Imbalances between Consumption and Investment (1) — Michael Pettis on Crises of Imbalance

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1.

Underlying the following argument by Michael Pettis is one of the fundamental equations used in national accounting.

GDP = C + I

I am not going to discuss niceties and problems of this equation, though hope to give a critical assessment of the formula in some future post. For the time being, suffice it to state that GDP (Gross Domestic Product) stands for all products and services produced in an economy within the accounting year. It is a proxy for economic activity, a proxy for the use of economic resources and practices.

The right hand side of the equation

C + I

implies that all products and services (GDP) are either consumed (C), or they are not consumed (I). All products and services that are not consumed are invested, either productively or unproductively. So investment is a category that does not entirely stand for what we would usually regard as investment; it stands for “all product and services that are not consumed” in the period in question. 

Obviously, in a reasonably efficient economy, a large part of I will actually be investment, and, indeed, productive investment. In an economy, large quantities of what is not being consumed will be used to enable the production of value-adding goods and services in the future. Therefore, I would accept that

GDP = C + I

does represent a modern economy reasonably well—very crudely, of course. But for certain purposes, a broad perspective may be more useful than one narrowed down to just a few special aspects.

2.

Now we are in a position to turn to Michael Pettis central thesis: economic crises are characterised by imbalances in the elements that make up the fundamental equation

GDP = C + I.

A large portion of C, in fact, the largest part of it, consists in household consumption. The core thesis, then, is:

If C is too small relative to I (with GDP held constant), the economy is bound to be struggling with a paucity of effective demand.

Pettis offers a remarkably incisive statement of what is meant by deficiency in effective demand, quoting Marriner Eccles, the head of the US central bank from 1932-48 (Pettis, 2013, p. 198):

As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth—not of existing wealth, but of wealth as it is currently produced—to provide men with buying power equal to the amount of goods and services offered by the nation’s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929–30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations.

But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.

And Pettis goes on to explain, where “investment” (I) and “savings” (S) are identical terms as far as our equation is concerned: GDP = C + I = C + S:

The key point here is that all other things being equal, rising income inequality forces up the savings rate [people have less left to afford consumption]. The reason for this is pretty well understood: rich people consume a smaller share of their income than do the poor. 

The consequence of income inequality, Eccles argued, is an imbalance between the current supply of and current demand for goods and services, and this imbalance can only be resolved by a surge in credit or, as I will show later, by rising unemployment [such that with fewer resources including people employed, supply will adjust downwardly to “effective demand”].

Even more pointedly, Pettis refers to a statement by Eccles:

I will again quote Mariner Eccles, from his 1933 testimony to Congress, in which he was himself quoting with approval an unidentified economist, probably William Trufant Foster.³ In his testimony he said:

It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. 

They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they cannot save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying.

It is for the interests of the well-to-do—to protect them from the results of their own folly—that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not “soaking the rich”; it is saving the rich.

Incidentally, it is the only way to assure them the serenity and security which they do not have at the present moment.

In sum: to understand the basic thesis that consumption may be insufficient relative to investment (or its equivalent: savings), we need to accept that by I and S what we mean is products and services not consumed, many of which, therefore, being available or actually being used to enable production and consumption in the future. 

Under certain circumstances, we may be dedicating too many resources to building up supply, in the sense that people do not have sufficient means to absorb the supply on offer. In this situation, we have an under-consumption crisis.

Continued here.