Sunday, February 19, 2012

The Fallacy of "Consumption Driven Growth"

There is an annoying bit of economic illiteracy floating around that needs to be addressed. It often shows up in the newspapers and the other social sciences, and it needs to be squashed. This is, as the post title says, the idea of "Consumption Driven Growth".

Here's the example that inspired this post. My friend is a TA in a Geography class. One of the exam questions asked students to compare the economic growth of China and Brazil and the answer key said

China's growth in more investment driven. That means the Chinese are making things that make other things: factories, roads, telecom systems, urban metros, etc. Brazil's boom on the other hand is largely consumer and consumption driven, which doesn't create more favorable conditions for future growth.

This is wrong. It is completely backwards. It is the equivalent of me telling my class that jungles cause rain.

The correct answer is that productivity improvements are propelling growth in both Brazil and China. China has a higher higher investment rate, which is causing a temporary, and unsustainable, boost in the growth rate.

To show why, I will give a quick overview of the Solow Growth Model. This is normally an intermediate Economics issue, but it is included in the intro Econ textbook that I use, and this inclusion was one of the reasons I chose the book.

All economic output is divided between investment and consumption. Consumption is things like food and shelter that make your life better. Investment increases your capital stock, which is things like roads and factories that help you produce output more efficiently. More capital means more output, which means more resources that can be invested. If you keep investing the same percentage of your output, this would cause a never-ending positive feedback loop if it were not for depreciation.

Each year, some percentage of your capital stock falls apart and needs to be replaced. You have to divert investment spending to repairing things. While depreciation is a constant fraction of capital, each extra unit of capital gives you diminishing returns. Eventually you hit a point where the extra output that something adds to the economy is less than what it costs to repair. Think Bridges to Nowhere. Assuming no technological growth or improvement in the institutions of the country, depreciation plus diminishing returns mean that the economy will find an equilibrium where the capital stock is constant.

A one-time investment will do nothing in the long run, if people keep the same investment rate, because it will just fall apart. The capital stock will decay back to its initial equilibrium. We see this when some charity builds a road in Africa, where the government cannot maintain it, and it falls apart.

A permanent increase in the investment rate will permanently boost the capital stock. This causes a temporary boost in the growth rate, but you will eventually hit an equilibrium where the capital stock is no longer growing. Once you hit that equilibrium, the growth rate goes back to normal.

You cannot keep a permanently higher growth rate through investment, because you would have to keep constantly increasing the percentage of output invested, and the investment rate is limited to 100%. There exists some rate of investment that produces the highest amount of consumption in the long run, and it does not make sense to invest more.

Every economist knows that China's investment driven growth rate is not actually sustainable. They are doing what Japan did back in the 80's, and that ended in two decades of stagnation as the economy rebalanced itself. However, there is not anything unsustainable about Brazil's growth, except the bits driven by natural resources. 

The talk about consumer demand driving economic growth is superficial nonsense. All economic growth comes from productivity. You can have temporary bubbles driven by debt, or inflation, or transfers from other places, but that is not happening in Brazil. Their economy is growing because they are getting better at making stuff. The Brazilians are choosing to spend more of their new wealth on consumption, and their government is not using any financial repression to stop them.

There is a theoretical way for "Consumption Driven Growth" to happen. People split their time between leisure and work, and work allows them to purchase consumption goods. If people are all consuming a lot of leisure, and someone introduces a new consumption good that is highly desirable, than people will choose to work more because the relative rewards of work have gone up. This would generate economic growth. This situation, however, is not an accurate description of any major period of economic growth. Brazilians are working less, and enjoying more leisure, than before. All throughout history, the introduction of new consumer goods has happened along with with shorter workdays, not longer ones.

It is true that people are motivated to work, and become more efficient, and generate economic growth, because of a desire to consume. But this fact is pointless as a tool of economic analysis. The desire to consume is always there. It is a human universal to want more consumption, and to use consumption as a signal of social status. What matters is if you have the resources to fulfill those desires, and that depends on how much you can produce. Saying that consumption caused some period of economic growth is like saying that sex caused the baby boom.

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