“Analysts watch consumer spending closely because it represents roughly two-thirds of all economic activity.”
(October 30, 1993)
In the early 1990s, in the depths of the recession, Range Rover, a British maker of sports-utility vehicles, ran an unusual ad in USA Today. It announced its formula for ending the downturn: “Buy Something.” Of course, Range Rover wanted you to buy their car, but in any case, purchase something. “Buy a microwave, a basset hound, theater tickets, a Tootsie Roll, something.” Anything to get the economy moving again.
In late 1991, Federal Reserve chairman Alan Greenspan suggested that the economic contraction was caused in part by retrenchment in consumer and business debt during the early 1990s. The implication is that the economy could be on its way to recovery if only consumers and business would start spending again, even if it meant spending beyond their means.
Falling Under the Keynesian Spell
For decades, members of the media and the financial community have fallen under the Keynesian spell, emphasizing the importance of demand over supply, of deficits over surpluses, of debt over equity, and of consumption over saving. For them, the key to prosperity is found in encouraging a high level of consumption, even if it means going deeply into debt. The establishment press is so enamored with consumption that it highlights monthly changes in consumer spending, consumer debt, consumer prices, and surveys of consumer confidence, looking for any encouraging signs. After all, doesn’t consumer spending represent two thirds of total economic activity?
Well, no, it doesn’t. The idea that consumption is the largest sector of the economy is based on a grave misreading of gross domestic product (GDP).
According to 1993 data, consumption expenditures represent 66.1 percent of GDP, or approximately two thirds. Government purchases are second at 18.3 percent, and investment, which includes residential housing, comes in third at 15.6 percent. Business fixed investment is only 11.5 percent of GDP. By making the standard assumption that GDP measures total economic activity, the unsophisticated journalist has concluded that consumer and government spending are by far the most important sectors of the economy, while business investment rates a poor third.
Much mischief in government policy has arisen in consequence of this misinterpretation of national income statistics. Many lawmakers have passed legislation encouraging consumption at the expense of investment. At the same time, they see no reason to cut capital gains taxes or corporate income taxes, since the business investment sector appears to be relatively small and unimportant.
The Source of the Fallacy
What’s gone awry? The source of the error is that GDP is not a measure of total economic activity. As anyone who has taken Econ 101 knows, GDP measures the purchase of final goods and services only. GDP deliberately leaves out spending by business in all the intermediate stages of production before the retail market. It does not include spending (what economists call “working capital”) by natural resource companies, manufacturers, and wholesalers. Obviously, financial journalists need a refresher course in economics.
In sum, GDP does not measure total spending in the U.S. economy, only final retail purchases by consumers, business, and government.
Introducing a More Accurate Statistic
To determine total economic activity, we need to look at gross domestic output (GDO), a statistic I developed in my book, The Structure of Production (New York University Press, 1990). It measures gross expenditures at all stages of production, from raw commodities to finished products. Based on the input-output data prepared by the U.S. Commerce Department, I estimate that consumption expenditures actually represent only about 33 percent, or one third, of economic activity in the United States, not two thirds as is commonly reported. Moreover, gross investment by business represents the majority (54 percent) of total spending in the economy if you add together gross intermediate expenditures (“working capital”), business fixed investment, and residential housing. Government purchases represent the remainder, or 13 percent.
This new statistic, GDO, provides a more complete indicator of total economic activity. As such, it suggests a far different interpretation of how the world works. In fact, we come to the opposite conclusion: Investment is far more important than consumption. The U.S. economy, like all economies, is investment-driven, not consumption-driven. Consumption is ultimately the effect, not the cause, of a nation’s prosperity.
An individual becomes wealthy by producing and investing first, then increasing his consumption—not the other way around. To go on a spending spree using credit cards or other forms of debt may initially give the impression of a higher standard of living, but eventually the individual must pay the piper or face bankruptcy. The same principle applies to a nation as a whole.
“But,” retort the big spenders, “if consumers stop buying, business will eventually stop producing.” Granted, the whole purpose of production is eventual consumption. Per capita consumption is usually a reasonable measure of national wellbeing, and business must be responsive to consumer needs. But the real question is, how do we improve our standard of living? There is only one proven way, and that is by raising the amount of capital invested per worker. Economic progress is achieved when business increases its profits by providing customers with better products at cheaper prices. That requires a direct investment in capital. Those who postpone consumption now and invest their savings productively will be rewarded with higher consumption later.
Consumer Spending Not a Leading Indicator
If the U.S. economy is consumption-driven, why aren’t retail sales a leading indicator of economic activity? Of the eleven components in the U.S. Department of Commerce’s Index of Leading Indicators, only one, the Consumer Expectations Index, is directly linked to future retail sales. The other leading indicators are almost entirely related to capital investment and earlier stages of production, such as manufacturers’ orders, sensitive materials’ prices, contracts for plant and equipment, and stock prices.
Retail sales are in reality an unreliable indicator of where the economy and the stock market are headed. Industrial output is a much better forecaster. And, contrary to what the national media often reports, retail sales are relatively stable compared to industrial production, just as consumer prices are nowhere near as volatile as commodity prices. Financial analysts seeking to pinpoint changes in the direction of the economy and the stock market will be disappointed if they rely entirely on retail sales as a guide.
The Crisis in Productivity and Investment
Stimulating consumer spending in the short run will undoubtedly encourage some lines of investment. If people go on a buying spree at a local grocery store or mall, merchants and their suppliers will see their profits go up. But the consumer spending binge will do little or nothing to construct a bridge, build a hospital, pay for a research program to cure cancer, or provide funds for a new invention or a new production process. Only a higher level of saving will do that. Thus, in nations following Keynesian pro-consumption policies, it is not surprising to see luxurious retail stores and malls along side dilapidated roads and infrastructure. Their consumption/investment ratio is systematically out of balance. Peter Drucker chastises the United States and other Keynesian industrial nations for a “crisis in productivity and capital formation” and “underinvesting on a massive scale.” The current administration has done little to reverse this trend.
Saving, investing, and capital formation are the principal ingredients of economic growth. Countries with the highest growth rates (most recently in Southeast Asia and Latin America) are those that encourage saving and investing, i.e., investing in new production processes, education, technology, and labor-saving devices. Such investing in turn results in better consumer products at lower prices. They do not seek to artificially promote consumption at the expense of saving. Stimulating the economy through excessive consumption or wasteful government programs may provide artificial recovery in the short run, but cannot lead to genuine prosperity in the long run.
Using our new statistic, GDO, we now see that cutting taxes on business and investments (interest, dividends, and capital gains) will have a dramatically favorable effect, far more than previously thought. When business investment represents 54 percent of the economy, not 15 percent, reducing investment taxes can have a multiplying impact on the nation’s economy.
In sum, it is capital investment, not consumer spending, that ultimately drives the economy. As economist Ludwig von Mises declared forty years ago, “Progressive capital accumulation results in perpetual economic betterment.”