How Can We Base an Economy on Consumption?

BY busadmin  January 20, 2010 at 1:42 PM EDT

Question: I have heard and read many times that consumer spending is a major part of our economy. Reading the paper on a recent morning, I read that consumer spending accounts for 70 percent of U.S. economic activity. It is said that a lack of consumer spending contributes to the current recession. I’m having trouble understanding this.

How can a nation base its economy on consumption? Isn’t it more sound to base an economy on production? How do we continue to buy products from other nations without producing things they will in turn buy from us? There should at least be equal parts of consuming and producing. I must be missing something, please help to sort this out.

Paul Solman: First off, as an aside, you should know there’s a debate about how much of our economy is accounted for by “consumption.” See Mike Mandel in Business Week for an argument that the number is smaller than 70 percent.

But regardless of the true portion, when people say that “consumption” accounts for 70 percent of GDP, they don’t mean “consumption” instead of “production.”

They mean “consumption” as opposed to “investment spending,” “government spending” and “net exports”: what we sell abroad minus what we import from abroad. Theoretically, consumption could equal 100 percent of GDP. Yet, if net exports were zero (exports=imports), U.S. “production” would also equal 100 percent of GDP. You see the point?

So let’s not bad-mouth consumption. In fact, here’s a favorite economist’s verdict on the matter:

“Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer. The maxim is so perfectly self evident that it would be absurd to attempt to prove it.”

The economist is Adam Smith; the book, An Inquiry into the Nature and Causes of the Wealth of Nations; the point, that the “nature” of wealth is the material enjoyment of life, as in Smith’s Glasgow of 1776 compared to the hardships in the Highlands nearby, or worse still, in Asia, where Smith reports that missionary nuns drowned newborn Chinese girls as they baptized them and “by this means these sad victims of family indigence find eternal life in these same waters in which their short life is snatched from them.” Talk about nasty, brutish and short!

In fact, “consumption,” broadly defined, is the whole purpose of Smith’s inquiry, and of wealth itself.

What you really mean, I think, is: Can we afford to consume MORE than we produce, as measured by importing more than we export. Or, to put it another way: Do consumption and production always have to be in balance?

Apparently not. The much-discussed “global imbalance” of recent decades is, broadly speaking, the consumption, in America, of the production of Asia. As we first explained on the NewsHour in the pre-Internet 1980s, the United States buys more of what Asia produces than Asia buys of ours. (“Asia” was Japan in those days; China now). Asia maintains a low value on its currency to keep its prices low and induce us to continue buying. Meanwhile, as Asia amasses more of our money than we do of its, it keeps the game going by lending us back our money so we can buy Asian some more. Its people have jobs. Our people have cheap stuff. That’s the game.

Perhaps gradually, perhaps screechingly, play comes to a halt. That’s why the U.S.-China relationship has been dubbed “Chimerica”: It can’t last indefinitely. Eventually, the seller’s currency rises in value against the buyer’s. The buyer’s trade deficit shrinks, just as does the seller’s surplus. Case in point: It took 360 Japanese yen to buy one dollar in 1970. Today, it takes less than 100. That has made Japanese goods and services about 4 times as expensive in America, relatively speaking and all else equal, than they otherwise would have been. The same, it can reasonably be projected, will happen to the Chinese currency some day. The reason many argue for it happening sooner: to ease the inevitable adjustment by making it gradual.

“Adjustment” means a much weaker dollar, which in turn means that we can afford less from abroad. Thus our standard of living, by definition, goes down. But since AMERICAN goods and services would then be cheaper, we’ll be producing more once again.

A final PS: “Production” should not be confused with making “things.” Most of what we “produce” in America is “services” – what I’m doing this very moment. Our future prosperity will depend upon our ability to provide services that people will want, at a price they’re willing to pay. Some of those people will be in other countries. But most may continue to be right here in our huge, resource-rich homeland. In which case, consumption will still command the lion’s share of the U.S. economy.