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The Dangerous Fallacy that Consumer Confidence Drives Economic Growth
Wednesday, July 25, 2007
As members of the economic commentariat financial journalists are expected to know what they are talking about when they write on economics. Unfortunately such expectations are doomed to be confounded. If it were otherwise these commentators would have long ago abandoned the dangerous fallacy that "consumer sentiment" is the economy's driver that raises spending, forces businesses to fill their order books, invest in new plant and employ more people. In short, we are right back to the mercantilist fallacy that consumption drives the economy.
That this ridiculous fallacy is still widely held and promulgated is a damning indictment of the appalling state of what passes for economic thought in our newspapers and business magazines - not to mention our universities and colleges. It certainly reflects badly on the intelligence of these financial writers that they are intellectually blind to the fact
that consumption is posterior to production, as it is impossible to consume what is not produced. Consumption in the necessary order of things is the effect of production, not production the effect of consumption. (James Stuart Mill, Commerce Defended, C. and R. Baldwin, 1808, p. 79).
Clearly our modern economists are unable to grasp the fundamental truth that "'Consumption' is...the extermination of power to demand". (W. H. Hutt, A Rehabilitation of Say's Law, Ohio University Press, 1974, p. 90). Therefore consumption grows out of production and not the reverse. This is why the great consuming nations are also the great producing nations. You cannot consume what has not been produced. "Ah!", our consumptionists would exclaim, "but increased spending leads to greater demand for inventories and encourages investment and employment and hence stimulates growth". Not true. If this were so economic growth would not have opportunity costs. In other words, growth would not require savings.
Economic growth consists of increasing investment in the capital structure. For the structure to expand by adding more and more complex stages more savings are needed. Now capital goods are future goods which are, in a sense, converted, into present goods (consumption goods) during the production process. It follows that present goods are savings that are converted into future goods. Another way of putting this is to say that savings are spent in a way that directs production from present consumption to greater future consumption.
The effect of increasing genuine savings and therefore growth is to investment in more roundabout processes that increase productivity and by doing so raise the value of the workers' marginal product and hence their real wages. The reverse is equally true. And this is what John Stuart Mill meant when he wrote that
I apprehend, that if by demand for labour be meant the demand by which wages are raised, or the number of labourers in employment be increased, demand for commodities does not constitute demand for labour. I conceive that a person who buys commodities and consumes them himself, does no good to the labouring classes; and that it is only by what he abstains form consuming, and expends in direct payments to labourers in exchange for labour, that he benefits the harbouring classes, or adds anything to the amount of their employment". (John Stuart Mill, Principles of Political Economy, University of Toronto Press, 1965 p. 80)
Therefore consumer spending can do nothing to raise real wages because it does nothing to increase productivity. This can be illustrated by what would happen to an advanced country that embarked on a process of dissaving (capital consumption): initially rates of return would increase in the consumer goods industries (the lower stages of production) and fall in the producer goods industries (the higher stages of production); the higher stages of production would start disinvesting and the lower stages would start expanding relative to the capital goods' industries; productivity would slow and so would the growth in real incomes; eventually, the economy would regress and real incomes and living standards would fall. All because the country had swallowed the myth that consumption was the real road to prosperity.
It is a disgrace that so many commentators have lost sight (that is if they ever saw it) of the basic economic fact that only production can give rise to consumption. The logic of this statement leads to the vital conclusion that savings fuel the economy while entrepreneurship drives it. Despite the obvious importance of this issue our economic commentariat adamantly refuse to debate it.