Consumer spending, investment and the trade cycle

Gerard Jackson

This is a general response to a comment posted by Nottrampis. Once I began to write I realised my reply would be better as a post rather than a comment.

No matter what Keynesians argue, investment is not driven by consumer spending. This fallacy is based on a total misunderstanding of the nature of derived demand. (I shall deal with this fact in later posts). Investment is driven by the prospect of profit. In a free market the rate of interest determines the length of investment projects. Consumer spending has nothing to do with it.

In a multi-stage economy it is the volume of business spending that determines consumer spending. If it were otherwise the consumer goods producing industries would be less stable than the capital goods industries. They are not. No matter what any Keynesian asserts, the fact remains that the largest number of payments is not made by consumers to producers but between producers and producers, meaning that it is production that creates purchasing power and not wages. (Say’s Law again).

Now for some facts: It was estimated that out of the 14 million unemployed in March 1933 only about 1.5 million came from the consumer goods industries. This situation was entirely due to the colossal failure of the Hoover administration to grasp the reality of gross business spending. Unfortunately for the world Roosevelt was every bit as bad.

More facts for the crucial period 1929-1933: In 1929 the two-way division between employees and corporations was 81.6 per cent and 18.4 per cent respectively. By 1933 the employees share had rocketed to 99.4 per cent, payrolls fell from $32.3 billion to $16.7 billion and unemployment rose to 25 per cent. In the same period labour’s proportion of national income rose from 59 per cent to 73 per cent. Additionally, personal consumption as a proportion of GNP rose from 76 per cent to 83 per cent.

While every point I have raised here will be dealt with in much greater detail at a later date one thing does remain: the facts of the Great Depression do not support Keynesianism.

You wrote: “funny how there is no golden age in countries following classical economics”. You are wrong again. The nineteenth century was, at the time, considered the greatest because of its industry, inventions and growth in living standards. What gave us the nineteenth century is the same thing that laid down the foundations of our present prosperity. Compared to what preceded it, it was indeed a Golden Age.

As for Hawtrey, I have not read all of his books but I have read Century of bank rate, Good and Bad Trade, Art of central banking, and Currency and Credit. From an Austrian perspective his analysis of the trade cycle is dangerously wrong. With respect to Hawtrey warning about the Great Depression I presume you are referring to Ronald Batchelder and David Glasner’s paper Pre-Keynesian Monetary Theories of the Great Depression: What Ever Happened to Hawtrey and Cassel?

It is true that Hawtrey and Cassel expressed warnings but so did others. Writing for the Austrian Institute of Economic Research Report, February 1929, Hayek successfully predicted that “the boom will collapse within the next few months.” Colonel E. C. Harwood — who founded the American Institute for Economic Research — persistently warned that the Fed’s monetary policy would cause a depression. Benjamin M. Anderson used his position as chief economist at Chase National Bank and editor of the Chase Economic Bulletin to sound the alarm about the Fed’s monetary policy and the coming crisis that it was generating. Then there was Ludwig von Mises who had been warning for years that the central banks’ loose monetary policies would bring on a depression.

The brilliant Mr Keynes was not so prophetic. Felix Somary, a Swiss banker, recalled in his The Raven of Zurich (London: C. Hurst, 1960) that Keynes had approached him in the mid-20s for stock recommendations. Somary, who subscribed to the Austrian School of economics, refused to give him any, warning that a speculative bubble was emerging. Keynes cockily replied: “There will be no more crashes in our lifetime.” The financial collapse apparently did nothing to dent his self-confidence. Once the depression was underway he still hailed the price stabilization scheme that caused it as a “triumph.” When it suited him, Keynes’ conceit apparently left him unfazed by mere facts.

Hawtrey and Cassel, according to Batchelder and Glasner, blamed gold for the depression. The others I mentioned blamed the Fed’s loose monetary policies and its religious-like faith in a stable price level. Under the influence of Irving Fisher virtually the whole of the American economics profession had fell prey to the fallacy that a stable price level means there is no inflation. Yet it is this fallacy that led to the crash of 1929. The irony is that Ralph Hawtrey was one of the guiding lights of this dangerous policy.

Note: I believe that when dealing with the boom-bust phenomenon economists must also adopt a historical perspective. For any theory of booms and busts to be correct it must, like the laws of supply and demand, apply to all places at all times. This is why I shall be posting articles on medieval booms, Tulip Mania, the South Sea Bubble, the mighty crash of 1825, Britain’s Railway Mania of the 1840s and so on. I think it needs to be stressed that when speaking of the trade cycle Austrian economists are referring to a specific economic phenomenon and not to economic fluctuations in general.

16 thoughts on “Consumer spending, investment and the trade cycle”

  1. The facts about the unemployment and consumption in the great depression are very suggestive. I’m very interested in seeing a more detailed post on the topic.

  2. The future posts Gerry referred to are bound to be real zingers when you think about his eye-openers on the classical economists, the great depression and the economic collapse of 1937-38. I never knew about that one until I read Gerry.

  3. Same here Arnold. It looks like there is more to it than I thought, although I cant imagine what.

  4. I’ve been thinking abut derived demand and I still can’t figure out where it fits in.

  5. too busy at present to comment but will. This is in my Around the Traps out now.
    I do put in articles I disagree with!

  6. This is hilarious. Steve Kates is mouthing off this morning about how “Catallaxy is such a fund of insight and knowledge.” Yeah, and that’s why we have to come here to learn what the classical economists really said about the trade cycle. If “Catallaxy is such a fund of insight and knowledge” then why did they get it wrong about Australia and the great depression. If they have a “fund of insight and knowledge” why are they scared to debate these topics?

  7. I totally agree that investment is determined by future profits.
    what we usually see if demand for their product rises so does profit.
    If consumers stop buying their goods and series as we see in any depression then investment stops.
    consumers start buying again and hey presto business start investing again.
    consumption is important as it about 70% of GDP but Investment is the most important part as Keynes emphasised.
    The ‘Golden age’ you talk about what what occurs when industrialization occurs. Germany and the US were both doing this bigtime although at the time a lot of nations were spending quite large on battleships ( Read Dreadnought).

    I will take a rest and wait to see what others think.

  8. Ref: Nottrampis

    GDP is not a gross figure. It is a net figure that greatly exaggerates the role of consumption in economic activity. What matters is gross spending. And it is gross spending that produces the goods for consumption, not the reverse. In addition, you have misconceived the nature of derived demand otherwise you would not think that consumer spending drove investment. So once again, investment is forgone consumption.

    The classical economists fully understood that policies promoting consumer spending in the belief that it would expand the ‘capital stock’ would in fact have the reverse effect. Additionally, the great error of focusing on consumer spending ignores the vital role of interest and the structure of relative prices as well as the capital structure.

    It is a great pity that our right, who claim to have read the classical economists, do not use their influence to make these crucial points.

    However, as I said in my post, I will get around to explaining the points that I raised.

    PS. I fail to see what dreadnaughts have to do with the matter.

  9. Gerry in your Golden age spending big time on Battleships led the way.

    Navies had to change from wooden ship to modern battleship.

  10. Ref: Nottrampis

    I am at a loss to see your point. To begin with, your history is all wrong. Britain went from wooden warships to ironclads and then to iron. The Royal Navy’s program of fully switching to iron warship began more than 60 years before the first dreadnaught. And no one was daft enough to preach that building these battleships promoted economic growth.

  11. Gerry ,

    most nations were quite into building as many dreadnoughts as possible post 1905.
    it put the UK budget in an impossible position as it did the German one.
    It is part of the reason why these countries were developing so quickly.

  12. Nottrampis,

    You have it exactly back-to-front again. The reason these countries were able to build so many advanced warships was because their economies were developing quickly. Britain launched the first dreadnaught in 1906 but government spending in 1913 was only about 15 per cent of GDP (the Boer War had driven it to over 18 per cent of GDP) while defence spending was approximately 3 per cent of GDP.

    The idea that building battleships hastened economic growth is plain ridiculous.

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