Tuesday, March 8, 2011

Why the Big Deal About Consumer Spending?

Copyright, The New York Times Company

Economic commentary makes a big deal out of consumer spending, but with little explanation. The many facets of consumer spending are confusing, and public policy often ends up treating the symptoms rather than curing the disease.

Both Republican and Democrat politicians tout their economic policies as ways to put money in the hands of consumers. Unemployment insurance, for example, helps people who are unemployed, of course, but it is also purported to benefit employed people because the unemployment benefits received are spent elsewhere in the economy.

Much of the debate about President Bush’s 2008 tax rebate centered on whether taxpayers would spend it, rather than invest or save it.

But a person receiving money from the government has to do something with the it. And policymakers like to tout investment as healthy for the economy, too. So isn’t investment just as good as spending? Don’t we admire the thrifty more than the spendthrifty?In order to answer these questions, we need to know whether consumer spending has a causal influence on the wider economy – as politicians often suggest – or whether it is a barometer of economic efficiency.

Journalists and commentators often note that consumer spending is more than 80 percent of private-sector spending and more than two-thirds of all spending. Thus, at first glance, it would seem that inducing a person to spend would have a larger impact on gross domestic product than inducing that person to invest.

However, the size of the consumption sector is not evidence of its potency, because any one dollar is necessarily a smaller share of consumer spending than it would be as a share of investment. One dollar either has a larger effect on the smaller investment sector or a smaller effect on the larger consumption sector – the effect on the total economy could well be the same by either route.

Regardless of whether consumer spending stimulates the wider economy, economists generally agree that it is an excellent barometer of the economy. Soviet-style economies sometimes achieved high levels of production but could never be considered successful without permitting high levels of consumer spending.

Consumers tend to spend more when they expect their futures to be successful and tend to tighten their belts when bad times are on the horizon. Consumers vary in terms of where they live, their occupations, their expectations and their spending patterns.

Aggregate consumer spending is a kind of referendum among many different people, and we can tell from the changes in the aggregate whether spending increases outweighed spending decreases.

In this view, a consumer spending drop is a symptom of problems ahead, even if it does not contribute further to the disease.

The distribution of wealth and saving is even more unequal than the distribution of consumer spending; more people are consumers than are investors. For politicians seeking voting majorities, this alone may be a reason why they want to see more money in the hands of consumers rather than in the hands of the relatively small group of investors. But this does not mean that consumer spending stimulates the economy, just that it stimulus incumbents’ re-election.

Nevertheless, Keynesian economists continue to insist that consumer spending is more than a barometer of the economy — that consumer spending is a driver of the economy, and that right now it is a problem for our country every time a person shifts spending away from consumer goods and toward saving.

Regardless of whether Keynesians are correct, they often do not explain themselves. In a way, they agree with me that consumer spending is not the root cause of recessions, because they believe that the real problem is deflation – the tendency for wages, the prices of consumer goods and the prices of investment goods to fall rather than rise – and that deflation is the result of consumers’ belt-tightening.

In the Keynesian view, large sectors of the economy accidentally fail to keep pace with deflation, so wages and prices there end up being too high, compared with wages and prices elsewhere in the economy (or compared with wages and prices expected in the future). The sectors with sticky prices have trouble selling their goods (customers view the goods as too expensive) and workers in sectors with sticky wages have trouble finding a job (potential employers view the workers as too expensive).

Wages and prices are measured in units of money – how many dollar bills or debits to one’s checking account it takes to buy something. So deflation is equivalently a rise in the relative value of money, checking accounts and other liquid guaranteed financial assets (hereafter, I refer to the three as money).

Assuming that deflation is the root problem, Keynesians emphasize consumer spending because they assume that a consumer who doesn’t spend is a consumer who tries to add to her or his holdings of money. With more demand for money, money becomes more valuable and nonfinancial goods and services become less valuable – deflation.

Conversely, when a person is willing to part with her or his money to purchase consumer goods, that reduces the value of money and raises the value of the consumer goods – inflation.

That’s why Keynesians like it when (during a recession) the government borrows money from investors to, say, give funds to the unemployed. They assume that the investors would have held on to money if they had not lent it to the government, and they assume that the unemployed will not hold on to the money they receive in the form of unemployment insurance.

Putting aside the fact that redistribution from investors to the unemployed is a rather indirect means of reducing the relative value of money (that is, creating inflation), Keynesians have assumed, rather than proved, that investors finance their lending to the government out of their money holdings rather than by reducing their purchases of investment goods.

If it were even partly the latter, then the borrow-to-finance-unemployment-benefits policy could itself create deflation as it puts downward pressure on the prices of investment goods.

Regardless of whether you agree with the Keynesian assumptions, the facts fail to confirm their emphasis on consumer spending as a driver of the economy. When the latest recession got under way, hiring fell much more than consumer spending.

More recently, we have seen real consumer spending reach all-time highs, while employment remains lower than it was 10 years ago. All of this is consistent with my view that consumer spending reacted to a bad labor market and rejects the assertion that a consumer spending recovery would bring back the labor market.

Public policy needs to help cure the labor market disease, not merely treat the consumer sector symptoms.


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