Consumption and Economic Growth

By Christopher Lingle

GUATEMALA CITY ― Much of the public and many economists believe that higher consumption and government spending can drive economic growth.

However, a clear understanding of sustainable economic growth reveals that the principal requirements are an adequate fuel of savings that allow entrepreneurs to invest in new or better production facilities.

Clarifying these points is crucial to craft the right policy responses to the economic and financial turmoil facing the world today.

Policymakers often use the guise of stabilizing the economy to mask their intention to enhance their own base of political support. As such, they finesse policy prescriptions to improve their chance of maximizing electoral backing.

Unfortunately, there is wide support for the idea that additional fiscal commitments and artificially lower interest rates make economic good sense. But increased public sector spending is definitely not what is needed to boost a sluggish economy.

Economies in recession that seek to restore sustainable economic growth require more savings rather than less. Or at least, existing savings must be used more efficiently.

More savings increase the pool of funds for borrowing and lead to lower interest rates so that there can be an expansion in production. Then able entrepreneurs operating within a competitive framework guide this one-two punch of more savings and investments.

For evidence that savings are more important than consumption, consider the economic growth in Asian countries like China, Japan or Korea, which have high saving rates. Their enviable performance was not based upon domestic consumption.

The misunderstanding about consumption has led some economists to accept the ``paradox of thrift." This involves more saving, causing consumption demand to fall so the reduction in output and investment paradoxically leads to less output and rising unemployment.

Thus, individuals attempting to set aside funds for their own future needs benefit themselves at the expense of the overall economy.

This argument portrays savings as an economic curse while depicting spending, either by governments or consumers, as an economic virtue. Guess which story public officials are most likely to believe!

But the paradox of thrift involves a disconnection between the micro- and macro- economy whereby saving and investing are assumed to be unrelated. There is also an assumption that investment is a function of overall spending whereby an increase in consumer demand can lead to increased investment.

The original formulation of this ``paradox of thrift" did not actually address the affect of increased savings. Indeed, it is based upon confusion over the effect of sudden increases in the demand for cash balances rather than sudden increases in savings.

Increased consumption means that less is saved so that fewer resources can be used for investment purposes. The reduction in investment will cause the production structure to contract so that future living standards are lower than they would have been.

This misguided argument finds support from politicians who find that trading short-term gains against long-term instability is an attractive proposition.

Nonetheless, encouraging consumption cannot strengthen an economy since the real economic problem involves providing the means of consumption. Governments should pursue policies that stimulate production and savings instead of encourage consumption.

Saving involves the diversion of expenditure from present consumption to be used by producers as investment goods that allow expanded output of goods that can be consumed in the future.

As such, thrift as savings is another form of spending with an extended time horizon. When less is consumed today, more can be consumed tomorrow because the capital structure is longer and more productive.

Since economic growth is the outcome of forgone consumption that allows investment and spending on capital goods, fewer resources should be allocated to consumption.

Continued growth and rising living standards require that there be more capital accumulation arising from improved channeling of savings to wealth-generating activities.

In the case of the United States, high consumer spending contributed to the most recent downturn in its economy and continues to interfere with the emergence of a sustained recovery.

And monetary and fiscal policies that try to direct economic activity toward increased consumption only have temporary benefits, if at all, while setting into motion the next boom-and-bust cycle.

A reasonable public policy move would be to expand tax-exempt savings in order to boost the level of savings in the economy. Tax cuts that reduce the overall tax burden will accelerate recovery by encouraging increased savings.

With more resources returned to the private sector, a higher ratio of savings to consumption will allow more funds to be made available for business investment.

A better remedy for current economic problems is to improve the operation of the financial intermediation process that channels savings to investors. It is much better to have more funds directed to young, private entrepreneurs.

By investing funds in commercially viable projects, they will create more jobs and greater wealth that will underwrite the economic future.

Since support for increased overall spending by households or governments involves a misspecification of the underlying problems of the crisis, it may prolong economic misery.

Christopher Lingle is a research scholar at the Centre for Civil Society in New Delhi and visiting professor of economics at Universidad Francisco Marroquin in Guatemala. He can be reached at CLingle@ufm.edu.