Economic Growth Comes from Consumer Saving, Not Spending

The Federal Reserve’s inflationary monetary policy perversely incentivizes consumer spending when what the economy needs for real growth is consumer saving.

A little over a week ago, the New York Times told us that “The Economy Looks Solid”, and I wrote an article titled “Are You Prepared for a Recession?” explaining why that just isn’t so. Rather, the Federal Reserve’s inflationary monetary policy has fundamentally distorted the very structure of the economy in harmful ways. Now this week, the Times is telling us “A Recession Is Coming (Eventually)”. It’s a helpful article that explains indicators that have historically been fairly accurate predictors of recessions, but the Times still gets its analysis wrong in fundamental ways.

The impetus for the earlier Times article was the expectation that the Fed will soon implement a rate cut for the first time since it pushed them to near zero in response to the “Great Recession” that began in the final quarter of 2007, in the wake of the collapse of the housing bubble. Since that recession’s official end in 2009, the Fed has allowed interest rates to rise incrementally while still maintaining them artificially low—meaning lower than they otherwise would be if rates were determined by the market rather than by fiat from a government-legislated monopoly over the currency supply.

This is precisely how the Fed caused the housing bubble: its policy of maintaining artificially low interest rates in reaction to the bursting of the “dot com” bubble, coupled with government policies encouraging homeownership, incentivized unsustainable levels of borrowing and spending. The Fed’s policy didn’t create economic growth in the form of increasing property values; it created the illusion of economic growth by diluting the purchasing power of the dollar, with the price inflation showing up in the housing market.

While backing away from the claim that the economy “Looks Solid”, the Times in its article explaining recession indicators still fundamentally mischaracterizes the state of the economy. The way the Times treats it, the so-called “business cycle” of booms and busts is just a natural market phenomenon. There is nothing in the article to indicate to readers that Fed policy itself—which is inherently anathema to the principle of free markets—is what has made the next recession inevitable.

The article, written by Ben Casselman, is a very helpful overview of metrics that have historically been associated with recessions. These include a rapid increase in unemployment, an inversion of the yield curve (when interest rates on long-term Treasury bonds falls below short-term bonds), a drop below 50 points on the Institute for Supply Management’s Manufacturing Index (indicating a contracting manufacturing sector), and a decline in consumer spending of 15 percent or more over the course of a year.

But despite acknowledging a few warning signs, the Times still gets it fundamentally wrong by misinforming readers about what causes economic growth. With respect to what the Times variably calls consumer “sentiment” or consumer “confidence”, the article asserts, “Consumers drive the economy, now more than ever. It is pretty much impossible for the economy to keep growing if Americans decide to keep their wallets closed.”

We are supposed to accept this as axiomatic. Indeed, the Fed policy of maintaining artificially low interest rates is in large part intended to encourage borrowing and consumer spending. And this policy does succeed in its aim. We saw that during the housing bubble, when artificially low interest rates fueled spending in the housing sector, causing an unsustainable boom that inevitably turned to bust.

That’s how the Times gets it precisely wrong. Economic growth does not come from consumers spending borrowed dollars on things they wouldn’t otherwise buy if the cost of borrowing was higher. It comes from consumers deferring their spending to the future. That is, economic growth is not caused by spending, but by saving.

We’re supposed to believe that the boom-bust cycle is just a naturally occurring phenomenon that our wise overlords at the Federal Reserve do their best to try to mitigate, but which they are sometimes unable to do anything to stop. The reality is that the Fed caused the last recession and has already caused the next one by responding to the last one by doing even more of the same as what caused it, only on a massively greater scale. In response to the bursting of the housing bubble, the Fed quadrupled the base money supply to push interest rates down.

This monetary inflation fundamentally distorts the very structure of the economy. Instead of economic growth occurring as a result of resources being efficiently allocated toward productive ends by the market’s pricing system, the Fed’s price fixing of interest rates causes perverse incentives and widespread misallocation of resources.

In a free market, interest rates, like other prices, would be determined by supply and demand. If saving rates are high among consumers, banks will have full reserves with which to extend loans and so will attract borrowers with low interest rates. If saving rates are low and reserves dwindle, banks will attract depositors with higher interest rates.

To investors and entrepreneurs, low interest rates indicate that consumers are deferring their spending and that there is a large pool of capital available from which to borrow and invest into advancing means of production in order to meet that future demand. It is this investment that enables businesses to produce better goods and services for lower prices, which is what enables advancements in the societal standard of living—that is, real economic growth.

Market prices are essential for economic growth to occur. Prices are the signals that instruct investors and entrepreneurs where to direct resources. Bureaucrats and technocrats in Washington do not know better than the free market with its pricing system how to efficiently direct scarce resources toward productive ends as determined by the will of consumers, which is to say by all of us. There is no more profound manifestation of democratic principles than the free market.

However, in the anti-free market system that exists in the United States, the Fed’s price fixing sends wrong signals. Borrowing and spending occur based on an illusion of high rates of savings; an illusion of a large pool of available capital from which to borrow and spend. Resources are wastefully misallocated. Investments are made into projects which will never be able to be completed because no government legislation or central bank policy can revoke the law of supply and demand. Eventually, the Fed must either risk a painful market correction by allowing interest rates to rise or risk its monetary inflation causing runaway price inflation.

Wealth does not come from a printing press. When a government-legislated privately-owned monopoly creates “money” out of thin air in order to purchase government debt and to incentivize more debt among consumers, the result is not an increasing standard of living. Instead, the consequence is illusory growth that really is unsustainable—a bubble that must inevitably burst.

And that is how the Fed has guaranteed the next recession. The Times is right to tell its readers that a recession is coming. It’s wrong, however, to leave readers with the impression that this is just some kind of natural market phenomenon and to tell them that consumer spending is what drives economic growth.

Instructively, the Times includes one explicit caveat to its explanation of recession indicators, which is that “Economists are notoriously terrible at forecasting recessions”.

Now you know why. It’s because mainstream economists advocate state interventionism generally and central banking particularly. Most economists belong to a professional class of technocrats who serve the function of manufacturing public consent for existence of central banks like the Federal Reserve. That role requires them to feign or maintain real ignorance about how monetary inflation causes bubbles instead of economic growth.

Hence the public constantly being misinformed that economic growth comes not from savings and capital investment, but from debt and consumer spending. Precisely the opposite of what the Times tells us, what truly makes it impossible for economic growth to occur is the Fed policy of perversely incentivizing Americans to never keep their wallets closed.

To learn more about how the Fed caused the housing bubble, with relevant lessons for today, read my book Ron Paul vs. Paul Krugman: Austrian vs. Keynesian Economics in the Financial Crisis.

This article was originally published at Foreign Policy Journal.

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