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.

businessspending2008-10

businessspendingUS1998-2010

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.

* * * * *

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.

21 thoughts on “Recessions, investment and total spending: an Austrian perspective”

  1. These charts blow a hole in the idea that consumer spending drives economic growth. I used to think that gdp really was gross spending. It wasn’t until I came here that I discovered it excluded masses of exchanges among firms. I know see how important the subject is.

  2. Gerry exclusion of housing from investment floored me at first but the more I think about it the more sense it makes. When you think about it its really silly to treat spending on a new house as the same thing as a firm spending on a new factory.

  3. I now see where Gerry is going when he talks about business spending versus consumer spending. If economic policy keeps directing more resources to consumption then there has to be less total spending on capital goods.

  4. Nick hit the nail on the head. With Keynesians it’s always spending. So what they are really saying then is that it doesn’t matter what you spend on its all the same. Unbelievable.

  5. Gerry exclusion of housing from investment floored me at first but Nick’s comment struck me as bing right. How can economists think spending on machinery does the same thing for labour as spending on a big house.

  6. If Gerry is right about housing and investment doesn’t this mean that the consumption line in the graph is distorted? And what about the housing crash and America sub-prime bubble?

  7. Off topic for a moment. I see that Alan Moran is at it again. He is whining about the RET (Renewable Energy Target). He keeps moaning about its costs. If he really had half a brain he would do as Gerry said and simply tell everyone the bloody thing doesn’t work. Not Moran. Gerry explained that the problem is energy density. I googled Moran on this. I could not find a thing by him that even acknowledged that energy density was an “insurmountable” problem. All I found were dollar costs.
    http://catallaxyfiles.com/2014/08/19/renewable-target-is-not-sustainable/

    I raised this issue because Moran’s stupid attitude is typical of the right. We shouldn’t forget Gerry reminder that Alan moran didn’t hat the guts to publicly attack John Humphreys lousy paper when it was first published and he still refuses to attack it. The man is a bad joke and a coward. No wonder Crikey was able to do him over.
    http://www.crikey.com.au/2014/01/29/will-abbott-appoint-an-ipa-man-to-a-renewables-review/

  8. Sarah’s off topic post about Moran tells us why there are no economic debates on the right. If they cannot deal effectively with solar fraud then it’s no wonder they avoid real economic arguments. Sarah might seem a bit harsh on the coward bit but I think she is spot on.

  9. Getting back on topic I find it strange that other anti-Keynesians haven’t used the gross spending approach. Also strange is that they ignore statistics about investment and consumer spending.

  10. It’s a shame mindless Marxists such as Paul Krugman are rewarded with Nobel Prizes while the leftists attempt to silence brilliant economists such as Gerry. The funny thing is Keynes didn’t really fully believe in Keynesian economics himself.

  11. I’ve been thinking the same thing, Biggles. I’ve noticed that free market commentators at Catallaxy and the Institute of Public Affairs seem to be very light on details. Alan Moran appears different regarding alternative energy until you notice that he never deals with the fundamentals, only the peripherals.

  12. It is pretty easy really. companies invest when sales are increasing and they believe they will continue to increase. They cut investment when they believe sales will fall.
    they fell well before consumption in 2008 because the credit markets froze and companies couldn’t borrow.
    Unemployment being a lagging indicator falls rises/falls well after other indicators. in 2008 companies hung on until they finally had to shed labour

  13. It is not easy at all, Nottrampis. Your view would only hold if economies consisted of a single stage of production. In any case, the 2001 recession completely refutes you as manufacturing was shedding jobs even as consumption was still rising along with the aggregate demand for labour. In fact, in January 1999 I was pointing out that US manufacturing was already signalling an impending recession. And this was when consumer spending was still booming.

    The fact remains that consumer incomes are dependent on total business spending, not the reverse, which means that changes in aggregate consumer spending are the product of changes in business spending.

  14. Ref: MK on housing

    It is obviously true that if housing is not included in consumption you will get a distorted result. My point is that housing is a consumption good. That houses take a heavy hit during recession is to expected given their prices. One must never confuse the effect for the cause.

  15. I don’t think so Gerry. Business change their view before consumers.
    I also do not think one theory explains every change in economic circumstances.

    Having said that i have put this in my Around the Traps. I hope you get more page views because of it.
    Just because I disagree doesn’t mean this isn’t worth reading and commenting on!

  16. Nottrampis, as I have written numerous times when it comes to the trade cycle the Austrians are referring to a specific economic phenomenon and not to economic fluctuations in general. However, I consider the points you raised to be important and that is why I shall deal with them in detail within the next couple of weeks.

  17. Keynes created the perfect political playbook with his book the General Theory because he ascribed gov’t interventions like propping up wages, increased taxes, regulations, tariffs, etc to “animal spirits” and cash hoarding instead of naming these interventions as the cause of unemployment during the great depression. From then on all sorts of economists and politicians have advocated inflation as the quick fix instead of addressing the structural issues caused by gov’t intervention.

    Its important to note that Keynes actually somewhat of a Hawk when it came to inflation. If anyone reads his other writtings besides the General Theory, he does mention that inflation can be a problem and is something to worry about.

    Keynes General theory framework was really just a special case to use monetary policy to neutralize the effects that govt intervention caused which he never states was caused by govt. During the Great Depression policies to prop up wages first in a deflationary environment with jawboning by Hoover and later in an inflationary environment with regulations, by Roosevelt, increased taxes (payroll, etc), regulations( minimum wage, wagner act, NRA codes), tariffs and other policies caused profit margins to narrow and unemployment to soar. Keynes thought by using inflation it would increase the prices of producer and consumer goods thus widening profit margins leading to increased employment thus neutralizing the effects that all the govt interventions had on the economy. That seems to be his rationale for the General Theory which has been taken too far by his followers.

  18. You are quite right about Keynes and inflation. He made it clear more than once in the General Theory that his policy was to use inflation to cut real wages. However, the classical economists were aware of the fact that an inflationary policy could be used to increase the demand for labour by reducing real wages. They also knew it was a dangerous fraud.

  19. firstly if anyone thinks Kruggers is a Marxist then they are a fool he is anything but.

    Cutting real wages was a necessary ingredient of getting out of a depression with a liquidity trap. As we saw in Australia if you cut nominal wages it has a detrimental impact on the economy.
    Having inflation instead of deflation means real wages are cut and Monetary policy can work again!
    Hawtrey thought this could be done merely through a large devaluation which was Keynes’s preferred option however he thought the devaluations would probably not be large enough and history showed He was correct and Hawtrey wrong.
    It is why Keynes was so critical of Roosevelt.
    Classical economics merely made economies worse. as we saw in Germany and here until our massive devaluation.

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