Consumption not the spark behind economic growth

Christopher Lingle, Bali

Indonesia's economic growth exceeded 5 percent in the third quarter of this year, up from a revised 4.54 percent in the previous quarter. Many commentators have suggested that a consumption boom was behind much of this news. For its part, consumption grew by 5.1 percent in the third quarter.

It is often pointed out that private household consumption contributes almost 80 percent of GDP. And so it is understandable that it is so often mistakenly depicted as a primary driver behind Indonesia's economic growth.

It is a mistake to consider the increase in personal consumption as being behind the real growth in GDP in Indonesia or any other country. It is the economy that keeps the consumer afloat and not the reverse.

This is not an unanswerable argument like the chicken-or-egg issue. There is strong theoretical backing and ample historical evidence to make a decisive stand. Paraphrasing an economic law named after 19th Century French economist, Jean-Baptiste Say, market economies work on the basis of the supply of one good creating the demand for one or more other goods. In other words, you must first produce to be able to consume.

And so it is that the appropriate direction of causation is that production creates the basis of purchasing power that allows consumption to take place. Evidence of this is seen in that those countries with high levels of consumption are those with the highest levels of production.

Another reality check relates to whether more new jobs are being created. For increased consumer spending to be sustainable, there must be employment growth as well as higher labor productivity. It turns out that household spending, job growth and rising productivity depend upon increased business investment.

At the same time, simple logic reveals that increasing current consumption means less is saved so fewer resources are available for investments that allow future consumption. And the reduced investment causes the production structure to contract so that future living standards are lower than they would have been.

In all events, the theoretical approach to national income accounting is deeply flawed.

This causes the estimates of GDP to greatly understate business spending and grossly over-exaggerate consumer spending as a proportion of total economic activity.

When calculations of total business expenditures take into account spending between stages of production, it is considerably higher than consumer spending. However, most business spending is left out of GDP calculations because this supposedly would involve double counting.

To reiterate, growth is driven by capital accumulation, not consumption. As more capital is accumulated, more can be produced so that more can eventually be consumed.

And it is increased productivity from capital accumulation that brings higher living standards. Increased material means of production provide the basis for more real savings so that when accompanied by technological change and entrepreneurs willing to take risks, there can persistent increases in economic growth.

Neither deficit spending nor low interest rate can change the real fundamentals of an economy. Politicians might believe that stimulating the economy is a good idea since it can win votes. But economists should know better that short-run economic stimulus is misguided and leads to long-run losses.

One way to change economic fundamentals and encourage a sustained recovery is permanent reductions in marginal tax rates and the reduction or elimination of capital gains taxes. Capital gains taxes and high marginal tax rates do not punish the wealthy. It is those who seek to increase their wealth that bear the heaviest burden.

The misguided conventional wisdom about the role of consumption and aggregate demand in an economy must be abandoned. Those believing consumption and demand are essential to economic growth must accept that government spending on armaments and weaponry is good for an economy. Perhaps they also believe in the tooth fairy?

But neither war nor terrorist acts are beneficial to overall economic growth. Were it otherwise, the rebuilding after natural disasters like hurricanes and floods would make them welcome events.

A more important indicator of sustainable future growth is higher business investment and capital formation. And so it is encouraging that domestic investment rose as indicated by the rise in gross fixed capital formation by 13.1 percent year-on- year in the third quarter.

Unfortunately, the World Bank has pointed out that Indonesia's rampant corruption, legal uncertainties and threat of terrorism create a hostile climate for investors. These conditions inhibit both foreign direct investment (FDI) inflows as well as domestic investment.

For Indonesia to enjoy sustained economic growth, there must be a greater focus upon encouraging fixed capital formation.

The writer is Professor of Economics at Universidad Francisco Marroqumn in Guatemala and Global Strategist for eConoLytics.com. He can be reached at clingle@ufm.edu.gt