Declining Consumption and Secular Stagnation

Brad DeLong notes that lack of consumption is not especially responsible for currently low levels of aggregate demand. I am not so sanguine. At first approximation, this is hardly surprising. There is some truth to the Austrian principle that recessions arise from a decline  in investment during the boom. (There are many flaws to this theory, not the least that spending on consumption goods increases only in relative, not absolute, terms). Since most consumers smooth their spending over time, to the extent liquidity is not a problem (and it was), what happened is exactly what you would expect.

Unfortunately, to the extent this stagnation is secular, we can’t ignore consumption. Take a stylized accelerator model which says that I/Y_r = (K/Y)g_r, where I/Y and K/Y are the investment and capital stock to potential income ratio respectively and g is the potential growth rate. Let’s state secular stagnation as the state where an economy is (for the foreseeable future) demand constrained and g as a function of r drops by some constant amount. (That is, the real interest rate necessary to maintain some level of growth is lower than it used to be).

So, for whatever reason, when the long-run potential growth of the economy falls, firms are not as driven to invest in future profits and therefore the level of investment has to fall. This must either be accompanied by a corresponding increase in consumption or decrease in total income.

The question we should be answering then isn’t whether consumption has increased as a share of GDP, but whether it has increased enough given a lower potential growth rate. Even under generous assumptions, this is probably not the case:

The growth in consumption as a share of GDP – which we will generously define as 1 – max_t(C)/min_t(C) – is just over 18%. Over the same period, real income grew by an average of 3.2%. Taking this as the former potential, and 2% as the new normal g has fallen by around 60%. Even with an optimistic assumption that the economy will grow at 2.5%, the fall in potential g still outweighs the increase in consumption. (This is all under the assumption that K/Y has and will remain fairly constant. Piketty says no. I don’t buy that this will be significant enough to outweigh everything else, but that is for another post). 

This is, of course, a simplistic assumption. The accelerator model is naturally stylized and investment may not fall nearly as much as suggested. Increased consumption of capital (“wear and tear”) may be one such reason, though that seems ever unlikely in an economy increasingly-oriented towards investments in intellectual property and information rather than coal mines. So if it is not the case that increasing consumption is necessary to maintain a certain level of income, it is certainly interesting to see the assumptions and model under which that is so.

The United States is simultaneously too much like China, and not enough like China. On the one hand, falling potential growth in both countries necessitate a decreasing reliance on private investment. On the other hand, unlike China, there is much the United States can and should do to increase public investment in green technology, basic research, and stronger infrastructure.