“A more sensible description of what grows the economy”

Julie Novak, from whose all-seeing eyes nothing remains hidden, came across this article by Martin L. Mazorra with the perfect title, “Goods Buy Goods“. This is, of course, the classical definition of Say’s Law. I reproduce the entire blog post below:

One day last week, on CNBC’s Kudlow and Company, Larry gave his expert guest the last word: she justified her optimism for stocks by the fact that consumer spending appears to be trending higher and that ‘consumer spending is 72% of the economy’. Larry closed the evening’s show by telling her she had it ‘almost right’. That (words to the effect) what this economy needs is more saving, and business investment, as opposed to more consumer spending. I don’t always agree with Mr. Kudlow, but in this instance I believe he was spot on. Although I had no idea where she had it ‘almost right’. She was at least 72% wrong. Of course her assertion that ‘consumer spending is 72% of the economy’ comes straight from the GDP equation, and is an oft-quoted justifier for policies aimed at boosting demand. Once upon a time, I fell prey to the same misconception.

Here, in my (evolved) view, is a more sensible description of what grows the economy: From page 26 of Steven Kates’s Say’s Law and the Keynesian Revolution:

If one takes the annual produce of a country, writes Mill, and divides it into two parts, that which is consumed is gone. On the other hand, that portion which is used in the production process returns in the following year, with a profit. The more of the produce of a country that is devoted to productive uses, the faster that country grows.

And (from page 40) on the cause of recessions:

The basis of the law of markets is that goods buy goods, but only if the right goods are produced. If the wrong goods are produced, then they cannot be converted into the universal equivalent (i.e. money). If a proportion of goods cannot be sold, then their owners cannot buy. If one set of producers cannot buy, then a second cannot sell. The result is a general downturn in the economy and warehouses filled with unsold goods. But the cause of recession is not demand deficiency or over-production but the production of the wrong assortment of goods and services. The adjustment process thus required is the redeployment of capital from areas where there is too little demand into areas where there will be demand for the goods produced. There is no reason that the process of readjustment will be rapid, but there is no reason to believe that the downturn will be permanent.

So, under whose command should we expect the greatest likelihood of producing the right assortment of goods and services; a self-serving producer of goods and services, or a self-serving politician? Certainly the market, all on its own, can, for a time, produce the wrong assortment of goods and services. However, left to its owns devices—and to natural consequences—the market will adjust accordingly and purge its excesses. The politician, on the other hand, has a professional interest in circumventing the suffering of his supporters, and is adept at neutralizing the natural consequences for the producers of the wrong goods by spreading the loss among the entire population. And, alas, he in effect neutralizes the redeployment of capital from areas where there is too little demand into areas where there will be demand for the goods produced. Hence, a very slow recovery…

When one thinks about the last recession, housing comes to mind. Government-(explicitly)-backed mortgages (Ginnie mae), government-sponsored enterprises (Freddie and Fannie) and a variety of tax incentives are the brainchildren of politicians incentivizing the production of a particular good. Plus, the Fed had flooded the financial sector with liquidity enough to fund the manufacture of trillions of dollars worth of derivative securities designed to leverage—many times over—the housing market. In the end we had the definition of resources diverted to the production of the wrong good, and, thus, the greatest recession since The Great Depression…

This is exactly right and a perfect restatement of the classical explanation of the recession we continue to refer to as the Global Financial Crisis. The notion that consumers drive 70-plus percent of the economy is just one of the many Keynesian idiocies bequeathed to us today. When it comes right down to it 100% of the economy is devoted to raising consumption. Why else would anyone produce anything unless it eventually led to higher personal living standards. Retail is, however, less than ten percent of total economic activity if one looks at the value added data rather than at C+I+G. Most people across an economy are in the inputs industry, every one of which is directed towards satisfying consumer demand eventually, but only eventually. In the meantime they are producing iron ore and concrete, lumber and nails, factories and 747s, none of which are bought as consumer items. And this only begins the story of why the focus on consumer demand is absolutely misplaced if you want to understand how an economy actually works.

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3 Responses to “A more sensible description of what grows the economy”

  1. Produce more, and produce more of value, by:

    Diverting capital away from land and into production;
    Minimising the impact of regulation;
    Removing tax system imposts on production;
    Reducing the scope of government;

    thus attracting skill and capital.

    Fixing Tasmania 101.

  2. Simon

    Nice explanation, thanks!
    So how does this work for emergencies, war and plagues etcetera? Are they still to driven by alarming necessity or do we ask some poor rube to manufacturer and stockpile on the chance it might happen? Sometimes market mechanisms are dangerously slow and incongruous with the needs of the people.

  3. Pingback: the GFC recession … | pindanpost

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