A myth about consumer spending
For real economic indicators, look to investment and business spending.
new york — Every year, and especially during holiday-shopping season, we hear the familiar refrain: "What the consumer does is the most important thing."
"If shoppers stop spending, we're in big trouble."
"Consumer spending accounts for 70 percent of the economy."
These Keynesian principles have become ingrained conventional myths. But they're not true. Many factors are far more significant than consumer spending in stimulating the economy: business spending on capital goods, tax cuts, lower interest rates, and productivity. In the business cycle, production and investment are what lead the economy into and out of a recession. All the while, retail spending is relatively stable.
In fact, retail sales are so stable that they cannot be used to predict the next recession or bear market on Wall Street. Inflation-adjusted retail sales actually rose during the 2001-03 recession and bear market, as industrial production fell.
As Larry Kudlow of the news television show "Kudlow and Company" puts it: "Though not one in a thousand recognizes it, it is business, not consumers, that is the heart of the economy. When businesses produce profitably, they create income-paying jobs and then consumers spend. Profitable firms also purchase new equipment because they need to modernize and update all their tools, structures, and software."
Granted, personal consumption expenditures represent 70 percent of gross domestic product, but GDP only measures the value of final output. It leaves out a big chunk of the economy – intermediate production and goods-in-process at the commodity, manufacturing, and wholesale stages.
I calculated total spending in the economy at all stages to be more than double GDP (based on gross revenue figures from the Internal Revenue Service). By this measure, which I have dubbed Gross Domestic Expenditures, or GDE, consumption represents only about 30 percent of the economy. Business investment, including intermediate output, represents more than 50 percent of the economy.
Thus, the truth is the opposite of the conventional wisdom: Consumer spending is the effect, not the cause, of a productive healthy economy.
This truth prevails in the marketplace: It's supply – not demand – that drives the economy. Productivity and saving are the keys to economic growth.
But what about the Consumer Confidence Index that the media highlights every month? Isn't it a leading economic indicator? Indeed it is, but it's only one of 10, and the rest are related to business, for example: manufacturers' new orders, building permits, unemployment claims, average weekly manufacturing hours, real money supply, stock prices, the yield curve, new orders for nondefense capital goods, and vendor performance. Retail sales are not a leading indicator.
Moreover, the Consumer Confidence Index is a misnomer – the questions asked consumers are more about business conditions than spending attitudes. Here are the questions consumers are asked to determine their "expectations":
1. Are current business conditions good, bad, or normal?
2. Do you expect business conditions to be good, bad, or normal over the next six months?
3. Are jobs currently plentiful, not so plentiful, or hard to get?
4. Do you expect jobs to be more plentiful, not so plentiful, or hard to get over the next six months?
5. Do you plan to buy a new or used automobile, home, or major appliance within the next six months?
6. Are you planning a US or foreign vacation within the next six months?
In other words, the much-touted "consumer" confidence index is a forecast based more on the outlook for business, employment, and durable goods than on retail sales and consumer spending. It does not ask about consumption patterns other than for durable goods. It asks nothing about food, clothing, entertainment, and other short-term buying, because these expenditures seldom change from month to month except in December.
The reality is that business and investment spending are the true leading indicators of the economy and the stock market. If you want to know where the stock market is headed, forget about consumer spending and retail sales figures. Look to business spending, price inflation, interest rates, and productivity gains.
Mark Skousen is editor of Forecasts & Strategies and holds the Benjamin Franklin Chair of Management at Grantham University in Kansas City, Mo. He is the author of "The Structure of Production."