Why economic policies promoting consumer spending are bad for an economy

Gerard Jackson

Some readers, still swayed by the current orthodoxy, are a little puzzled by the argument that government policies that bring about increased consumption come at the expense of economic growth (capital accumulation). The classical economists fully understood that economic growth was forgone consumption, meaning that investment, spending on capital goods, can only take place by directing resources away from consumption. It follows that the reverse must be true. Promoting consumption at the expense of savings results in resources being redirected from investment.

Unfortunately, policy-makers, not to mention a huge number of economists, genuinely believe that increasing the demand for consumer goods, by whatever means, will raise profits and thereby raise the demand for more capital goods which in turn would lead to an increased demand for labour. This Alice-in-Wonderland thinking (meaning the Keynesian multiplier) leads to the absurd conclusion that massively raising the spending power of the unemployed would generate enormous growth.

Moody’s Mark Zandi actually argued this when he stated that “the bang for the buck is very high” from extended jobless benefits and would yield $1.64 of GDP. It didn’t take long for fellow Democrats to jump on his magic wagon, with Pelosi claiming that $1 spent on food stamps yielded $1.79 of GDP. But this is not how derived demand works, as any Austrian economist would immediately point out. The problem here is a complete failure to grasp the real nature of demand, including derived demand. Like the classical economists the Austrians argue that demand springs from production: that production, meaning supplies, is what really constitutes demand.

This brings us back to investment. The Austrian school of economics stresses that increased investment lengthens¹ the capital structure which increases the future flow of goods hence raising real wages and consumption. Within this insight lies the concept of the balance between savings (investment) and consumption. This concept should never be lost sight of. So long as the real savings-consumption ratio is maintained living standards will continue to rise.

I think that any discussion of the savings-consumption ratio must be accompanied by an explanation, no matter how brief, of the Austrian theory of the trade cycle. After all, it was the experience of the Great Depression that led to the present economic orthodoxy. The Austrians argue that credit expansion disturbs the balance and generates the business  cycle². The problem starts when monetary policy throws the savings-consumption ratio out of kilter by generating a boom. If the boom is allowed to continue consumption eventually begins to rise relative to investment spending. The effect will be to create a profits squeeze in the higher stages of production causing manufacturing to contract. As Hayek put it, the higher stages become unprofitable

not because the demand for consumption goods is too small, but on the contrary because it is too large and too urgent to render the execution of lengthy roundabout processes profitable³.

In fact, even if savings were increased their beneficial effects could be more than cancelled out by an increased demand for consumer goods [ibid, pp. 228-33]. Raising the demand for consumption goods relative to producer goods causes non-specific factors to shift to the lower stages of production, those close to the consumption stage. Now these factors, like all factors, are complementary, meaning that they have to be used in cooperation with other factors. Shifting non-specific factors from one line of production to another therefore sees the abandonment of specific factors, factors that only have one function.

This causes excess capacity to emerge as the shift towards consumption increases. Even though employment would fall in manufacturing the employment level could still be kept comparatively steady by the increased demand for labour in the lower stages of production. As this process gets underway labour costs in the economy rise even as manufacturing employment falls. This is the final stage of the boom. Now the final stage was so well documented in the nineteenth century that Marx was able to attack Rodbertus’s underconsumption theory of the trade cycle by stressing that

crises are precisely always preceded by a period in which wages-rise generally and the working class actually get a larger share of the annual product intended for consumption⁴.

Unfortunately economic thinking has now deteriorated to the point that one of the major economic fallacies the classical economists refuted is now presented on a daily basis in universities, colleges and the media as an irrefutable fact. The result is that governments the world over are implementing policies that direct economic activity to increased consumption at the expense of gross investment. As the Austrians are forever pointing out, it is gross investment, expenditure on all future-goods factors, that maintain the capital structure: not net investment or consumer spending

We are thus left with the conclusion that fighting a recession by encouraging consumption will prolong and perhaps even deepen it⁵. One thing is certain from an Austrian perspective: if the critical point is reached where increased consumption spending continues to drive down gross investment then real wages must eventually fall if the phenomenon of permanent widespread unemployment is to be avoided.

¹When Austrians speak of lengthening the capital structure they are not suggesting that stages of production will be continuously added to the structure ad infinitum, as some critics seem to think. The lengthening of investment periods does not always require more stages of production. In some cases a lengthening simply involves the replacement of existing stages with more advanced but more time consuming stages. I stressed the addition of more stages to emphasise the importance of the stages of production analysis. Failure to grasp this importance and the vital role of Austrian capital theory is why R. G. Hawtrey and Keynes were completely surprised by the arrival of the Great Depression.

²If the savings-consumption ratio is driven out of balance then what the classical economists called disproportionalities will be created. The classical economists linked the emergence of disproportionalities directly to the idea of circulating capital being converted into fixed capital. James Wilson, founder of the Economist, discussed this issue in his magazine. The article in question was later published in his book Capital, Currency and Banking as Article XI, The Crisis, The Money Market. Wilson’s opinion that “railway mania” caused excess investment by converting circulating capital into fixed capital was supported by John Stuart Mill (Principles of Political Economy, Vol. II, University of Toronto Press, Routledge & Kegan Paul, 1965, p. 543.) Colonel Torrens was also in full agreement, stating that “[t]he railways were rapidly absorbing the circulating capital of the country, and outbidding commerce in the discount market”. (The Principles and Practical Operation of Peel’s Act of 1844 Explained and Defended, London: Longman, Brown, Green, Longmans, and Roberts, 1857, p. 74.) The stress on real factors means that these discussions came tantalisingly close to anticipating the Austrian theory of the trade cycle.

³Friedrich von Hayek, Profits, Interest and Investment, Augustus M. Kelley Publishers, 1975, pp. 255-263).

⁴Karl Marx, Capital: A Critique of Political Economy, London: Swan Sonnenchein & Co., 1910, p. 476

⁵I have had numerous exchanges with Keynesians over the years on this particular point. They argued that post-WWII recoveries from recessions refuted the Austrians. This only proves that Keynesians have never read the Austrians because what they cite as evidence against the Austrian view actually supports it. The Austrians stand with the classical economists when they say that driving down the rate of interest encourages business spending. This is exactly what Keynesians argue, except they refuse to recognise that the policy ends badly. That there are circumstances where lower rates do not trigger business spending is a fact that Austrians are also aware of. The point remains that this criticism of the Austrians does not even dent their trade cycle theory.