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Wednesday, July 21, 2010

Is It Spending or Consumption?

The economy is not a machine.

In reading the various pundits giving advice on what the government should be doing (or not doing) about the current recession, people that economist Robert Higgs properly calls “vulgar Keynesians” are claiming that we need “more spending.” From Paul Krugman, who puts the full weight of the prestige of his Nobel Prize behind this exhortation for the government to spend more, to President Obama, who declared last year that this country must spend its way out of recession, the belief by many is that the more people spend, the more prosperity they create.

While I have openly criticized this strategy before, today I wish to take a different path. I want to go after the fundamental concept of what Keynesians and their followers call “spending,” because I wish to show that this whole idea is wrongheaded, demonstrating a deep-seated misunderstanding of economic processes.

The Austrian view sees an economy as a complex web of various structures of production, with entrepreneurs making decisions based on what they believe consumers will wish to purchase. The capital structure is interrelated with the rate of interest and relative prices of factors of production and final goods.

Furthermore, an economy exists because people are acting purposefully to fulfill their various needs. As Adam Smith so aptly noted, all production ultimately is for consumption, and I often return to Lawrence Reed’s classic “7 Fallacies of Economics,” which lists “production for its own sake” as one of the fallacies that governments often pursue.

The larger point is that production and consumption are related. Furthermore, within the means-end framework of Austrian economics, production is a means to consumption, not an end in itself. Thus it, like production, is purposeful and serves a larger end for individuals. (I am reminded of this when I read criticism from leftists of the “mindless consumption” that Walmart supposedly has engendered. Consumption is not a “mindless” activity.)

Buying Back the Product

On the other side is the view that consumption is merely “buying back the product” that was made. Socialists (as well as Keynesians) believe that because individuals generally do not spend all their income at once, capitalism has the chronic problem of underconsumption. That is, if people are not willing to spend enough to purchase everything that was produced at prices that will equal their cost of production, then a “surplus” of goods will arise and firms will have to lay off workers.

When this situation comes about, with consumer spending not being robust enough to “buy back the product,” then government must fill the “spending hole.” Thus the economy simply is a circular flow in which people produce goods, others buy them, and the process repeats itself.

If we step back and take a hard look at these two competing (Austrian and mainstream) views, we cannot help but notice that the popular (read: vulgar Keynesian) way of looking at an economy is mechanistic at best and absolutely impersonal at worst. In this view, the “purpose” of an “economy” is to clear goods from shelves so people can be employed making things to put back on the shelves. Consumption is reduced to “spending,” and to make things worse, people are supposed to “spend” as their “patriotic duty” to “support the economy.” What “economy”?

Professor Higgs writes:

He [the vulgar Keynesian] supposes: if only the government stepped in and used its own deficit spending to make up for the reduced private investment and consumption spending, then business would be restored to profitability and workers reemployed without any economic restructuring.

Indeed, anyone who believes an economy is nothing more than a mechanical operation in which some people produce, others spend, and then government makes up the difference really does not understand economic processes. Consumption and production are not two independent and unrelated activities; they are intricately tied together to reflect how people meet their needs. Unfortunately, many of today’s “great minds” in economics do not understand that simple point of economic logic. The economy – and real people – suffer because of that.

  • Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Economics from Auburn University. He is a member of the FEE Faculty Network.