This post is the third in a series of articles that explains the new economic theory I proposed in Five Short Blasts. If you haven’t read the previous articles yet, just go to “The Theory Explained” category of this web site. This series of articles will be archived there in reverse chronological order. Just scroll down to find the beginning of the series.
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In Part 2, we debunked the myth that improvements in productivity drive incomes higher. Instead, we found that it is only a growing demand for labor (growing faster than the supply) that will drive incomes higher. What’s critical is that per capita consumption keep pace with productivity (which is per capita output). Otherwise, wages will begin to decline and unemployment and poverty will rise, resulting in a declining standard of living. I closed Part 2 by claiming that there is something at work in the economy that is doing just that – driving down per capita consumption.
Actually, there are three constraints on per capita consumption:
1. First of all, income is obviously a constraint. You can’t consume more than you can afford to buy. Well, not for long, at least. You can borrow money and consume beyond your income, but that’ll catch up with you at some point. Anything that tends to reduce incomes or creates the perception of having less money to spend will tend to drive down per capita consumption.
It’s this constraint that gets all of economists’ attention. They use macroeconomic measures to determine our overall ability to consume – measurements like store sales, total consumer spending and so on. If these start to lag, the Federal Reserve will lower interest rates to boost your perception of how much money you have to spend.
2. A second constraint is resources. We’re beginning to see this with oil. The world is starting to run short; prices are rising and people are forced to cut back on their driving, reducing the per capita consumption of oil in the U.S. Economists recognize this constraint but pay it no mind. They shrug it off with the assertion that market forces will drive higher efficiency, recycling and substitution to off-set the shortage. Why are they so glib about resource shortages? Because an economist named Malthus raised alarm about this very issue over 200 years ago. But when crop yield grew even faster than the population, he was mocked as a sort of “Chicken Little,” and his theory led others to dub economics “the dismal science.” In spite of the fact that Malthus was not wrong, but merely ahead of his time, anyone who dares to suggest that resource shortages could become a problem is immediately branded a “Malthusian” and dismissed by economists.
3. There is a third constraint which no one recognizes, and it is this constraint which is at the heart of the theory I’ve presented in Five Short Blasts. That constraint is space – the finite, inhabitable land space available, whether in a country, a continent or the earth as a whole. You’re probably wondering how that could possibly be a constraint on per capita consumption. The best way to illustrate this may be to use a hypothetical example.
Picture in your mind one relatively large island in a world that is otherwise covered by sea. And let’s say that half of this island is available for housing for its citizens. The other half is used for farm land, mining, parks, infrastructure and so on. When this island is relatively sparsely inhabited, each family, on average, lives in a 2,000 square foot single-story house on a 1/4-acre lot. On average, each homeowner has a two-car garage and his/her family owns two cars. Each has an assortment of gardening tools for maintaining their lawns, shrubs and gardens. Some have larger, houses, more cars and bigger lots. Some smaller and less. But, on average – in other words, in per capita terms (the number of things owned per person) – this is the way it works out. Also, on average, each family consists of four people and one of them is a worker, providing the family’s income.
Over the course of many years, the population of this island rises to the point where the land available for housing, 50% of the island, is now fully occupied. But still the population grows. No problem. The average lot size, at 1/4 acre, is relatively large. Developers find that they can build the same size houses on smaller lots. The smaller lot sizes actually make the homes more affordable. But what happens to the consumption of gardening tools? Some people have started buying less, because they don’t need as much for their small lots. So, although total sales still grow, in per capita terms a slow decline has begun.
As population growth continues further, even the smaller lot approach becomes unsustainable. Another developer comes up with a brilliant solution – stack the houses vertically! Everyone can still have 2,000 square foot homes, but now some live in apartment buildings. Although the apartment owners are only allotted one parking spot each, the elimination of yard work altogether is a counter-balancing selling feature.
So the per capita consumption of gardening equipment declines further. And now the per capita consumption of cars has begun to decline as well. And consider this: although the square footage of homes remains unchanged, what has happened to the per capita consumption of building materials required to construct them? For example, with several homes now under one roof, the per capita consumption of roofing materials has gone into decline. So too has the per capita consumption of concrete and rebar used in the foundation. And, eventually, as the population grows more, the apartment sizes are getting smaller. Now the per capita consumption of everything used to build and furnish housing is in decline.
And think beyond the homes and cars. As this island became more densely populated, the per capita consumption of infrastructure like roads, pipelines, transmission lines and power lines also declined. So too has the per capita consumption of playground equipment and fencing in the parks. And once all of the boat slips in the marinas were filled, the per capita consumption of boats declined too.
At the same time that per capita consumption is declining across the board on this island, the per capita contribution to the labor force remains the same – one out of four people. The productivity of the workers on this island has remained the same or improved. That, coupled with declining per capita consumption, means that the demand for labor is falling. This falling per capita consumption, in the face of steady or rising productivity, is rapidly driving up unemployment and poverty. Voters’ approval rating of the government of this island is slipping.
Now, let’s step back and look at the situation on this island from two different perspectives: as seen through the eyes of the CEO of the company that builds cars on this island, and as seen through the eyes of one of his auto workers. The CEO sees that, as the population grew, car sales rose proportionately. At some point, though, the growth in sales slowed – continuing to rise, but not at the same rate. Nevertheless, sales are still rising and the CEO is quite pleased.
What the auto worker sees is that, thanks to rising productivity, employment in the car company held steady while sales volume continued to rise. In spite of this productivity improvement, the company began cutting wages and benefits. Why? Because, for some strange reason, unemployment was on the rise and, with surplus workers in the labor market, the competition for jobs at the car company was growing more intense. With unemployed workers willing to take jobs at the car company for less pay (some pay is better than none, after all), this is putting downward pressure on wages.
Finally, let’s view this situation from the perspective of an economist working for the government. What you see is that, despite total growth in GDP on this island, unemployment is one the rise. You consult with the CEOs of various companies, including the car company, and all tell you the same thing: “We need more growth!” Remember, as an economist, you don’t measure or study per capita consumption and have no reason to think that it might be declining. Your training tells you that, to stimulate growth, you need to pump more liquidity into the economy. You need to lower interest rates and make more money available for lending. And a little more population growth would help too. And, in fact, this may actually work for a while. But the problem keeps coming back. So you lower interest rates further and get more creative with lending standards. And the government offers job retraining programs to unemployed workers.
This all sounds quite familiar, doesn’t it? In Part 4, we’ll leave behind this once-idyllic hypothetical world, return to the 21st century on planet Earth, and see how this same situation may be playing out here.