A common fallacy has it that consumption drives the economy. According to this oft-repeated myth, higher consumer expenditures inspire businesses to spend and invest more so that employment and incomes rise.
Perhaps because it seems so obvious and logically sound, this mistaken view is accepted by the vast majority of the economics profession and with near-unanimity by non-economists. But this “consensus” perspective is flat wrong since it involves a fundamental confusion about the role of consumers in a market economy.
Getting an intellectual argument wrong would be bad enough, but it also provides support for poor public policy choices. As it is, those who think consumers are keeping the economy afloat also believe that ending the current slowdown requires “stimulus” of more government spending or interest rate cuts.
Not so long ago, these views were discredited after contributing to an orgy of politicized overspending and mounting public debts during the 1970s. Following this path led to a perfect storm of recession and inflation that became known as “stagflation”.
For reasons of political expediency rather than economic veracity, government officials gleefully embrace advice to boost spending based on inflationary and deficit financing. After all, the pay-offs in terms of heightened electoral support are immediate while the costs are deferred to a distant future.
Unfortunately, deficit financing and cheap money policies lead to fundamental economic imbalances in the form of growing public sector debt or inflation or bubbles, or all of the above. To make matters worse, most “stimulus” policies fail to achieve their goals.
Despite deficit spending of nearly a trillion dollars, the US economy remains mired in its longest recession since World War II. And successive governments in Japan spent hundreds of billions of dollars since 1990 without putting the local economy on a strong growth path.
One failure of stimulus spending is seen in the likelihood of a “jobless recovery”. This arises due to the focus on spending rather than creating incentives for entrepreneurs to invest in new projects. While economic growth can occur from printing more money or increasing government debt, increased employment can only come from higher private investment.
An alternative view on how an economy keeps the consumer afloat is found in the contributions of French economist Jean-Baptiste Say. He identified an eponymous economic law that specifies that production in market economies supplies goods that form the basis for demand for other goods. (One need not be an economist to understand that something must first be produced before it can be consumed.)
As it is, increased production requires more investment that depends upon savings derived from surplus production from an earlier period. Using investment funds to buy capital goods that increase productivity will lead to higher wages and living standards so there can be both more consumption and more savings.
As such, consumption follows production. Since consumer spending does not on its own lead to higher productivity, it cannot cause real wages to rise or be the source of sustained growth.
Without increased real earnings brought about by increased productivity, economic booms backed by higher consumption will be illusory and temporary. In the US, the usual suspects of loose monetary policy and expanded credit promoted binge buying and rising debt levels that pumped air into various bubbles.
With that track record, it would seem paradoxical that government stimulus policies encourage more buying and more borrowing! As such, they have almost certainly pumped air into what is likely to be a mini-bubble on global bourses.
A better approach to economic recovery would be to lower the overall tax burden to encourage households and businesses to save more and to increase investments. But it seems certain that governments are more likely to raise tax rates than lower them.
Another possibility to boost long-term economic growth would be to ensure access to reliable, low-cost energy supplies. Unfortunately, the global trend has been to promote unreliable alternative (“green”) energy sources that are only viable when they receive expensive subsidies.
In all events, economic growth requires increased savings rather than more consumption. Increased savings allow more investments so that the capital structure has more production stages of greater complexity to boost specialization and expand the division of labour. But as most central banks are keeping interest rates artificially low, there is a weak incentive to increase the stock of saving.
Politically inspired “stimulus” to increase consumption cannot stimulate an economy. True economic stimulus comes from policies that promote saving to encourage investment.
Christopher Lingle is a research scholar at the Centre for Civil Society in New Delhi and visiting professor of economics at Universidad Francisco Marroquin in Guatemala. Comment at firstname.lastname@example.org