With Black Friday and Cyber Monday now behind us, economists and investors are hoping people shopped till they dropped in order to give the economy an extra boost. In addition, the latest GDP report on Tuesday came in higher than expected, largely driven by consumer spending. However, buying more flat screen TV’s isn’t what makes an economy healthy.
Many people believe the fate of the economy relies on retail sales and consumer spending, especially because news outlets continually note that “the consumer sector accounts for two-thirds of the economy.” Unfortunately, this is not only misleading but it is also mistaken economic theory.
What GDP Is – And Is Not
The measure of GDP, or gross domestic product, is simply the value of all goods and services sold within a country. While this seems like a simple enough calculation, the devil diddles in the details.
One problem is that the calculation only accounts for the sale of final goods and services. This is done in an attempt to avoid double counting. For example, if a steel maker produces steel that is then sold to an automaker to build a car, only the final sale of the car will be counted and not the earlier sale of the steel. This is one reason why GDP data is so dependent on consumer spending.
This leads many to believe that consumer demand and spending is what drives an economy forward. This is a notably Keynesian idea where recessions are caused by drops in demand and cautiousness causes consumers to keep their wallets closed. Following this line of thinking, the solution to any stagnant economic growth becomes obvious: get people spending!
True, there is a grain of truth here because the money I spend on a new sofa goes into the hands of the shopkeeper who then has income to spend. In the same manner, if nobody buys my services, I will not have any money to buy that new sofa. The gears of the economy would grind to a halt without spending.
Putting The Cart Before The Horse
Spending money does move the economy, but only to the extent that it is an exchange of goods and services. The critical step everyone seems to forget is that in order to spend money, you must have that money in the first place!
How do you get that money? By producing something of value that someone else wants. Therefore, it is production that drives the economy, not consumption. There is never a problem or a drop in consumer demand because people never tire of wanting new and better things; the problem is maximizing production to fulfill more of those wants and needs.
How is production increased? By increasing productivity. How is productivity increased? By saving, or deferring consumption so new tools can be forged and research undertaken to increase productivity.
A Robinson Crusoe Economy
Imagine you and your friends are stranded on a deserted island, and it takes all day to catch that one fish or harvest those few coconuts that you need just stay alive. Your economy is 100% consumption, correct?
How could you improve your standard of living? Not by consuming more, but by actually consuming less. You and your friends would need to go hungry for a day or two and use your new-found spare time to construct a fishing net, fashion a spear, or create other tools to make procuring food easier.
This would in turn make you more productive, allowing you to gather more food during the course of a day. With the extra food, you could go back to 100% consumption and live a slightly better life, but to achieve an even better standard of living, you would need to continue to save and continue to defer consumption.
Why This Is Crucial
It is saving and producing that should be the focus in order to grow an economy. Sustainable increases in
consumption are a symptom of an economy that has already grown and produced more, not the cause of prosperity.
GDP is merely a statistic. Although it is not a bad thing per se, what gets measured also gets managed – even manipulated – by governments. Telling the populace that consumer confidence is high and consumer spending is up can make an economy look stronger, inducing governments and central banks to continue to pursue policies that boost spending.
Indeed, not only are central banks continuing to try to keep interest rates low and stock markets high to produce a “wealth effect” of more debt and more spending, but governments are also considering additional spending measures (government spending is also counted in GDP).
Investors need to remember the true causes of wealth creation, and seek to protect their own wealth in the face of a government-managed economic environment.