theory is the primacy of consumption and its impact on growth. And there is a certain truth to that, because without economic activity, without people buying things, there can be no growth. And thus Keynesians assert that in times of economic inactivity or a recession, governments should run deficits in order to spur consumption, to restart the engines of the economy … to recharge the “animal spirits.”
Others, in particular myself, think that income is far more important. Keynesian monetary policy, by lowering rates, encourages people to take on debt. But debt is future consumption brought forward, so all we are really doing is buying things today rather than in the future. Whereas if we create more income, we not only have more to spend today but we will also have more to spend in the future. And thus, David, supply-siders would argue that lowering taxes will drive economic growth as incomes grow.
Lowering taxes has the side benefit of increasing savings, which is the mother’s milk of investment and growth. Look at the following chart from Ned Davis. What it shows is that an increase in consumption (as measured by personal consumption expenditures) as a percentage of disposable personal income is not a necessary condition for growth. In fact, as the data in his tables shows, lower consumption percentages correlate strongly with higher growth. Yes, I know, correlation is not causation. But it does suggest an area for further investigation. And lower consumption also generally goes along with higher savings, which of course is the source for increased investment, which is the ultimate driver of growth.
Here are the same tables in a size you can probably read:
Quoting Ned Davis:
So what are some of the problems that continue to weigh on growth? Well, my usual suspects are debt and low savings and investment. But let’s look at them from different perspectives today. One of the things the U.S. government has tried to do to goose economic growth ever since 2000 was to stimulate consumption. And consumption has indeed been high relative to income, as featured on [the chart below]. But note that, in what must be a shock to most Keynesian economists, growth has historically done better when the levels of consumption were low – another way of saying savings were high.
The Source of Growth
Let’s talk first about some things you and I can agree on, and then about the sources of recent growth. The economy has been growing at roughly 2% since the end of the Great Recession, a very mediocre recovery to say the least. At least a third of that growth has come directly from the oil fracking boom, which is all about technology and nothing about government policy. Further, much of the ancillary growth in the economy has come from the availability of low-cost energy to manufacturing, encouraging large manufacturers to come back from all over the world to locate near what will be a long-term supply of plentiful, cheap natural gas. Witness the $750 million plant built by Nucor Steel on the Mississippi River in Louisiana, one of hundreds of plants scattered around the country near cheap sources of energy.
Quite frankly, about the only thing that has kept the United States from looking like Europe the past five years has been the remarkable innovation in the technology that allows us to extract oil and gas at reasonable prices (and, luckily, we also happen to have them in abundance).
But it is not just the fact that we have the technology and remarkable shale resources. Look at this slide sent to me by my friend Mark Yusko (one of 98 in his remarkable PowerPoint deck, which I sent on to my Over My Shoulder readers. While the US is indeed blessed, there are other parts of the world that have enormous potential as well.
Why has it happened here and not elsewhere? Because we have the other necessary ingredients for growth: the rule of law, private property (notice that none of the oil boom has occurred on US government property), access to capital markets, a relatively free market, and an innovative society. Look at that map and guess where the new winners will be. This of course does not show the conventional natural gas reserves of Russia or the Middle East. As you and I both probably believe, natural gas will be the transition energy source on our way to a solar society (or one based on some other, even cheaper and renewable energy source).
I am a huge fan of the energy boom and can’t resist just one more slide before we move on. It shows one of the regions in the Permian Basin (in West Texas, in what might otherwise be known as godforsaken country, although I risk offending my fellow Texans who live in Odessa and Midland, where George W. Bush ran his first political race and lost). What is remarkable is that this is a region from which you would think we had pulled, or at least explored and found, every last bit of oil and gas possible over the last 60 years. But that’s not the case. There are verified reports that an entirely new zone has been found in what is now projected to be the second largest oil field in the world (after the Ghawar field in Saudi Arabia). The discovery of “whales” in what was supposedly thoroughly explored territory are not supposed to happen, according to the Peak Oil theorists.
The fascinating thing is that there are five different vertical zones in this one field (and there are many fields with similar characteristics), all susceptible to horizontal drilling from one well location. This means one pad (where a drilling rig sits) can take the place of 40 or 50 conventional pads. Besides being more cost-efficient, this technology is certainly more environmentally friendly. They will be drilling 25 wells from what is basically one pad, extending the wells in all directions for over two miles. The old images of a forest of derricks and dust are from a bygone era. I assume they will use the same technology being developed here in the Bakken, too, where derricks are now moved a little ways to drill the next hole. (The Bakken itself is now assumed to have at least four recoverable vertical zones. The newly discovered Permian Basin zones in Texas make the Bakken look small.)
This brings up an ancillary issue that I will really have to do a whole letter about. Whatever growth there is in the US, the Federal Reserve is taking credit for; yet we are seeing Larry Summers and many others blaming something they call secular stagnation for the halting recovery. The problem with the punk growth is not their Keynesian uber-easy monetary policy – gods forbid you would think so – no, it’s the fault of the free market for not responding. So something must be broken in the market – our economic theory is still sound and working fine!
This is where we get what I think is the greatest confusion of causation and correlation in economics. Every economic recovery post-recession since World War II saw fiscal deficits and easier money. Economists then ascribe recovery to fiscal deficits and easier money .
Bullschmitt. (Another technical economics term for new readers.) What happened in every recovery was that businesses restructured, pure and simple. They figured out how to reduce costs, turn a profit again, and move forward. This is been the modus operandi of businesses since the Medes were trading with the Persians. Do lower rates help? Of course. Has increasing leverage in society also been a great source of growth? Absolutely. But as Rogoff and Reinhart’s work clearly shows, when you come to the end of that debt-fueled growth period, you have a financial crisis that sometimes takes two decades to work your way out of. Yes, we do have a structural problem, but it is the structure of our reigning economic theory that has brought it on. To the extent that there has been a recovery, it has been due to businesses restructuring on their own.
Our monetary policy has simply served to enrich those who were already rich, in the hope that somehow economic recovery would trickle down. We have forced savers to reach for yield and pushed them into ever more risky investments at precisely the time the Boomer generation should be retiring and looking for safe havens.
That does not mean we are doomed to a slow-growth decade if we take the proper steps to restructure things. Let me just say that the team that is at the helm today is so convinced of the correctness of its policies that the words restructure and change are simply not in their vocabulary.
And talk about assumptions in models! If you look at the forecast from the Congressional Budget Office for the next 10 years, you will notice that they assume there will be no recession. If there is even a mild recession, the federal deficit and debt blow out to gargantuan proportions, creating even more of a problem of “crowding out” than we have today.
Let’s conclude with a few thoughts from the report from the venerable Ned Davis, mentioned above:
Excess debt and low investment in particular have hurt productivity. In fact, there has been very little growth in non-financial productivity over the last year (or the last few years), as featured in the nearby chart [which I did not include]. And that lack of investment also probably means a halt to the improvement in the federal deficit.
In conclusion, monetary growth and low interest rates have worked to the extent that we are seeing half-full economic growth, which should continue. Yet, longer-term problems with debt, savings, and low investment weigh on growth potential.
That is the real problem with your Keynesian-fueled recovery. It is fueled too much by debt and not enough by productive income. We have borrowed from the future for decades, and now the future is here, and it’s payback time. And as we all know, payback is a bitch.
The Real Driver of Growth
But let’s not lose hope. Growth springs from more than property rights, the rule of law, competitive free markets, and a strong work ethic. Those are certainly the basic conditions necessary for the type of growth we have seen in the last 200 years. But the scientific revolution that started concurrently with the Industrial Revolution in the late 1700s has spurred an ever-increasing cycle of innovation.
This article from this week’s Economist frames the story:
Over the past few decades it has become clear that innovation – more than inputs of capital and labour – is what drives a modern economy. In the developed world, the application of technological know-how and scientific discoveries by companies, institutions and government establishments accounts for over half of all economic growth. Because of its seminal influence on wealth-creation in general and employment in particular, the manner in which innovation functions – especially, the way it comes and goes in Darwinian bursts of activity – has emerged as a vital branch of scholarship.
What researchers have learned is that waves of industrial activity, first identified by the Russian economist Nikolai Kondratieff in 1925, have a character all of their own. Typically, a long upswing in a cycle starts when a new set of technologies begins to emerge – eg, steam, rail and steel in the mid-19th century; electricity, chemicals and the internal-combustion engine in the early 20th century. This upsurge in innovation stimulates investment and invigorates the economy, as successful participants enjoy fat profits, set standards, kill off weaker rivals and establish themselves as the dominant suppliers.
Over the years, the boom peters out, as the technologies mature and returns to investors slide. After a period of slower growth comes the inevitable decline. This is followed eventually by a wave of fresh innovation, which destroys the old way of doing things and creates conditions for a fresh upswing – a process Joseph Schumpeter, an Austrian economist, labelled “creative destruction”.
Back in the late 1990s, Babbage noticed that the waves of innovation had begun to speed up (see
