Before the terrorist strikes on Sept. 11, the confidence and spending habits of US consumers were viewed as an important economic indicator. After the past few weeks of high volatility in the stock markets and disruptions to the economy, it would seem that the role of consumption spending on domestic economic growth is even more important.
Under normal conditions, rising consumer spending is portrayed as being good for jobs and will boost domestic economic growth. Although consumption of imports will benefit other countries, household consumption is not as important as generally portrayed.
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When spending is down, jobs and growth are meant to suffer. And high measures of consumer confidence are portrayed as a positive economic indicator.
Unfortunately, this simple analysis is wrong. According to this logic, increased spending to replace buildings or aircraft or other damaged property should be good for the economy. But that is patent nonsense. While some sectors may benefit, resources will be diverted from other sectors. This zero-sum outcome means that there are no net gains to the economy as a whole.
Those who believe that consumption and demand are the keys to economic growth must also believe that government spending on armaments and weaponry will bring a boost to the economy. But neither war nor terrorism is beneficial to overall economic growth. Were it otherwise, natural disasters like hurricanes and floods would be welcome events. It will come to a surprise to many that consumption is not now nor was it ever a driving force in the US or any other economy. The benighted among us on this matter include most politicians, TV talking heads and a surprising number of economists. Non-economists might be forgiven for being misled by commentators that note that consumption spending makes up about 65 percent of total demand. But it is not demand that drives economic growth. Consumption can only occur after things have been produced. In this sense, goods are exchanged for goods and money only serves as a medium of exchange. A quick test of this logic is seen in economies where barter dominates. The appropriate direction of causation is that the act of production creates the basis of purchasing power that brings about consumption.
Evidence of this is seen in that those countries with high levels of consumption are those with the highest levels of production. It turns out that estimates of GDP greatly understate business spending and grossly over-exaggerate consumer spending as a proportion of total economic activity. Total business spending is actually several times greater than consumer spending. However, most business spending is left out of GDP calculations because this supposedly would involve double counting. To reiterate, growth is driven by capital accumulation, not consumption. Increases in productivity that give rise to higher living standards come from capital accumulation. These increases in the material means of production require a stock of real savings. As more capital is accumulated, more can be produced and more can eventually be consumed.
Clarifying these points is crucial even if it does not directly help to combat the evils of terrorism. But it will help shape how to craft the right policy responses to the economic turmoil facing the US and threatening much of the rest of the world. Needless to say, much of the economic response will be focused upon manipulating the demand side of the economy. This is the aim of the interest rate cuts by the US Federal Reserve and the expected stimulus effects of eliminating the budget surpluses and replacing them with public-sector deficit spending.
None of these steps will work to create a sustained boost in the economy. For growth to occur in a sustained manner, there must be an increased level of real savings accompanied by technological change and a group of entrepreneurs willing to take risks. These are not affected by such superficial moves such as deficit spending and interest rate cuts or even tax rebates. (Tax rebates are not the answer now nor were they when the Democrats foisted the argument on to their gullible Republican colleagues.) None of these moves change any fundamentals in the economy. And the temporary boost that they might give may do more long-term harm than it does short-term good. What then can be done to change economic fundamentals in order to encourage a sustained recovery? Instead of one-time tax rebates, there should be permanent reductions in marginal tax rates to reduce the disincentives caused by high taxes. There should also be a large reduction or elimination of capital gains taxes. There are those who would have us believe that cuts in these taxes benefit the wealthy. However, such an assertion is either disingenuous or ignorant or the result of being blinded by the populist rhetoric of class warfare. Capital gains taxes and the imposition of high marginal tax rates do not punish the wealthy. In both instances, those who seek to increase their wealth bear the burden. In so doing, such a tax regime reduces the level of productive economic activity and leads to slower job growth.
Clearly, this is the opposite of what needs to be done. It is counter-productive in the battle against terrorism to weaken the US economy. Moving forward toward a strong recovery will require jettisoning conventional wisdom that has become deeply imbedded in economic analysis. In the end, this might prove to be as difficult as rooting terrorists out of their lair in faraway places.
Christopher Lingle is global strategist for eConoLytics.com.
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