The best way to understand what is happening in the US or Japanese economy is to stop believing that consumption is the engine of economic growth. Higher consumption will not bring a permanent reversal of negative economic trends in the US. Likewise, Japan's economy is not languishing simply because of a dearth of household spending.
Unfortunately, the notion of consumption-led growth has very deep roots in the calculations of gross domestic product (GDP). So, the first step in abandoning the assumption that the demand for final goods and services is at the heart of economic growth requires rethinking GDP.
As it is, GDP reflects an attempt to measure the final output of goods and services as an indicator of national income. In the process of calculating GDP spending on intermediate stages of production is purposely overlooked on the presumption that including them would involve double counting. However, this means that all goods in the process of being produced or working their way through the wholesale stage are overlooked.
This exclusive focus upon final goods and services of GDP estimations implies that the availability of goods arises out of the desires of consumers. Yet these desires can only be accommodated if they are preceded by an act of production that provides their supply and income to labor as the means to satisfy demand.
By taking the supply of goods for granted, the GDP framework ignores the various stages of production that lead to the arrival of a final product. For example, intermediate goods required in the production of final goods are not readily available and must precede the demand for the eventual output.
Ignoring these crucial aspects of commercial activity contributes to a misunderstanding of how an economy works. In particular, developments in the earlier stages of production are important determinants of business cycles since they are especially responsive to changes in interest rates and technological innovations.
In the first instance, focusing upon final output leads to the mistaken belief that consumer spending is more important than capital investment in an economy. This false conclusion is drawn from the fact that consumption expenditures account for around two-thirds of measured GDP.
In all events, business investment drives economic growth whereas consumer spending is a consequence rather than a cause of economic growth. It is the innovation of entrepreneurs and their use of accumulated capital combined with technological change that creates new jobs and wealth.
Another flaw is the inclusion of government spending in GDP data as if it provides an autonomous addition to national output. This supports a misleading conclusion that government spending can stimulate economic growth, even when deficits are the source of the new funds.
There are problems with GDP even when one accepts the dubious logic that underlies its questionable legitimacy. For example, the spread of e-commerce as well as increased global operations of MNCs and their use of transfer pricing have weakened the conventional measures of aggregate economic activity. And GDP may substantially underestimate economic activity in modern economies because technological advances usually increase the number of production stages.
As it is, GDP does not reveal whether final goods and services produced during a particular time period reflect an expansion in real wealth or because of capital consumption. For example, if a government spends money to build a monument it will add nothing to the general well being of the population. However, these expenditures will be counted in GDP measures as adding to economic growth. Instead, wealth production has been stifled since funds spent on the monument were diverted from entrepreneurs who would have spent them on wealth-generating activities.
Given the logical flaws and practical difficulties in keeping up with changing conditions, it would be better to abandon GDP rather than fine-tuning it. Entrepreneurs depend upon specific economic indicators such as prospects for profit and loss in their endeavors rather than general indicators. Since profits and losses are the most important economic indicators shaping their decisions, entrepreneurs tend to create their own sources of information.
Despite so many problems, there is a continued reliance upon GDP measures as an indicator of economic strength. This view supports the conventional economic wisdom that recessions result from sudden declines in household consumption. This logic provides governments and central bank officials with justification for interfering in the economy through active monetary and fiscal policy.
By tampering with monetary and fiscal policies, governments induce wealth producers to redirect their activities. This process is evident in the US where expectations of a recovery are based upon increased consumer spending.
In fact, these expenditures are probably the result of interest rates that are artificially low. As such, current consumption spending does not reflect a change in households' long-term real earnings patterns. It is likely, then, that low interest rates have brought a temporary respite in the downsizing and liquidation of US economy's excess capacity.
Christopher Lingle is Global Strategist for eConoLytics.com.
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