Consuming Our Way to Prosperity Is Macro Folly

BY John Papola  March 6, 2013 at 10:43 AM EST

Produced by Emergent Order for Econstories.tv, a place to learn about the economic way of thinking through the eyes of creative director John Papola and creative economist Russ Roberts.

A Note from Paul Solman: We first encountered John Papola via “Fear the Boom and Bust,” his stunning Keynes vs. Hayek rap, made in collaboration with old friend Russ Roberts. The rap lyrics are extremely even-handed debating the merits of Friedrich Hayek vs. John Maynard Keynes. While the Hayek character may be the less attractive of the two rappers, the video climaxes with Keynes’ head in the toilet, a victim of overindulgence.

The image of Keynes vomiting befits the libertarian bent of Papola, who believes the key to economic growth is savings and investment not “consumption.” I asked him to elaborate in print, if only for an excuse to link back to “Macro Follies,” and then elicit a response from economic historian James Livingston.


John Papola: The American people are repeatedly told by financial pundits and politicians that consumption is an “engine” that “drives” economic growth, because it makes up 70 percent of GDP. This past December, my team and I produced a new EconStories video, “Deck the Halls with Macro Follies,” which took aim at this very old, yet common, economic fallacy.

Our video appeared in a holiday Making Sense segment as a counterpoint to a recent book by James Livingston, “Against Thrift,” a text which attacks private savings and investment and celebrates consumption. Mr. Livingston’s book, as well as recent commentaries by Paul Krugman and other Keynesian economists demonstrate that after two centuries, the debate over what grows the economy is still far from settled social “science.” Though Mr. Livingston makes a stronger claim than some about the allegedly stimulative powers of consumption, his view is thoroughly within the mainstream economic narrative.

It’s of course true, self-evident even, that the goal of economic activity for each of us is to live a better life. This often, though not always, means consuming more goods and services from holiday gifts to houses to healthcare. But consumption is our goal, not the means to achieve it. Confusing our ends with the means has trapped popular economic discourse in a veritable dark age.

The systematic failure by Keynesian economists and like-minded pundits to distinguish between consuming and producing value remains the single most damaging fallacy in popular economic thinking.

This doctrine of underconsumptionism is wrong for a number of reasons:

  1. The historical record on economic growth and recession is marked by a clear pattern of investment-led booms and busts, rather than changes in consumption. Investment leads, consumption follows.
  2. The design of GDP statistics has a Keynesian bias that creates a misleading picture of what composes our economy, where value is actually added and thus what activity actually creates real income and enables our consumption.
  3. By the very nature of consumption, it is logically impossible, absurd even, to consume our way to plenty.

A History of Macro Follies

Here is the how the historical record on economic growth conflicts with this consumption doctrine. Economic growth (booms) and declines (busts) have always been lead by changes in business and durable goods investment, while final consumer goods spending has been relatively stable through the business cycle.

Booms and busts in financial markets, heavy industry and housing have always been leading indicators of recession and recovery. The dot-com boom and bust, the Great Depression and our current crisis all exhibit the pattern.

For example, during our past two decades of booms and busts, investment collapsed first, bringing employment down with it. Consumption spending actually increased throughout the 2001 recession — financed, in part, by artificially easy credit — even as employment was falling along with investment.

During our continuing crisis, consumption spending returned to its all-time high in 2011, yet investment to this day remains at decade lows, producing the worst recovery in growth and employment since the Great Depression. Labor force participation hasn’t been this low since the 1980s. But why?

As John Stuart Mill put it two centuries ago, “the demand for commodities is not the demand for labor.” Consumer demand does not necessarily translate into increased employment. That’s because “consumers” don’t employ people. Businesses do.

Since new hires are a risky and costly investment with unknown future returns, employers must rely on their expectations about the future and weigh those decisions very carefully. Economic historian Robert Higgs’ pioneering work on the Great Depression suggests that increased uncertainty can depress job growth even in the face of booming consumption. Consumer demand that appears to be driven by temporary or unsustainable policies is unlikely to induce businesses to hire.

Increased investment drives economic growth, while retrenched investment leads to recession and reduced employment — and it always has. John Maynard Keynes, like most business cycle theorists before him and since, paid particular attention to this boom and bust in investment, blaming volatility on the “animal spirits” of businessmen. This observation about the importance of “confidence” is surely true, if somewhat obvious.

Unfortunately, Keynes and his successors focus on aggregate levels of spending and often explicitly disregard the details of how money is spent and resources are employed. This lead him and the profession down a dark road to the defunct underconsumptionist ideas of the early 1800s which haunt us to this day. Keynes repeatedly asserts throughout his famous tome, “The General Theory,” that even wasteful expenditures could increase the wealth of society.

Is it any wonder that so many of our policies are focused on consuming and sometimes even destroying wealth rather than creating it?

Those who blame our stagnation on a lack of consumer demand rely on a dangerous brew of dubious data and discredited doctrines. The past several decades in America have been marked by a collapse of real savings encouraged by artificially easy credit from the Fed, along with explosive growth in government spending. All these combined to bring about a debt-fueled spending binge, with disastrous consequences. If ever there was an experiment in trying to consume our way to prosperity it was the first decade of the 21st century, and the results speak for themselves.


Before I Can Consume, I Must Produce for Others

By definition, the gross domestic product (GDP) is a summary of final sales for new goods and services and not of all economic activity. Raw materials, intermediate goods and labor costs, which comprise the bulk of business spending are not treated in GDP, but are rather rolled up in the final sale price of the “consumer” spending. Only capital equipment, net inventory changes and purchase of newly constructed homes constitute “investment” according to GDP. This framing of the data makes the “consumption drives the economy” a foregone conclusion. But this is circular reasoning.

Where do so-called “consumers” get their money to spend? Before we can consume, we need to produce and earn a paycheck. And paychecks have to flow to productive — that is value-creating — behavior, or value is simply being transferred and destroyed. Our various demands as consumers are enabled by our supply as workers and producers for others. That’s the classical “Law of Markets”, often referred to as Say’s Law, in a nutshell.

For employees, those paychecks are income, but for the employers, wages represent most business’ single largest expense. Yet GDP does not treat employee wages or materials as “investment spending,” even though any business owner regards salaries as the most important and largest investment that they make. Instead, employee wages appear in GDP data as consumption when income is spent on final goods like food, clothing, gadgets, and vacations.

Moreover, since GDP is an accounting summary, it adds consumption and investment spending together. But this masks the fact that these two activities are actually in opposition in the short run. In order to invest more today, we have to save more and consume less. As a result, GDP by itself reveals nothing about what grows an economy. At best, it demonstrates how large the economy is and whether it’s growing or shrinking of time.

Digging below the surface of GDP reveals a structure of value-adding production far more complex than the simplistic analysis given by most media reports. According to government income data, more than 70 percent of Americans earn their incomes from employment in domestic business. Yet the retail sector of our economy, for example, only contributed 6 percent of GDP.

Bureau of Labor Statistics (BLS) data on employment show that only about 11 percent of employed Americans work in “sales and related occupations”. That leaves a great deal of economic activity and employment to the “business to business” sector, which composes most of the real economy.

Most of the value-adding activities occur between a vast structure of businesses and workers starting with raw materials and blueprints and come together over months (sometimes years when R&D is included) before a final sale can be made. At each stage, the activity is funded not by current “consumer spending” but through a combination of new investment and savings such as each company’s reinvested earnings.

The farther from a final good a business’s output is, the more it relies on credit markets and the more it is subject to distortions on the savings and investment side. And since employment is spread across this time structure with relatively few working in final retail stage, savings and investment changes have dramatic impacts on employment. It is this relationship between the time structure of production, employment and interest rates which forms the basis of Hayek’s theory of the business cycle.


Organic Growth

My wife Lisa and I have personal experience with dynamics that the top-down Keynesian point-of-view ignores. Several years ago, we launched a side-business designing, manufacturing and selling reusable cloth diapers to moms interested in saving money and cutting down on trash. We called them “wee-huggers.”

To start the business, we got a small capital contribution from my brother-in-law in exchange for equity in the company. These savings were put to use buying the raw materials, designing the diaper prints, hiring sets of skilled people both to sew the diapers and to build the website. Designing, testing and producing the product and website took over a year.

Almost none of that activity was included in GDP for that year, except through the “consumer spending” of people we paid. Throughout this stage, no “product” existed for others to demand or for us to sell and generate income. The time Lisa and I spent building the company was also a very real form of investment itself. This so-called “sweat equity” is just as much of an investment as a financial contribution.

When we finally began selling our product to customers, the income generated was barely enough to cover the real costs. We reinvested all of it into new inventory for the business, keeping nothing for ourselves in the hopes of improving our approach. Consumption didn’t create our output. Investment did. After an additional year of persistent reinvestment, we realized that we would need even more investment to make the business viable.

Our costs were too high per diaper and our local production capacity was too low and unproductive to keep up with demand. Moms loved wee-huggers and we struggled to keep the product in stock. Yet we felt the competition didn’t permit us to raise our prices.

The only way to make the business grow would have been to secure enough capital to invest in a major manufacturing facility with higher productivity equipment and division of labor. We chose instead to focus on a business where both of us, as MTV Networks creatives, believed we could add more value: our new media company, Emergent Order.

Mr. Livingston derides small businesses in his interview because, despite accounting for the majority of employment, most tend to close within 18 to 24 months, as ours did. But it is through this dynamic market process, painful as it was for us and many others, that we discover the most valuable ways to serve one another.

And while particular businesses fail, the ongoing dominance of small business as employers for most Americans demonstrates a clear history that new firms come to take the place of old ones. Livingston’s criticism is thus a one-sided coin.


Don’t Put the Shopping Cart Before the Horse

There is a fundamental illogic to the notion that an economy can be grown by encouraging consumption. When a person consumes, by definition, they use things up. The very process leaves us with less than before. Growing the availability of valuable goods and services for society by using them up is not just an impossibility — it’s truly an absurdity.

If each and every one of us stopped producing for others and all solely acted as “consumers” with our proceeds, it’s pretty easy to see how quickly we would run out of everything. In no time our shelves would be as bare and our people as poor as the citizens of the former Soviet Union depicted in the holiday PBS NewsHour story.

Referring to people as “consumers” is itself a misnomer. Though economists teach their students about “supply” and “demand” as distinct activities, this depiction is just a useful fiction for helping to organize one’s thoughts. It’s a “model,” not reality.

Economic activity is exchange. We produce so that we may exchange with other producers. The reciprocal exchange relationship was much easier to see in a barter economy. The farmer trades his wheat in exchange for candles from the candlestick maker.

John Stuart Mill wrote, commodities are ultimately bought with other commodities. Though we featured French economist Jean Baptiste Say in our video, for his name is most often associated with the ideas we’re exploring, Mill was in fact a far clearer enunciator of this law of markets — that our demand for goods and services is enabled by our supply to others. Put another way, to engage in trade, you must bring something to the market.

This essential law of markets remains just as true in our modern, monetary economy though it is harder to see and understand because nearly all of us work in exchange for money first, and then use that money as a “medium of exchange” to trade our work for other things.

Good macroeconomics should be focused on this coordination among value-adding producers and be on the lookout for financial disruptions and mismatches between the supply and demand for their medium of exchange: money itself. This has been the classical focus of macroeconomics from David Hume and John Stuart Mill through Friedrich Hayek and Milton Friedman.

For most of human history, ordinary people had to spend their lives growing food. Today, we have many billions more people on the planet. And yet food is cheaper, better and of greater variety than ever before. Still, almost nobody works in agriculture. We didn’t create this wealthy, amazing world by eating. We did it by saving our seed corn, investing and ultimately inventing our way out of farming jobs. Thank heavens we did.

There are important lessons for public policy that come from these classical insights. Any program which accelerates the consumption of value, or worse, the destruction of value, ultimately make our society poorer. Despite what Keynes and his modern followers claim, wars, natural disasters, terrorist attacks, faked alien invasions or programs that encourage us to destroy our used cars — all make us poorer. These schemes reduce the amount of valuable goods and services available for society.

Some may consider unemployment benefits to be a necessary policy on humanitarian grounds, but they by no means “stimulate” the economy. The recipient, after all, is consuming without producing any value for others. Disincentives for people to be productive, which have exploded in recent years, not only reduce employment, but reduce output and growth as well. This last point used to be widely believed by economists, including the immensely popular and polarizing economist, Paul Krugman, whose own 2009 textbook blamed extended unemployment benefits as one of the main reasons for decades of European stagnation and high “structural” unemployment. Now, I fear that a decade of Keynesian macro follies has brought Euro-sclerosis to America.

Savings and investment are the true engines of economic growth. When successful, they increase the total amount of valuable goods and services for people to enjoy. They build a better mousetrap and allow us to do more with less. A growing economy is a growing supply of goods and services being exchanged between productive people.

To paraphrase monetary economist Scott Sumner, there are only two ideas students of macroeconomics should be taught: Say’s Law of markets and monetary equilibrium theory. The rest of Keynesianism, with its focus on real spending, government deficits and encouragement of unproductive consumption, can and should be discarded.

Mr. Livingston and I clearly both share a love of commerce and commercial culture. It is a beautiful thing to provide service to others. Honest free enterprise is an amazing and moral system precisely because it requires that we must give before we can receive.

We must produce before we can consume. If we want sound and sustainable economic growth, each of us has to discover the most valuable ways to serve others and contribute to the supply of wealth before we can take from it.


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This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions