Blinded by the ‘animal spirits’ myth

A crushing consensus argues that economic growth can be revived by an increase in individual consumer demand, but it ignores the importance of production and limits the scope of prosperity.

Perhaps the most pervasive, peculiar and damaging preconception about the economy is that this is an age of consumer capitalism. From this perspective it is consumption, mainly by individual consumers, that drives economic activity. Although it is acknowledged that production played an important role in the past it is viewed as being secondary today.

The statistic used more than any other to support this argument is that about 70% of American GDP is accounted for by consumption. At first sight it seems like game, set and match to the proponents of consumer capitalism. It also appears to follow that the recipe for economic recovery lies in reviving consumer demand or what are sometimes called the “animal spirits”. Once consumers regain confidence it is argued that the economy should move back to an upward path.

If only the 70% figure were interrogated more often it would become clear it does not support the consumer capitalism argument. On the contrary, capitalism is just as dependent on production as in the past. Indeed without the act of production it would not be possible to have any consumption. Once this point is understood it provides a fundamentally different perspective on solutions for the current crisis.

It is not widely realised that GDP can be measured in three ways. America’s Bureau of Economic Analysis (BEA) does spell this out in a primer on “Measuring the Economy” on its website (www.bea.gov) but it is not consulted often enough. Although the debate about definitions is technical it has huge consequences in relation to understanding the economy and practical policy. Unfortunately, most of the discussion relies instead on the headline figure that personal consumption expenditures (PCE) accounts for about 70% of American GDP. (Perspective continues below)

The first measure of GDP, although rarely referred to in the public discussion of economics, is the production or output measure. This is calculated by adding up the value added in production in all sectors of the economy.

By this measure GDP is calculated by production with consumption mathematically equal to zero. It provides a striking counterpoint to those who claim that contemporary capitalism is defined by consumption.

Of course it would be foolish to dismiss consumption in an all-rounded study of the economy. Production and consumption are both part of the picture. But the output measure of GDP is a useful reminder of the one-sidedness of much of the contemporary debate with its near blindness to production.

The second measure of GDP, the income measure, is relatively uncontentious. This is essentially a measure of all forms of earnings in the economy, including labour income and corporate profits.

The third measure of GDP, and by far the most often referred to in the public debate, is the expenditure approach. Although there is nothing inherently wrong with this method it is important to be aware of its limitations.

For a start this measure is defined by the BEA as “the sum of expenditures, or purchases, by final users”. The phrase “final users” is crucial here. This element of the definition skews the statistics towards individual consumers and away from business demand. Kurt Richebächer, an economist who died in 2007, explained that by this measure:

“Heating oil and electricity delivered to the consumer increase GDP. Yet the huge deliveries to businesses are left out of the account. The logic behind this difference in statistical treatment is to avoid double counting. But one of the results is a grossly distorted picture of overall economic activity. As a result, business outlays enter GDP accounts as a net figure, capturing only the small part being spent on final, finished plants and machinery.”

Richebächer also pointed out the expenditure measure systematically underestimates the importance of capital investment in economic activity. Although investment appears as a component of the expenditure measure of GDP it is not given its due weight. Investment in business can have a large multiplier effect because capital spending in the present can lead to a higher level of output in the future.

In contrast, the multiplier effect on consumer spending, if it exists at all, is likely to be much smaller. Consumer spending can benefit individuals in the present but it has little impact on growth.

”If only the 70% figure were interrogated more often it would become clear it does not support the consumer capitalism argument”

Michael Mandel, formerly the chief economist of BusinessWeek, has provided two additional reasons to be wary of the 70% story. First, PCE includes all of America’s huge health spending despite about half of it coming via government. As he has argued: “When Medicare [social insurance programme] writes a check for your mom’s knee replacement, that gets counted as consumer spending in the GDP stats” (“Consumer spending is Not 70% of GDP”, Business Week, August 14, 2009).

Second, much consumer spending in America is to buy goods produced elsewhere. But just because goods are imported from, say, China or Taiwan it does not mean they do not need to be produced. The internationalisation of manufacture is an important trend but it does not follow that production itself has disappeared.

Although the argument about different measures of GDP is technical it has important practical consequences. A proper understanding of the concept shows that it does not validate the idea that contemporary capitalism can be defined in relation to consumption. Indeed, it is impossible to understand the market economy properly without first understanding the role of production.

The contemporary blindness to the importance of production shows a lack of any historical imagination. It is a reflection of a consensus that is deeply pessimistic about the possibilities of making society wealthier. This view finds it hard to fathom the possibility of bolstering economic growth apart from short-term boosts to consumer demand.

Let us hope 2012 brings more challenges to this deadening consensus.

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Daniel Ben-Ami is a writer on economics and finance. His personal website can be found at www.danielbenami.com.