in investment. Stimulating more consumption will only widen the mismatch between resources invested in higher-order stages of production geared toward future production on the one hand and demand for consumer goods in the immediate present on the other. That’s why economist Gottfried von Haberler, speaking during the Great Depression, warned about “a one-sided strengthening of the purchasing power of the consumer, because it was precisely this disproportional increase of demand for consumers’ goods which precipitated the crisis.”

But what about over production?

The usual fallacy that comes in reply is that if we increase our productive capacity too much, we’ll have  general overproduction: the economy will produce more goods than people can afford. … [but] the increased production is precisely what gives people the wherewithal to buy the newly created goods. And the more goods we produce, the less expensive in terms of money they will be, thereby making it possible for people to buy the increased supply. As we noted above, a consumer is able to buy things only because he himself has produced things in the past. Thus it is production that makes consumption possible. As long as firms produce things consumers want in the proportions they want, therefore, the more we produce the more we can consume. The contention that there can never be a general overproduction of all goods, and that increased supplies of goods themselves constitute the demand for other goods, is known as Say’s Law, after economist J.B. Say. (John Maynard Keynes famously claimed to have refuted Say’s Law, but, as usual with Keynes, he did so only by misstating the law and then refuting his own misstatement.)

Think of all the houses that were built during the recent American housing bubble. Government policy, including the cheap credit policy of the Federal Reserve, encouraged this excess of home building. the boom in home purchases in turn led many people to believe that home prices would continue ever upward. As a result, we might say there was an “overproduction” of homes. But there certainly was not a general overproduction of all goods in the economy. All the resources—capital, labor, parts, land, etc.—poured into making houses would have gone elsewhere if not for this building boom. Entrepreneurial error or government interference can produce overproduction in a particular economic sector—but only to the extent that other sectors underproduce. The overproduced sector, in a market economy, will suffer as prices go down and costs of production go up, which then drives businesses out of that sector and frees up resources for other sectors.

Consumptive expenditure vs. productive expenditure:

Adam Smith made an important distinction between consumptive expenditure (or nonproductive consumption) and productive expenditure (or productive consumption). Consumptive expenditure uses up some good without providing for its replacement, such as when a person wears out an air conditioner in his home after a series of hot summers. Productive expenditure involves using something up in order to create still more (and/or more valuable) resources in the future. Investing in machinery that increases productivity is an example of productive expenditure, since a machine can often produce far more goods than were expended in building the machine itself. Consumptive expenditure uses up, exhausts, and destroys; productive expenditure provides for its own replacement in the form of an increased supply of goods in the future. Smith put it this way:

A thousand ploughmen consume fully as much corn and cloth in the course of a year as a regiment of soldiers. But the difference between the kinds of consumption is immense. The labor of the ploughman has, during the year, served to call into existence a quantity of property, which not only repays the corn and cloth which he has consumed, but repays it with a profit. The soldier on the other hand produces nothing. What he has consumed is gone, and its place is left absolutely vacant. The country is the poorer for his consumption, to the full amount of what he has consumed. It is not the poorer, but the richer for what the ploughman has consumed, because, during the time he was consuming it, he has reproduced what does more than replace it.

In effect, then,  when we’re being urged to consume more in order to “help the economy,” or when the government engages in “stimulus” packages meant to encourage consumer spending, they are suggesting we’d all be better off if we used up a lot of things without providing the resources for their replacement. Just take and take and take—and that will make everyone rich!

Savings is not bad for the economy!

And incidentally, money that people save is not a drain on the economy. Just the opposite. Savings provide the pool from which business can draw to build new, more productive equipment that can produce capital and consumer goods in ever-greater quantities at lower costs in the future. Without saving, without abstention from consumption, this process, and the increase in living standards that accompanies it, could not occur.

Society is wealthier today because of an increase in production, not an increase in consumption:

We are much wealthier now than we were 300 years ago not because we consume more today, We consume more today because we can produce much more, and it is this production that itself both fuels our ability to consume and increases our standard of living.

Stimulus packages that focus on increasing consumption will prolong the crisis or make it worse (or both):

“Stimulus” packages that encourage both private nonproductive consumption and public nonproductive consumption (i.e., federal spending) will only intensify the present crisis and hollow out the economy’s productive capacity still further. And on top of that, they seek to strengthen the economy by the obviously paradoxical means of building roads and bridges funded by more debt—like a homeowner who decides to solve his debt problem by borrowing more money to remodel his house.

  • Mike Tosoni

    Matt, I’m so glad you read Meltdown. After reading it, especially chapters 4 and 6, do you find yourself any closer to adopting a free-market position on money and banking? The Austrians could use a guy like you.

    Another thing. You made a passing point in this post that you “wouldn’t call the other [spending-drives-the-economy] view ‘illogical,’ although [you] do believe it is wrong.” I don’t understand. Isn’t the very point of this post to demonstrate that such a view is illogical and, therefore, wrong?

    Excellent post. Keep writing about this stuff.

  • Matt

    Mike: It makes me more open to the free-market position on money and banking. I see the arguments, and want to think more about it. I’ve purchased some more resources from the Austrian School.

    In regard to calling the other view illogical: I certainly agree that it is wrong, which does imply logical errors; my only point was regarding the tone and manner in which to disagree. Given the importance of communicating respect even in disagreeing, I think that there were some places in the book that could have done that better.

  • Mike Tosoni

    Awesome, Matt. You are in for one sweet and thrilling ride. Your worldview is on the verge of radical modification. Austrianism : Economics : : Calvinism : Theology.