# Driver of an Economy - Productivity or Consumption?



## Damian85 (14 Mar 2009)

Does productivity (Austrian view) or consumption (Keynesian view) fuel an economy? What are peoples' opinions on this?

*Try not to bring gold into the debate if at all possible*


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## mathepac (14 Mar 2009)

As a country that produces very little gold, but was a huge consumer during the Celtic Tiger "bling" era, our consumption of gold has got us into yet another fine mess, to paraphrase my own favourite economists, Laurel & Hardy. 

If the abbots of the monasteries in the days of the Island of Saints and Scholars had been prescient, they would have designed and implemented a recycling policy for old gold chalices, croziers, amulets and torcs, instead of using them as land-fill. This could have avoided the balance of trade deficit created by the demand for the gold that the Tiger Cubs needed to emphasise their importance to themselves and the journos in "Howya" magazine. 

So in my view a lack of productivity in relation to existing gold stocks and high gold consumption lead to our being economically snookered, so to speak.


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## Timbo (19 Mar 2009)

Damian85 said:


> Does productivity (Austrian view) or consumption (Keynesian view) fuel an economy? What are peoples' opinions on this?
> 
> *Try not to bring gold into the debate if at all possible*


 
YOu have posed this question in a way that indicates you don't understand either of the things you think you are citing.

Keynes never said or thought that "consumption was a driver of an economy" - whatever that actually means.

Keynes thought, as all economists do, that consumption is something funded out of income, alongside saving, within households.

His claim to fame is that he constructed a model to help describe why an econonomy might become stuck with spare capacity in goods and labour markets - commonly known in current times as "Keynesian" recession, or sometimes a "profits" recession. 

His approach explained how an economy might get stuck in a rut, so to speak, with companies unwilling and able to increase output and hence demand for employment due to an absence of profit. While households, underemployed, did not have sufficient income to promote demand for output that might restore profits and prompt demand for labour - a vicious cycle enforced by nominal wage rigidity (i.e. money wages won't fall for contractual and other reasons that might otherwise promote more labour demand without an increase in final demand pushing up output first).

So, in relation to your question:

All welfare/income/wealth/utility whatever monicker you wish to put on it arises from our propensity to combine labour, capital and technology for productive use (i.e. we transform some stuff into other stuff to meet our needs and wants).

Under some circumstances (_*not every recession mind - and almost certainly not this one*_) a kick to final demand can provide the initial boost to push an economy out of a (Keynesian recession) rut.


What I am effectively doing is kicking into touch all the nonsense you see in the press and media about "confidence" being something in any way important. It's not.


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## Damian85 (19 Mar 2009)

Cheers for reply Timbo. I'm not sure you answered what I was asking as such though, and perhaps I phrased it incorrectly or inaccurately, and please feel free to correct me.

Many western economies have been using credit to consume over the last decade. Keynes was an advocator of this under a pretence that _"in the long run, we are all dead"_. Keynes seemed to favour deficits and favoured consumption. Ideally a global fiat monetary policy would then inflate away large amounts of this in a perpetual cycle.

The Austrain economic message of sound money, savings and productivity has now started coming into the mainstream in light of a possible defunct and heavily criticised Keynesian style monetary system.

I was enquiring which school of thought would be carried forward into the future..


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## Protocol (20 Mar 2009)

The long run drivers of output growth are as follows:

Y = A f (K, L, HC)

Y = output / income

A = level of technological progress or knowledge
K = physical capital stock
L = labour force
HC = human capital

In the short run, the level of Aggregate Demand or spending can affect output, i.e.

Y = C + I + G + X - M


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## Timbo (23 Mar 2009)

Damian85 said:


> Cheers for reply Timbo. I'm not sure you answered what I was asking as such though, and perhaps I phrased it incorrectly or inaccurately, and please feel free to correct me.
> 
> Many western economies have been using credit to consume over the last decade. Keynes was an advocator of this under a pretence that _"in the long run, we are all dead"_. Keynes seemed to favour deficits and favoured consumption. Ideally a global fiat monetary policy would then inflate away large amounts of this in a perpetual cycle.
> 
> ...


 
I answered the question.

If you want it simply:

Consumption is not a "driver of an economy" - which I will interpret as "creates income/output growth over time in an economy". It is something that occurs in an economy.

Special note. Keynes never ever suggested it did.

As noted in other reply, if consumption increased from some exogenous shock, then you would naturally get a short-term output response. But that wouldn't last.


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## Protocol (23 Mar 2009)

Yes, the long-run driver of incomes per person is not consumption.

It is productivity, which is driven by technological progress.


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## Purple (24 Mar 2009)

Protocol said:


> It is productivity, which is driven by technological progress.


It’s driven by a bit more than that.
What about cost competitiveness (value)? Sure technological progress is a major factor but a product that is 10% better but three times the price is still not going to sell.


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## shnaek (24 Mar 2009)

Timbo said:


> What I am effectively doing is kicking into touch all the nonsense you see in the press and media about "confidence" being something in any way important. It's not.



I have to disagree with this. Confidence is important. Many people underestimate the influence of human psychology in economic matters. Consumption is also important. The hoarding of money is bad for society, particularly when an economy is in recession. You will often see government implementing 'use it or loose it' type policies during recessions in order to encourage people to consume the goods that others produce.


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## Protocol (24 Mar 2009)

Purple said:


> It’s driven by a bit more than that.
> What about cost competitiveness (value)? Sure technological progress is a major factor but a product that is 10% better but three times the price is still not going to sell.


 

Productivity is a reflection of cost competitiveness.

Denmark has high costs and taxes, yet are still rated a competitive economy, as they have high productivity.

In a way, they can justify / earn / deserve their high costs / wages as they have high competitiveness, which is driven by technology, innovation, infrastrucure, skills, etc.

We are really saying the same thing, just in different ways.


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## Chocks away (24 Mar 2009)

mathepac said:


> As a country that produces very little gold, but was a huge consumer during the Celtic Tiger "bling" era, our consumption of gold has got us into yet another fine mess, to paraphrase my own favourite economists, Laurel & Hardy.
> 
> I didn't know that they did _una voce _
> 
> ...


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## Timbo (27 Mar 2009)

Purple said:


> It’s driven by a bit more than that.
> What about cost competitiveness (value)? Sure technological progress is a major factor but a product that is 10% better but three times the price is still not going to sell.


 
No.

Technological progress is the determinant of increase in income per capita (i.e. total factor productivity).

See: Solow growth model.


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## Purple (27 Mar 2009)

Timbo said:


> Technological progress is the determinant of increase in income per capita (i.e. total factor productivity).
> 
> See: Solow growth model.



I'm familiar with the Solow growth model. What I don't get is how it accounts for competition between businesses, states and regions to apply technological development to the output of goods and services and how education, infrastructure and access to markets impacts on that growth.
Basically how does an micro-economic theory work in the real world.

I accept that technological advantage offers productivity advantage but I don't see how it outweighs efficient management, low wages, advantageous taxation models and access to markets all by itself. For example if company A use the latest technology to produce product X but company B also makes product X and pays only 10% of the wage rates of company A, works longer hours, pays lower taxes and has better access to the end market then they will still be able to get product X to market for a lower price.

The other factor is that technological advancement is mobile and can be exploited in low-cost (and even generally low-tech) regions. Therefore while the microeconomic model works in the micro environment of a particular corporation it cannot be taken as the dominant factor when developing the economic policy of a country (since that country cannot follow the technology and capital to low-cost high-return regions).

I could well be wrong, if so I’d love to hear why.


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## Purple (4 Apr 2009)

No takers on the Solow Growth Model then?


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## UptheDeise (4 Apr 2009)

Many Western countries have used credit as a source of money. To increase this 'money' they just boosted credit lines or created artificial ones.

Whether Keynesian believed that consumption should fuel an economy or not is irrellevent because that most certainly has being the outcome of his economic model adopted by the USA and Britain.


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## Timbo (6 Apr 2009)

Purple said:


> I'm familiar with the Solow growth model. What I don't get is how it accounts for competition between businesses, states and regions to apply technological development to the output of goods and services and how education, infrastructure and access to markets impacts on that growth.
> Basically how does an micro-economic theory work in the real world.
> 
> I accept that technological advantage offers productivity advantage but I don't see how it outweighs efficient management, low wages, advantageous taxation models and access to markets all by itself. For example if company A use the latest technology to produce product X but company B also makes product X and pays only 10% of the wage rates of company A, works longer hours, pays lower taxes and has better access to the end market then they will still be able to get product X to market for a lower price.
> ...


 
The glib answer is that the Solow model just works. It is nicely prdictive over time and over geography. Even after the quite massive foray into neocalssical endogenous growth theories, Solow still is the most parsiminous explanatory model.


But to address you serious points, a few things for you to consider.


Growth theory is typcally macro based, as you identify. In that I mean that it takes observations of aggregate measure for output, capital stock, labour etc. to formulate and then test. But in addition to the fact that it has proved quite robust for its predictive qualities over time and across countries,, we also have the benefit now of knowing that this broad macro framework is consistent with micro foundations. (i.e. the work on macro economics from micro foundations revealed that these macro, observation-based - models are consistent simplifications of models you might derive from aggregating micro economics applied to indiviudal agents, as you do in your post.
Secondly, some points about the Solow model.


The term "technology" and "technological progress" should not be contrued to mean that "the most moderen technology is employed in production". It means that output is constrained by technology presently available and this would be relfected in the form of the production function - which the Solow model doesn not specificy. An extremely important distinction. Think of your differnet producers (say, in China and in the US) both using effectively the same production function (i.e. same technology) but they are simply on different poiints of the production frontier. If the Chinese producer was using labour as expensive as the US producer they would, given the current technology constraint, move around the production frontier by employing more capital and less labour and probably end up near the US producer.

Next, you identify the way different producers might use differing combinations of technology, labour and capital (possibly availiing of different prces for each). That is fine. Each is still optimising output given their constraints in labour and capital, the relative prices of those factors and the form of the production function they might be faced with (which is going to be influenced by technology).
After considering some of these things you might now begin to identify that growth models are used for that - modellng growth. Not output. The Solow model, like other, does not try to mimic how much output is produced, but only how it changes over time. By that I mean two things are implied (i.e. fall out of the model):
The marginal factor product of labour and capital
The relative factor cost of labour and capital
BUt we aren't required to do this, because the model just works. In technical jargon, the explansion path of output is well predicted over time by:
a relaxation in the technology contraint
a shift in the marginal product of labour and capital
And this has been emprically tested across any number of countries and it is a nicely predictive model.


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## Purple (10 Apr 2009)

Thanks for the post Timbo. The issues I have the Solow models are:
1) It is specific to the country/region that it is measuring. In other words it measures the growth of the Chinese economy relative to the Chinese economy and not specifically per capita income increases within China or relative values internationally within the domestic model. The problem with this is more obvious when looking at many African economies where growth rates have been very high for decades at a time but population growth has been greater and so per capita income has dropped. Also, labour intensive production without a banking system to distribute capital, and a legal system which defines ownership (and so allows assets to be valued and leveraged), hugely limits the possibility of movement to higher-tech production and increases in per capita income levels. Which leads me to;

2) “Technology”. I know that in the context of an economic growth model "technology" is essentially the ability of a country/economy to combine inputs (labour and capital) to produce the optimum output but it's very hard to hold that thought and not drift back, however subconsciously, to thinking about technology at technological advancement.

I n a nutshell it is a good model for measuring output which makes it a useful tool to answer a specific question but it's hardly the economics equivalent of a unified field theory in physics.

Again, I'm open to correction on all of the above.


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## Timbo (14 Apr 2009)

Purple said:


> Thanks for the post Timbo. The issues I have the Solow models are:
> 1) It is specific to the country/region that it is measuring. In other words it measures the growth of the Chinese economy relative to the Chinese economy and not specifically per capita income increases within China or relative values internationally within the domestic model. The problem with this is more obvious when looking at many African economies where growth rates have been very high for decades at a time but population growth has been greater and so per capita income has dropped. Also, labour intensive production without a banking system to distribute capital, and a legal system which defines ownership (and so allows assets to be valued and leveraged), hugely limits the possibility of movement to higher-tech production and increases in per capita income levels. Which leads me to;
> 
> 2) “Technology”. I know that in the context of an economic growth model "technology" is essentially the ability of a country/economy to combine inputs (labour and capital) to produce the optimum output but it's very hard to hold that thought and not drift back, however subconsciously, to thinking about technology at technological advancement.
> ...


 
Basically the model robustly predicts changes in output over time compared with other competing theories (see neoclassical endogenous growth theories).

The most important implication is that all the nonsense you see and hear about "promoting growth", "creating knowledge economies", all types of industry policies and attempts to "pick winners" from politicians, commentators and forum contributors amounts to ill informed drivel.

All you can do is make your economy open to technology and a free trade in all things and allow it to adjust its use of resources naturally and keep a minimal public sector footprint on the economy.

However, politicians and interest groups couldn't have that.

1) What you identify here is no flaw in the model. PErhaps you are thinking about the most simple Solow growth model. It has been found that a number of other factors can help determine output.

For example, corruption is a negative, as is civil disruption and violence, lack of well enforced property rights, laws etc. Your African examples all fail on those, while successful developing nations all pass on those.

An interesting one which often people find counter intuitive is that democratic forms of government are a negative. Benign dictatorship appears superior. By that I mean that, democracy follows development and prgression to first would levels of income, it does not lead. Again compare African democracies with less democratice countries like Malaysia or Indonesia, or China.

All in all the model is quite good in a predictive sense and tells us that you can't create growth in incomes and propsrity, you can only get in the way and retard it in some way or another:

*Something Irish governmetns have appeared adept at doing in the past and look like repeating now.*

2) Technology simply means the state of human thinking and enterprise at any point in time. Apart from a very small number of exceptions (e.g. monopoly patents, protects military secrets etc.) this is avaiable to be deployed anywhere in the world. Pretty much the same level of technical knowledge is avaiable to any geographical location in the world - there are no boundaries to human knowledge. It just is.


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