The Importance of the Propensity to Consume

Employment is a function of the expected consumption and the expected investment.

Consumption is, ceteris paribus, a function of net income, i.e. of net investment.

Net income = Consumption + Net investment 

An investment that withholds its actual spending is less favourable to consumption, and therefore to employment.

An example is a house which continues to be habitable until it is demolished.

Let us assume that:

• an annual rent is paid by the tenants.
• the landlord does not spend this money

This money is a drag on employment throughout the life of the house.

• This money suddenly becomes usable in a lump sum when the house has to be rebuilt.

In a stationary economy, all this might not be worth mentioning.

• This is because in each year, the depreciation of old houses would be exactly offset by the new houses built to replace those reaching the end of their lives in that year.

But such factors might be serious in a dynamic economy, especially after a lively burst of investment in long-term capital.

• In such cases, a large amount of investment money is set aside to eventually be used to replace capital equipment.
• Incomes cannot increase until such money is spent.

Thus sinking funds, etc. are provisions to pay for anticipated replacements.

• These tend to withdraw spending power from the consumer long before the actual replacements are done.
• They diminish the current effective demand
• They only increase it in the year in which the replacement is actually made.

If the effect of this is aggravated by “financial prudence”, i.e. by its being thought advisable to “write off” the initial cost more rapidly than the equipment actually wears out, the cumulative result may be very serious indeed. In the United States, for example, by 1929 the rapid capital expansion of the previous five years had led cumulatively to the setting up of sinking funds and depreciation allowances, in respect of plant which did not need replacement, on so huge a scale that an enormous volume of entirely new investment was required merely to absorb these financial provisions; and it became almost hopeless to find still more new investment on a sufficient scale to provide for such new saving as a wealthy community in full employment would be disposed to set aside.

This factor alone was probably sufficient to cause a slump.

“Financial prudence” of this kind was continued to be exercised throughout the slump by those great corporations which were still in a position to afford it, it offered a serious obstacle to early recovery.

In Great Britain at the present time (1935), the substantial amount of house-building and of other new investments since the war has led to an amount of sinking funds being set up much in excess of any present requirements for expenditure on repairs and renewals. This tendency which has been accentuated, where the investment has been made by local authorities and public boards, by the principles of “sound” finance which often require sinking funds sufficient to write off the initial cost some time before replacement will actually fall due.

This results that even if private individuals were ready to spend the whole of their net incomes it would be a severe task to restore full employment in the face of this heavy volume of statutory provision by public and semi-public authorities, entirely associated from any corresponding new investment.

The sinking funds of local authorities now stand, I think,[4] at an annual figure of more than half the amount which these authorities are spending on the whole of their new developments.[5]

Yet it is not certain that the Ministry of Health are aware, when they insist on stiff sinking funds by local authorities, how much they may be aggravating the problem of unemployment.

In the case of advances by Building Societies to help an individual to build his own house, the desire to be clear of debt more rapidly than the house actually deteriorates may stimulate the house-owner to save more than he otherwise would; — though this factor should be classified, perhaps, as diminishing the propensity to consume directly rather than through its effect on net income.

In actual figures, repayments of mortgages advanced by Building Societies, which amounted to £24,000,000 in 1925, had risen to £68,000,000 by 1933, as compared with new advances of £103,000,000; and to-day the repayments are probably still higher.

That it is investment, rather than net investment, which emerges from the statistics of output, is brought out forcibly and naturally in Mr. Colin Clark’s National Income, 1924-1931. He also shows what a large proportion depreciation, etc., normally bears to the value of investment.

For example, he estimates that in Great Britain, over the years 1928-1931,[6] the investment and the net investment were as follows, though his gross investment is probably somewhat greater than my investment, inasmuch as it may include a part of user cost, and it is not clear how closely his “net investment” corresponds to my definition of this term= (£ million)

1928 1929 1930 1931 Gross Investment-Output 791 731 620 482 “Value of physical wasting of old capital” 433 435 437 439 Net Investment 358 296 183 43

Mr. Kuznets has arrived at much the same conclusion in compiling the statistics of the Gross Capital Formation (as he calls what I call investments in the United States) 1919-1933.

The physical fact, to which the statistics of output correspond, is inevitably the gross, and not the net, investment. Mr. Kuznets has also discovered the difficulties in passing from gross investment to net investment. “The difficulty”, he writes, “of passing from gross to net capital formation, that is, the difficulty of correcting for the consumption of existing durable commodities, is not only in the lack of data. The very concept of annual consumption of commodities that last over a number of years suffers from ambiguity”*.

*These references are taken from a Bulletin (No. 52) of the National Bureau of Economic Research, giving preliminary results of Mr. Kuznets’ forthcoming book

He falls back, therefore, “on the assumption that the allowance for depreciation and depletion on the books of business firms describes correctly the volume of consumption of already existing’ finished durable goods used by business firms”. On the other hand, he attempts no deduction at all in respect of houses and other durable commodities in the hands of individuals. His very interesting results for the United States can be summarised as follows=

(Millions of Dollars) 1925 1926 1927 1928 1929 Gross capital formation (after allowing for net change in business inventories) 30,706 33,571 31,157 33,934 34,491 Entrepreneurs’ servicing, repairs, maintenance, depreciation and depletion 7,685 8,288 8,223 8,481 9,010 Net capital formation (on Mr. Kuznets’definition) 23,021 25,293 22,934 25,453 25,481

(Millions of Dollars) 1930 1931 1932 1933 Gross capital formation (after allowing for net change in business inventories) 27,538 19,721 7,780 14,879 Entrepreneurs’ servicing, repairs, maintenance, depreciation and depletion 8,502 7,623 6,543 8,204 Net capital formation (on Mr. Kuznets’ definition) 19,036 11,098 1,237 6,675

Several facts emerge with prominence from this table. Net capital formation was very steady over the quinquennium 1925-1929, with only a 10 per cent increase in the latter part of the upward movement.

The deduction for entrepreneurs’ repairs, maintenance, depreciation and depletion remained at a high figure even at the bottom of the slump. But Mr. Kuznets’ method must surely lead to too low an estimate of the annual increase in depreciation, etc.; for he puts the latter at less than 1 1/2 per cent per annum of the new net capital formation.

Above all, net capital formation suffered an appalling collapse after 1929, falling in 1932 to a figure no less than 95 per cent below the average of the quinquennium 1925-1929. The above is, to some extent, a digression. But it is important to emphasise the magnitude of the deduction which has to be made from the income of a society, which already possesses a large stock of capital, before we arrive at the net income which is ordinarily available for consumption. For if we overlook this, we may underestimate the heavy drag on the propensity to consume which exists even in conditions where the public is ready to consume a very large proportion of its net income.

Consumption is the sole end and object of all economic activity.

Opportunities for employment are necessarily limited by the extent of aggregate demand.

Aggregate demand can be derived only from present consumption or from present provision for future consumption.

The consumption for which we can profitably provide in advance cannot be pushed indefinitely into the future.

We cannot, as a community, provide for future consumption by financial expedients but only by current physical output.

In so far as our social and business organisation separates financial provision for the future from physical provision for the future so that efforts to secure the former do not necessarily carry the latter with them, financial prudence will be liable to diminish aggregate demand and thus impair well-being, as there are many examples to testify.

The greater, moreover, the consumption for which we have provided in advance, the more difficult it is to find something further to provide for in advance, and the greater our dependence on present consumption as a source of demand.

Yet the larger our incomes, the greater, unfortunately, is the margin between our incomes and our consumption.

So, failing some novel expedient, there only answer to the riddle is that there must be sufficient unemployment to keep us so poor that our consumption falls short of our income by no more than the equivalent of the physical provision for future consumption which it pays to produce to-day. Or look at the matter thus.

Consumption is satisfied partly by objects produced currently and partly by objects produced previously, i.e. by disinvestment. To the extent that consumption is satisfied by the latter, there is a contraction of current demand, since to that extent a part of current expenditure fails to find its way back as a part of net income.

Contrariwise whenever an object is produced within the period with a view to satisfying consumption subsequently, an expansion of current demand is set up.

All capital-investment sooner or later results in capital-disinvestment.

Thus, the problem of providing that new capital-investment shall always outrun capital-disinvestment sufficiently to fill the gap between net income and consumption.

This presents a problem which is increasingly difficult as capital increases.

New capital-investment can only take place in excess of current capital-disinvestment if future expenditure on consumption is expected to increase. Each time we secure today’s equilibrium by increased investment, we are aggravating the difficulty of securing equilibrium tomorrow.

A diminished propensity to consume today can only be accommodated to the public advantage if an increased propensity to consume is expected to exist some day.

Popular opinion seems only to be aware of this ultimate perplexity where public investment is concerned, as in the case of road-building and house-building.

It is commonly urged as an objection to schemes for raising employment by investment under the auspices of public authority that it is laying up trouble for the future.

“What will you do when you have built all the houses and roads and town halls needed?"

But it is not so easily understood that the same difficulty applies to private investment and to industrial expansion; particularly to the latter, since it is much easier to see an early satiation of the demand for new factories and plant which absorb individually but little money, than of the demand for dwelling-houses.

The obstacle to a clear understanding is, in these examples, much the same as in many academic discussions of capital, namely, an inadequate appreciation of the fact that capital is not a self-subsistent entity existing apart from consumption.

On the contrary, every weakening in the propensity to consume regarded as a permanent habit must weaken:

• the demand for capital
• the demand for consumption.