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The underconsumption myth is back again
Gerard Jackson
Chris Caton, a prominent economist, warned that 2005 could be a very bad year for economy because people have started to repay their mortgages. Now why would this cause a recession? Because, according to Dr Caton, it would leave people with less to spend. (Tim Colebatch, Outbreak of thrift threatens economy, The Age, 16 February 2005).
Obviously he has caught the underconsumption bug. This was made glaringly clear by his statement that "To maintain the recent rate of growth in consumer spending, we must withdraw even more equity in the next year than in the past year. This is very unlikely to happen, so consumer spending growth will slow, the only question being by how much.”
Dr Caton’s analysis reminds me of Keynes’ absurd suggestion that amortisation triggered America’s Great Depression. This silliness was followed by the equally absurd notion that depreciation did the dirty deed. (Come to think of it, Keynes is the person from whom the eminent Dr Caton seems to have obtained his economic views on spending).
The classical economists thought they had put to rest the fallacy that thrift causes recessions. As Ricardo said in an exchange with Malthus: “To save is to spend,” meaning that in order to raise living standards genuine savings must be used to accumulate additional capital. (Malthus quietly dropped his anti-saving views after Britain quickly recovered from the 1824-25 depression).
By the end of the year I will have repaid my mortgage. Does this mean my total spending has fallen? Of course not. What was spent on the mortgage will now be spent elsewhere. If I chose to increase my savings ratio would this cause spending to fall? Certainly not. When people save they temporarily transfer purchasing power from themselves to borrowers.
In the Austrian school of economics, to save means to shift spending from consumption goods to future goods, i.e., capital goods. (To make things simple I have ignored changes in cash balances).
This underconsumptionist nonsense was demolished in 1929 by Frederich von Hayek, a prominent member of the Austrian School of economics, when he effectively disposed of Foster and Catchings’ underconsumption theory (see The Paradox of Saving, Profits, Interest and Investment).
What the likes of Dr Caton have not grasped is that consumer demand is only a small fraction of total economic spending and does not drive investment. On the contrary, diverting more expenditure to consumption would have the effect of shortening the capital structure thus lowering living standards (Hayek, Prices and Production and Profits, Interest and Investment).
Therefore it is total business spending that drives the economy, not consumer spending. In 1928, for instance, M. W. Holtrop calculated that consumer spending in the US was about 8.3 per cent of what was spent on producer goods, which also included intermediary goods. (See Friedrich von Hayek’s Prices and Production for a detailed explanation).
However, GDP shows consumer spending at about 66 per cent of total spending. The error here is that GDP is not gross, it is value added. This means that an enormous number of intermediary transactions consisting of vital inputs are ignored because they have been defined as double-counting.
This spending on inputs is a significant component of business spending and ignoring it only serves to exaggerate consumer spending by underestimating business spending and hence gross outlays. Surely if it is necessary for businesses to take account of this spending why should economists ignore it?
And what about the debt and the housing boom that so concerns Mr Colebatch? Look no further than the Reserve Bank. From 1996 to September 2004 currency grew by 72.7 per cent, bank deposits by 108.3 per cent and M1 by 100.3 per cent.
That reckless monetary expansion is the root of so many of the problems that Colebatch denounces is not something that seems able to penetrate his Keynesian skull. No wonder he’s the economics editor of The Age.
See Getting it right on recessions and the ‘wealth effect’ for example of Colebatch’s brilliant economic thinking.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 21 February 2005