Sunday, September 11, 2011

Consumption and Investment

Over on The Coordination Problem, Steve Horwitz pointed to a post by Robert Higgs. The argument is that real consumption has "recovered," reaching the level of its previous peak. Real investment, on the other hand, remains well below its previous peak. Higgs takes this to be evidence for his view that "regime uncertainty" is causing inadequate investment and responsible for the recession.

However, in a growing economy, real consumption is increasing all the time. To say that real consumption has recovered to where it was four years ago tells us little. The key question is where real consumption stands relative to its previous growth path.

The diagram below shows that real consumption remains well below its growth path of Great Moderation from 1984 and 2007. While it is .8% above its previous peak in 2007, it is now nearly 12% below its previous growth path.

However, it is true that investment is especially depressed. The broad measure that Higgs reports, real gross domestic investment remains 21% below its peak in 2006 and 36% below its growth path of the Great Moderation.

This measure of investment, however, includes residential investment. Real nonresidential investment also remains 15.5% below its previous peak in 2007 and 19% below its trend from the Great Moderation.

Nonresidential investment is approximately $327 billion below trend. Real consumption expenditure is $1.26 trillion below trend.

According to the Congressional Budget Office, real GDP is $977 billion below potential. This suggests that a full return of consumption to trend is not possible. Will nonresidential investment return all the way to trend? Will it supplant part of residential investment, surpassing its previous trend so that the total moves towards its past trend? Or will real investment, either total or nonresidential, remain below trend so that real consumption will recover more?

I have no idea, and am content to allow market forces--adjustments in interest rates and preferences--determine the allocation of resources.
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