Investment, consumption and business cycles

The following is taken from a piece in the FT by Samuel Brittan

Railway buffs will be familiar with trains that have a locomotive behind as well as in front of the carriages. But a train with only a rear locomotive? Maybe in some remote part of the Andes, but hardly a normal phenomenon…

…So far the government has focused mainly on stimulating business investment, equivalent to trying to drive from the rear locomotive. There have been bouts of investment-led growth – such as the US and UK 19th-century railway booms. But the normal process is for consumption to lead. The latest project – the funding for lending scheme –seems better designed than most. But it cannot be large enough to lift the whole economy.

Samuel is spot on. The pattern of recession and recovery is historically led by movements in consumption, both on the way down and the way up. Don’t get me wrong, reducing red tape and making our economies more competitive and addressing structural issues like the UK’s pensions funding shortfall are big issues that will need to be addressed over the medium to long-term. But cutting back on government expenditures at the same time that private expenditures are simultaneously decreasing is like trying to run up an escalator which is going down.

Politicians arguing for public sector spending cuts often use phrases such as ‘we are reducing the deficit so as to encourage private sector investment’ . The argument of the austerity brigades (and austerity light brigades such as the UK and US) usually centers around the fact that for recovery, we need strong private investment to pull us out of the slump with private incomes and thus consumption following, and in order to do so it is usually argued that government must ‘get out of the way’. Again my argument is not with the idea of reducing government expenditures. My argument is that we shouldn’t be reducing them now (at least not with further monetary easing that is effective), and we certainly shouldn’t be doing so in anticipation that private investment will pull us out of the slump and back to better times. Take a look at the following two graphs;


Both plot the annual percentage change in real personal consumption expenditures (multiplied by 6 for scaling) in the US, but each plots an alternative measure of private investment (again – annual percentage change).  In each graph you’ll notice that all the major peaks and troughs (bar one or two) in consumption precede those in investment by approximately 1-3 quarters. So for the US to have an investment driven recovery, it would seem that it would be a major break from previous trends. Furthermore, with extremely similar economic structures, I think it would not be unreasonable to extend such an argument to the UK, the other major developed economy currently undergoing ‘voluntary austerity’.

Remember those two graphs next time you hear a politician use the ‘government needs to get out of the way’ spiel as an argument for current economic austerity programmes.