The consumption fallacy: another lesson for the US economy
Gerard Jackson
Claims by economic commentators that consumption is driving the US economy are outright nonsense. According to this line of thought when consumers increase their spending they cause businesses to fill their order books, invest in new plant and employ more people. In short, consumption drives the economy, even when fuelled by debt.
That this economic fallacy is still widely held and promulgated is a shocking indictment of the appalling state of what mainly passes for economic thought in the media as well as academia.
Consumption drives nothing, particularly the US economy. It is, as the classical economists termed it, the "extermination of value".
Therefore consumption grows out of production and not the reverse. This is why great consuming nations like the US economy are also great producing nations. You cannot consume what has not been produced. "Ah!" our consumptionist would exclaim, "but increased spending leads to greater demand for inventories and encourages investment and employment and hence stimulates growth". Not true.
This is made clear by real economists who point out that the actual cost of growth is forgone consumption. Growth is increasing investment in the capital structure. For the structure to expand by adding more and more complex stages more savings are required. Now capital goods are future goods which are, in a sense, converted, into present goods (consumption goods) during the production process.
It follows that present goods are savings that are converted into future goods. Another way of putting this is to say that savings are spent in a way that directs production from present consumption to greater future consumption.
The effect of increasing genuine savings and therefore growth is to investment in more roundabout processes that increases productivity and so raises the value of the workers' marginal product and hence their real wages.
The reverse is equally true. And this is what John Stuart Mill meant when he wrote that the "demand for commodities [consumer goods] is not the demand for labour". He elaborated by stating:
"I apprehend that if by demand for labour be meant the demand by which wages are raised, or the number of labourers in employment be increased, demand for commodities does not constitute demand for labour. I conceive that a person who buys commodities and consumes them himself, does no good to the labouring classes; and that it is only by what he abstains form consuming, and expends in direct payments to labourers in exchange for labour, that he benefits the harbouring classes, or adds anything to the amount of their employment."
Therefore consumer spending does nothing to improve the US economy because it does nothing to increase productivity. This can be illustrated by what would happen to an advanced country that ceased saving: interest rates would rise, rates of returns would increase in the consumer goods industries (the lower stages of production) and fall in the producer goods industries (the higher stages of production); the higher stages would start disinvesting and the lower stages would start expanding; productivity would slow and so would the growth in real incomes; eventually, the economy would regress and real incomes and living standards would fall. All because the country had swallowed the myth that consumption was the road to prosperity.
It is a disgrace that so many commentators have lost sight (that is if they ever saw it) of the basic economic fact that savings fuel the economy, entrepreneurship drives it and consumer preferences direct it.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 23 August 2004