TGIF: Supply Precedes Demand

"Consumption is the sole end and purpose of all production." —Adam Smith, The Wealth of Nations, 1776

"In the market economy the consumers are supreme. Their buying and their abstention from buying ultimately determine what the entrepreneurs produce and in what quantity and quality." —Ludwig von Mises, Planned Chaos, 1947

If the ultimate purpose of economic activity is consumer welfare, you might think that government measures to increase consumption ought to be taken seriously. But that would be hasty. Even though many smart people, even economists, do so, there's a simple reason it's mistaken: consumption cannot precede production, and increased consumption cannot precede increased production. That would seem to be logically unexceptionable. You cannot eat what is not on your plate. Consumption is the purpose of but not the stimulus to production.

An ever-present and permanent necessity of life, consumption does not make production possible; it does not improve production over current conditions. What does? Deferred consumption—that is, saving.

Robinson Crusoe wanted to consume the moment he landed on that naturally stingy island. However, his desire to consume did not create consumer goods, and he could not consume what was unavailable. His unaided labor allowed a low, literally hand-to-mouth, perhaps subsistent level of production and consumption, but greater consumption required savings, which required the diversion of time, energy, and resources from consumption to production. Consuming less in the present, he accumulated fish, berries, or coconuts so he could consume them later on while he was making, say, a fishing net, which would deliver more fish than his bare hands could deliver.

This all makes perfect sense once the point is examined, but many important people don't get it. That's why American presidential administrations have pushed "stimulus" bills—massive government spending ostensibly to goose the economy and create prosperity. The government is widely seen as the spender of last resort. (Government spending is consumption not production because it is not the outcome of the market process but rather the reflection of the preferences of politicians spending other people's money without their consent.)

Market-guided economic growth—higher living standards for all—requires increased investment aimed at better buildings, machines, tools, production and management methods, research and development, etc. Investment is the complement of saving. Even simply maintaining the capital structure as it is requires savings. When people live below their means—save—they directly or indirectly put their surplus income to work. This can happen in many time-consuming ways, the details of which we need not discuss here. (A good portion of Mises's Human Action and Murray Rothbard's Man, Economy, and State is devoted to explaining this process.) 

When people save, they of course do not renounce all consumption for all time. They save because they want to consume even more in the future than they could consume in the present. The returns on saving and investment (entrepreneurial profit, interest, dividends, capital gains, etc.) make that possible.

In contrast, when the government tries to stimulate economic growth by directly increasing consumption, it defies logic or attempts to. (So what else is new?) Where does the government get the money it then spends or hands out? I can think of three typical ways: 1) it can tax people; 2) it can borrow money from willing lenders; and 3) it can create money through its central bank, the Federal Reserve. (Nos. 2 and 3 are linked when the Fed buys, or monetizes, government bonds from the original lenders. A fourth revenue option, selling government-"owned" land and buildings, raises a question: by what right do politicians sell assets their predecessors acquired through theft (eminent domain) and interference with private appropriation of unowned land through homesteading?

How can government spending and transfers promote consumer demand? Taxation simply moves money—at the point of a gun—from some people to others. Where's the gain? (In fact, it's a loss because the money might be moved from savers to nonsavers.) If it borrows, the government again transfers money from some to others, promising to tax people in the future to pay off the loan plus interest. So while borrowing appears voluntary, it actually rests on the threat of physical force later on. Finally, if the government creates money through the Federal Reserve, monetary inflation indirectly transfers purchasing power from some to others because some people will get the watered-down, price-increasing fiat currency sooner than others. (Monetary inflation also distorts the structure of production.)

Thus the government's attempt to increase production through increased consumer spending is a losing proposition. People will always want and need to consume. So the government need not manage consumption, just as it need not manage the law of gravity. What it needs to do is keep clear of saving and investing. It can do this by abolishing all taxes on those activities. It's not only good sense, it's a matter of justice because taxing savings and investments constitutes double and triple taxation. That's just not fair. (Not that single taxation is fair, but let that go today.)

Finally, to bring this all home, let's recall one of the great insights of the early classical liberal political economists, Jean-Baptiste Say. Say's Law of Markets, or Say's Law, has been misconstrued in an effort to discredit the free market. Say answered the old saw that economies slump because of underconsumption (or overproduction of everything). Say told his readers that in a money economy, production and consumption were two sides of the same coin. (Pun intended.) People produce goods for the market so they can "buy" money with which to purchase, sooner or later, consumer goods produced by others.

As Mises wrote:

Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities.

Every commodity produced is therefore a price, as it were, for other commodities produced. The situation of the producer of any commodity is improved by any increase in the production of other commodities.

John Stuart Mill noted:

What supports and employs productive labour, is the capital expended in setting it to work, and not the demand of purchasers for the produce of the labour when completed. Demand for commodities is not demand for labour. The demand for commodities determines in what particular branch of production the labour and capital shall be employed; it determines the direction of the labour; but not the more or less of the labour itself, or of the maintenance or payment of the labour. These depend on the amount of the capital, or other funds directly devoted to the sustenance and remuneration of labour.

Despite this long understanding, many people think that the key to prosperity lies in consumer spending. Much is made of the fact that consumer spending is close to 70 percent of GDP. Google's Gemini AI Overview echoes the popular view that "consumer spending is the largest component of GDP and is a major driver of the economy. It's a key factor in determining whether the US economy is growing or shrinking." (Emphasis added.)

That sort of thinking has led to much mischief. Yet Murray Rothbard wrote in Chapter 6 of Man, Economy, and State:

A common fallacy ... holds that the important category of expenditures in the production system is consumers’ spending. Many writers have gone so far as to relate business prosperity directly to consumers’ spending, and depressions of business to declines in consumers’ spending.... [B]ut it is clear that there is little or no relationship between prosperity and consumers’ spending; indeed almost the reverse is true.

What makes an economy better for everyone is the prospect of a return to producers' time-consuming and risky efforts; this depends on the difference between what capitalists pay upfront—to workers, landowners, and other factor owners—and what they reap later through the sale of partially finished producer and completed consumer goods—if their market forecasts were accurate. "It is not the total quantity of money spent on consumption that is relevant to capitalists’ returns," Rothbard wrote, "but the margins, the spreads, between the product prices and the sum of factor prices at the various stages." (Emphasis in original.)

A prosperous economy for all features long and time-consuming chains of production. And time entails the risk of failure and loss, as well as the prospect of profit. Also, machines, tools, etc. wear out. "[W]ith production divided into stages, it is not true that consumption spending is sufficient to provide for the maintenance of the capital structure." That requires capitalist-entrepreneurs to save and invest persistently rather than consume. Rothbard: "[W]e must realize that there is nothing automatic about this investment. There is no natural law that they must reinvest this amount."

And if they consume instead?

It is evident that the entire market-born production structure would be destroyed..... [C]ivilization advances by virtue of additional capital, which lengthens production processes. Greater quantities of goods are made possible only through the employment of more capital in longer processes. Should capitalists shift from saving-investment to consumption, all these processes would be necessarily abandoned, and the economy would revert to barbarism, with the employment of only the shortest and most primitive production processes. The standard of living, the quantity and variety of goods produced, would fall catastrophically to the primitive level.

As Rothbard sums it up: "There is, in fact, never any need to worry about the maintenance of consumer spending. There must always be consumption." (Emphasis in original.)

(On the misunderstanding of the role of consumer spending, by all means, see John Papola's (of Dad Saves America) two excellent videos here and here.)