Recovery Depends on Investment and Capital Accumulation

Some of the feedback I've received on the article "An Economy on Life Support Is Not Recovering" shows a fundamental misunderstanding my critics have about the arguments presented there. In retrospect I see that a more detailed explanation is needed.

In reply to the article there are those who state what the article acknowledges, that Gross Domestic Product (GDP) grew and unemployment dropped from 1933 until 1937. This is taken as proof of the success of the New Deal. Their mistake is thinking that all GDP numbers are equal. They are not, as I explain below.

GDP growth based on private investment in productive capital is the only basis for real growth. In other words companies must invest in factories and other productive facilities (capital accumulation). This investment must come from people's savings, i.e. it must be based on real production, real resources that have been produced. In this way the economy can grow in a realistic and sustainable manner.

When the government spends untold fortunes to stimulate the economy, GDP and unemployment numbers may temporarily improve, but this improvement is illusory. All one does under this scenario is put more money out chasing a stagnant or declining supply of goods and services. The resources used in such a process are not being invested in any kind of productive facilities. On the contrary, productive facilities are being run down to support the make work projects that the government is spending tax money on. (I know that governments also spend money by running deficits, but ultimately the debts must be paid out of tax revenues. Governments can also "print" money, that is paid for with inflation)

As Frank Shostak explains in "What is up with the GDP?":

The GDP framework cannot tell us whether final goods and services that were produced during a particular period of time are a reflection of real wealth expansion, or a reflection of capital consumption.

For instance, if a government embarks on the building of a pyramid, which adds absolutely nothing to the well-being of individuals, the GDP framework will regard this as economic growth. In reality, however, the building of the pyramid will divert real funding from wealth-generating activities, thereby stifling the production of wealth.

The whole scheme wouldn't work even if the government could spend massively forever, but, anyway, the reality is that it can't. When the day of reckoning comes and the government's spending slows the economy slows with it. This is exactly what happened in 1937.

Of course, the government could ignore the "day of reckoning" and just keep on spending, but the result then is the disaster we see in Zimbabwe today.

Hopefully, this clarifies the argument put forward in the article "An Economy On Life Support Isn't Recovering".

In closing I'd like to anticipate the counter argument that spending on infrastructure such as roads, bridges, mass transit, and schools isn't make work but needed improvement. To a very small degree this is true, however, most of the money will be spent according to political pull rather than necessity. Politicians excel at making the usually false argument that project X in their district is of vital importance and most necessary. The reality is that they just want more pork to pass around to supporters to buy votes and campaign contributions. Remember, a bridge to nowhere is not an investment, it's a waste of resources.

I would like to thank Ralph Mullinger for reviewing this article and for his feedback.

2/25/2009 update: Reinforcing the points made above is 'Economic Recovery Requires Capital Accumulation, Not Government "Stimulus Packages"' Thank you, Professor Reisman.