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The Pulse of Capitalism

Issue Number 03-1, April 2003

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International Comparisons
Business Activity Indicators
Financial Indicators - United States
Selected International Transactions - United States

Of Demand and Investment Cycles

It is a common saying that the more things change the more they stay the same. In economics this means that although economic processes grow and become more complex there are still certain fundamental principles that determine their result.

This thought was brought home to the writer recently in reading a description of the contribution of Robert Malthus to economic thought. (The Basic Teachings of the Great Economists, John W. McConnell, p. 260)

"...The 'rhythmic rise and fall of business activity' received little attention [from the classical economists of the 19th century]. The search for additional explanation of the business cycle leads away from classical economic theory and into the domain of its critics. Robert Malthus, whose niche among the world's great thinkers is due to his ideas on population, was also a truly great economist. Malthus was the first to admit that crisis might arise from conditions inherent in the capitalist system. His ideas on the causes of crises can be stated briefly. Production he believed depended upon the continuation of effective demand. This effective demand was one that established a price high enough to allow a producer to pay all expenses of production and still provide a profit. But he pointed out that the value of products was always more than the sum paid for the labor necessary to produce them. Hence the body of laborers themselves could never represent a demand big enough to enable the producer to obtain a profit. The additional demand for goods must of necessity come from another source. The capitalists themselves could not be depended upon to provide the necessary demand since they were more interested in saving than in spending. Consequently the demand must come from what Malthus called unproductive consumption. As unproductive consumers Malthus enumerated landlords, menial servants, statesmen, lawyers, judges, soldiers, physicians, and clergymen. If, however, the rate of capital accumulation in a very progressive country was rapid,, and if the nonproductive classes were encouraged to save rather than consume, effective demand would fall and industry would come to a standstill.

"Malthus was the forerunner of many who believed that crises and depressions were the result of under-consumption. In the light of later economic thought, Malthus might at first glance be classed among the revolutionary economists. He was no doubt one of the first to note the inconsistencies and contradictions in capitalism, but he noted its flaws with regret, for the ability of capitalism to produce was fully known to him."

The first thing to note in Malthus' theories is that he focuses on the key question, one that is still key today, namely, what determines demand? His analysis is fascinating because it is made in the context of much simpler conditions than those prevailing today. He first notes that the goods-producing process does not generate enough income to buy the products brought to market because they are priced to include a profit for the producer. Yet under most conditions, they are bought, and so where does the additional demand come from? His answer is that it comes from other classes outside of the capitalist production cycle - the "nonproductive" or in modern terms the services sector. But the next question should be, where does their income come from, and now things become more complex.

Let us speculate on Malthus' enumeration:
  • Landlords - ultimately from the produce of the land. In Malthus' time this would be a legacy of feudalism.
  • Menial servants - could be derived from anyone with income above their subsistence needs. Many would be land-based.
  • Statesmen, soldiers, judges - primarily from the state (crown) out of tax revenue derived from varied sources, including duties on imports.
  • Lawyers and physicians - Lawyers would have served the wealthy classes, physicians a more varied clientele. Both groups would depend on others with the ability to pay them.
  • Clergymen - perhaps the state (Church of England), also rents and contributions from parishioners.

Clearly income is a more complex process than just the wages paid to labor and the revenue gained from the sale of products. The unproductive consumers receive income from capitalists, landlords, merchants, and each other. Domestic demand is supplemented by foreign demand, and domestic demand is satisfied by foreign production as well as domestic. But, more fundamentally, at any given time there is an existing supply of money (wealth) that can be used for consumption. The interplay of all these factors determine demand in the market place.

Another key part of Malthus' theory is the need to recycle the income stream. "...if the nonproductive classes were encouraged to save rather than consume, effective demand would fall and industry would come to a standstill." This would be true if they put their money under the mattress but not if they recycled it through the banking system. Moreover, this phenomenon is not limited to the "unproductive classes". If landlords, merchants, capitalists, or workers sidetrack their money stream, effective demand will fall. [In this connection, it is interesting to note a similar misconception prevalent today - the contention that raising taxes reduces demand. In reality, raising taxes redirects demand from one path to another without affecting the total.] In Malthus day invention and industry were expanding rapidly. There were ample opportunities to invest profitably over time; consequently, periods of overproduction were short and self-correcting. Broadly speaking, this was the period of laissez-faire that came to an end with the Great Depression. In the period since then, "natural" economic development has been supplemented by state intervention, and that development has led to the situation we face today.

The Business Cycle Today

One of the most extraordinary developments since Malthus' day has been the change in the composition of the work force. In his time the overwhelming part of the work force was factory workers, artisans, servants, and farm workers. The "unproductive classes", whom we have identified as today's service sector, were a tiny minority. Today, by contrast, "goods producing" workers are only 21 percent of the labor force whereas "service producing" workers are 79 percent. Only one-fifth of the work force is needed to produce all our material needs. Malthus would be astounded by this turnaround.

Some classical economists believed that wage-earners' incomes would constantly tend to be depressed to the subsistence level. This did not happen so that today a large part of the labor force are among the affluent while a diverse group at the top of the income scale can only be classed as the "super rich". Thus, many more than the capitalists can "not be depended upon to provide the necessary demand since they are more interested in saving than in spending".

Malthus identified under-consumption as the cause of business cycle crises. He did not consider the role of investment, however. Capitalists "prefer to save rather than spend," he noted, but he did not pursue the consequences of their saving. In a period of economic expansion (such as his), saving is recycled into investment in new or growing industries, and thus adds to the demand from workers and "unproductive consumption". This need to recycle excess income in one form or another is extremely important , and is key to analyzing business cycles.

Malthus and his contemporaries could easily see the possibility of under-consumption, but amid the poverty of the period they could not have visualized the possibility of over-consumption. Over-consumption results when it leads to waste. Waste results when valued resources are directed to frivolous or destructive purposes. An example of the former is Las Vegas where vast human efforts are devoted to momentary and self-deceptive indulgence; an example of the latter is current military technology that has created so much destructive power that it threatens our continued existence.

Waste is found on the individual level as well as the mega level. We have long been known as a "throw away" society which encourages us to replace rather than conserve and protect. We are beginning to recycle waste, but little is being done to choke it off in the first place. Among the affluent this whole problem manifests itself in excessively large, luxurious homes and cars, extravagant spending on entertainment, and accumulation of enormous financial assets.

At the same time, we live in a period where unprecedented amounts of indebtedness have been incurred, and this relates back to the recycling of income. During the nineties, billions of dollars were invested in the telecom-internet-computer sector in a classical investment type development of new technology. But the scope and speed of development for this technology were greatly misjudged. The market failed expectations leading to a collapse in market valuations generally. Unfortunately, this sector was the only game in town for investment capital as excess capacity had become rampant. A new situation emerged - excess capital along with excess productive capacity. What resulted was quite dramatic - a drastic drop in gross investment as shown in the following table:

($bns of dollars) Gross Private
Domestic Investment
Nonresidential Investment Residential Investment
Yearly increase 1996-2000 124.5 101.3 16.1
Net change 2000 Q2 - 2002 -202.8 -145.9 17.4
Source: Economic Indicators

Thus, in 2001, instead of getting a boost of $124.5 bn from gross investment, the economy experienced a decline of $188.3 bn or a total turnaround of $312.8 bn. Most of this change has been in the nonresidential or business sector, but even the much celebrated residential sector is now growing at a slower rate than in recent years. As the data indicate, residential investment is only about one fourth as large as nonresidential.

To appreciate the importance to the economy of the collapse of the technology boom, we must remember that constant growth is a prerequisite for continued employment growth and rising equity markets. Even though our productive capacity is more than sufficient to meet all our needs, the economy will falter if GDP fails to rise. The collapse of the tech boom marked a failure in the recycling process that will continue to undermine the economy the longer it continues. Capitalism must continue to expand or it will collapse.

Two indicators illustrate our present situation. The first is our depression-level short term interest rates. The 3 month Treasury rate at 1.17% in January 2003 is negative after inflation. The 10 year rate at 4.05% is the lowest since 1963. The second indicator is the 2002 data for gross private domestic investment. This data shows a leveling off of domestic investment but no meaningful upturn. Both indicators point toward continued weakness, two and one half years after the investment decline began.

This leads us right back to the dilemma Malthus faced "if the nonproductive classes were encouraged to save rather than consume, effective demand would fall and industry would come to a standstill". Except that today we don't need more consumption - the affluent classes already consume too much; and today we already have a huge pool of saving but no profitable place to invest it. The recycling of excess income (saving) has reached an impasse, but we are not yet ready to face it. Yet we can't find solutions until we do.

International Comparisons
Canada Germany Japan United Kingdom United States
GDP (% chg. one year ago)
4.0 1.9 2.8 2.6 3.4
0.9 -0.1 -1.9 1.6 0.5
3.9 0.5 2.8 2.1 2.9
Industrial Production (1997=100)
115.0 112.3 99.5 103.4 115.3
111.0 112.8 92.3 101.2 111.2
112.9 111.3 91.0 97.7 110.5
Retail Sales (volume chg. at annual rate)
3.9 -2.9 -1.1 4.4 2.6
5.7 -4.1 -4.4 5.7 6.5
1.4 -3.2 -3.0 6.4 4.9
Consumer prices (1995=100)
109.0 107.0 101.5 114.2 113.0
111.7 109.6 100.8 116.3 116.2
113.9 111.0 99.9 118.2 118.0
Unemployment Rates
6.8 9.6 4.7 3.6 4.0
7.2 9.4 5.0 3.2 4.8
7.7 9.7 5.4 3.1 5.8
Interest Rates
5.78 4.39 * --- 6.11 5.82
3.98 4.26 * --- 4.97 3.40
2.61 3.32 * --- 3.99 1.60
Stock Indices (ending)
8,933.68 6,433.61 13,785.69 6,222.50 10,786.85
7,688.41 5,160.10 10,542.62 5,217.40 10,021.50
6,614.54 2,892.6 8,579.95 3,940.40 8,341.63
Current Acc't Bal's ($bn) latest 12 months
12.7 -29.8 117.7 -24.5 -410.3
18.9 10.2 91.2 -25.1 -393.4
11.0 50.4 115.0 -15.5 -503.4
Foreign Exchange Rates
1.49 0.92 * 107.80 1.52 119.68
1.55 0.90 * 121.57 1.44 126.08
1.57 0.95 * 125.22 1.50 127.19
Currency units per U.S. $
UK pound in U.S. $s
U.S. dollar: index of dollar against major trading partners, January 1997=100
* Euro area (US$/Euro)
Sources: Economist, Economic Indicators,
F.R. Bulletin, Survey of Current Business

GDP rose in all five economies in 2002 over the preceding year, with Canada showing the largest increase. Industrial production, however, fell except in Canada. It is worth noting that Britain, along with Japan, now has a rate lower than the 1997 base.

Retail sales slumped except in Britain. Germany and Japan have now experienced three years of negative growth while Canada's volume dropped 4.3 points. As usual, consumer prices advanced in all countries except Japan. These advances erode savings and exert downward pressure on consumption.

Unemployment rates advanced except in Britain. The U.S. rate has now risen each year since 1999. Low interest rates are another pervasive indicator of economic weakness. The U.S. rate is the lowest it has been since 1954, but the economy shows few signs of reviving. So much for another accepted dogma - that a cut in interest rates will automatically promote prosperity. Today, even zero interest rates and cash rebates for purchases barely sustain consumption.

Little wonder stock investors are feeling shell-shocked. Each market index in our table has fallen for two successive years, and each except Canada has fallen for three successive years. The German index fell 44% in 2002, but the others also had large losses. In the U.S., mutual funds have begun to experience net redemptions in place of net sales, which puts further downward pressure on market prices. But the problem is, there are no good alternative investments.

The U.S. current account deficit took another giant leap in 2002 from $393 billion to $503 billion. This is almost four times what it was in 1997. An increase in the deficit on goods plus a decrease in the surplus on services accounted for most of the increase with the remainder due to a deficit on investment income and an increase in the deficit for unilateral transfers. Germany's surplus of $50 billion was due to a huge trade surplus of $110 billion - larger than Japan's. Interestingly, this was also the first year for free circulation of the euro currency.

The U.S. dollar was strong through most of the year, but the euro strengthened in the closing months. The pound also strengthened while the yen declined.

Business Activity Indicators - United States
2000 2001 2002
Industrial Production (1992=100) 115.3 111.2 110.5 *
    Capacity Utilization Rate (% total industry)
82.7 77.3 75.6
Manufacturers' New Orders (billions of $s) 347.2 321.4 318.9 #
New Construction Expenditures (billions of $s) 820.3 842.5 846.6 *
Real Gross Priv. Dom. Invest. (chained[1996]$s) 1,762.9 1,574.6 1,589.5
Business Sales - Mfg. & Trade (billions of $s) 828.0 815.1 823.5 #
Business Inventories (ending) (billions of $s) 1,198.4 1,122.0 1,143.9
Retail Sales (billions of $s) 254.9 264.0 272.2 #
Retail Inventories (ending) (billions of $s) 416.5 395.5 425.9
Per Cap. Personal Consump. Expend.'s (chained [1996] $s) 22,061 22,390 22,873 *
Nonagricultural Employment (millions) 131.7 131.9 130.8 #
    Goods Prod. (millions)
25.7 24.9 23.8 #
    Services Prod. (millions)
106.1 107.0 107.0 #
# Monthly average Source: Economic Indicators

Industrial production declined again in 2002; the decline was broad, affecting all sectors except utilities. The capacity utilization rate also declined to 75.6, its lowest level for a decade. Manufacturers' new orders also fell for a second consecutive year. Capital goods orders declined more than durables as a whole, another indicator of the weakness in investment.

New construction expenditures continued their long rise with the increase centered in residential and government construction. Commercial and industrial expenditures fell $35.3 bn.

The slight rise in real investment is misleading. Nonresidential investment in structures, equipment, and software fell, while residential investment and private inventories rose.

Business sales rose $8.4 bn in 2002 but were still below the 2000 total. From 1993-2000 yearly increases ranged from $30-40 bn. Business inventories also rose but remained below the 2000 level. Retail sales have continued to rise though at a slower pace. Retail inventories rose above the 2001 level. Business and retail inventory-sales ratios are relatively low. Retail sales have been sustained by continued growth in per capita personal consumption expenditures.

Employment data is key to continued consumer spending and this data is not encouraging. Employment fell 1.1 million in 2002 after a slight rise in 2001. The decline was mainly in goods production but there was also a slight decline in services, the first since 1958. In February 2003 employment fell 308 thousand, 204 thousand in services.

Financial Indicators - United States
2000 2001 2002
National Income (billions of $s) 7,984.4 8,122.0 8,361.3
    Percent change
6.9 1.7 2.9
Per Cap. Disp. Personal Income (chained [1996]$s) 23,501 23,692 24,525
Avg. Real Gross Wkly Earnings (1982=100) 272.36 273.26 278.31
Gross Saving " 1,807.8 1,662.4 1,588.2
    Personal "
201.5 169.8 306.7
    Business "
1,170.6 1,229.5 1,298.1
    Government "
435.7 263.1 -16.6
Commodity Price Index (1995=100) 72.7 65.4 74.7
Producer Price Index (1982=100) 138.0 140.7 138.8
Corp. Profits (with i.v.a.&c.c.a.) (billions of $s) 788.1 731.6 778.8 *
Interest Rates - 10 year Treas. 6.03 5.02 4.61
Money Supply - M3 (ending) " 7,090.5 7,993.5 8,510.7
    Percent change
8.6 12.7 6.5
Federal Gov't. Current Surplus or Deficit (NIPA) " 206.9 72.0 -180.7 #
Commercial Bank Credit (ending) " 5,234.0 5,451.0 5,885.9
Consumer Credit (ending) " 1,560.6 1,666.9 1,725.7
Credit Market Debt (ending) " 27,348.6 29,393.6 31,702.2
    Household Sector "
7,075.1 7,686.8 8,443.8
    Nonfinancial Business "
6,514.3 6,932.5 7,134.3
# 3 Qs Sources: Economist, Economic Indicators, F.R. Bulletin, F.R. Flow of Funds

National income growth accelerated from 1.7% in 2001 to 2.9% in 2002. These rates were well below those of the preceding four years which had ranged between six and seven percent. In addition, the largest component, compensation of employees, rose just 2.1%. Real per capita income rose considerably more than in 2001 while real weekly earnings rose more than in the past four years.

Gross saving fell again in 2002 due to the reversal in government saving which has declined from $435.7 bn in 2000 to $-16.6 bn in 2002. With war costs piled on top of declining federal revenues, this trend will surely intensify. Personal and business saving accelerated.

Certain commodity prices such as fuels rose strongly in 2002 while others such as metals remained weak. The overall index is down 25% from the base year, 1995. Producers' finished goods prices declined in 2002 led by consumer items. Prices of durable goods as well as equipment and software fell.

Ten year Treasury yields fell through 2002 and into 2003; the rate by March was down to 3.65%, lowest since 1958. These rates reflect high risk aversion and lack of profitable investment prospects anywhere in the economy.

M-3 money growth was only about half as rapid as in 2001 and the slowest since 1995. Savings deposits grew strongly.

As noted under government saving, federal finances have experienced a severe downturn. With receipts falling and expenditures swelling, the administration proposes to accelerate both trends. Apparently rationality in both foreign affairs and fiscal policy has departed Washington.

Total bank credit rose strongly in the second half of 2002. The upsurge was led by investments in Treasury and Agency bonds, and by real estate loans. Commercial and industrial loans fell $66.3 bn.

Interestingly, consumer credit grew only about half as much as in the preced-

ing two years and did not accelerate in the first quarter of 2003.

Credit market debt growth accelerated from 7.5% in 2001 to 7.9% in 2002. Household debt grew 9.8% due to a surge in home mortgage borrowing. Business borrowing increased 2.9%. With all this debt, bankruptcies have been at a high level but apparently did not rise in 2002.

Selected International Transactions - United States
2000 2001 2002
Trade Balance on Goods & Services ($bns) -378.7 -358.3 -435.5
    Goods "
-452.4 -427.2 -484.4
    Services "
73.7 68.9 48.8
US Owned Assets Abroad, net [inc/capital outflow(-)] " -606.5 -371.0 -156.2
Foreign Owned Assets in US, net [inc/capital inflow(+)] " 1,016.0 752.8 630.4
    Net change in US Int'l Inv. Pos'n. "
409.5 381.8 474.2
Net change in Foreign Owned U.S. Securities
    Treasury Securities & Cy Flows "
-86.1 26.9 118.3
    Other U.S. Securities "
499.2 434.3 318.6
Sources: Economic Indicators, Survey of Current Business

The negative balance on goods and services surged to a new record high in 2002. The balance of $-435.5 billion contrasts with the balance of $-104.7 bn in 1997, just six years ago. The balance on goods grew from $-196.7 bn to $-484.4 bn while the surplus on services shrank from $91.9 bn to $48.8 bn.

Goods exports fell in 2002 from 2001 while goods imports rose. Exports and imports of services both rose, but imports rose $20.1 bn more than exports. The increase in goods imports was mainly due to consumer goods and automotive products. The increase in services imports was largely accounted for by higher insurance costs (which were lower in 2001 due to recoveries in connection with the 9/11 attacks).

These current account trends along with the explosion in credit market debt are time bombs waiting to explode.

Net recorded financial transactions into and out of the U.S. have declined over the past three years. U.S. owned assets abroad rose less than half as much in 2002 as in 2001. The slowdown was due to reduced purchases of foreign securities (actually to net sales) and lower claims on foreigners reported by U.S. banks. Foreign owned assets in the U.S. increased less than in 2001 mainly due to a slowdown in securities purchases.

Foreign purchases of Treasury securities and U.S. currency rose $91.4 bn, but purchases of other U.S. securities fell $115.7 bn. Presumably this shift represented the same "flight to quality" that characterized U.S. securities markets.

Copyright © Andrew Caughey, 2003

The Pulse of Capitalism is published quarterly. Comments may be sent to Pulse Publication, P.O. Box 140, Gibsonia, PA 15044. Telephone: (724) 443-2396
Material may be reprinted with acknowledgement of the source. Economic statistics are revised routinely and may, therefore, differ from one report to another.

Published May 2003

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