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The myth of consumption-led growth

by on July 20, 2011

Henry and Lawrence Gruijters explain how public spending may not be such a positive thing, as dynamic effects are often ignored. First published in The Graduate Times

All too frequently we hear that consumption enhances growth. This cannot be further from the truth as the following simple example explains:

A farming society needs to save 10% of its crops in period 1 to reseed its farms and get the same return in period 2. Instead of consuming 90% of its crops the society could accept a period of austerity and consume just 80% of its original crop leaving it 20% to reseed the farm. Assuming that there is an abundance of agricultural land, his 20% will give the farmer 200% of his original period 1 crop. If the society wrongly feels that more consumption drives growth, it may be inclined to live extravagantly and consume 95% of the crops in period 1 leaving the society only 5% of its crops to reseed. Society’s output in period 2 will then be just 50% of its original crop.

Many, including Labour Shadow Chancellor Ed Balls (see his London School of Economics speech), seem to view public spending as a positive thing, so that the more spending there is, the better. They feel that if the UK government and society stop consuming the economy will no longer grow. Economists are obsessed with growth, and there are many growth theories and models. Most emphasise the importance of savings for capital accumulation to fuel investment, none to my knowledge, emphasise increasing consumption. Economists fail to convey the important message that extravagant consumption in one period comes at the cost of lower consumption in the next. There should be more focus on lifetime consumption than current consumption figures.

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