How Consumer Spending And Economic Growth Is Linked

How Consumer Spending And Economic Growth Is Linked

How Consumer Spending And Economic Growth Is Linked

Anyone who’s paid attention to Wall Street for more than a few hours knows that the media loves to speculate on what the latest economic reports mean for the markets. Everything from job numbers to housing starts to consumer spending is discussed and analyzed until opinions (often contradictory) are given as to what it means for the future.

While some indicators are considered more meaningful than others, one finds itself among the most looked at figures and seems to spark the most contention: consumer spending. It’s not without good reason. Even freshman year economic majors know how important spending is to an economy, but citing figures alone and drawing conclusions is an oversimplification of a dynamic process that fuels economic growth.

A Brief History of Economic Growth and GDP

Before we take a look at how consumer spending and the economy are linked, let’s review how growth occurs in the economy. The textbook definition of growth is an increase in the capacity of the economy to produce goods and services. Several factors are responsible for influencing economic growth:

  • Investment – An increase in investment means an increase in productivity. Investing requires a decrease in spending so that more money is available for investments.
  • Innovation – Technology can radically alter the economic landscape. When more output is able to be generated from the same amount of input, productivity increases.
  • Increased Specialization – The division of labor means that more efficiency occurs when workers specialize. This increase in efficiency means greater output will be generated.
  • Increased Input – The more workers or machines an economy has, the more output is created.

One of the key ways analysts use to determine how much the economy is growing is accomplished by measuring the GDP (Gross Domestic Product). The GDP is the total value of all goods and services produced by a country, regardless of whether it was actually made in another country. One of the most common ways of measuring GDP is the expenditures method which looks like this:

GDP = C + I + G + NX

                                                            C = Consumer spending

                                                            I = Business investments

                                                            G = Government spending

                                                            NX = Net exports

We can see from the above equation that consumer spending is a vital part of economic growth along with capital investments, government purchases by local, state, and federal branches, and exports that foreigners buy from the U.S. However, it’s an incomplete picture as GDP fails to distinguish between “good” and “bad” spending. If the government were to spend on rebuilding after a natural disaster, it would look the same as if the government instituted an infrastructure overhaul, even though the infrastructure rebuild would clearly be a gain whereas the disaster only detracted from the overall health of the economy.

The GDP ignores debt levels as well, so deficit spending looks like a positive gain and it fails to adequately represent economic sentiment. The GDP could be higher, but it could be caused by a higher number of hours being worked rather than wages. The primary focus of GDP is on total output, but doesn’t include total consumption which is important for our nation’s welfare. Importing more goods than we export could mean that we are better off because we can consume more, but this would cause net exports to show as a negative and drag down GDP even though consumers are actually living better.

The Role Consumer Spending Plays

The household clearly plays an essential role when it comes to supplying the economy with enough spending to generate growth. The firm, or employer, is responsible for paying a livable wage to the household in return for services. The government collects a percentage of wages as tax revenue which produces goods and services and is dependent upon the household and the firm alike in order to function properly. Financial institutions like banks are responsible for lending out funds to both the household and the firm for investment and spending purposes. A disruption in any of the four sectors can have disastrous results.

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If consumers cut back on spending, this will both reduce tax revenues and cause demand to slip. Suppliers will in turn cut back which results in lower wages and higher unemployment and can lead to a recession. In extreme cases, the lack of tax revenue can cause government defaults and the slowdown of banks lending money can create panicked bank runs.

The total real impact consumer spending has on the economy depends greatly on a relative viewpoint. For example, from a strict GDP sense, consumer spending represents 70% of it but the measurement counts certain things twice. From another perspective, consumer spending only accounts for 30% of real growth, driven mainly by capital investments, rather than households.

Retail sales are a good way of looking at consumer spending habits. However, looking at the below leading economic indicators, it’s primarily driven by business activity rather than consumer activity.

  • Manufacturers’ new orders
  • Building permits
  • Unemployment claims
  • Average weekly manufacturing hours
  • Real money supply
  • Stock prices
  • Yield curve
  • New orders for non-defensive capital goods
  • Vendor performance
  • Consumer expectations

Even the Consumer Confidence Index that’s hailed as a barometer for spending has little to do with households, but rather on businesses. Here are the questions asked to come up with the results from this index:

  1. Do you feel that current business conditions are good, bad, or fair?
  2. Over the next 6 months, do you feel that business conditions will be good, bad, or fair?
  3. Do you feel that the current job market is plentiful, not plentiful, or difficult?
  4. Over the next 6 months, do you feel that the job market will be plentiful, not plentiful, or difficult?
  5. Over the next 6 months, do you feel that your total family income is positive, negative or neutral?

The forecast made from the Consumer Confidence Index aligns more with entrepreneurs and businesses than households and consumers. Still, consumer spending is an intricate part of the economy, if only correctly tied more to effect rather than cause.

Alternative measures like the Genuine Progress Indicator (GPI) have been put forward rather than strictly relying on misleading GDP data. It takes into account 26 different indicators which focuses more on the quality of life of the citizens in an economy instead of measuring just goods and services produced and consumed. While it’s unlikely it will replace GDP as a national indicator, it does prove a point that economic growth can come from more than just spending.

Current Affairs

We’ve already established that consumer spending accounts for a part of GDP, albeit a smaller role than investment, which translates into overall growth and also revealed that spending is more likely an effect of a robust economy rather than the cause of one. With that in mind, we can make some predictions from current data.

A recent Harris Poll of 2,000 adults revealed that consumers are more confident about the economy and spending more. In the next six months, Americans are expected to spend more on dining out and entertainment while savings don’t appear to be growing at all. 26% of Americans don’t have an emergency savings account and a generational gap shows how money is most likely to be spent. 64% of Millennials plan on saving and investing more while 38% of Generation Y says that they’ll be spending more for personal use.

Data taken from the U.S. Bureau of Economic Analysis (BEA) indicates an increase in personal income and a decrease in savings over the past couple years. From the first quarter of 2012 to the first quarter of 2014, personal income has increased from $13,548.6 billion to $14,409.6 billion – a 6% rise. Disposable income had a 5% jump from $12,085.7 billion to $12,712.0 billion while personal saving dropped nearly 18% to $558.1 billion from $657.3 billion. Consumer spending in the same time-frame rose around 5% from $10,373.1 billion to $10,859.2 billion.

GDP from 2012 climbed 8% from $15,533.8 billion to $16,800 billion in 2014. According to the IMF though, the U.S is expected to have overall GDP growth in 2014 of 2%, down from previous estimates of 2.8%. As consumers spend more and the GDP slips, evidence begins to build a case against the myth of consumer spending as the main driving force of the economy.

While correlation doesn’t equal causation, a better gauge of the economy can be found by looking at capital investments. The latest May Durable Goods Report shows signs of weakness in the economy:

New orders for manufactured durable goods in May decreased $2.4 billion or 1.0 percent to $238.0 billion, the U.S. Census Bureau announced today. This decrease, down following three consecutive monthly increases, followed a 0.8 percent April increase. Excluding transportation, new orders decreased 0.1 percent. Excluding defense, new orders increased 0.6 percent.

As the stock market teeters at its current heights, fears that a bear market could be right around the corner seem well-grounded. Consumer spending may be rising, but it could be a lagging indicator rather than a leading one. The long bull market is flashing warning signals and economic indicators like the Durable Goods Report seem to corroborate the story.

Fariba Ronnasi
CEO, Elite Wealth Management

Full Disclosures:
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions on the companies mentioned through stocks, options or other securities.

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