The Austrians Are Right: Consumer Demand Does Not Drive the Economy

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In last week's article (The US economy: recession, depression and monetary mismanagement) I pointed out that consumer spending is only about one-third of total spending. What this means is that business spending is what drives the economy and not consumption. Well, this was just too much for some readers. They argued that it is obvious that "user demand drives the economy". It was obvious to Aristotle that heavier objects fell at a faster rate than lighter objects. It took a practical experiment by Galileo nearly 2000 years later to disprove Aristotle's commonsense approach by demonstrating that all objects fall at the same rate.

I am not going to be severe with my critics. After all, they are merely repeating what has been poured into their heads and what one finds in every standard economics textbook. But like Aristotle's commonsense opinion about falling objects, what they have been taught is demonstrably wrong. To begin with, production is the source of demand, not consumption. This would be self-evident in a barter economy. Unfortunately the emergence of money has cast a veil over this fundamental fact. In a state of barter, goods exchange directly against other goods. Wheat for olives, wood for flour, cattle for sheep, etc. The classical economists understood this and this is why, in the words of John Stuart Mill, they stated that "supplies constitute demands" and what was important was not consumption but production.

In his Prices and Production Hayek used what he called "Jevonian triangles" to illustrate the fact that there exists a capital structure — the length and slope of which is determined by the rate of interest — consisting of numerous stages down which there flows partly finished goods (circulating capital sometimes called working capital) until they reach the consumer in their finished form. Three important facts immediately stand out: production takes place through time, that it moves from stage to stage and that total expenditure on production must exceed the price of the final good. However, the orthodox approach to capital and the current method of national accounting leads to the conclusion

... that the total expenditure made in production must be covered by the return from the sale of the ultimate products; but it remained unrefuted, and quite recently in our own day it has formed the foundation of some very erroneous doctrines. The solution of the difficulty is, of course, that most goods are exchanged several times against money before they are sold to the consumer, and on the average exactly as many times as often as the total amount spent for producers' goods is larger than the amount spent for consumers' goods. (Hayek, Prices and Production, Augustus M. Kelley 1967, pp. 47-48)

We can now see that aggregate spending is not only dominated by business spending but that the latter is the truly vital element. Should spending between stages of production fall for any reason real consumer spending would also drop. On the other hand. a fall in consumer spending due to increased savings would expand the production structure. It is true that a sudden and significant increase in savings by consumers would disrupt production in the lower stages. But this would only last until the necessary adjustments that would bring the proportions between savings and consumption once again into equilibrium. However, I have never known of a situation in which there was a sudden and unexpected increase in savings. What can happen is that a recession can lead to an increase in the demand for cash balances, which seems to be the case at the moment in America.

From the preceding it is obvious that because production moves through stages each firm becomes a customer for another firm's output. In short, one firm's output becomes part of another firm's inputs until the finished good reaches the consumer. We can illustrate this process with a simple four-stage economy: the farmer sells wheat to the miller for $100, the miller grinds the wheat into flour and then sells it to the baker for $110, the baker then turns the flour into bread which he sells to consumers for $120. Although the orthodox view states that the $120 equals gross domestic product it is self-evident that this $120 is actually the net product. It cannot be otherwise when the value-added method is used. Yet economists emphatically state that all

purchases of materials and services from other firms are excluded, because those dollars will get properly counted in NNP from the reports of other firms. (Paul Samuelson, Economics, edition, McGraw-Hill 1976, p. 185).

But they are not counted. The miller spends $100 on inputs, the baker spends $110 on inputs and the consumer spends $120 on the baker's output. Therefore gross domestic product equals $330 and not $120, a net figure. Of importance is the proportion of consumer spending to business spending. In our highly simplified example this is 120:210. The spending that occurs between stages of production is in fact savings.

In order to increase output more circulating capital is needed which means more fixed capital will also be required. But the only way to do this is to spend more on investment and less on consumption, making investment forgone consumption. It follows from this that any attempt to increase consumpton can only take place at the expense of inter-firm spending. In other words, it would require a fall in savings otherwise known as capital consumption.

The fallacious approach of mistaking the net figure for the gross figure has led to the thinking that consumer spending must — because it is by far the largest component of GDP — maintain production. Yet it is clear from our simple example that investment is not a function of consumption.

This type of function could only emerge in a two-stage economy, which is how the great majority of economists treat economies. However, we have seen that a policy of encouraging consumption could — by changing the structure of relative prices in favour of greater consumption — lead to a drop in spending at the higher stages of production and hence in total output. (Hayek explain this process in The Paradox of Savings in Profits, Interest and Investment, Augustus M. Kelley Publishers, 1975, pp. 255-263).

Now the farmer uses fixed capital goods to plant, collect, store and then deliver his product to the Miller. In turn the Miller uses fixed capital to grind the wheat into flour. The baker uses fixed capital to take delivery of the flour and transform it into bread. To argue, therefore, that "production is merely a matter of adjusting inventories" is to reveal an utter ignorance of capital theory.

Using the powerful tools of Austrian capital theory I was able to predict the recession that Bush inherited from Clinton and the course it would take . I then pointed out that the same thing would happen to Bush, stressing that Greenspan's monetary policy was laying down the foundations for another recession. Moreover, I also called these recessions before any orthodox economist did. I did the same thing with the Australian recession. The usual run of economists failed because they not only have no capital theory they still insist on rigidly sticking to the fallacious idea that GDP is a truly gross figure.

The following books are, in my opinion, essential reading for a thorough grasp of capital theory:

Eugen von Bohm-Bawerk's monument three volume Capital and Interest, 1884-1912, Libertarian Press, 1959.

Friedrich von Hayek, Prices and Production, Augustus M. Kelley, 1967

Friedrich von Hayek, Profits, Interest and Investment, Augustus M Kelley Publishers, 1975

Friedrich von Hayek, The Pure Theory of Capital, The University of Chicago Press, 1975

Richard von Strigl, Capital and Production, The Ludwig von Mises Institute, 2000

Israel M. Kirzner, An Essay on Capital, Augustus M Kelley Publishers, 1966

Mark Skousen, The Structure of Production, New York University Press, 1990

Roger W. Garrison, Time and Money: The Macroeconomics of Capital Structure, Routledge, 2001