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.