Mises Daily Articles
The Fallacies of Underconsumptionism
In my capacity as an economics student one of the hardest things to grasp has always been the exact relationship between consumption expenditures, savings, and prosperity. At the undergraduate level, I was fed the standard IS/LM story, which says in effect that consumption drives production. The standard story can be told in a few simple sentences using some obvious "facts" about the functioning of the economic system.
Business firms will hire workers and produce things if and only if they can reasonably expect to generate enough sales revenue to cover the cost of the operation plus at least the going rate of profit.
Capital goods industries adjust their production plans to the demand experienced by the consumer goods industry. Should the demand for consumer goods diminish, for whatever reasons, firms will cut production and layoff personnel.
During the periods of economic crisis, a reduction of wage rates is said not to be working at the level of the economic system as a whole because lower wages would mean less spending for consumer goods, thus further aggravating the crises.
The cure, it is said, must come from increased public expenditures that are financed by government budget deficits along with the increases of money supply and credit expansion.
The purpose of this article is to show the precise relationship between consumption expenditures, saving, capital accumulation, and prosperity. It will be shown that consumption in real terms as well as consumption expenditures stated in monetary terms are themselves not the cause but an effect of greater saving and capital accumulation.
Demand for Commodities Is Not Demand for Labor
In order to recognize the fallaciousness of the standard story in the clearest light possible, we must first establish a correct connection between the demand for consumer goods and all other economic activities, most notably, of course, the demand for labor.
The first step in the analysis is to understand the simple observation that the two phenomena, namely, purchasing of consumer goods and the demand of labor services represent two physically separate events. That is, when one buys a consumer good one does not simultaneously buy anything else but the consumer good in question. In particular, one does not buy either labor services or capital goods. It is important, at this stage of analysis, to keep all other possible future consequences of the initial purchase out of the picture, and to focus on the mere fact that demand for consumers' goods and, here, demand for labor services constitute two separate events. Saying that demand for consumer goods must be viewed and assessed separately, is not an invitation to somehow disregard the role of the consumer or consumer demand. Nobody denies the fact that the purchase of consumer goods has important economic consequences for the production process in question. But in order to arrive at a clear picture of the functional relationships involved, it is indispensable to take account of the logical separateness of the two events.
Moreover, one should also realize that to demand consumer goods, in the sense of expending a definite amount of money, is to diminish one's ability to demand, say, labor services. That, of course, is an obvious example of scarcity. If I spend my entire monthly income, say, on gambling, I will have no means to purchase other things. The same kind of scarcity applies with equal force to a very complex economic system as well, with the only difference being that the constraining factor at the level of the economic system as a whole is the quantity of money and volume of spending. Even under the condition of a fiat monetary system where the quantity of money is capable of expanding very rapidly, the logic of scarcity applies to it with equal force as well. The very act of deciding between the demand for commodities and the demand for labor services already presupposes scarcity regardless of how rapidly the supply of money may increase.
In light of the preceding simple analysis, one can already draw very important conclusions. To claim, for example, that the cause of, or the solution for, the unemployment problem is an insufficient demand for consumer goods, is to commit an elementary logical fallacy and to claim, in effect, that the demand for consumer goods somehow incorporates the demand for labor services, that in the very moment when one buys a consumer good one purchases some labor services; or to put it more precisely, that demand for consumer goods is more than itself.1
The Concept of Productive Expenditure2
The existence of the separate demands for consumer goods, capital goods, and labor services, respectively, enables us to distinguish strictly between the two kinds of expenditures that exist in the market economy. The first kind can be called consumption expenditure and is related to the demand for consumer goods. The second kind can be called productive expenditureand is related to the expenditures made by business firms on account of capital goods and labor services. A distinctive feature of productive expenditures, of course, is that they must come from the funds saved, i.e., not expended in the purchase of consumers' goods.
Observe, as a further major point, the very crucial difference between the two kinds of expenditures. From the point of view of a consumer, the money he spends on buying consumer goods is gone, and the consumer goods once physically extinguished or otherwise happening to be of no use to the consumer, must be procured again. In order to buy the goods and services he needs, the consumer must see that he finds a source of money income. This is a distinctive feature of consumption expenditures. Consumption expenditures are dependent on outside sources.
The productive expenditures, on the other hand, are made by business firms precisely for the purpose of bringing in subsequent sales revenues that usually exceed the money costs expended in the production process. From the viewpoint of an entrepreneur, the productive expenditures constitute the means in order to bring in more money than previously expended.
Saving and productive expenditure, not consumption expenditure, is what constitutes the demand for labor and capital goods and is what enables and sustains the roundabout capitalist production processes that enable business firms to increase their production and, as a consequence, to cut the costs of their products.
The greater the saving and productive expenditure of businessmen and capitalists, the greater is the demand for labor and capital goods relative to the demand for consumer goods and the higher are both wages and the productivity of labor, the latter because of the production and employment of more capital goods per worker.
The emergence of wage earners along with an abundance of low priced consumer goods brought about for the first time in the history of mankind the phenomenon of the mass market and mass consumption. And as the word "mass" suggests, the overwhelming majority of consumers, and the vast economic significance they have, represent the newly created class of wage earners. As should have become clear, mass consumption is actually the effect and not the cause of higher productivity and prosperity, contrary to what the underconsumptionists believe.
Supply creates its own demand and not the other way around. And especially during periods of economic crisis, which have always and exclusively been a product of a governmentally inaugurated policy of inflation and credit expansion, the most pernicious thing to do is to increase government expenditure at the expense of saving and productive expenditure.
It means that especially taxation of corporate profits, inheritances, and distributed dividends channels the very funds into consumption expenditures that would have provided the necessary means for the demand for capital goods and labor services. Thus, all kinds of public expenditure increased in this way, including the projects with a seemingly beneficial character such as public works, building up of infrastructure in the form of highways or communication facilities, spending for education and schooling etc., can only contribute to more unemployment.3 To the extent that government expenditure is increased on a foundation of new and additional money, the only way that it can serve to increase the demand for labor and capital goods is not in the mere fact of its existence but only to the extent that the resulting additional sales proceeds are saved and productively expended by their recipients.
The basic error of underconsumptionism is the belief that prosperity correlates directly and positively with consumption spending, that in demanding consumer goods one somehow demands labor services along with the intermediate goods that contribute to the production of the final product. The error stems from the misidentification of the forces that are actually responsible for mass consumption and for rising prosperity in real terms. The actual forces are saving and productive expenditure made by the business firms.
With respect to economic theory, it is very important to realize that a correct understanding of the functional relationship between consumption, saving, productive expenditure, and prosperity cannot be provided on the basis of contemporary economics because it confuses things to such a degree as to be virtually worthless.
- 1. It is worth mentioning that our very system of national accounting commits precisely this kind of error when it accuses the separate counting of all intermediate goods (i.e. capital goods) of "double-counting." For a devastating critique of the present system of national accounting, see Reisman, George G. (1996) Capitalism: A Treatise on Economics, Jameson Books, Ottawa, Illinois, pp. 674–99, and Reisman, George G. (2004) The Value of Final Products Counts Only Itself: Today's Gross Product Is Net Product, The American Journal of Economics and Sociology, Vol. 63, No. 3 (July, 2004).
- 2. For a detailed discussion of the concept, see Reisman (1996), pp. 441–62. Any interested reader should pay particular attention to his critique of the concepts of imputed income and opportunity cost, which appear on pages 456–62. Professor Reisman's critique of the two concepts brings the significance and the role of productive expenditure into an especially clear light. In the opinion of the present writer, the concept of productive expenditure along with the doctrine that demand for commodities is not demand for labor, are capable of bringing a radical change to the whole of economic theory.
- 3. For a detailed discussion of the effects of public expenditures on employment and economic recovery, see Reisman (1996), pp. 697–98, 714–15, 829-830, 833–34, 887–88.