John Papola, the producer of the Keynes-Hayek Rap has an incredibly accurate article at Forbes.com which he has titled “Think Consumption Is The ‘Engine’ Of Our Economy? Think Again” which is in every way an all points defence of Say’s Law right down to quoting John Stuart Mill on “demand for commodities is not demand for labour”.

Have you heard that the economy is like a car? It’s the most popular analogy in financial reporting and political discourse. The American people are repeatedly told by financial pundits and politicians that consumption is an ‘engine’ that ‘drives’ economic growth because it makes up 70% of GDP. One notable Nobel-winning economics pundit with a penchant for bizarre growth theories even recently noted that an economy can be ‘based on purchases of yachts, luxury cars, and the services of personal trainers and celebrity chefs.’ Conversely, other economists including Nobel-winner Joseph Stiglitz claim that our economy is stuck in ‘first gear’ due to inequality: too much income is concentrated among too few rich people who tend to save larger share of their income and thus have a lower ‘marginal propensity to consume’. The Keynesian message is clear: if you want to put the economic pedal to the metal, get out there and consume!

Not so fast, Speed Racer. The systematic failure by Keynesian economists and pundits to distinguish between consuming and producing value is the single most damaging fallacy in popular economic thinking. This past Christmas, we produced a playful video called ‘Deck the Halls with Macro Follies’ exploring the history of this popular myth. If the economy were a car, consumer preferences would surely be the steering wheel, but real savings and investment would be the engine that drives it forward.

A History of Macro Follies

The historical record on economic growth conflicts with this consumption doctrine. Economic growth (booms) and declines (bust) have always been led by changes in business and durable goods investment, while final consumer goods spending has been relatively stable through the business cycle. Booms and busts in financial markets, heavy industry and housing have always been leading indicators of recession and recovery. The dot-com boom and bust, the Great Depression and our current crisis all exhibit the pattern.

One notable Nobel-winning economics pundit with a penchant for bizarre growth theories even recently noted that an economy can be ‘based on purchases of yachts, luxury cars, and the services of personal trainers and celebrity chefs.’ Conversely, other economists including Nobel-winner Joseph Stiglitz claim that our economy is stuck in ‘first gear’ due to inequality: too much income is concentrated among too few rich people who tend to save larger share of their income and thus have a lower ‘marginal propensity to consume’. The Keynesian message is clear: if you want to put the economic pedal to the metal, get out there and consume!

For example, during our past two decades of booms and busts, investment collapsed first, bringing employment down with it. Consumption spending actually increased throughout the 2001 recession (financed, in part, by artificially easy credit) even as employment was falling along with investment. During our continuing crisis, consumption spending returned to its all-time high in 2011–yet investment to this day remains at decade lows, producing the worst recovery in growth and employment since the Great Depression. Labor force participation hasn’t been this low since the 1980s. But why?

As John Stuart Mill put it two centuries ago, ‘the demand for commodities is not the demand for labor.’ Consumer demand does not necessarily translate into increased employment. That’s because ‘consumers’ don’t employ people. Businesses do. Since new hires are a risky and costly investment with unknown future returns, employers must rely on their expectations about the future and weigh those decision very carefully. As economic historian Robert Higgs’ pioneering work on the Great Depression suggests, increased uncertainty can depress job growth even in the face of booming consumption. As recent years have demonstrated, consumer demand that appears to be driven by temporary or unsustainable policies is unlikely to induce businesses to hire.

The past several decades in America have been marked by a collapse of real savings encouraged by artificially easy credit from the Fed, along with explosive growth in government spending. All these combined to bring about a debt-fueled spending binge, with disastrous consequences.

Increased investment drives economic growth, while retrenched investment leads to recession and reduced employment–and it always has. Those who blame our stagnation on a lack of consumer demand rely on a toxic brew of dubious data and dangerous theory.

Before I Can Consume, I Must Produce for Others

By definition, GDP is a summary of final sales for new goods and services and not of all economic activity. Raw materials, intermediate goods and labor costs, which comprise the bulk of business spending are not treated in GDP, but are rather rolled up in the final sale price of the ‘consumer’ spending. Only capital equipment, net inventory changes and purchase of newly constructed homes constitute ‘investment’ according to GDP. This framing of the data makes the ‘consumption drives the economy’ a foregone conclusion. But this is circular reasoning.

Where do these ‘consumers’ get their money to spend? Before we can consume, we need to produce and earn a paycheck. And paychecks have to flow to productive — that is value-creating — behavior, or value is simply being transferred and destroyed. Our various demands as consumers are enabled by our supply as workers/producers for others. That’s the classical ‘Law of Markets’, often referred to as Say’s Law, in a nutshell.

For employees, those paychecks are income, but for the employers, wages represent most business’ single largest expense. Yet GDP does not treat employee wages or materials as ‘investment spending’ — even though any business owner regards salaries as the most important and largest investment that they make. Instead, employee wages appear in GDP data as consumption when income is spent on final goods like food, clothing, gadgets, and vacations. Moreover, since GDP is an accounting summary, it adds consumption and investment spending together. But this summarizing masks the fact that these two activities are actually in opposition in the short run. In order to invest more today, we have to save more and consume less. As a result, GDP in-and-of-itself reveals nothing about what grows an economy; at best, it demonstrates how large the economy is and whether it’s growing or shrinking.

Digging below the surface of GDP reveals a structure of value-adding production far more complex than the simplistic analysis given by most media reports. According to government data, more than 70% of Americans earn their incomes from employment in domestic business. Yet the retail sector of our economy, for example, only contributed 6% of GDP. Bureau of Labor Statistics (BLS) data on employment show that only about 11% of employed Americans work in ‘sales and related occupations’. That leaves a great deal of economic activity and employment to the ‘business to business’ sector, which composes most of the real economy.

Most of the value-adding activities occurred between a vast structure of businesses and workers starting with raw materials and blueprints and coming together over months (sometimes years when R&D is included) before a final sale can be made. At each stage, the activity is funded not by current ‘consumer spending’ but through a combination of new investment and savings such as each company’s reinvested earnings. The farther from a final good a business’s output is, the more it relies on credit markets and the more it is subject to distortions on the savings and investment side. And since employment is spread across this time structure with relatively few working in final retail stage, savings and investment changes have dramatic impacts on employment. . . .

Organic Growth

My wife Lisa and I have personal experience with dynamics that the top-down Keynesian view ignores. Several years ago we launched a side-business designing, manufacturing and selling reusable all-in-one cloth diapers to moms interested in saving money and cutting down on trash. We called them “weehuggers”.

To start the business, we got a small capital contribution from my brother-in-law in exchange for equity in the company. These savings were put to use buying the raw materials, designing the diaper prints, hiring sets of skilled people both to sew the diapers and to build the website. Designing, testing and producing the product and website took over a year. Almost none of that activity was included in GDP for that year, except through the “consumer spending” of people we paid. Throughout this stage, no “product” existed for others to demand or for us to sell and generate income. The time Lisa and I spent building the company was also a very real form of investment itself. This so-called “sweat equity” is just as much of an investment as a financial contribution.

When we finally began selling our product to customers, the income generated was barely enough to cover the real costs. We re-invested all of it into new inventory for the business, keeping nothing for ourselves in the hopes of improving our approach. Consumption didn’t create our output. Investment did. After an additional year of persistent re-investment, we realized that we would need even more investment to make the business viable.

Our costs were too high per diaper and our local production capacity was too low to keep up with demand. Moms loved weehuggers and we struggled to keep the product in stock. Yet we felt the competition didn’t permit us to raise our prices. The only way to make the business grow would have been to secure enough capital to invest in a major manufacturing facility with higher productivity equipment and division of labor. We chose instead to focus on a business where both of us, as former MTV Networks creatives, believed we could add more value: our new media company Emergent Order.

Our recent video“Macro Follies” is just one of the fruits of that decision. We followed our passion, but we were also guided through market prices and profits toward the best way for us to create value for others.

Don’t Put the Shopping Cart Before the Horse

There is a fundamental illogic to the notion that an economy can be grown by encouraging consumption. When a person consumes, by definition, they use things up. The very process leaves us with less than before. Growing the availability of valuable goods and services for society by using them up is not just an impossibility—it’s an absurdity. Consumption is the goal, but it is production that is the means.

For most of human history, ordinary people had to spend their lives growing food. Today, we have many billions more people on the planet. And yet food is cheaper, better and of greater variety than ever before. Still, almost nobody works in agriculture. We didn’t create this wealthy, amazing world… by eating. We did it by saving our seed corn, investing and ultimately inventing our way out of farming jobs. Thank heavens we did.

There are important lessons for public policy that come from these classical insights. Any program which accelerates the consumption of value, or worse, the destruction of value, ultimately make our society poorer. Despite what Keynes and his modern followers claim, Wars, natural disasters, terrorist attacks, faked alien invasions, or programs that encourage us to destroy our used cars — all make us poorer. These schemes reduce the amount of valuable goods and services available for society. Some may consider unemployment benefits to be a necessary policy on humanitarian grounds, but they by no means “stimulate” the economy. The recipient, after all, is consuming without producing any value for others. Disincentives for people to be productive, which have exploded in recent years, not only reduce employment, but reduce output and growth as well. This last point used to be widely believed by economists–including the immensely popular and polarizing economist, Paul Krugman, whose own 2009 textbook blamed extended unemployment benefits as one of the main reasons for decades of European stagnation and high ‘structural’ unemployment. Now, I fear that a decade of Keynesian macro follies may have brought Eurosclerosis to America.

Savings and investment which enable increased productivity, greater specialization and trade are the true engines of economic growth. Increasing consumption is a result of that growth, never the cause of it. If we want sound and sustainable economic growth, each of us has to discover the most valuable ways to serve others and contribute to the supply of wealth before we can take from it. Much like everyone else, even Santa Claus must produce all year long before people get to enjoy their presents.

To Outsmart ObamaCare, Go Protean is an article from The Wall Street Journal about how to keep the number of employees under 50 which is necessary if a business is to remain out of the reach of Obamacare. The core suggestion is that businesses stop employing and contract everything out creating what is described as a “protean corporation”. Why I mention it, though, is because I thought this observation of the partnership of employees with the government was particularly sharp:

When a person is an employee, he or she is, by definition, in partnership with the government — the Equal Employment Opportunity Commission, the Occupational Safety and Health Administration, etc. — and is subject to all the government’s regulations. But when a protean corporation enters into a relationship with that same person, now a corporation, it is a purely contractual relationship with a fellow enterprise. As long as there is no fraud or breach of contract, and the agreement is legal, the government really has nothing to say.

The notion that the government really has nothing to say is highly unlikely but there really is something in the suggestion. As usual, in its efforts to make employment more secure it has made it less so, but there’s nothing new about that when it comes to government policy.

There was a time that the role of economic theory was to promote market outcomes, to understand and explain how they worked and why they are beneficial to us all. Now economists see their role as explaining why markets cannot be expected to work and why their operation can be expected to cause harm to the majority of the population. And not just some of the time but all of the time. I have been reading Joe Stiglitz’s The Price of Inequality (2012 – see how up-to-date I am) which is a quite sobering experience. There is no form of interference with the operation of the market that he would not endorse on the road to greater “equality”. He and Krugman are the Marx and Engels of American economic theory. This more or less sets it out:

Private rewards and social returns are not well aligned when competition is imperfect; when there are externalities (where one party’s actions can have large negative or positive effects on others for which he does not pay or reap the benefit); when there exists imperfections or asymmetries of information (where someone else knows something relevant to a market trade that someone else doesn’t know); or where risk markets or other markets are absent (one can’t, for instance, buy insurance against many of the most important risks one faces). Since one or more of these conditions exist in virtually every market, there is in fact little presumption that markets are in general efficient. This means that there is an enormous potential for governments to correct these market failures. (p34)

Enormous and never ending. Compare the above with a second bit of analysis, again from a Nobel Prize winner, this time the 1977 winner, James Meade. If there’s a dime’s worth of difference between the two, I haven’t run across it yet. The following is from Meade’s The Intelligent Radical’s Guide to Economic Policy (1975) which I have been reading at the same time as I have been ploughing through Stiglitz.

On the foundation of this market mechanism there must be built a superstructure of of governmental interventions and controls. Some of these interventions are needed simply to set a background of conditions in which free competition can work effectively; others are needed to replace entirely the mechanism of competitive markets, where the mechanism cannot be expected to operate effectively; others have an intermediate purpose, namely to modify without replacing the operation of a market price mechanism.

If you want to understand our economic problems, there’s nowhere better than to look at the advice from the economics profession itself. Everything needs fixing by governments. Virtually nothing can be left to run itself. If there is anything left of the free market after this, I am not sure where it is.

I’m in New Zealand doing some work that has brought me this way. But I thought I’d share this posting on the History of Economics website I put up yesterday. The query had been a follow up to my previous posting on Macro Follies but the fellow who put it up specifically said he didn’t want to reopen these issues but would like to know where he can get some information on the classical theory of the cycle. I was a couple of days late in getting to this reply, but this is what I have finally contributed. Interestingly, no one has posted since and there had only been six contributions before mine. It cannot be that across the world of historians of economics no one any longer even knows where to find a discussion of the theory of the cycle prior to Keynes although you never do know. You really never do know.

If you interested in the classical theory of the cycle and where to read it from the perspective of someone who actually thought it was valid, then the best place to go is to the first edition of Haberler’s Prosperity and Depression published by the League of Nations in 1937. Some tinge of a Keynesian influence but minimal. A second alternative, if you will allow me to say this, is from my Free Market Economics: an Introduction for the General Reader (Elgar 2011) where in Chapters 14 and 15 I discuss and explain the classical theory of the cycle with much of it based on Haberler and give lots of examples.

But it is possible to pick up just about any text published in the nineteenth and early twentieth centuries and find a discussion of the business cycle which was an integral part of the study of any student of economics, in spite of what Keynes might have said. As it happens, I am in New Zealand at the moment and have been scouting the second hand book shops and picked up a copy of Political Economy for Use in Schools and Private Instruction published in London in 1873 by William and Robert Chambers who also seem to have written it although no author is named.

It’s a short book, only 154 pages, but has a section that runs from page 137 to 143 on “Commercial Convulsions”. The discussion is part theory but also focuses on the railroad mania of 1846 which, as described, was in almost every respect identical to the GFC other than that in 1846 the problem was with the capital that poured into building new railroad lines and we were dealing with housing; and they discussed the problems as they affected bond holders while in 2008-09 it was the CDO’s and other credit instruments. If you read it, it may be quite a revelation how much they understood then.

But in the next chapter on “Accumulation and Expenditure” it explains more than half a century before the publication of The General Theory the problem with taking a Keynesian approach to induce recovery. This is from page 146:

If we compare productive and unproductive expenditure, it will be found that the unproductive is most agreeable at the time, to all parties concerned in it. In fact, it is the spending in enjoyment of what other people have made by industry and frugality; hence arises the popularity of the man who is spending money rapidly and thoughtlessly; all around him derive immediate advantage from it. If they are working, and making their daily bread at the same time that they are receiving money thoughtlessly spent, it is so much enjoyed by them in addition to what they can otherwise obtain. If they are idle, which is the far more common case, then they have the satisfaction of enjoying themselves in idleness. Their fate in doing so may not be a happy one, but it is their choice, and they praise the spendthrift who gives it them.

What can I say? The book reminds me once again that a high school student in 1873 might have had a better grasp of the nature of the cycle and the problem with public spending than does our learned profession today. If you are interested in a simple explanation of the classical theory of the cycle, just get a copy of this book which was doing no more than stating the common view of the time which was the common view right through to 1936.