How does a consumer-based economy generate wealth?

February 11, 2009 3:21 PM

Economics newb asks: how does a consumer-based economy generate wealth?

I hear things like, "70% of the U.S. economy is based on consumer spending." It seems like if this were the case, then money would just be "recycled." How is there a net gain or production of wealth for the country if most of it is a result of people spending money internally? I must be missing something simple...

posted by wastelands to Work & Money (17 answers total)

All of the economy is based on recycled money. There is only so much money to go around (called the money supply, M3 being everything). The net gain comes in when a company sells more and then decides to produce more.
posted by Brennus at 3:30 PM on February 11, 2009

Population growth is inevitable.
posted by infinityjinx at 3:40 PM on February 11, 2009

* In countries that save more, banks have their deposits, which they lend out. In the US, people save less, so banks get money by charging people interest on loans and though other means. More or less. Money is shifted around. So, our economy is driven by spending and not saving. The money ends up out there in the economy either way.

* In a country like ours where people spend more and save less, employment and overall production might be the same as a savings-based country. But more people will work at stores and shit. There are tons of reasons why one or another balance of savings and spending in a country might be better than another, but it's really just a matter of internal accounting. The economy doesn't care who has the money, per se.

* Everyone does produces something. Every company at least tries to create a good or a service that people want. That's "production." Lots of people produce things and work at companies that seem frivolous. This is only because the people making the necessities of life are so efficient. We're all living off the surplus that's created by manufacturing and farming.

* Every free economic transaction creates wealth. Me buying a candy bar from you makes us both richer, since we both have things we value more. "Wealth" and "value" are not the same as money, or even necessarily the same as purchasing power.

* But, our economy isn't really sustainable anyway and hasn't been for years. America's trade surplus is us collectively buying more than we earn. That means to the country what it means to an individual: debt. If you're going into debt to pay for college or fix up your house, that's a good thing. If you're going into debt in order to buy candy corn and plasma TVs, that's a bad thing. We're more the latter.
posted by yesno at 3:46 PM on February 11, 2009

All of the economy is based on recycled money. There is only so much money to go around (called the money supply, M3 being everything).

Whoa, whoa. The money supply is not fixed. At any given time there is only so much money to go around, but this amount is constantly increasing.
posted by mr_roboto at 3:53 PM on February 11, 2009

Best answer: Well that depends on what you mean by "generate" and what you mean by "wealth"...

But glossing over those arguably impossible-to-define terms, "consumer spending" isn't just on services. Much of it is also on goods, like food, clothes, electronics, cars, etc. These come from somewhere, i.e. raw materials which are taken from the ground and mixed with human labor to produce new material goods, which one might arguably characterize as "wealth".

The reason consumer spending constitutes such a large percentage of GDP is that GDP is really only measuring goods consumed that year. As such, only retail transactions are counted as part of GDP. Take Acme Widgets as an example. Say Acme buys parts from its supplier, converts them into a finished product, and sells them to Wal-Mart for distribution to customers. Acme and Wal-Mart also pay their employees as part of this process. None of those transactions appear as part of GDP. Only when Wal-Mart sells Acme widgets to consumers does GDP tick up a notch.

The reason economists count this way is because otherwise you'd have a single consumer sale registering two, three, four, x times before it reaches its ultimate destination in your shopping cart, so an Acme Widget which sells at Wal-Mart for $2.99 would have a GDP value several times that, reflecting the transactions which went into its creation. This doesn't make a lot of sense, so economists only count consumption when calculating GDP.

Now both Acme and Wal-Mart do engage in transactions that contribute to GDP, as both Acme and Wal-Mart are the final consumers of things they buy to conduct their business. They need light-bulbs, floor wax, window cleaner, paperclips, computers, all sorts of things. These are definitely GDP expenditures. But they tend to represent a very small portion of most businesses' revenues, so the corporate consumption factor of total GDP tends to only be in the low double-digit percentages (I think 10-15% but I'm having trouble coming up with a figure for that). The government spends money this way too, more than corporations (especially in recent years) but the vast majority of goods consumed in the country are consumed by, well, consumers.

So the reason we can still "generate" "wealth" while having 70% of our economy made up of consumer spending is that GDP is really only a measure of goods consumed, i.e. retail sales of new goods.
posted by valkyryn at 4:00 PM on February 11, 2009

Population growth is inevitable.

Tell Scandanavia this. They will laugh like I am. Population Decline, via Wikipedia.

Meanwhile, in an article called "Money and the Crisis of Civilization" Charles Eisenstein (and I'm not vouching for his correctness) attempts to explain how we create money and how that all feeds into itself to keep us afloat.

At a conference I went to last week at the Federal Reserve Bank of Philadelphia, it was discussed that we have transitioned from a manufacturing to a service sector economy, which is how our economy generates income. (It's easy to quantify how a manufacturing economy generates income: you "make stuff." Less easy to quantify is a service economy, wherein we "do stuff.") The speaker, Sean Egan of Egan-Jones Ratings, was describing the steps we may need to take to restore trust in our financial system, in order to keep people around the world using our financial system, which is a source of income which pretty directly supports our consumption. I also remember a lot of conversations along these lines in law school, about our legal system being able to serve as a forum for suits from around the world with long-arm jurisdiction - which in turn generates income for our country and our legal profession.
posted by greekphilosophy at 4:09 PM on February 11, 2009

I had been wondering the same thing for the last couple of years ("why aren't we just recycling money?"), and just starting taking a macroecon class to clear it up for me. yesno already said it above, but I wanted to expand on this point, because it seems both important and non-obvious.

First, define wealth as whatever people value. So if two people engage in voluntary trade, the wealth of both increases. Like if I buy pants for $40, I must have valued the pants more than $40, and the store must have valued $40 more than the pants. So the sum of all wealth in the world has increased, even though the total amount of money hasn't. This is why consumer (or any sort of voluntary) spending generates wealth.

Contrast this with a zero-sum game like poker, where everyone wants just one thing: the pot. I think (market-based) economics is a non-zero-sum game precisely because different people value different stuff.

I've been in this econ class for a grand total of five weeks, so economists, please correct me if I'm wrong.
posted by molybdenum at 4:37 PM on February 11, 2009

Wealth could be defined as the stuff you have, that you don't have to keep buying. You can then use your earnings to buy other stuff, or purchase the services of others. The more stuff we, individually, or as a society, build and buy that we then don't have to keep building and buying, is wealth. Look at something like a house. If built right, a house can provide shelter for generation after generation of families. For a hundred years, that house allows a family to not have to build another house. They can use their money to buy other stuff.

Or, wealth is the difference between the utility value of the stuff we buy and sell, and the cost. Look at going and getting a haircut. Its cost and value are pretty much equal to the buyer. You don't really gain any wealth in buying a haircut, but the barber does. At the end of the month, after he pays all his expenses, hopefully he has some money left over. Or, look at credit. If used smartly, credit builds wealth. You pay the lender a little money to use his money, which generates wealth for him. You use that money to buy something you couldn't afford otherwise. If that something is valuable and will last you longer than it takes to pay for, now you have wealth. Like that house. You pay for 30 years, but when its done, now you don't have to pay for housing. Suddenly, you have an extra $1000 a month. You have built wealth. The lender is wealthier, you are wealthier, the economy has built wealth.

That's balanced out by wealth destruction in the form of inflation and investment failures. Say I'm a manufacturer. I need a new machine. I borrow money and buy it, believing that with this new machine I will be able to make more stuff and sell it. But, I'm wrong and go bankrupt. My shareholders lose, my creditors lose. The only one who wins in that scenario is the person who sold me the machine. But to the economy as a whole, that's a net loss. Investment failures could even be very minor- I buy a DVD player believing I will get 5 years of utility out of it. But I only get 1 year. It cost me more than the utility I got from it, and that's a sort of investment failure.
posted by gjc at 4:43 PM on February 11, 2009

I teach intro to macro economics

At a most basic level the economy grows when we buy new capital which includes buildings, machines, computers, or education (human capital). If we have more capital than last year, then we will most likely grow economically. About 15% of the income generated in the US is reinvested in new capital.

A good way to understand the economy as a whole is to think about how do you grow your own wealth? You save, right? Someone who saved 15% of their own income could generate a lot of wealth with those savings.

Now US GDP is about $14 trillion. 10 trillion of that is consumer spending, which as you point out is about 70%. The government spends about 3 trillion or 20%, which is calculated separately in GDP. Finally the US invests 2 trillion dollars in new capital each year. This new equipment helps the economy grow.

If you add the numbers 10 + 2 + 3 = 15 not 14 .We get more goods from other countries than we send to them (we have a trade deficit). In exchange we give other countries $s or the promise of future $s. Most of the time with the $s other counties buy US assets including capital or create new capital for example Honda (a Japanese company) owns a factory in Ohio. This isn't necessarily bad, because this capital can be operated with American labor, which creates income for American workers.

Let me know if that helps.
posted by akabobo at 6:34 PM on February 11, 2009 [1 favorite]

First, define wealth as whatever people value.

NO NO NO

These come from somewhere, i.e. raw materials which are taken from the ground and mixed with human labor to produce new material goods, which one might arguably characterize as "wealth".

YES YES YES

I found my thinking about economics greatly clarified when I came across the classical definition of wealth: "that produced by labor which provides utility" -- "utility" being defined as "services satisfying human needs and wants".

This definition gets to the rock-bottom issue of what wealth really is -- it is physical stuff that somebody made somewhere. It is not the money in your wallet or Wall Street securities or numbers on your bank statement -- those are claims to wealth, but not actual wealth.

A nation becomes wealthy over time by producing stuff that provides services that improve the standard of living. The difference between wealth and poverty is this stuff -- it is the roof over your head, the nice well-designed concrete sidewalks, the weather-proof and well-organized local road network -- these are all physical goods that provide useful services over time.

Human actors can also provide services in the economy -- the piano teacher, the auto repairman, the hairdresser. To the extent these actors do not consumer resources purchased from outside the local economy, it can be said that these transactions are just rotating money around the economy; eg. the piano teacher bartering with the auto repairman's labor charge to rotate her tires in exchange for teaching Junior piano for an hour.

But in the end we all must consume physical goods to produce our services, and this production and consumption of stuff is where every economy is grounded and must pay its own way via a balance of trade, or eventually find itself choked off from expansion if it is consuming more goods than it is producing.
posted by troy at 7:28 PM on February 11, 2009

^ addendum: though it must be said that it is possible for an economy to thrive by doing value-add labor that maximizes its trade balance, eg. the LA economy's production and export of porn videos, TV shows, and movies. The profit margins on this stuff is high compared to the capital and intermediate goods consumption required, making LA quite collectively wealthy over the last century.

This harkens back to Adam Smith's "division of labor" observation, that the production of wealth is increased by industrial specialization and trade.
posted by troy at 7:44 PM on February 11, 2009

troy, you're describing what looks suspiciously like a productive/unproductive distinction in the economy. The French physiocrats latched on to that in the eighteenth century (I link to Wikipedia here for the link's sake only; the interpretation there isn't very good). This has roots in classical economics but is completely out of favor in contemporary circles.

I happen to agree with you. I'm just sayin' is all.

molybdenum, the reason economics isn't a zero-sum game (it's worth mentioning that some people have believed that it is a zero sum game; the physiocrats were one such group) is not because people value things differently, but because there are constant increases in the "inputs" of wealth: labor and raw materials. Granted, it's possible to consume more raw materials than one produces in a given period of time, but do this long enough and you starve. Additionally, though there is a limited supply of labor available at any one place at any one time, labor isn't something you can "use up" over time, so one might conceive of the way labor works as if there were six billion new man hours of labor injected into the economy every hour of the day. The productive use of labor, combined with raw materials, is responsible for the growth of the economy.

As a corollary: want to know why the economy is tanking? It's because we've stopped mixing labor with raw materials. The 78% of the US economy devoted to "services"? There's a good argument to be made that a big chunk of this doesn't represent wealth at all, as it doesn't represent the mixture of labor with raw materials, it represents labor alone. Granted, a certain amount of this may be necessary for the economy to function--we need lawyers to negotiate contracts and diagnostic physicians to take care of us even though neither of them really produce anything the way GM does used to--but there's good reason to believe, and economists have believed in the past, that labor alone is not a source of wealth.

All: don't confuse money with "wealth." Money is simply a more-or-less arbitrary medium of exchange. Money is the unit in which we may choose to measure wealth, i.e. it may represent wealth, but money itself is not wealth, because money is only useful in that it can get you other things. Wealth, however defined, is something that you'd want for reasons beyond its mere exchange value.
posted by valkyryn at 8:57 PM on February 11, 2009

This has roots in classical economics but is completely out of favor in contemporary circles.

cf Gaffney, LOL.

that labor alone is not a source of wealth

I like to think that "good" labor helps make the actual wealth-producers more productive.

The bottom line if not dirty secret of the economy is that with manufacturing advances it would be possible to live the life of a king on not much money -- we are awash with riches -- if it were not for the abundance of rentiers -- the "professional" guildmembers, landowners, and financiers -- parasitically taking their cut of the flow.

This is why LAND costs so much in most places, we have so much surplus wealth that we bid up the price of land -- plain abstract site value -- to astronomic heights.

And WRT labor alone not being a source of wealth, there is a subtlety here that can be expanded. Wealth is simply having a want or need met. Goods provide services that meet these needs, but so can service workers, as how the 19th century middle & upper classes employed the lower class to perform labor directly, before labor-saving devices replaced this labor.

Henry George had an interesting analogy, that goods store service-providing as coal stores energy; so wealth is simply the physical crafted into service-providing form.

I haven't yet worked out how IP fits into this. Clearly knowledge and entertainment are desirable states that we seek, so possession of these is a form of wealth somehow, even though these can be reduced to digital bits & bytes. Is the man happily playing WoW 20 hours a day not wealthy?
posted by troy at 11:07 PM on February 11, 2009

troy, Gaffney, as a critic of the reigning neoclassical orthodoxy, would be something of a pariah in the economic community, so I stand by my statement.

And you're being far too subtle by half with the rest of your discussion. Nineteenth-century middle/upper classes did indeed employ the lower classes to "perform labor directly," as they had for all of history, but in most cases this labor involved the physical manipulation of stuff as a critical component. Granted, house servants don't make anything new and are thus arguably unproductive as far as the economy goes, but in essence, they live off the largess of their patrons.

If Henry George really did believe that about labor, he's channeling Marx, who got there first. But the problem is that no one, not Marx, not anyone else, has been able to come up with a coherent theory which explains how a purely labor-based theory of value would actually work. You just can't do the math. The classicals before him viewed wealth as stuff you could possess. The physiocrats thought that only agricultural production constituted wealth. Smith wanted to expand this to include manufactured goods. Ricardo moved back towards a purely agricultural model. But the idea that the satisfaction of any demand, period, constitutes wealth, regardless of the nature of the demand or the nature of the satisfaction, is a neoclassical idea, i.e. no older than about 125 years if that, and completely untenable.

Take your WoW player for example. By your definition he is wealthy. So's the guy who spends his entire day jacking off. I suggest that if your definition of "wealth" includes both of those characters than it isn't a definition worth having.

The answer is that intellectual property does not constitute wealth. But I'm not going to get any further into that because I'll be writing my graduate thesis along those lines. Don't want to spill the beans, etc.
posted by valkyryn at 5:03 AM on February 12, 2009 [1 favorite]

Response by poster: MetaFilter: the guy who spends his entire day jacking off.

Had to be done, sorry... :-)
posted by wastelands at 7:00 AM on February 12, 2009

Related question for the economics-knowledgeable on here:

Is MeFi wealth?

We, as a society, have Wikipedia and Google and IMDB and AskMeFi available to us. From my perspective, it is wealth, since it provides something I value and saves me time (I don't have to spend two hours going to the library to find out who wrote the sound track for The Ghost and Mrs. Muir; it's at my fingertips).

But there's nothing physical (excluding the servers and the wires of the Intertubes).

Is it wealth?
posted by kristi at 1:28 PM on February 14, 2009

Response by poster: kristi, according to the strictest dictionary definition of wealth, no, knowledge is not considered wealth because it's not material. However, it's clear that it is wealth in the larger sense, "All goods and resources having value in terms of exchange or use." I exchange money to get Internet access. I pay the $5 MeFi fee to join this community. I use my limited free time to be here. Etc.
posted by wastelands at 1:51 PM on February 14, 2009