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Panacea Du Jour

The Daily Reckoning

Paris, France

Tuesday, 21 January 2003

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PANACEA DU JOUR
by Kurt Richebächer

It used to be elementary knowledge among economists that
rising investment in tangible assets - factories, offices,
machinery and other forms of equipment - is paramount for
economic growth and general prosperity.

First, it generates demand, employment, incomes and
tangible wealth while the factories and the equipment are
built and produced. Once the capital goods are installed,
they increase supply, employment, incomes and productivity.
The key point to see is that investment is the one and only
GDP component that adds both to demand and supply.

But mainstream American economic thought seems to overlook
this reality. It places, first of all, an unusual emphasis
on consumption as the prime mover of economic growth, and
there is furthermore a general disregard of what is
happening to saving and capital accumulation.
Alternatively, the emphasis is on autonomous changes in
productivity growth through new technologies as the root
cause of economic growth and profitability.

This is a radical departure from the thinking of the old
economists. Measured by the rate of productivity growth,
the U.S. economy appears to be in excellent shape,
definitely better than the whole rest of the world. But
measured by its record-low rates of saving and capital
accumulation, it is in most miserable shape. What is the
right interpretation?

For America's policymakers and economists, productivity
growth seems to be that great magic that solves all
problems and that will sustain an economic recovery. It
appears to be a widespread view that the measured stellar
productivity growth is the main warrant of a mild recession
and of an impending recovery.

The crucial point to see about productivity growth is that,
by itself, it only means that hours worked have risen less
than real GDP. But there is nil economic merit in this
effect unless it is accompanied by an improvement in some
other kind of the economy's performance such as growth of
output, profits or investment. In the case of the United
States, in actual fact, everything else is deteriorating.
That is probably the main reason for the general, singular
focus on productivity growth.

Looking at the whole postwar period, the United States
actually experienced its most vigorous and definitely its
most healthy economic performance in the 1960s. Its rates
of national saving and of capital investment were then at
their highest in the whole postwar period, and so were its
rates of business profits. The main purpose of moderate
borrowing on the part of the consumer at the time was the
financing of new homes, and the main purpose on the part of
businesses was the financing of new investment in plant and
equipment, that is, in tangible assets. In essence, it was
overwhelmingly borrowing for capital formation.

This pattern of borrowing began to change gradually in the
1970s and rather dramatically in the 1980s. From then on,
debt growth went exponential. Consumer debts have since
skyrocketed by 473% and business debts by 382%. These
numbers compare with simultaneous GDP growth by 283%.

A drastic change in the use of the new debts was the other
striking new feature of the developing borrowing binge.
Exploding credit quantity implied plunging credit quality.

Consumers started to borrow like crazy to finance increased
current spending, and businesses borrowed like crazy no
longer to invest in plant and equipment, but to finance
financial transactions - mainly leveraged stock buyouts,
mergers, acquisitions and stock repurchases - that were
thought to be more appropriate for quickly raising
shareholder value.

Ever since firms and retailers invented consumer
installment credit in the 1920s, U.S. economic growth has
become heavily geared to consumer spending and borrowing.
But this traditional consumption bias took a big leap in
the 1980s and in particular in the late 1990s. The most
striking characteristic of both periods were exploding
consumer debts and collapsing national saving.

In the 1980s, in actual fact, the hemorrhage of national
saving had caused great and widespread concern. Many
American economists expressed their strong misgivings about
the implicit negative effects on capital investment. This
time, in diametric contrast, nobody seems to care or even
take notice.

There seems to prevail a widely accepted view that credit
creation makes old-fashioned saving from current income
superfluous. As to the equal utter lack of interest in
capital formation, the apparent explanation is a singular
focus on productivity growth. Why are saving and investing
even necessary, if the U.S. economy is enjoying stellar
productivity growth without them?

What's wrong with this view? In short, everything. It's
macroeconomic nonsense.

Productivity growth is not the panacea for which American
policymakers and most economists seem to take it. If there
is insufficient demand, as today, increasing productivity
can only result in increasing numbers of unemployed
workers, declining capacity utilization and, ultimately,
slower growth.

What really induced generations of economists of all
schools of thought to elevate saving to an indispensable,
key condition for economic growth? The basic reason is that
it is the limiting factor for capital investment. Short of
nirvana, all resources are scarce. Due to this elementary
wisdom, new capital investment can only come about to the
extent that somebody makes the resources for the production
of the capital goods available. That somebody happens to be
mainly the consumer. By saving, that is, by spending less
than he earns, he effectively releases the necessary
productive resources for investment.

But this necessary release of productive resources is true
only for saving from current income, coming implicitly from
current production. The attendant release of resources is
what makes this kind of saving indispensable for investment
and economic growth.

In essence, capital formation represents the surplus of
production over consumption, and that has to be made
possible by saving. To quote Friedrich Hayek on the
subject: "Saving is not synonymous with the formation of
capital, but merely the most important cause which normally
leads to this result."

A lot of energy has been devoted to whether there will be a
double-dip into recession. This is the wrong question. What
really matters, instead, is whether capital spending will
rebound after its steepest decline in the whole postwar
period. This is also a question that can be answered with
reasonable foundation from the available data.

If yes, the U.S. economy has a chance for a sustained
recovery. If not, it will be Japanese-style near-stagnation
and sub-par growth for years to come. We think the
prevailing conditions speak overwhelmingly for the latter.