US economy: Why Wall Street keeps getting it wrong

That Wall Street has no understanding of what drives economies was made abundantly clear by its rampant confusion in late 2000 when it became obvious that the US economy was tanking. Whenever the economy slows slowdown or contracts Wall Street immediately targets consumer spending as the culprit. When the US economy booms, consumer spending is applauded as the saviour. The result is that eyeing consumer spending means that other trends are either misunderstood or largely ignored.

Economic folklore — and that’s all it is — on Wall Street and in the mainstream media has it that consumer spending drove the boom. (I didn’t mention the Bush boom because most journalists are pretending it doesn’t exist). In support of this myth they point to the fact that consumer spending is about 66 to 70 per cent of GDP. Simple arithmetic therefore shows that should the largest component of GDP fall then GDP would contract.

The error here is in thinking that GDP measures gross expenditure when it does not. Spending on intermediary goods, goods that flow from one stage of production to another, is excluded. Include this spending and consumer spending as proportion of GDP falls enormously. Therefore it is total business spending that drives the economy, not consumer spending.

In 1928, for example, M. W. Holtrop calculated that consumer spending in the US was about 8.3 per cent of what was spent on producer goods, which also includes intermediary goods. On reflection this only makes sense. (See Friedrich von Hayek’s Prices and Production, p. 47, Pub. Augustus M. Kelley 1967). Using the Survey of Current Business for 2002 I calculated that while GDP was $10.083 trillion dollars total outlays were over $18 trillion once spending on intermediary goods was accounted for. This means that consumer spending accounted for only a third or even less of US economic activity

The net-value-added approach has the effect of treating the economy as consisting of two simple stages: the production stage and the consumption stage. In reality the economy consists of innumerable stages of production of staggering complexity. Today’s economists were not the first to make the two-stage error, as one might call it. Adam Smith did the same thing when he wrote that

the value of goods circulated between the different dealers, never can exceed the value of those circulated between the dealers and the consumers; whatever is bought by the dealers, being ultimately destined to be sold to the consumers. (An Inquiry into the Nature and Wealth of Nations , Vol I, p 322, LibertyClassics, 1981).

Although classical economists who relied on Smith’s authority have some excuse for being misled by this fallacy modern economists do not. In Prices and Production Friederich von Hayek described in considerable detail the complex nature of the production structure. On page 47 he also pointed out that Smith’s error led to “a justification of the erroneous doctrines of the Banking School”.

The importance of the above is vital if we are to understand what is happening at the moment (not just in the US but also in Australia) and why danger signals are overlooked. Despite evidence in 2000 that the capital goods industries in the US were cutting back, many commentators ignored this trend because consumer spending and retail sales were still holding up. So long as spending in these area was maintained or even increased, so it was reasoned, the economy was in no danger of sliding into recession.

But as I have explained before, credit expansion stimulates the capital goods industries into expanding output beyond the point that is economically justified. By the time this has been discovered these companies find themselves squeezed between rising costs and falling demand. The result is that production has be cut and labour laid off. According to this line of reasoning falling production means that expenditure on intermediary goods must drop. In other words, business spending is falling.

Now an initial fall in business spending need not register in GDP figures if consumer spending offsets it. This happens in two ways: 1. The factor payments that these companies have made are still working their way into consumer spending. 2. Consumer credit — underpinned by credit expansion — continues to sustain consumption. With consumer spending still growing, it’s possible that employment in the consumer industries will still grow. This is what happened during the Clinton recession. Although production dropped consumer spending raced ahead.

Obviously this situation cannot be maintained. Eventually, a matter of months, consumer spending also starts to fall. Unless, of course, the Fed pumps up the money supply, as it did in late 1999, but these monetary injections can only have temporary effects because real economic forces will once again reassert themselves. Moreover, the profit squeeze could be so tight, as happened in the Great Depression and in Japan during the 1990s, that even extraordinarily low interest rates will fail to stimulate output.

The proper course of action will be to allow the recession to run its course. Governments can still take commendable action — like cutting taxes and red tape. But if they want to deepen and prolong the depression all they need to do is lift taxes and try to fix prices and raise costs with a number of regulatory measures. In other words, exactly what Hoover and Roosevelt did and what Gore would have been inclined to do if he had won the election. Unfortunately Keynesianism still rules the roost, even if it does tend to do it from the shadows.

President Bush did the right thing in cutting capital gains taxes. This policy certainly raised the level of real savings and investment. On the other hand, the Fed’s slack monetary policy also laid down the foundations for another recession that will once again be laid at the feet of the market or — as Keynesians ‘sagely’ say — the “animal spirits” of businessmen.

You wrote:

1. "The final price of goods sold includes all the steps to make and add value to the product."

2."If the author's concept were to be used, then products would be sold below cost and someone would be losing a lot of cash."

First, it is ludicrous to think that the prices paid for consumer goods are anything like an accurate gauge of economic activity. What consumer spending shows you is a single element of economic activity... that in which people buy "stuff". The choices people make in spending... or not... have almost ZERO connection to the spending cycle or capital cost in making those goods available. Timing of consumer purchase decisions, in particular, are short range decisions, while the capital investments made to enable their production are based on long range FORECASTS of what people will probably want.

Second, it is easy enough to find MANY easily understood examples of this in the market. The opposite, however, would be hard to justify with evidence. How many consumer products do you know of that people pay for before they are made, so that the "cost" of their production is connected to the purchase price paid? Instead, what you see is companies raising capital, spending money to build factories, design products, buy materials, package products, ship them to stores... all before the first consumer purchase is possible. Their PLAN for investing to enable consumer purchases doesn't guarantee that sales will occur... or that the sales revenues will cover costs, much less make a profit. Even successful products will operate in the loss column for YEARS before they begin to write in black marks in company ledgers. Microsoft "sells" game consoles... really gives them away, hoping and expecting to make enough money on future sales of games that the really HUGE sunk cost in producing those consoles will eventually prove justified. If Microsoft never sells more than a handful of games... because a competitor offers superior consoles or game products that consumers prefer to buy... the real MS investment in production of consoles and games... doesn't cease to exist in terms or real past expenditure... it instead ceases to exist as real future value. If no one buys a single MS game, that doesn't mean the salaries already paid cease to exist, that the economic activity they represented didn't exist, because there isn't a direct connection between them and consumer spending in the form of completed sales.

The entire economy operates that way. Companies raise capital and invest (spend) in a forward looking fashion and WITHOUT buying "stuff" in the form of finished consumer goods. Consumers buy what is available when they want and can afford it. The Dot.Com bubble was an extreme instance... in which much of the economy was inflated by "irrational exuberance" (in Greenspan Speak) in NON-consumer "economic activity" most of which never really existed as "production" of anything of real value... and about ZERO of which could be discerned from any consumer spending pattern. Yet, despite all the failure and lost investment... the internet HAS had real economic impact and has made the economy more efficient... just not in a way in which that efficiency was easily reaped as profit by most Dot.Com startups.

Maybe you're too young to remember "gas wars" when that related to prices cut below cost by gas stations on opposite street corners, instead of the more obvious modern implication... but I'm sure you've seen "going out of business sales" which really were more than a come-on?

So, in a useful measure of overall economic activity "The final price of goods sold" DOES NOT "include all the steps to make and add value to the products" of the entire economy. The final price of goods sold is a market function... not a cost function... and it is independent from spending involved in making the investments enabling or the cost of materials involved in production. The assumption that price reflects an intrinsically profitable balance in supply and demand is wholly specious. Price reflects a competitive dynamic... not a balance. Some products succeed and make money equal to or greater than that invested in them. Others do not. There IS waste in the economy. Not all products made ARE sold... or sold for more than they cost to produce. Not all investments pay off... and arguing the reverse in any of this is to argue that all investments pay off, that all stocks always increase in value... a theory you are welcome to test in the market yourself.

The beauty of this is that efficient production is enhanced by risk taking, including the large long range investments in future failures. It is better to over-produce and have some products fail to return their investment... than to try and match production to demand with supply in a command economy. Products that DO succeed make up for losses in broad economic terms... which is not the same thing as saying that ONLY measuring goods sold in a particular channel... is the same thing as measuring ALL economic activity. Consumer spending measures... consumer spending.
Why would you expect it to be a proxy for other economic decisions that have radically different drivers, cycles and timing considerations?

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