Stimulus Package Has No Clothes

The $168bn economic stimulus package that was pushed through earlier this year on falling growth concerns is just about seeing the light of day now as many people will receive their rebate checks in the next few weeks. At the time the package was being debated, there were many naysayers who believed that the stimulus would come too late, or be insufficient to avoid a recession. Others believed that the stimulus would backfire with recipients spending their rebate checks on paying down debt or other such activities and not consumption. Still others questioned the prudence of attempting to prevent a recession today at the expense of pain at a future date, effectively robbing Peter to pay Paul, except Peter is yet unborn and cannot object.

I refrain from linking to any of these naysayers as it is not important who opined where on the spectrum. Sadly, they are all barking up the wrong tree. The stimulus package is all of the above, yet none at the same time. It is too little too late, many people will pay down debt instead of spend, and it will create debt that future generations must pay back. However, all of these are red herrings. Everyone who has weighed in on this issue, barring the Mises Institute, seems to have a political agenda. In this article I hope to lay bare the economics behind the stimulus package. In doing so, much like the little boy who said that the emperor has no clothes, I am stating a couple of simple, fundamental, yet widely ignored truths. They are:

1. Business spending and not consumer spending accounts for most of economic activity.
   
2. Savings and not consumption is the root of economic growth. Consumption, by its very nature, is the anti-thesis of growth.

The former implies that the stimulus package cannot prevent a recession if a recession is on the cards, while the latter implies that the stimulus package will actually exacerbate any slowdown. I fully recognize that both these statements sound absurd to anyone trained in the Keynesian tradition, which is why I hope the reader can look beyond the shock value of my claims and instead rationally evaluate them.

Consumer Spending in Perspective

Today, 70% of GDP is consumer spending, which leads many commentators to conclude that consumer spending is the health of the economy. Unfortunately, this is not true. During the 2000-20002 recession while the economy was clearly in a downward phase, consumer spending actually rose. This is a conveniently ignored fact that demonstrates a shortcoming in the existing paradigm. In reality, business spending accounts for the majority of economic activity, clocking in at around $25 trillion yearly, while consumption is a mere $7 trillion (even that is high by relative historic norms). The reason this is ignored by non-Austrians is for 2 reasons:

1. First, as George Reisman has argued, it gets hidden in the Keynesian formulation of GDP as GDP = C + I + G + NX. Reisman says:
   

   In this article, I prove, to the contrary, that consumption is not the main form of spending in the economic system and that the source of most spending is, in fact, saving. I prove my claims by starting with the very formulations of the expenditure aggregates presented by the Keynesian doctrine itself.
   

   Further,
   

   The truth is that the great bulk of spending and income payments in the economic system is concealed under net investment! Net investment is analogous to an iceberg, nine-tenths of whose volume is concealed beneath the surface. Only in the case of net investment, what is concealed can easily be much more than nine-tenths.

   Thus,
   

   The belief that [consumption is the main source of spending] rests on a radically incomplete, highly superficial understanding of the formulas.

2. The second reason has to do with the Keynesian preoccupation with GDP. I have argued earlier that GDP is only indicative of economic output, and not economic growth. The common rebuttal to my argument is that one does not want to double count intermediate transactions in determining growth. However, by focusing on only consumer goods, Keynesian's actually ignore the vast majority of economic activity: the higher stages of production. The production structure is narrowest at the consumer end, and expands radically as one moves towards the higher stages of production. The more technology and roundabout methods entrepreneurs invest in, the more the production structure fans out. This is precisely why consumer spending can continue to expand while the economy as a whole experiences a retrenchment. This is also why thinking in terms of GDP to understand the direction of the economy can be misleading. One needs to look at, amongst other things, manufacturing, business spending, and the calculus of credit creation along different parts of the production structure.
   

The conclusion is that stimulating consumption, even if consumption was the source of economic growth, is not going to prevent an economy that is experiencing retrenchment in the higher stages of production from skirting a recession.

The True Nature of Economic Growth

As hinted at in point 2 above, the essence of economic growth rests in expanding the production structure. At the risk of over simplifying: assume you have 1 machine that can produce 10 widgets in a year. Assume further that the machine is made of 20 widgets. For the economy to "grow" there must be capacity for increased widget production. To this end, 20 widgets, 10 widgets for 2 years, must be saved to build a new machine. In those 2 years GDP drops to 0, but after 2 years the economy has actually grown 100%. On the other hand, if the first machine is consumed, you have a one time GDP increase of 100%, but have no capacity for future output. There appears to be a disconnect between GDP and economic growth.

This overly simplified example is intended to demonstrate that saving and investment (20 widgets to create the second machine) is economic growth even if GDP falls, while consumption (consuming your first machine) cannibalizes the production structure leaving you with diminished capacity for future output, even if it creates a boost to GDP. Shostak illustrates this idea more carefully using Crusoe economics in his article on the subsistence fund.

Conclusion

The implication for the "stimulus" package is that if the package actually does stimulate consumption then it will be at the expense of investment. The package will create a one time shot in the arm to GDP, but will actually cannibalize the production structure creating a diminished capacity for future output. Reisman makes the same argument towards the end of his article.

Since increasing the capacity for future output is the essence of growth, any real stimulus package should encourage investment consistent with consumers time preferences. Of course, that is an oxymoron because no government intervention can achieve that end. Only the free market left to its own devices can coordinate savings and investment for sustainable growth -- admittedly another bizarre sounding claim to anyone from the Keynesian tradition, but one that the Austrian school has clearly elucidated in the Austrian theory of the business cycle.