More Consumer Debt a Good Thing?

So yesterday we had another example of how one's analytical framework drives one's perceptions of the economy and prospects for prosperity. Business Insider's Joe Weisenthal writes that "Sorry, But the Idea That We're In a Recession Is Nonsense."

Exhibit A in making his case is that there has been a substantial uptick in consumer credit:

To further bolster his claim, Weisenthal points out that personal consumption relative to wages has been increasing. There has been no serious effort for households to retrench their consumption spending since early 2008.

I do not dispute this data and understand why Weisenthal sees all of this as good news for the economy. He does so because of his generally Keynesian macroeconomic framework. For him the economy is GDP, which is driven by aggregate demand which is actualized in spending. Because approximately 70% of GDP is made up of consumer spending, it is perceived that consumer spending drives the economy forward to expansion and development.

Whether or not we are in recession, recovery, or economic twilight, I would not venture to guess. It seems to me that the numbers outlined above are not definitive. That the rate of consumer spending to wages and consumer credit is increasing could merely be evidence that people's incomes are not keeping up with their buying habits. It could be that households are buying more necessary staples with a credit card. That would not be a recipe for happy economic times ahead.

 What I do know is that sustainable prosperity is built neither upon consumer spending nor borrowing. Sustainable economic expansion is the result of increases in per capita capital, which requires saving and investment. It, therefore, requires a relative decrease in consumption compared to saving.

Bernanke Tells Students We Need More Consumption

In his series of lectures entitled The Federal Reserve and the Financial Crisis he is delivering at Georgetown, Chairman of the Federal Reserve, Ben Bernanke keeps pitching them. In his first lecture, "The Origins and Mission of the Federal Reserve," he explained his views on the nature of central banking and his thoughts on the gold standard (he does not like the proposition).

In his second lecture, "The Federal Reserve after World War II" delivered Thursday, Bernanke said that U.S. households need to spend more on consumption in order to continue economic recovery.

“Consumer spending is not recovered, it’s still quite weak relative to where it was before the crisis. In terms of debt and consumption and so on we’re still way low relative to the patterns before."

This is the sort of analysis that is natural for people who mistake GDP for economic activity. Certainly increased consumption spending will boost GDP, but more consumption will not provide for sustained recovery. After the initial round of consumption, where will we get more consumer goods to consume again? Only if they have been produced. The larger the percentage of our income we spend on consumption, the less we save and invest and the lower our productivity.

After a period of capital consumption due to malinvestment encouraged by the central bank, the only way for the economy to get back on its way to economic expansion is via capital accumulation. That requires more saving not less, which means less consumption not more. Perhaps one of the reasons we got into the crisis is that people took on too much debt and engaged in too much consumption, while the Fed bank rolled the whole thing. If so, getting back to pre-crisis levels of debt and consumption is the last thing we need right now.

Monetary Inflation Benefits Those Who Get the New Money First

Money is not neutral. The premise of the neutrality of money asserts that when the stock of money changes, the only result is a change in overall prices, such that real economic conditions remained unchanged. It has been argued, therefore, that all of this monetary inflation we've had over the past several decades has had no real negative impact on standard of living  for people. Prices have rise, but so has our monetary incomes, so we are left no worse off.

While it is true that there is no general social benefit from monetary inflation, it is not true that money is neutral. As Mises explains the consequences of monetary inflation:

The additional quantity of money does not find its way at first into the pockets of all individuals; not every individual of those benefited first gets the same amount and not every individual reacts to the same additional quantity in the same way. Those first benefited? In the case of gold, the owners of the mines, in the case of government paper money, the treasury now have greater cash holdings and they are now in a position to offer more money on the market for goods and services they wish to buy. The additional amount of money offered by them on the market makes prices and wages go up. But not all the prices and wages rise, and those which do rise do not rise to the same degree. If the additional money is spent for military purposes, the prices of some commodities only and the wages of only some kinds of labor rise, others remain unchanged or may even temporarily fall. They may fall because there are now on the market some groups of men whose incomes have not risen but who nevertheless are obliged to pay more for some commodities, namely for those asked by the men first benefited by the inflation. Thus, price changes which are the result of the inflation start with some commodities and services only, and are diffused more or less slowly from one group to the others. It takes time till the additional quantity of money has exhausted all its price changing possibilities. But even in the end the different commodities are not affected to the same extent. The process of progressive depreciation has changed the income and the wealth of the different social groups. As long as this depreciation is still going on, as long as the additional quantity of money has not yet exhausted all its possibilities of influencing prices, as long as there are still prices left unchanged at all or not yet changed to the extent that they will be, there are in the community some groups favored and some at a disadvantage. Those selling the commodities or services whose prices rise first are in a position to sell at the new higher prices and to buy what they want to buy at the old still unchanged prices. On the other hand, those who sell commodities or services whose prices remain for some time unchanged are selling at the old prices whereas they already have to buy at the new higher prices. The former are making a specific gain, they are profiteers, the latter are losing, they are the losers, out of whose pockets the extra-gains of the profiteers must come. As long as the inflation is in progress, there is a perpetual shift in income and wealth from some social group, to other social groups. When all price consequences of the inflation are consummated, a transfer of wealth between social groups has taken place. The result is that there is in the economic system a new dispersion of wealth and income and in this new social order the wants of individuals are satisfied to different relative degrees, than formerly. Prices in this new order can not simply be a multiple of the previous prices.

This phenomena is being played out right now in front of our very eyes. The New York Times reports that sales of luxury goods are recovering strong, even with price mark ups! Notice this very revealing passage pinpointing the cause of the new luxury good boom:

What changed? Mostly, the stock market, retailers and analysts said, as well as a good bit of shopping psychology. Even with the sharp drop in stocks over the last week, the Dow Jones is up about 80 percent from its low in March 2009. And with the overall economy nowhere near its recession lows, buying nice, expensive things is back in vogue for people who can afford it.

Perhaps the above thinking is partly to explain Bernanke's recent pronouncement of future monetary profligacy. If the Fed can bolster equity prices again, consumer spending will be further stimulated and the "economy" will receive the elusive "jump start" the Fed has been trying to initiate. Of course, on the other hand, pesky reality and economic law will continue to assert themselves.

Is the Health of the Economy Dependent on Consumption?

Too many economic journalists think so. This week's Exhibit A comes from Martin Crutsinger, economics writer for the Associated Press. He claims that whether we have sustained economic recovery depends on people increasing their consumption spending. Crutsinger writes

For the economic recovery to gain strength -- and the unemployment rate to come down in any meaningful way -- consumers will need to become less frugal.

Later in the piece he notes that even when people are spending on consumer goods, they are not buying them with credit.

Even the way people are paying for things shows a change in attitude about money. Consumers shied away from accumulating new debt during the second quarter, according to the latest reports from MasterCard Inc., and Visa Inc.

Overall card use rose 14 percent. But the growth came almost entirely from debit cards, which rose to $465 billion, from $408 billion a year ago. Credit card use edged up less than a percent to $345 billion from $342 billion last year.

The upshot of this view of the economy is that prosperity rises and falls with consumption. If people spend more money on consumer goods, retailers reap profits, hire more workers, and incomes expand. If people reduce consumption and increase savings, however, retailers feel the pinch, lay off workers and incomes fall. It is an easily understood tale, but it only captures part of the effects of changes in consumption and spending.

The fact of the matter is that one of the primary reasons the economy is in such a mess is that, with the help of the Federal Reserve and the commercial banking system, people were encouraged to take on too much debt in the form of things like home mortgages and consumer credit. Too much consumer spending financed with credit is part of the problem. It will not be the solution for recovery.

Economic prosperity occurs when people are able to obtain more and better goods they desire at lower prices. This is made possible by production, not consumption. We produce in order to consume, not consume in order to produce.

It is impossible to consume food, clothing, shelter, automobiles, or recordings of the Dvorak Serenade for Strings in E, Op.22 if they are not first produced. Production requires the use of land, labor, and capital goods. The more capital goods there are the more productive the land and labor will be. Capital goods, however, must also first be produced. That means that, in order to benefit from the use of capital goods, resources must be directed away from consumption and the production of consumer goods and invested in the production of capital goods that can then be used to produce even more consumer goods. The restriction of consumption is what economists call saving. Therefore, saving is not a hamper to the recovery.

Nay, saving is required for recovery. A tremendous amount of capital was squandered during the economic boom of the mid-2000s. This malinvestment came to light during the recession and can't be fixed by increases in consumption. Given the increases in government intervention in the automobile, financial, and health care industries over the past two years, one of the only bright spots is that people appear to be increasing saving. This is not something of which to be fearful, but to hope continues.