Sorry James Livingston, you need investment to create wealth

In yesterday’s New York Times, Rutgers historian James Livingston argued that private investment is not necessary to create wealth:

AS an economic historian who has been studying American capitalism for 35 years, I’m going to let you in on the best-kept secret of the last century: private investment — that is, using business profits to increase productivity and output — doesn’t actually drive economic growth. Consumer debt and government spending do. Private investment isn’t even necessary to promote growth.

This is not merely wrong—it is staggeringly, destructively wrong.

Living standards rise when new ideas are turned into goods and services that people want. You cannot have cars or televisions or smart phones without mines to harvest the raw materials, railways and ports to transport them, factories to transform them into components, and more factories to assemble the finished goods.

All of these elements in the production process require investment. Moreover, all those investments need to be replaced as the existing capital is worn down and as new technology is developed. Yet Livingston claimed that private investment is “unnecessary” for economic growth. Nothing could be further from the truth.

To support his case, he compared the growth in the level of real GDP per person with the change in the proportion of GDP devoted to private investment:

Between 1900 and 2000, real gross domestic product per capita (the output of goods and services per person) grew more than 600 percent. Meanwhile, net business investment declined 70 percent as a share of G.D.P.

The comparison has no meaning whatsoever. Livingston might as well have compared the world’s population with the price of the S&P 500.

A more interesting comparison would be the amount of money spent on private investment and personal consumption. It turns out that relationship has been stable and mean-reverting since the end of WWII:

Livingston also confused business investment with the accumulation of net corporate savings. This is a serious error. The large cash piles that the American corporate sector has hoarded in the past few years reflect the choice not to invest:

At least Livingston got one thing right: these savings “do not drive economic growth — they’re just restless sums of surplus capital, ready to flood speculative markets at home and abroad.” The solution, however, would be for companies to invest more rather than less.

But why should they? Without demand for their products, businesses have no reason to build out capacity. The last time American businesses went on an investment binge that ignored the needs of consumers at home and abroad (in the second half of the 1990s) they created a huge overhang of waste and debt that led to the downturn of the early 2000s. Right now, American households are maxed-out and foreigners are unwilling to import enough American products to make up the difference at current exchange rates.

Livingston’s advice for regular Americans is: “save less and spend more in the name of a better future.” Perhaps he does not know this, but household deficits have to be funded by surpluses elsewhere—like those hated corporate savings. He may also not be aware that American households, which have lost about $7 trillion in the past five years, have very good reasons for rebuilding their balance sheets and reducing their debt burdens. Moreover, we are in this unfortunate situation precisely because too many Americans borrowed like crazy in the 1990s and 2000s only to find that they were unable to pay it back.

Professor Livingston seems to be an accomplished intellectual historian. His economic analysis, however, leaves much to be desired.


About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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