Perhaps one of the biggest misconceptions about America’s recent period of high growth is that consumption was the principal driver behind it. Embodied as the notion of a so-called wealth effect, the misconception is so deeply entrenched that its internal contradictions are overlooked and alternative views are simply ignored. As it is, this misguided thinking is used in diverse settings to (mis)interpret economic conditions.
For example, consumer spending cannot keep America’s economy afloat for much longer. Nor should it be expected to be the driving force behind the revival of Japan’s. By the same token, lagging household consumption should not be blamed for Japan’s ongoing economic malaise. For it is only investments that find their way into productive activities, especially in manufacturing, that can bring sustained boosts to an economy. Consumer spending is not a key indicator, as many have portrayed it. (A counterargument to consumption-driven growth is that the wealth effect that was supposed to have powered the U.S. economy did not operate in reverse when the stock market collapsed and considerable sums of wealth evaporated.)
Without an increase in real earnings brought about by rising real income from increased productivity, an economic boom on the back of consumption will be an illusion. In the case of the United States, the usual suspect was an expansion in credit that promoted binge buying and an imaginary wealth effect.
In most instances, consumption is the result rather than the cause of growth. An exception occurs when promiscuous central-bank policy causes excessive expansion of credit. But this can only create an artificial and temporary sense of increased prosperity that eventually is brought to an end either by a bruising round of inflation or an overexpansion that leads to a collapse in profitability.
Credit expansions lead to a decline in interest rates and usually result in rising nominal incomes. As the financial system becomes flooded by cheap credit, people feel that they are becoming more prosperous and begin to expand their consumption through increased debt. As the demand for consumer goods increases relative to the demand for producer goods, inputs are bid away from more complex productive activities at higher stages in the production process. This puts cost pressures on firms in those higher stages and will eventually cut into profits.
And so it is that cyclical downturns are brought about by falling profits that result from faulty credit policy. This always first appears in manufacturing and tends to be pronounced in the higher stages of production that require more sophisticated capital inputs.
So what is going on now? Why is consumption remaining so high in the United States and why is it not possible for it to reverse the negative economic trends? The effects of excessive credit growth can survive an initial slump in business conditions because binge borrowing is like other bad habits and broken slowly. American households have been spending like there is no tomorrow because the credit taps were opened wide enough to allow them to borrow money cheap.
Masked by Consumer Spending
Yet the collective gaze will begin to shift to longer time horizons as job cuts become deeper and more workers face the prospect of losing their jobs. While manufacturing tends to decline first, continued consumer spending disguises this effect by keeping the demand for labor at lower stages of production comparatively stable. Consequently, the unemployment level does not rise sharply.
But now the declines in U.S. manufacturing are becoming too large not to have an impact on investment spending needed to create new jobs. The latest data indicate that the sector has suffered deep cuts in employment. As it is, over 113,000 manufacturing jobs were lost in June after 127,000 were shed in May. And more layoffs were planned. Declining profits lead to a decrease in capacity utilization so that unsold goods begin to accumulate. (According to the Fed, excess capacity is at the highest level in almost 20 years.) As profits fall, employment and retail sales also go down. Consequently, an industrial slowdown brings about excess capacity and rising inventories.
Both these problems will emerge even if there are continued advances in technology. An indicator of the magnitude of these problems is seen in shrinking dividends. As a percentage of prices, dividends are now about 2 percent, substantially lower than their historical average of 4.5 percent. It turns out that yields of 2 percent or less have preceded economic slumps. Although slowing profits are causing dividends to fall, the real cause is overheated monetary growth and credit expansion that caused shares to be overvalued.
Unfortunately, cheap-money policies will not resolve the fundamental economic imbalances. Indeed, additional rounds of interest-rate declines may actually worsen them.
With debt-servicing expenditures as a percentage of American household income at a record high, it becomes increasingly problematic when mortgage debt is used to finance other debts or maintain consumption levels. As it turns out, interest-rate cuts have encouraged an expansion in second mortgages and long-term refinancing to consolidate short-term debts, like credit cards, that demand higher interest rates. Eventually, additional consumption borrowing will lead to a crushing debt burden that brings personal bankruptcies and weaknesses in the banking system. In turn, the collapse of consumption will contribute to business failures and more weaknesses in the banking system.
Where does this all lead us? The first lesson is that fiddling with credit policies is the source of all modern booms and busts. Understanding this involves the realization that market instability is not the source of most economic turmoil. Likewise, government actions are the source of extreme swings in economic activity and are unlikely to provide the best cure for them.
In fact, government interventions in credit markets or the use of deficit spending can only shift the pain from the present to the future. Since politicians almost always choose this cowardly path, their actions provide more evidence that decisions based on politics seldom lead to sound economic outcomes.
Unfortunately, the painful adjustments of squeezing out excess capacity will require substantial downsizing so that labor is released and used in more productive sectors of the economy. It may seem unjust that some individuals will bear the brunt of the suffering. However, it might provide some solace that most others will benefit from the process. And these include youthful new job-market entrants who would otherwise shoulder the burden of delayed adjustments that would reduce future growth rates and job opportunities for them.
Universidad Francisco Marroquín