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Will Consumption Save Us?

Mises Daily: Monday, April 30, 2001 by

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According to the latest government statistics, the "heroic consumer" is keeping us out of recession, or at least is making our economy grow.  That was the lead story on "NBC Nightly News" recently, which meant I was not much interested in hearing how it ended.  Myths are myths, whether told by storytellers or by Tom Brokaw.  At least Aesop’s Fables have decent morals; stories of the "heroic spender" can only bring trouble if they are not properly refuted.

We have been down this road before.  In 1934, Punch published "I Want To Be a Consumer," which was meant to be satire on economic commentary of the day.  Today’s economists and media pundits take this with dead seriousness, as though grown men and women are supposed to believe that all we need to do to be prosperous is to spend, spend, spend.

The reasoning goes as such: Confident consumers do not fear the future, which means they spend almost all (if not all) of their money balances on hand.  This creates demand for goods, which means that factories and businesses are humming along at full or near-full capacity.  On the other hand, should the consumer lose heart and not spend as much, then demand for goods is dampened, inventories begin to enlarge, and people are soon out of work.

While John Maynard Keynes wrote that investors are moved by "animal spirits," it is safe to say that Keynesian economists, both in academe and on Wall Street, also see those same spirits haunting consumers.  When both consumers and investors lack confidence about the future, then the economy is in real trouble, these economists believe, since neither will spend the needed amounts to keep things going.  (How often have we heard the statement, "Consumer spending drives two-thirds of the economy"?  Investors, of course, are supposed to drive the other one-third.)

The problem here is that these "economists" and their allies are confusing cause and effect.  Carl Menger, in his groundbreaking Principles of Economics, begins that classic book with the following statement:

All things are subject to the law of cause and effect.  This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary.

Yet, what we hear today is nothing more than the confusion of cause with effect.  To put it bluntly, decreases in consumer spending do not cause recessions or economic downturns.  They are the results of these economic phenomena.  

Let us take the example of Fred and Jane.  Until recently, Fred’s business has been doing well, but things have begun to slow down.  Jane also works as a middle manager for a large corporation.  Both hear rumors of layoffs and downsizing.

Realizing that they could see a serious cut in their income should either one be laid off, they immediately begin to cut back on their spending and eliminating the marginal spending, which means no more candlelight dinners at the French restaurant for the time being.  Since they have obligations like house and car payments, they want to be sure they can continue to pay their bills even if one or both lose their jobs.

This does not mean they have been stuffing their money in mattresses.  To the contrary, they have been placing their money in relatively safe, interest-bearing accounts at the bank.  (Fred and Jane are not so heroic as to place their money in U.S. government bonds.)  Their savings will help provide a pool of funds that their bank will be able to loan when business conditions improve.

In other words, the Freds and Janes of the world have not caused this latest business downturn—or even the latest upsurge.  Rather, they are simply responding to business conditions as they believe affect them, or will affect them in the near future.  Far from being irresponsible, unpatriotic louts, as the Brokaws of the world might believe, Fred and Jane are being responsible citizens.

Unfortunately, Keynesian economists believe that even if it is OK for a few Freds and Janes to save in anticipation of slower economic times, when large numbers of people do the same, it can trigger an avalanche of unemployed resources, as producers lay off thousands of people in response to the sudden fall in demand.  Another way to say it is that, even if Fred and Jane have not caused the recession, their actions make things worse, which means the government must either encourage them to spend more money or find a way to spend it for them.

Like so many things in Keynesianism, this is a lie built around a kernel of truth.  No doubt, if large numbers of people began to rapidly increase their savings, demand for some goods would fall in the short term.  Marginal producers might very well find themselves pushed out of business.

Contrary to what Keynesians would have us believe, however, that is not the end of the story.  As the economy moves through its adjustment period, malinvestments are liquidated, but new opportunities also appear.  Many of these opportunities for startups and expansions will be funded by the very savings that individuals set aside to serve as cushions through the hard times.

In one way, the consumer is obviously very important to the economy—but not necessarily in the manner Keynesians might think.  Consumers decide the direction the economy will move, and their actions also determine the value not only of consumer goods, but also of the producer goods needed to make them.  In fact, the reason that most recessions occur is because consumer spending has not been prevalent enough in some areas of investment to warrant continued outlays into those lines of production.  This is not an issue of aggregate spending, but rather of proportionate spending.  

These problems are especially magnified when the Federal Reserve artificially lowers interest rates, either through forcing down its discount rate or by creating vast new amounts of bank reserves through its open-market processes.  Such actions often encourage investment into areas of production which patterns of consumer spending do not permit to be maintained.  As in all other economic downturns, the current economic slowdown features businesses that have been severely hurt (high-technology firms) and those companies that have remained relatively unscathed (consumer-goods producers and retailers).  Thus, we may hear about layoffs in Silicon Valley, but few will lose their jobs at Wal-Mart.

It is sad that, even though Keynesian economics has been discredited time and again, we still hear the pundits declare that consumers cause recessions—and prosperity—simply by choosing to spend or not to spend.  The "heroic consumer" who spends and spends in the face of adversity needs to be put to rest.

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William Anderson (send him mail) currently teaches economics at North Greenville College but will move to Frostburg State University for Fall 2001. See Anderson's outstanding Daily Article Archive.