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June 15th 2015 print

Peter Smith

Spending Our Way to Penury

Infrastructure spending by government takes us away from the main game, which is to grow private sector investment and production. In the end result, that pays the bills and spending doesn’t. Rather than fixating on national spending aggregates, economists should concentrate their efforts on production

mythsThere are two ways at looking at the state of the economy as a whole. It can be looked at from the supply side or from the demand side. The latter makes no sense. And wouldn’t you know it, this is the one used by most economists as they pore over demand (expenditure) aggregates in the national accounts, inevitably drawing spurious conclusions.

Reserve Bank Governor Glenn Stevens, whose recent speech I will come to, exemplifies the modern economist’s fascination with meaningless and incompatible demand aggregates. This is potentially harmful and costly. It can lead very easily, as the Wayne Swan years showed, to the delusion that spending money is equivalent to making money.

The national accounts break down national production into expenditure aggregates. Why do that you might ask? Why not just measure what we produce as a nation? Well that is attempted too but, like an unfavoured child, is kept out of sight while attention is showered on the spending counterparts of production.

Surprise! Surprise! The development of national accounts in the 1940s was inspired by the work of John Maynard Keynes. Keynes was besotted with demand and the likelihood of it endemically falling below the level needed to maintain full employment. It is obvious, in worrying unceasingly that people wouldn’t want to spend enough, that he had never spoken to housewives of Beverly Hills nor, more pertinently, to the poor and downtrodden in the more closely located East End.

But, that aside, if spending is regarded as putting a brake on production then it follows that spending is the sin qua non of economic progress and deserves prominence. If, on the other hand, like the rational economists before Keynes, you believe that you have to pick coconuts before you can eat them, just maybe the (spending) cart is being put before the (production) horse.

Without getting caught up in the details, the national accounts broadly mirror production as the sum of government expenditure (ex transfer payments), private business investment and consumption expenditure, together making up domestic demand. Finally, ‘net exports’ (exports minus imports) add the missing component of production and, voila, all is accounted for.

Tune in to Stevens addressing the Economic Society of Australia on June 10 in Brisbane for a case study on how to use these aggregate spending numbers to fill up speaking time without imparting the least bit of useful information or insight. Let me explain with two choice examples.

“During the late 1990s and early 2000s, very confident households spent and borrowed more, and saved less…That process faded started to fade about 2006 and finished more abruptly when the financial crisis hit. But by then the run-up in resource prices was imparting a very large stimulus to the economy and allowed for solid growth to continue…”

Now what do we conclude from this statement? One conclusion might be that if consumers remain ultra confident and spend madly we can have strong economic growth, even if the mining sector falls into disarray. It doesn’t sound right does it? It wouldn’t work for our own household or for those down the street. We know that the only sustainable basis for upping our spending is if we earn more. And we only earn more by producing more. Producing comes first.

Consumption expenditure does not drive growth. Consumption expenditure eats it up. Juxtaposing consumers spending with miners investing and producing is economic gobbledegook. Mind you, I am sure Steven’s economically credentialed audience saw nothing amiss, having been brought up on the same oil-and-water concoction. Take the following.

“The lower exchange rate has helped to produce a contribution from ‘net exports’ much greater that earlier forecast, while that from domestic demand has been much weaker.”

‘Net exports’ is par excellence among spending aggregates in giving no useful information. Exports might be going gangbusters while at the same time massive quantities of capital equipment are being imported to underpin investment and expansion. On the other hand, exports might be in the doldrums while imports have fallen off as the economy fades. ‘Net exports’ might be the same in both cases. As a measure, it provides useless information on the state of the economy.

Notice we are also being told that domestic demand is weaker than it was. If in fact national income is depressed because of falling commodity prices and because capital investment and production are subdued; then, perforce, spending will be dragged down, including spending on imports. This will tend to increase ‘net exports’, which we are then meant to accept, in a twist of logic, is adding to economic growth. It is an accounting balancing item. That is all that it is!

The problem that the Governor faces and all those like him is that his speeches are written by economists who don’t get out and about. What they do is to pore over the national accounts and concentrate their attention on spending aggregates, as Keynesians are wont to do. This is harmless in one sense. It just means that they are uninformed and uninformative. However, it becomes harmful and costly when description turns into advocacy.

Unsurprisingly, the advocacy is often in the form of increased spending. And so it was that the Governor advocated increased infrastructure spending by government to take the pressure off monetary policy in stimulating the economy. Now, thankfully, he is no Ken Henry and his particular proposal on infrastructure spending was eminently sensible in itself.

In a nutshell, he advocated that infrastructure spending should not be used ‘as a short-term counter-cyclical device’; he proposed ‘a long-term pipeline of infrastructure projects’, ‘appropriate governance on project selection’, ‘risk sharing between public and private sectors’, and ‘appropriate pricing for use of the finished product’.  All OK, but infrastructure spending by government takes us away from the main game, which is to grow private sector investment and production. In the end result, that pays the bills. Government spending doesn’t pay the bills.

Rather than fixating on national spending aggregates, economists should concentrate their efforts on production in all of its forms and on finding ways to remove impediments to the establishment and expansion of businesses. Not only would they be more informative but their advocacy would become appropriately focussed on what should be done to increase business investment and production. This might, of course, include some infrastructure spending but it would also certainly include tackling awkward political issues like workplace reform and the stultifying effects of environmental approval processes.

As it is, I am not at all what use it is to pay so many economists in the public service to offer shallow observations on the state of the economy by looking at the national accounts. One or two could do that and we could photocopy and distribute their findings under different fictitious names to add to the verisimilitude of the exercise. The rest might be profitably employed investigating the supply side of the economy and fearlessly exposing prevailing obstacles holding it back.

Peter Smith, a frequent Quadrant Online contributor, is the author of Bad Economics

Comments [3]

  1. Bill Martin says:

    Thank you Peter for reminding me of what I learned from your excellent book “Bad Economics”. It seems, though, that many others – particularly among those with influence on economic affairs – either haven’t read your book or failed to learn from it. As a matter of curious interest, the parallel between the AGW scam and Keynesianism is starling: Both have been proven wrong time after time yet they both stubbornly persist.

    Bill Martin.

  2. pgang says:

    So what is the true state of the national accounts? I’m guessing that with the catastrophic decline in mining investment and production, and the implosion of manufacturing and refining, that things are looking pretty grim. All of which tells me our input costs (labour, energy, etc.) are too high to remain productive and competitive. Mining has certainly been affected as much by decreasing productivity as it has by falling demand, including the productive use of capital.

    • Max Rawnsley says:

      ‘private sector investment and production” as Peter said is the game that must be played in our market economy. Productivity is the measure we need to see improved. This does go to costs to produce. This is very apparent but how do we get there with the existing limitation on choices as to industries and other opportunities.

      Politically any action is problematical with a Senate disposed to obfuscation. And a government seemingly incapable of either negotiating or selling the changes needed, if they could identify what is needed apart from political mantra. Both key parties rejoice in the achievement of FTAs and the possible TPP without an iota of policy change to ready the economy for these external influences.

      ‘productivity’ is a key problem if we are to enter into a sustainably competitive era with minimal reduction in living standards. As politics are now popularly conducted neither LNP not Labor will even open the discussion; they will not connect the dots linking ‘cost and ‘productivity’, referring to them as if they are unrelated. Each seeking the Treasury benches at any price.

      Th equation should centre on ‘supply’and so dies the solution. Where is the political will? Who will join the dots and sell the proposition to the Australian people?