Correction, Please!; M. Skousen

Mark Skousen is editor-in-chief of Forecasts & Strategies, one of the largest investment news letters in the country, adjunct professor of eco nomics and finance at Rollins College in Winter Park, Florida, and author of fourteen books, including The Structure of Production and Eco nomics on Trial. For information on his news letter and books, call Phillips Publishing Inc., at (800) 777-5005 or (301) 340-2100. by Mark Skousen Falling Under the Keynesian Spell For decades, members of the media and the financial community have fallen under the Keynesian spell, emphasizing the im portance of demand over supply, of deficits over surpluses, of debt over equity, and of consumption over saving. For them, the key to prosperity is found in encouraging a high level of consumption, even if it means going deeply into debt. The establishment press is so enamored with consumption that it high lights monthly changes in consumer spend ing, consumer debt, consumer prices, and surveys of consumer confidence, looking for any encouraging signs. After all, doesn't consumer spending represent two thirds of total economic activity?

Pro-Consumption Mischief Well, no, it doesn't. The idea that con sumption is the largest sector of the econ omy is based on a grave misreading of Gross Domestic Product (GDP). According to 1993 data, consumption ex penditures represents 66.1 percent of GDP, or approximately two thirds. Government purchases are second at 18.3 percent, and investment, which includes residential housing, comes in third at 15.6 percent. Business fixed investment is only 11.5 per cent of GDP. By making the standard assumption that GDP measures total eco nomic activity, the unsophisticated journal263 264 THE FREEMAN. MAY 1994 ist has concluded that consumer and gov ernment spending are by far the most important sectors of the economy, while business investment rates a poor third. Much mischief in government policy has arisen in consequence of this misinterpre tation of national income statistics. Many lawmakers have passed legislation encour aging consumption at the expense of invest ment. At the same time, they see no reason to cut capital gains taxes or corporate in come taxes, since the business investment sector appears to be relatively small and unimportant.

The Source of the Fallacy What's gone awry? The source of the error is that GDP is not a measure of total economic activity. As anyone who has taken Econ 101 knows, GDP measures the purchase of final goods and services only. GDP deliberately leaves out spending by business in all the intermediate stages of production before the retail market. It does not include spending (what economists call "working capital") by natural resource companies, manufacturers, and wholesal ers. Obviously, financial journalists need a refresher course in economics. In sum, GDP does not measure total spending in the U.S. economy, only final retail purchases by consumers, business, and government. Introducing a More Accurate Statistic To determine total economic activity, we need to look at Gross Domestic Output (GDO), a statistic I developed in my book, The Structure of Production (New York University Press, 1990). It measures gross expenditures at all stages of production, from raw commodities to finished products.

Based on the input-output data prepared by the U.S. Commerce Department, I estimate that consumption expenditures actually rep resent only about 33 percent, or one third, of economic activity in the United States, not two thirds as is commonly reported. Moreover, gross investment by business repre sents the majority (54 percent) of total spending in the economy if you add together gross intermediate expenditures (' 'working capital"), business fixed investment, and residential housing. Government purchases represent the remainder, or 13 percent. This new statistic, GDO, provides a more complete indicator of total economic activ ity. As such, it suggests a far different interpretation of how the world works. In fact, we come to the opposite conclusion: Investment is far more important than con sumption. The U.S. economy, like all econ omies, is investment-driven, not consump tion-driven. Consumption is ultimately the effect, not the cause, of a nation's prosperity.

An individual becomes wealthy by pro ducing and investing first, then increasing his consumption-not the other way around. To go on a spending spree using credit cards or other forms of debt may initially give the impression of a higher standard of living, but eventually the individual must pay the piper or face bankruptcy. The same principle applies to a nation as a whole. "But," retort the big spenders, "if con sumers stop buying, business will eventu ally stop producing." Granted, the whole purpose of production is eventual consump tion. Per capita consumption is usually a reasonable measure of national wellbeing, and business must be responsive to con sumer needs. But the real question is, how do we improve our standard of living? There is only one proven way, and that is by raising the amount of capital invested per worker. Economic progress is achieved when busi ness increases its profits by providing cus tomers· with better products at cheaper prices. That requires a direct investment in capital. Those who postpone consumption now and invest their savings productively will be rewarded with higher consumption later.

Consumer Spending Not a Leading Indicator If the U.S. economy is consumption driven, why aren't retail sales a leading indicator of economic activity? Of the eleven components in the D.S. Department of Commerce's Index of Leading Indicators, only one, the Consumer Expectations In dex, is directly linked to future retail sales. The other leading indicators are almost entirely related to capital investment and earlier stages of production, such as manu facturers' orders, sensitive materials' prices, contracts for plant and equipment, and stock prices. Retail sales are in reality an unreliable indicator of where the economy and the stock market are headed. Industrial output is a much better forecaster. And, contrary to what the national media often reports, retail sales are relatively stable compared to in dustrial production, just as, consumer prices are nowhere near as volatile as commodity prices. Financial analysts seeking to pin point changes in the direction of the econ omy and the stock market will be disap pointed if they rely entirely on retail sales as a guide.

The Crisis in Productivity and Investment Stimulating consumer spending in the short run will undoubtedly encourage some lines of investment. If people go on a buying spree at a local grocery store or mall, merchants and their suppliers will see their profits go up. But the consumer spending binge will do little or nothing to construct a bridge, build a hospital, pay for a research program to cure cancer, or provide funds for a new invention or a new production process. Only a higher level of saving willdo that. Thus, in nations following Keynesian pro-consumption policies, it is not surpris ing to see luxurious retail stores and malls along side dilapidatedroads and infrastrucTHE MOTHER OF ALL MYTHS 265 ture. Their consumption/investment ratio is systematically out of balance. Peter Drucker chastises the United States and other Keynesian industrial nations for a "crisis in productivity and capital forma tion" and "underinvesting on a massive scale. ,,1 The current administration has done little to reverse this trend.

Saving, investing, and capital formation are the principal ingredients of economic growth. Countries with the highest growth rates (most recently in Southeast Asia and Latin America) are those that encourage saving and investing, i.e., investing in new production processes, education, technol ogy, and labor-saving devices. Such invest ing in turn results in better consumer prod ucts at lower prices. They do not seek to artificially promote consumption at the ex pense of saving. Stimulating the economy through excessive consumption or wasteful government programs may provide artificial recovery in the short run, but cannot lead to genuine prosperity in the long run. Dsingour new statistic, ODO, we now see that cutting taxes on business and invest ments (interest, dividends, and capital gains) will have a dramatically favorable effect, far more than previously thought. When business investment represents 54 percent of the economy, not 15 percent, reducing investment taxes can have a mul tiplying impact on the nation's economy.

In sum, it is capital investment, not con sumer spending, that ultimately drives the economy. As economist Ludwig von Mises declared forty years ago, "Progressive cap ital accumulation results in perpetual eco nomic betterment. ,,2 0 1. Peter Drucker, Toward the Next Economics and Other Essays (Harper & Row, 1981), p. 8. 2. Ludwig von Mises, "Capital Supply and American Prosperity, " Planning for Freedom, 4th ed. (Libertarian Press, 1980), p. 197.