Say What?


The latest consumer price index figures were released recently. This data is said to provide economists with a guide to whether “price inflation” in the economy is increasing.

The inflation numbers came in ‘below expectation’ leading one economist to crow that “the inflation genie remains firmly in the bottle”.

The clear and present danger in Australia is rising electricity prices (up 20% in 1-year with nearly 9% over just the last quarter). Every household and business in the country is a consumer of electricity and the fear is that businesses will soon have little choice, but to pass on the rising costs of producing their goods and services to consumers, by way of higher prices.

If prices go up, consumers (we are told) will not spend as much, and the economy will plunge into recession. Or so it goes.

The focus, in all of this, is consumption. Economists call it “aggregate demand” (aka consumption spending) where the belief is that consumer demand for goods and services is what drives businesses to create stuff (and when they do, the economy grows) and thus any significant reduction in consumer demand for goods and services risks plunging an economy into recession.

The belief is a complete crock, but widespread nonetheless. It was the basis for the Rudd Government’s series of stimulus packages in 2008 and 2009, including (you may recall) the $950 Christmas bonus we all received and the reason a slew of ‘nation building’ signs popped up like mushrooms in public schools across the land, seemingly overnight.

On the face of it, the theory appears sound enough – if people have more money, they’ll spend more, and businesses will thrive, and they’ll hire people, who’ll have money to spend and on it goes.

Now I don’t know about you, but I find when I spend my money, I don’t seem to get any richer. On the other hand, I have found that when I save my money, and when I come to spend my savings (eventually) on stuff that helps me produce more stuff that people want, that’s when I seem to get ‘richer’.

The truth is that consumer spending is not the driver of economic prosperity. Investment is. It is businesses spending on ‘capital goods’ (machines and equipment etc that make other things), new technology, business risk-taking (entrepreneurship), and productivity that is the more significant indicator of a prosperous economy that leads to a higher standard of living for all people.

In the ordinary course of a business cycle, it is production and investment that leads an economy into, or out of, a recession. Consumer spending (retail sales) and subsequently inflation data, are components of economic activity and are not ‘leading’ indicators of the health or standing of an economy.

In Australia, consumer spending (personal consumption) represents almost 60% of the country’s Gross Domestic Product (GDP) and for this reason (perhaps) it would seem to be significant. But GDP is a measure of the value of final output and not everything that comes before it; the ‘intermediate’ production, goods-in-process and at various stages of production. That’s a pretty big chunk of the economy and if it were included, some estimates suggest consumption spending would fall (as a percentage of GDP) to a much smaller fraction. Business investment (including all those intermediate stages) would account for the larger part and certainly more than 50% of the economy.

And there, the truth of the matter is revealed – consumer spending is not the cause of a productive healthy economy, but is instead the effect.

It is supply – not demand – that drives our economy. Thus, the keys to economic growth are a pool of savings, productivity and technological advances. But don’t take It from me. It was the 19th century French economist Jean-Baptiste Say who first described this important principle – Say’s Law.

To understand where an economy is really headed you need to look beyond (consumer) inflation data to investment data, particularly business investment and sadly, here’s how that looks:

It is capital expenditures, corporate profits, and productivity gains that provide for the real picture of the state of our economy.

We know the mining boom is ‘over’ because mine owners have stopped investing in capital goods, plant, machinery and equipment to get the stuff out of the ground. Their expenditure – or lack thereof – looks like this:

How about everyone else? Non-miners; from retailers to manufacturers and every business in between. Are Australian companies investing in equipment and machines that make stuff? Nope.

Is there growing demand for more office buildings, factory floors and warehouse space? Nope.

There is an avert ‘consumption’ focus in the media because our major banking institutions and politicians are in the thrall of Keynesian economics; a particular ‘school’ of economics whose false logic plays beautifully into their hands. If demand creates supply as Keynesianism claims, then all that is needed is to manipulate interest rates lower, so the people (and businesses and government) can borrow more and spend more, and all this glorious spending will make everyone wealthy.

Under Keynes’s law ‘savers’ are bad for the economy, which is why the savings of generations of hardworking Australian’s are currently being plundered through the artificial lowering of interest rates by the Reserve Bank. Low interest rates may have lifted share prices and helped house prices go through the roof creating the illusion of wealth, but what is really happening is we are not creating new wealth, we are simply transferring the wealth from savers to debt accumulators.

When people save more, interest rates fall naturally as the surplus of funds available to lend competes for the attention of borrowers. In a country with a deep savings pool, businesses can tap vast financial resources to invest in new equipment, spend more on research, develop new processes, take a chance with an innovation or bring on a new apprentice or graduate. The effect of these things is what creates new wealth; it increases the size of the economic pie, instead of just rearranging who gets the bigger slices of the current pie. In an economy where the pie can get bigger, everyone gets to benefit even if their slice is proportionally smaller.

The aim of any business and the end of every endeavour of the business is to fulfil the needs of consumers. The most successful businesses are those that fulfil consumer needs the best – right product, right price, right service. It is entrepreneurs who determine what gets made, not consumers. It is entrepreneurs and the savers/capitalists who fund their ideas who have created all the cool stuff we have today – from iPhones, to digital cameras, to electric cars – and if we want life to be glorious; if we want a higher standard of living and things that make life better, safer, a pleasure, then the emphasis and focus in our economy needs to return to savings and investment, not price inflation and consumption.

Author: Scott Barlow
Head of Investments