Recessions, investment and total spending: an Austrian perspective

Gerard Jackson

I think it’s pretty clear that Keynesians and their votaries in the media have learnt nothing from the last recession. Their absolute faith in the fallacy that consumption drives economies is sufficient proof of that. Time and time again I keep reading that consumer spending is 70 per cent or so of GDP which means, according to them, that if consumer spending falls the economy will slide into recession. Austrian economics has continually pointed out how dangerously wrong this view is.

What really matters is total spending, of which business spending is by far the largest and most important component. The problem is that the commentariat unthinkingly swallowed the fallacy that including spending between stages of production would be a case of double-counting with the result that national income figures seriously underestimate actual spending.

If the orthodox approach was correct then eliminating spending on intermediate goods would have no effect on production. Yet we know that if this were to occur the economy would collapse. Fortunately some American government economists have finally recognised the problem. Beginning this year the Bureau of Economic Analysis started producing an additional measure of economic activity called gross output. However, the BEA had previously made spending estimates based on gross output. Some years ago it calculated that though GDP for 2000 was about $13 trillion actual spending came in at about $23 trillion. Although I think this is an underestimate it nevertheless revealed a fundamental and vitally important fact that business spending is what really counts for the economy.

It simply won’t do for Keynesians to argue that consumer spending drives the economy because it is 65 or 70 per cent of GDP and then deny the same reasoning to business spending when it is shown that the gross spending approach reverses the situation.

We are therefore correct in deducing that business spending is where we should first look for danger signs of an impending recession. Now this perspective is not unique to the Austrian school of economics. It was generally accepted before and during the Great Depression that it is fluctuation in the ‘rate of capital accumulation that constitute the trade cycle, something that classical economists were completely aware of¹. Chart 1 is a graphic example of this observation.

This brings us to the American economy. Chart 2 is from the Federal Reserve Bank of St. Lois and shows employment, gross private domestic investment (GDPI) and consumption spending for the period 1998 to 2010. A striking point is that consumption² continued to rise during the 2001 recession even though employment fell by 2 per cent and GDPI by 12.3 per cent.

The 2008 recession is particularly interesting. Despite the fact that GDPI started to contract in January 2006 and employment didn’t start falling until July 2007consumption didn’t begin its decline until April 2008. By the following April consumption began to recover after falling by 2.7 per cent. This is in stark contrast with GDPI which didn’t begin to recover until July 2009 after contracting by 35 per cent³. How any economist or finance writer can look at these figures and still categorically state that consumer spending is what drives the economy leaves me completely bewildered⁴.

I think I earned considerable bragging rights with respect to the 2001 recession. In 1999 I warned (in The New Australian) that the US economy was moving into recession. I emphasised the fact that manufacturing was contracting and shedding labour, a sure sign that recession had started. I also stressed that commentators were being deceived by the falling unemployment rate. This this situation led to Steve Slifer, then-chief economist for Lehman Brothers, to say of the US economy in January 2001:

It’s really an odd-looking slowdown. The manufacturing sector is, in fact, in a recession but not the overall economy. At least not yet.

This is what happens when you have been infected with Keynesianitis: it forces its victims to focus on aggregates and treat capital as homogeneous. This is why the likes of Slifer were unable to see that the boom was nearing its final phase. Consumer spending was quickly rising at the same time as business spending was falling, creating an additional demand for labour at the lower stages of production. I pointed out in numerous articles that this consumer-led demand for labour would serve to mislead people for a time as to what was really happening to the American economy.

I stressed that a point would be reached where aggregate unemployment would eventually begin to rise, even if consumer spending might still continue to rise. And this is precisely what happened, to the surprise of many but not members of the Austrian school of economics. The same thing happened with respect to the 2008 recession. Industries closest to the point of consumption hired 143,000 workers in September 2006 while in the same month manufacturing shed 33,000 jobs.

In January 2008 factory orders fell by fell 4.2 per cent and then by 3.3 per cent in September. The Institute of Supply Management’s manufacturing index fell to 52.0 in September. It was 53.8 in July, dropping to 52.9 in August, a month that experienced a fall of 4.4 per cent in orders for capital goods. Yet employers hired an additional 110,000 workers in September. We also find that during that 12-month period wages rose by about 4 per cent. But this is usual for a boom that is drawing to a close. Karl Marx, echoing the classical economists, pointed out 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 consumption⁵.

No wonder Keynesians were flummoxed.

Note: New housing as well as manufacturing is also a good economic indicator, not because housing is a durable good — so is my television — but because it is a highly expensive good whose services are continuously consumed for decades. It therefore has the characteristics of a durable capital good. Nevertheless, it is still a consumer good.

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¹The classical economists new that investment booms gave way to what they called disproportionalities. The collapse of the railway boom and the financial crisis of 1847 brought forth considerable and insightful commentary from Col. Robert Torrens and James Wilson, founder of the Economist. Unfortunately, Dr. Steve Kates has successfully persuaded a number of people that his explanation for the trade cycle is based on classical thinking. This is completely wrong. His opinions on the subject are completely at variance with what can be called the classical theory of the trade cycle.

²Housing is not generally included in consumption figures because it is considered an investment good. Housing should be defined as a highly durable consumer good. The difference between a capital good and a consumer good is that the former serves consumers indirectly while the latter’s services are consumed directly. In other words, a good is defined by its role in the capital structure. However, some Austrians, on account of durability, insist on calling houses capital goods.

³The GPDI does not include spending on intermediate goods. If total business spending had been used the drop in investment spending would have been far greater.

⁴Some economic commentators latched on to the view that the financial crisis was caused by the destabilising effect of a global savings glut. The idea of excess savings goes back at least to Jeremy Bentham. Using Say’s Law James Stuart Mill successfully explained to Bentham why the concept of surplus capital (which what excess savings amount to) was fallacious. Unfortunately, the idea was resurrected in 1829 by Edward Gibbon Wakefield who published his Letter from Sydney. (Actually it was from an English prison where he was being held for abducting a young heiress). Part of Wakefield’s thesis was that the colonies were needed to absorb England’s surplus capital. The idea was picked up again by J. A. Hobson and later adopted by Lenin.

What our highly paid financial commentators were unable to fathom, and still can’t, is that this so-called savings glut was nothing but excess credit created by the central banks. Once again the economic commentariat displayed an appalling ignorance of the history of economic thought.

⁵Karl Marx, Capital: A Critique of Political Economy, London: Swan Sonnenchein & Co., 1910, p. 476.