The economic driver is investment, not consumption!

When will the Keynesian holy grail of consumption be buried?
A flawed pillar of modern economics is the idea of consumption being the ultimate driver of growth. The flaw actually goes back to the misconception of national account and GDP which are not aligned properly in gross terms, thus blending net and gross data. For more information on the subject we highly recommend reading The Grossly Problematic Gross Domestic Product by Richard C.B. Johnsson.

The true underlying driver of economic growth is investment in capital goods which enhances production capacity, increases productivity and pushes the economy to the next technological level. With the US Q4 GDP report out last Friday, we now have the latest data on personal consumption and private investment, with the latter being a good indicator of the state of the US economy.

The first chart below shows US private investment and personal consumption since 1995, and as a quick scan shows, private investment has just climbed above the trough in 4Q 2002, when investment contracted after the dot-com bubble and mild recession. Consumption is humming along and is clearly above the previous peak in 4Q 2007. On a more positive note, the rate of change is positive and accelerating, a good indicator that the US economy is healing.



Investors overreacted to the GDP report
The headline US 4Q GDP figure was 0.2 percentage points lower than estimated, coming in at 2.8 percent YoY growth. Many economists claimed that the true disappointment was the 0.4 percentage point lower personal consumption rate of 2.0 percent YoY. The culprit was, of course, the savings rate. Never mind that investments cannot come about without prior abstinence from consumption.

We prefer a more sustainable consumption growth rate of 2 percent YoY with a savings rate around 4-5 percent rather than a consumption growth rate of 3 percent YoY with a savings rate of 2-3 percent. Our preference leaves room for real investments to grow and consumers to reduce leverage while increasing consumption. This is the preferred scenario instead of consumers increasing their leverage and investment growth stalling again.

One last note on investment versus consumption: Why is it so difficult for some people to understand the necessity of investment in relation to economic growth? It should be obvious that an individual with zero net worth and almost zero savings rate cannot initiate a new business based on a good idea because he has no savings (equity); no banks are willing to extend credit for ideas without equity involved.  Savings are necessary for entrepreneurial activity to flourish, thus creating economic growth.