Consumption Spending Is 70 Percent of GDP — So What?
By Robert Higgs • Sunday September 5, 2010 10:35 AM PDT • 33 Comments
It must be a condition of employment that a journalist who writes about the current recession include in his article the statement, “consumption makes up more than two-thirds of the economy” or “consumption spending accounts for 70 percent of GDP.” This seemingly simple, factual statement, however, is nearly always intended to carry some explanatory weight, and on occasion the writer spells out this explanation by adding a statement such as, “unless consumers begin to open their wallets and spend more, recovery from the current recession will be impossible.”
At first glance, this journalistic commonplace appears to make sense. Anyone can understand that, say, a store at the mall will not hire additional employees unless its sales increase enough to justify the additional expense. Hence, would-be employees will remain unemployed; they will purchase fewer consumption goods than they would have purchased if they had jobs; and therefore the stores will not hire more workers; and so forth. The circle of a theory of income and employment seems to be closed, and thus an explanation provided for the lingering recession: consumers are not spending enough.
One does not need a Ph.D. in economics, however, to discover that something must be wrong with this way of thinking about prosperity and recession. Checking the national economic accounts produced by the Commerce Department’s Bureau of Economic Analysis (Table l.l.6), one finds, for example, that the most recent quarterly peak in real personal consumption expenditure occurred in the fourth quarter of 2007. This spending ($9,244 billion at an annual rate) equaled 69.2 percent of contemporary GDP ($13,364 billion at an annual rate)—where the data are expressed in dollars of 2005 purchasing power. Real GDP did not fall significantly until the third quarter of 2008. When it reached its trough in the second quarter of 2009, it had fallen to $12,810 billion, down about 4 percent. At that time, real personal consumption spending was $9,117 billion, down only 1.4 percent, and equal to about 71 percent of GDP. Thus, as usual over the course of a boom and bust, consumption spending varied proportionately less than GDP as a whole.
As every student of the business cycle learns early on, the most variable part of aggregate expenditure is private investment. When real gross private domestic investment peaked, in the first quarter of 2006, it was $2,265 billion, or 17.5 percent of GDP. When it hit bottom in the second quarter of 2009, it had fallen by 36 percent to $1,453 billion, or 11.3 percent of GDP. (Deducting investment expenditures aimed at compensating for depreciation of the private capital stock [Table 1.7.6], we find that real net private investment – the part that contributes to economic growth—in the most recent quarter was only one-third as great as it was at its peak in early 2006.) The ups and downs of the business cycle are obviously driven not by consumption spending, but by investment spending.
In the second quarter of 2010, real personal consumption was $9,270 billion, or slightly above its previous peak, at an all-time high. If stimulating consumption spending were the key to an economic revival, we would have achieved one already. And if we accepted real GDP as an adequate index of the economy’s health, we might affirm that conclusion, given that in the most recent quarter, real GDP was only 1.3 percent below its previous peak. With the official unemployment rate stuck near 10 percent and millions of people having left the labor force or having settled for part-time work, however, that conclusion is hard to swallow.
The vulgar Keynesian focus on consumption unfortunately tempts politicians to approve “stimulus” measures aimed at pumping up this part of total spending—measures such as long extensions of unemployment insurance benefits, aid to state and local governments to help them avoid personnel reductions, and increases in the salaries of federal employees. Some economists even go so far as to single out such measures for special praise on the grounds that because such payments are most likely to give rise to consumption spending in the near term, they have the greatest “multiplier effect.”
Such arguments, however, fail to grasp the true nature of the boom-bust cycle, especially the central role of investment spending in driving it—and, more important, in driving the long-run growth of real output that translates into a rising standard of living for the general public. Politicians, if they truly wish to promote genuine, sustainable recovery and long-run economic growth, need to focus on actions that will contribute to a revival of private investment, not on pumping up consumption. In the most recent quarter, real gross private domestic investment was running at an annual rate more than 20 percent below its previous peak and, as noted, real net private investment was fully two-thirds below its previous peak.
To bring about this essential revival of investment, the government needs to put an end to actions that threaten investors’ returns and create uncertainty that paralyzes their undertaking of new long-term projects. Gigantic measures such as the recently enacted health-care legislation and the financial-reform law, which entail hundreds of new regulations whose specific content, enforcement, and costs are impossible to forecast with confidence, contribute to “regime uncertainty” and thereby encourage investors to hold large cash balances or to park their funds in short-term, low-yield, less risky securities. Such investments cannot support genuine recovery and sustained long-run growth.
In sum, our crying need at present is for a robust revival of private long-term investment. Consumption-oriented government “stimulus” programs, at best, only ensure a protracted period of economic stagnation.
Tags: Budget and Tax Policy, Economics, Employment, The State 
Hi Bob, One thing I noticed if I graphed the data all the way back to 1929 is that from 1932 to 1937, private investment increased from 1.78% of GDP to 9.87% of GDP. Why was private investment increasing at such a rapid pace with all the New Deal programs going on?
f4kingit | Sep 5, 2010 | Reply
Yes, the gross investment ratio increased substantially between the depths of the Depression (in 1932-34) and 1937, and real output also increased rapidly in those years. But investment remained low relative to its rate during the latter half of the 1920s. Net investment did not become positive — that is, gross investment did not become great enough to compensate for depreciation of the capital stock — until 1936 and 1937; and then, in 1938, it became negative again during the depression within the Depression.
Given the depths to which the economy had sunk in the early 1930s, a recovery was to be expected. It makes most sense to interpret this recovery as occurring in spite of the various New Deal measures that, in themselves, had a negative effect on the recovery. The economy is complex: there are always multiple changes pushing it up and down, and its movement is the resultant of these forces.
Robert Higgs | Sep 6, 2010 | Reply
Hello Robert,
I hope this note finds you well...
You state:
“To bring about this essential revival of investment, the government needs to put an end to actions that threaten investors’ returns and create uncertainty that paralyzes their undertaking of new long-term projects.”
********************
Therefore, preceding the “essential revival” taking place ... government needs to put an end to ... ITSELF!
What are the chances of that occurring? ZERO. Why? Mr. Martin gives us a clue:
“The plain fact is that those ‘who crave the comforts and security of subordination’ outnumber the ‘free souls,’ and there is no credible evidence that this relationship is likely to change in any appreciable degree now or at any calculable time in the future.” ~ James J. Martin, libertarian historian and editor
********************
C’est la guerre,
Capt. A.
Principaute de Monaco
GMT +2:00 CET
Capt. A. | Sep 6, 2010 | Reply
Hi Bob, Thanks, so even though gross private investment came back to pre-depression levels (~10%), when you take into account the capital stock depreciation that had occurred (since private investment went all the way down to 1% for some time), net private investment was actually under trend.
f4kingit | Sep 6, 2010 | Reply
I’m the living proof of your analysis, and I believe there are millions of others.
ralph | Sep 6, 2010 | Reply
So if there were no regime uncertainty where do you see all the private investment dollars going?
muirgeo | Sep 6, 2010 | Reply
Why would you use peak gross private domestic investment of 2006 as a baseline when it was clearly inflated from the bubble economy.
It seems to me THAT is the problem claiming investment spending drives the economy. When it is de-linked from true consumption patterns and based on speculation we get bubbles and crashes like the one we are currently in.
muirgeo | Sep 6, 2010 | Reply
f4kingit,
In 1936 and 1937, BOTH gross and net investment were still below their long-run trends. In those years, however, NET investment had again at least become positive, though barely.
Robert Higgs | Sep 6, 2010 | Reply
murigeo,
It would be foolish for me or anyone else to presume the knowledge of where investment would have been made had regime uncertainty not existed recently. Making those decisions is the activity of entrepreneurs, not economists or other outside observers.
In regard to your second comment, we do not know that investment in 2006 was “too high,” whatever we might mean by that judgment. We do know, however, that investment in the period from 2002 to 2006 was misallocated because of the incentives created by a number of government policies, especially in housing finance (e.g., Fannie, Freddie) and in the Fed’s management of monetary and credit conditions.
Robert Higgs | Sep 6, 2010 | Reply
So you DON’T know where these entrepreneurs would invest their money but you DO know they are not investing because of “regime uncertainty”?
Do you have evidence for that claim?
Also it looks to me like over the last 6 quarters private investment is up 16%. This compares to the 6 quarters prior to the peak private investment in Q1 of only about 7%.
muirgeo | Sep 6, 2010 | Reply
murigeo writes: “So you DON’T know where these entrepreneurs would invest their money but you DO know they are not investing because of “regime uncertainty”?
Do you have evidence for that claim?”
Yes, I have evidence. It consists of three main types: (1) extensive facts about the extraordinary government measures that have been taken or proposed during the past two years, along with the economic logic of how such changes would be expected to affect investor confidence; (2) a great deal of direct testimony by businessmen who have said that in view of what the government has done or might do soon, they are reluctant to invest; and (3) evidence on the changes in yield curves for corporate bonds, contrasted with yield curves for Treasury bonds of the same maturities. I have present this evidence from time to time over the past two years on this website. I invite you to review what I have presented. Your questions might be more pertinent if you had informed yourself better.
murigeo also writes: “Also it looks to me like over the last 6 quarters private investment is up 16%. This compares to the 6 quarters prior to the peak private investment in Q1 of only about 7%.”
This comment makes no sense to me. As I have documented, private investment fell tremendously between its 2006 peak and its early 2009 trough. The fact that it has recovered in small part since its recent trough does nothing to challenge the fact that it remains very far below its previous peak or any reasonably constructed growth trend for it. Its rate of growth before its 2006 peak has no relevance to the present discussion, which concerns the very low level of investment at present and the possibility that it remains so depressed because of regime uncertainty.
Robert Higgs | Sep 6, 2010 | Reply
It should also be considered that most consumption is to one degree or another an investment. There is a largely indistinguishable line between unproductive consumption and productive consumption (for example, where is the line draw between superfluous and luxurious consumption of food and food consumption that leads to higher productivity?).
The aggregation of consumption under that blanket term skews the true distinction between different “forms” of consumption. Whereas most consumption may lead to increases in wealth, by aggregating the concept of “consumption” government can therefore justify consumption programs which are actually unproductive (e.g. digging holes just to employ people).
Of course, this is all in support of Prof. Higgs’s point, which is completely on the mark.
Jonathan M. F. Catalán | Sep 6, 2010 | Reply
Capt. A.,
Subordination will last only as long as the checks from the subordinator do, i.e., only as long as Uncle Sugar’s welfare apparatus remains intact. That’s about to change, however, as the government resorts to a combination of selective default (raising the retirement age, means testing, etc.) and inflation in a desperate attempt to get out from under its otherwise unpayable debts and welfare liabilities.
I fear, however, that as this begins to happen, Uncle Strychnine will engineer an excuse to invade Iran and thus expand the war in the Middle East to the point of “changing the subject,” much as FDR did.
See also here — the point being that just as Prof. Higgs brilliantly analyzes in Crisis and Leviathan, the state thrives on crises, especially those it creates on purpose, in response to those it created by accident.
Glaucus | Sep 7, 2010 | Reply
Changing public policy to encourage risky high-yield investing is just the sort of thing that will reduce confidence in the market in the long term. More risk means more reward for the deeply connected few while the rest of us outside the loop are put off by the winner take all attitude of the market.
If investing were easier and safer more people would do it, driving the economy. Deregulation of the financial market has created this confidence problem. Deregulation has made understanding one’s investment harder, creating an unsafe atmosphere that will certainly lead to cascading panic at the hint of trouble.
Your solution, deregulating the health industry, is pretty stupid and tangential when you consider the real psychology at work.
Stimulus won’t work for a variety of reasons, (what happens when the money is no longer available), but you need to think a little about what’s really going on before you present your cliched solutions based on discredited theories.
TMS | Sep 7, 2010 | Reply
“In regard to your second comment, we do not know that investment in 2006 was “too high,” whatever we might mean by that judgment.”
I’m sorry but this statement is almost beyond belief. Consider the vast amount of accumulated debt in both the public and private sectors and you question weather there was a bubble or not?
The fact was there was NO DEMAND and when that happens the extremely wealthy and the Wall Street gang have to create demand and in this case they did so using financial alchemy only enabled by their lobbyist getting their industry deregulated just the way they wanted it.
muirgeo | Sep 7, 2010 | Reply
I find your most recent comment difficult to make sense of. You seem to have lost sight of what my comment was about — the ups and downs of consumption and investment spending over the business cycle. I said nothing about debt, one way or another, and deregulation is a red herring in this discussion.
Housing prices developed a bubble between 2002 and 2006; the stock markets might have developed a bubble by 2007 — that’s less clear. But there certainly was no bubble in economy-wide investment spending. As I said before, there was malinvestment, because housing-finance and monetary policies created incentives for unsustainable rates of house construction and house-lending.
Robert Higgs | Sep 7, 2010 | Reply
The problem lies in the crux between demand/consumption in inventories, falling consumption i.e. paying off massive private debt, leads to higher inventories and cuts in production/income etc.
What’s needed is effective direction of stimulus to employ all the un/der-employed at minimum wage, thus stabilizing demand and powerfully boosting private business and household confidence.
Reducing the stimulus takes money out of the economy and prevents the desired level of saving/debt paying to take place...now THAT’S real/ly Communism!
http://moslereconomics.com/mandatory-readings/
or
http://bilbo.economicoutlook.net/blog/?p=10384
Will Richardson | Sep 25, 2010 | Reply
This is not convincing. It breaks down on the microeconomic level:
What businessman in his right mind would hire if there was no demand? Businesses are already sitting on trillions in unspent cash.
Conversely, what businessman worth his salt would let “regime uncertainty” hold him back, if demand was up, if orders were going unfilled, and if customers were turning to competitors?
You have shown correlation between investment and growth in production. But correlation doesn’t equal causation. (Also, it is accepted that much of current investment is inventory replacement and that employers are squeezing more production out of remaining workers while exploiting the export market.)
We are in recession because middle class consumers lack the means to buy the goods and services they produce. We will remain in recession with high unemployment until aggregate demand returns, driven by consumption.
Investors won’t hire. Consumers can’t spend. What to do? The obvious answer is that the government must hire and spend to get the ball rolling. BTW, even Alan Greenspan has admitted that the what happened in 2007-2008 was not simply the down side of the business cycle.
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