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Consumer Spending Doesn’t Drive the Economy, Investment Does

May 17, 2010 By Mark Skousen 3 Comments

The Freeman
Foundation for Economic Education
May 17, 2010

“Consumer spending makes up more than 70 percent of the economy, and it usually drives growth during economic recoveries.” –“Consumers Give Boost to Economy,”  New York Times, May 1

Every quarter, when the government releases its latest GDP figures, we hear the familiar refrain:

“What the consumer does is vital for economic growth.”

“If the consumer starts saving and stops spending, we’re in big trouble.”

“Consumer spending accounts for 70 percent of the economy.”

The latter “fact” is repeated regularly in the news reports from the Associated Press, the Wall Street Journal, and the New York Times.

The truth is that consumer spending does not account for 70 percent of economic activity and is not the mainstay of the U. S. economy.   Investment is!   Business spending on capital goods, new technology, entrepreneurship, and productivity are more significant than consumer spending in sustaining the  economy and a higher standard of living.  In the business cycle, production and investment lead the economy into and out of a recession; retail demand is the most stable component of economic activity.

Granted, personal consumption expenditures represent 70 percent of gross domestic product, but journalists should know from Econ 101 that GDP only measures the value of final output.  It deliberately leaves out a big chunk of the economy — intermediate production or goods-in-process at the commodity, manufacturing, and wholesale stages — to avoid double counting.  I calculated total spending (sales or receipts) in the economy at all stages to be more than double GDP (using gross business receipts compiled annually by the IRS).  By this measure — which I have dubbed gross domestic expenditures, or GDE — consumption represents only about 30 percent of the economy, while business investment (including intermediate output) represents over 50 percent.

Thus the truth is just the opposite:  Consumer spending is the effect, not the cause, of a productive healthy economy.

The Importance of Say’s Law

This truth prevails in the marketplace:  It’s supply — not demand — that drives the economy.  Savings, productivity, and technological advances are the keys to economic growth.  This principle was discovered and developed by the brilliant French economist Jean-Baptiste Say in the early nineteenth century and is known as Say’s law.  In fact, he invented the word “entrepreneur” to describe the primary catalyst of economic performance.

Is retail sales a leading economic indicator?  Each month the Conference Board releases its Leading Economic Indicators for the United States and nine other countries.  The ten U.S. leading indicators are:

  • manufacturers’ new orders
  • building permits
  • unemployment claims
  • average weekly manufacturing hours
  • real money supply
  • stock prices
  • the yield curve
  • new orders for nondefense capital goods
  • vender performance
  • index of consumer expectations

As you can see, almost all of the indicators are linked to the early stages of production and business activity.

Misleading Consumer Confidence Index

What about the Consumer Confidence Index that the media highlights every month?  It turns out that the title is misleading.  The questions asked consumers are more about business conditions than spending attitudes.  Here are the questions consumers are asked to determine their “expectations”:

  1. Are current business conditions good, bad, or normal?
  2. Do you expect business conditions to be good, bad, or normal over the next six months?
  3. Are jobs currently plentiful, not so plentiful, or hard to get?
  4. Do you expect jobs to be more plentiful, not so plentiful, or hard to get over the next six months?
  5. Do you plan to buy a new/used automobile/home/major appliance [note: these are all durable consumer goods, not unlike durable capital goods] within the next six months?
  6. Are you planning a U.S. or foreign vacation within the next six months?

In other words, the much-touted “consumer” confidence index is more a forecast by consumers for business, employment, and durable goods than “retail sales” and consumer spending.  It does not ask any questions about food, clothing, entertainment, and other short-term buying, because these expenditures seldom change from month to month.

The reality is that business and investment spending are the true leading indicators of the economy and the stock market.  If you want to know where the stock market is headed, forget about consumer spending and retail sales figures.  Look to manufacturing, capital expenditures, corporate profits, and productivity gains.

Beware of Keynes’s Law

The reason we hear so much about the consumer is because the media and political pundits still live under the spell of Keynesian economics, which teaches that demand creates supply.  Keynes’s law is just the opposite of Say’s law (supply creates demand).  According to Keynesians, consumer spending drives the economy and saving is bad when the economy is in a short-term contraction.

In reality, increased savings can actually stimulate the economy, even if consumer spending is anemic.  A recent study by the St. Louis Fed concluded that in the short run, “a higher saving rate in the current quarter is associated with faster (not slower) economic growth in the current and next few quarters” (Daniel L. Thornton, “Personal Saving and Economic Growth,” Economic Synopses, St. Louis Fed, December 17, 2009).

How is this possible?  When people save more, interest rates fall and business can afford to replace their old equipment with new tools, spend more on research and development, or develop new production processes.  So while consumer spending may stay low, business spending can pick up the slack.  Remember, in a dynamic economy the decision by businesses to spend more investment funds and hire more workers is a function of both current consumer demand and future consumer demand.  And don’t forget, during a recession corporate profits often recover first, without an increase in customer demand, because companies can boost profits by cutting costs and downsizing.

In the long run new business strategies and spending patterns increase productivity and lower prices to consumers, which in turns means the consumers’ purchasing power increases.  As the St. Louis Fed concludes, “A higher saving rate does mean less consumption [in the short run], but it could also result in more capital investment and, ultimately, a higher rate of economic growth….  [T]he growth rate of real GDP has been higher on average when the personal saving rate is rising than when it is falling.”

Granted, the ultimate function of business activity and entrepreneurship is to fulfill the needs of consumers, and the most successful firms are those that satisfy their customers.  But more important, who discovers the new, improved products that consumers desire?  Who is the catalyst that determines the quantity, quality, and variety of goods and services?  Did the consumer come up with the idea of personal computers, SUVs, fax machines, cell phones, the Internet, and the iPhone?  No, these technological breakthroughs came from the genius of creative entrepreneurs and the savers/capitalists who funded their inventions.

Filed Under: Articles, Austrian Economics Article, Economics, Ideas on Liberty and The Freeman

About Mark Skousen

Mark Skousen is a professional economist, university professor, best-selling author, editor of the award-winning Forecasts & Strategies financial newsletter, and producer of FreedomFest, the largest annual gathering of free minds about liberty and freedom in the world. Skousen has been married to wife Jo Ann for 42 years, and has five children and five grandchildren.

Comments

  1. Craig Berlin says

    September 12, 2014 at 12:21 am

    Dear Mr. Skousen,

    I’m trying to write an article on tax overhaul and I’m having a very difficult time finding information on the number of commissionable transactions in a given time period, preferably in the U.S. annually. Do you know of any source for this information?

    Alternatively, I may try to piece together an estimate based on the volume (not of shares but of transactions) in given markets, such as the NYSE or from individual larger brokers such as Schwab.

    In addition, in order to do an analysis of consumption taxes, I need to know the total of not just consumer spending but ALL spending EXCEPT by the government and I’m not sure if that’s reflected in GDP or not.

    Any advice would be appreciated.

    Regards,

    Craig Berlin
    Austin, TX

    https://www.facebook.com/ThoughtsFromFarWestBerlin

    Reply

Trackbacks

  1. Mark Skousen’s Top Ten Favorite Articles says:
    January 27, 2011 at 5:24 pm

    […] 10. Consumer Spending Doesn’t Drive the Economy […]

    Reply
  2. What Comes First, Production Or Consumption. « AUSTRIAN ECONOMICS ADDICT says:
    November 20, 2012 at 3:03 pm

    […] consume more or can we consume more because the economy grows. This article by Mark Skousen title, “Consumer Spending Doesn’t Drive The Economy, Investment Does”,   explains the public’s perceived chicken or egg conundrum about production or consumption. […]

    Reply

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  • Craig Berlin

    Dear Mr. Skousen,

    I’m trying to write an article on tax overhaul and I’m having a very difficult time finding information on the number of commissionable transactions in a given time period, preferably in the U.S. annually. Do you know of any source for this information?

    Alternatively, I may try to piece together an estimate based on the volume (not of shares but of transactions) in given markets, such as the NYSE or from individual larger brokers such as Schwab.

    In addition, in order to do an analysis of consumption taxes, I need to know the total of not just consumer spending but ALL spending EXCEPT by the government and I’m not sure if that’s reflected in GDP or not.

    Any advice would be appreciated.

    Regards,

    Craig Berlin
    Austin, TX

    https://www.facebook.com/ThoughtsFromFarWestBerlin

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