How government spending levels hurt real wages and the standard of living

Gerard Jackson

Stephen Koukoulas was expressing a fallacious view shared by the vast majority of economists when he wrote  that

if wage levels remains too low for too long. It holds back or even oppresses growth in consumer spending. The household sector needs steady real income growth if it is to maintain a solid growth rate in consumption spending. While borrowing and a run-down in savings can temporarily underpin higher spending, more fundamentally sound and sustainable increases in spending rely heavily on household income growth.

This is the sort of plausible nonsense that leaves one in despair as to whether sound economics will ever gain ground in Australia, or anywhere else for that matter.

Koukoulas is obviously blind to the fact that his so-called economic opinion is first cousin to the purchasing power of wages fallacy that caused so much misery in the past.

It appears obvious to the man in the street that wages drive the economy because it is wages that purchase the products of labour. Therefore any reduction in wages must depress economic activity. Stephen Koukoulas would endorse this view, as would nearly all economic commentators, with the observation that as consumption is about 70 per cent of GDP it is self-evident that consumption is the principle driving force behind the economy.

But GDP is a net value-added concept and as such does not measure gross economic activity. Alert to this serious flaw America’s Bureau of Economic Analysis is now producing an additional measure of economic activity called gross output*. This new measure includes the extraction of raw materials right through their transformation into intermediate goods and then to the final point of sale. What this means for the orthodox view is striking. Let us take an economy whose GDP is 100 and aggregate consumption is 70 per cent. Now if the BEA approach assessed the economy’s gross output at 300 then consumption as a percentage of measured economic activity would drop to 23.3 per cent, thus undermining the received wisdom.

The Austrian school of economics spent decades warning that the GDP concept was dangerously deceptive because it misled policy makers and their economic advisors into designing policies that promoted consumption. It never occurred to these highly qualified economists that only in an extremely backward economy — one in which the mass of people were destitute — would consumer spending dwarf business spending.

As the BEA’s new measure clearly shows, it is gross business spending that needs promoting and not consumption. (Roosevelt’s disastrous economic policies demonstrated what happens when consumption is heavily promoted at the expense of business spending). The gross output approach reveals an important fact that all policy makers and the vast majority of economists overlook but the Austrians stress: production takes place in stages and it is in these stages that all intermediate production must take place. If spending falls here relative to consumption then wages must also eventually fall if unemployment is to be avoided. It can never be over-stressed that the largest

number of payments is not from consumers to producers, but is made between producers and producers, and tends to cancel out in any computation of net income of net product value. “In fact, income produced or net product is roughly only about one-third of gross income.” [Emphasis added]. What is cost for one producer is in part income for some other producer, but part of that income the latter has to pay out in costs to other producers in another stage of the productive process (for intermediate products, raw materials, supplies, etc.), and so on. All that is necessary in order that equilibrium be maintained is that consumers’ incomes equal the cost of producing consumers’ goods; the total of producers’ payments necessarily exceeds that of consumers’ incomes. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 71).

This brings us to Stephen Koukoulas’s opinion that a general fall in real wages is “a sign of slack in the labour market”. By this, of course, he means that the real demand for labour is sagging. This is just another way of saying that business is offering less in exchange for labour services. As a classical economist might say: The intensity of demand for labour is falling.

If a long term fall in real wages did set in then this would indicate that business spending (actually gross investment) relative to consumption is dropping which also means that per capita consumption is also falling. This happens in two ways: either the labour force is expanding faster than business investment or aggregate business spending is shrinking. As the Austrian school would put it, the capital structure is shortening.

Those with some knowledge of capital theory can easily see how the BEA’s gross spending approach reveals the truth of John Stuart Mill’s greatly misunderstood fourth proposition (inspired by John Rae’s work) that the “demand for commodities is not the demand for labour”, meaning that increasing consumption at the expense of investment must lower real wage rates. But this also means that raising government spending relative to business spending would have the effect of shifting resources away from gross investment to greater consumption at the expense future living standards. As Mill explained:

The circulating medium existing in a country at a given time, is partly employed in purchases for productive, and partly for unproductive consumption. According as a larger proportion of it is employed in the one way or in the other, the real capital of the country is greater or less. (Principles of Political Economy, Vol. II, p. 528, University of Toronto Press 1965).

The classical school was clearly aware that once government spending exceeded a certain point it would have a detriment effect on investment and hence real wages. I understand how all of this might seem rather strange but economic history confirms it. Before the emergence of industrialisation the ratio of gross business spending to total consumption had to be extremely low because society’s capital structure was very short, which means there was little in the way of intermediate business spending. Now a lengthy capital structure is impossible without the existence of fixed durable capital. This is a fact to which Simon Kuznets paid particular attention, stating that

one may ask whether there was any fixed, durable capital formation, . . . in pre-modern times, whether there was any signi?cant accumulation of capital goods with a long physical life that did not require current maintenance (or replacement) amounting to a high proportion of the original full value. If most equipment lasted no more than five or six years, if most land improvements had to be maintained by continuous rebuilding amounting to something like a fifth of the total value per years, and if most buildings were destroyed at a rate cumulating to fairly complete destruction over a period from 25 to 50 years, then there was little that could be classified as durable capital. . . . The whole concept of fixed capital may be a unique product of the modern economic epoch and of modern technology. (Cited in Fernand Braudel’s The Wheels of Commerce: Civilisation and Capitalism 15th-18th Century, Vol. 2, Phoenix Press, 2002, p. 247).

The question of government spending and growth is a vital one and it’s one to which gross output could make a significant contribution. But the concept also plays a significant role in Austrian trade cycle theory. Unfortunately, the likelihood that this will being debated is about zero for the same reason there is no debate on Australia in the Great Depression or the classical economists and the trade cycle. Australia’s right has made it very clear that once they decide an economic issue has been settled no further questioning is considered legitimate.

*I doubt very much if the BEA realises that their gross output concept undermines Keynesianism and the fallacious Keynesian approach to derived demand.

31 thoughts on “How government spending levels hurt real wages and the standard of living”

  1. A splendid post. I don’t pretend to know anything about capital theory but Gerry’s ability to put these arguments in plain English makes the concepts easy to grasp. I particularly like the way he uses economic history to support his argument.

  2. Gerry’s gift is an ability to write commonsense economics. He isn’t trying to impress anyone and he understands the need for history. Even better, he knows it. But the one thing he is right about that annoys me is that the things he raises will never be debated that mob at catallaxy and the Institute of Public Affairs

  3. better be careful Gerry otherwise Graham Young will be calling you a liar and telling everbody that you never read any of that stuff.

  4. But theyre right, Redeye. Everbody knows that Steve Kates and Sinclair Davidson are the experts. I know that kates is an expert because he is always telling everybody.

  5. We all know that that gang of posturing blowhards will never allow a debate on any economic topic that they cannot dominate.

  6. Having an intellectual gadfly like Gerry exposing the errors and fallacies of the Catallaxy crowd must be truly annoying for them. Seriously, how any informed person could put any trust in someone who lacks the intellectual mettle to defend his own arguments? Gerry did not attack them he attacked their arguments. All they had to do was defend them.

  7. Thats very interesting about pre-modern societies. I would never of thought of it. If the Austrians are right then a large scale reduction in business spending relative to consumer spending would be disastrous for the standard of living.

  8. Gerry also called business spending gross investment and the less and less of it relative to the population the poorer the people are. This suggests that a lot of government spending is keeping us from getting richer.

  9. It looks like your right, Mandrake. Gerry referred to total spending a number of times in Brookesnews and what it means for the economy. Out of curiosity I checked out Catallaxy and came up with this from Steve Kates

    What’s funny here is that when Gerry wrote about the concept Sinclair Davidson told Catallaxy readers not to trust anything he wrote. Now that Kates has written on it we are all supposed to take note. Davidson’s attitude tells us why there will never get an honest economic debate.

  10. I think Mandrake summed Gerry’s argument. It is arguments like these that need to be urgently debated. But as Sarah said about economic debates…

  11. Hi, Benson. You should have read Sarah. Debate is verboten down here. Anyhow, our right has set up the Australian School of economics and there is no way they are going to put up with the Austrian school.

  12. You don’t have to pretend to know anything Shylock. Wacko the Jacko pretends to know enough for you all.

  13. So John Wacko Humphreys decided to crawl out of his hole and do a bit of smearing. Tell me, Mr. John Humphreys, when is your lying mate Steve Kates going to admit that Gerry busted him? When is Sinclair Davidson going to stop pretending he knows about the Great Depression? What an absolute pair of cowards. Gerry caught the frauds red-handed and they are still brazening it out.

  14. Sarah, you are too, too hard on John Humphreys. The man is in pain. Gerry is producing great stuff and Humphreys cannot fault it so he has resorted to his childhood hobby of taunting those who are much better than he is. It is not that he just feels intellectually inferior to Gerry, he knows he is. Why else would he come here making a fool of himself? But you are right to raise the question of Kates and Davidson’s honesty. Humphreys is too dense to see that his friends bad behaviour makes Catallaxy a bit of a rogues’ gallery

  15. You can never be too hard on someone as low as John Humphreys. The man is a shameless liar. Steve Kates is still lying about reading the classical economists and that creep Humphreys is still throwing mud to try and cover for him. Gerry’s analysis might be wrong but one thing is clear and that is he has read the classical economists and Kates hasn’t. That’s a fact and John Humphreys knows it.

  16. If john Humphreys is in pain I hope it gets worse. We all know that if Gerry made even a tiny mistake Humphreys pals would be tearing at him. But Steve Kates and Sinclair Davidson are allowed to lie through their teeth and get away with it.

  17. Ref: Benson

    I sincerely hope you are right about Austrian economics gaining ground in the US. Australia, however, is an entirely different case. Getting the Austrian school a decent hearing Down Under is a truly Sisyphean task.

  18. Now that the Catallaxy crowd have set up their own school of economics Gerry’s “Sisyphean task” has become an impossible task. Hook or by crook they will do everything possible to sabotage the emergence of Austrianism in Australia.

  19. So John Wacko Humpheys is back. Question time again. When are you going to call Steve Kates a liar for conning people into thinking that he read the classical economists? When are going to call him out for writing tripe on the trade cycle? When are you going to call out Sinclair Davidson for trying to con people into thinking that he studied the great depression and the Austrians?

  20. I think there is something seriously amiss with John Humphreys. He cannot find a factual error in any of Gerry’s articles and yet he still comes here and makes a fool of himself. It seems the man cannot bring himself to admit that Steve Kates’ refusal to deny the charge that has been levelled against him would be considered as evidence by any reasonable person that he is just plain guilty.

  21. Nottrampis, you misunderstood me. I am referring to value-added and not net domestic product. As you know, one method of calculating GDP is to aggregate the output of a nations’s firms. The firm’s output is defined as value-added, which ignores the value of inputs on the fallacious grounds of double-counting. Samuelson illustrates this process in his textbook. (Samuelson, Economics, tenth edition, 1976, p. 185.) By definition, therefore, GDP excludes an enormous amount of economic activity. This is why Austrians welcome the BEA’s gross output measure.

    One result, as the Austrians point out, is that the GDP measure underestimates the severity of recessions. For example, In 1920 America’s GNP peaked at $88.9 billion (current prices). The following year it had fallen by 16.7 per cent to $74 billion. (Lester V. Chandler, American Monetary Policy 1928-1941, Harper & Row, 1971, p.22.) When I finally get around to writing about the 1920-21 depression, again, I shall try and explain why I believe the actual contraction could easily have been twice as large as the official figure if not larger.

    I might add that I used GDP because hardly anyone these days refers to GNP


  22. This post gave me a lot to think about and a lot of ammo. I work with a bunch of liberals and thanks to Gerry’s post I was able for the first time to shut them up on Obamas marvelous economy. I also got them thinking about mass illegal immigration and what it would to their wages. I wish tge GOP could do the same.

  23. Oh deary me – Gerry knows less economics than Homer! Be afraid, on the internet no one can hear you scream.

  24. I am no economist so I checked out what Gerry wrote in his comment. Just as I thought, it is 100 percent accurate. So little Johnnie Humphreys is lying again. All this cowardly troll has left in his tiny blowpipe are smears and lies. So it’s question time again for Wacko Humphreys, the right’s champion troll.

    When are you going to call Steve Kates a liar for telling people he read the classical economists when he has not? When are going to call him out for writing tripe on the trade cycle? When are you going to call out the incompetent Sinclair Davidson for screwing up the history of Australia in the Great Depression?

    Finally, if they are really right and Gerry is wrong why can’t they prove it?

  25. Well, Allan, I haven’t got around to the Wikipedia article as of yet. What you need to do is consider is that by devising a gross output measure, despite its flaws, the BEA took a significant step forward by drawing attention to the vital fact that business spending dwarfs consumer spending. This is a fundamental fact that one must focus on. It is something that proponents of government spending cannot escape.

  26. Gerry ,
    I just wanted you to clarify that.
    Thanks i put this in my Around the Traps despite disagreeing with it!

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