If the economy doesn't grow, will it collapse?

An interesting question has been posed, mainly by pundits concerned with peak energy but also by economist and fund managers -- whether the economy will shrink dramatically if the economy does not offer the promise of growth. This subject or question can be rephrased in several ways, such as "if the economy doesn't grow, will it collapse?" or, as Bill Gross of PIMCO theorized in his August 2010 Investment Outlook "...Not only growth but capitalism itself depends on a growing population," as, Bill Gross states, that a growing population implies steady growth in consumer demand.

However, most articles on this topic state capitalism will collapse without higher demand in the future, without going into detail as to why. Why, in more depth, will shrinking demand -- and also importantly lower expectations of demand -- lead to dramatically lower GDP numbers? This is to say, why can't capitalism exist in a steady state (no growth)?

John Maynard Keynes would answer this question based on the relation of investment to consumption demand as components of GDP, as explained in Chapters 5 and 6 of his General Theory of Employment, Interest and Money. The largest component of GDP is consumer demand. In the US consumer demand ranges from a high 60% of total GDP to low 70%s of GDP. Investment ranges around 15% of GDP (the other parts of GDP according to GDP = C+ I + G +(E-I) are net exports and governmental spending, which total in the US approximately 15% of GDP).

The investment component of GDP is related to the consumption measure, in so far that businesses will not invest in new capital and equipment unless they expect a steadily increasing market (demand) for their products and services.

So, if the businesses expect future demand to be lower, they will dramatically cut back on investment - why would a business invest in more capacity if it doesn't expect to have higher sales? This means that the 15% of GDP represented by investment will drop significantly faster than the 70% of GDP represented by consumption. John Maynard Keynes referred to the attitude of businesses to invest famously as "animal spirits" -- this phrase was recently picked up by George Acklof and Robert Shiller in their book with the same title, published in 2009. (Keynes exact discussion of animal spirits argued for a non-rational contemplation of future investment, verses other schools of economics that argued that investment was rational, but for this purposes of this post, we will not go into detail on this, the discussion however is important for implications on the future equilibrium of aggregate demand and aggregate supply in terms of GDP)(and actually is a bit beyond the understanding of the author :).

A Malthusian version, where peak energy or peak food results in high prices and therefore lower consumption, would also impact future investment, and also carry a re-enforcing cycle between consumer demand and investment (however the details of the exact transmission mechanism from higher prices to investment could be different than expectations of lower demand from for example higher saving rates, which is not analyzed here, in so far peak energy would be a production issue, not at first a demand issue).

The relation between investment and consumer demand can be explained as a self-reinforcing cycle. We can see many examples of re-enforcing cycles in nature, such as theoretically higher temperatures, which melt snow caps, which then do not reflect as much solar radiation, which then leads to higher temperatures, which further melts snow caps etc (this is theoretically proposed by scientists such as the late Steven Schneider of Stanford University). In a GDP measure, lower consumption could reinforce a lower investment, which in turn could reinforce lower consumption, leading to a downward cycle which means significantly lower GDP at the final equilibrium.

The idea here is relevant in so far that sustained declines to consumer demand, from a declining population (in Bill Gross's concerns, outlined above) to lower levels of consumer credit, to deleveraging of consumer debt, to average declines in expenditures from declining capital gains from property, can all lead to significantly lower GDP than at first calculated based on reduction in demand, through the relationship of demand with investment.

The analysis appears to be supportive of emerging economies such as China and Brazil (at first glance) in which businesses are more confident of future demand, in terms of a positive, self-reinforcing cycle between consumer demand and investment by business. (both Petrobras and Vale of Brazil have announced record breaking investment budgets for 2011 and beyond, for example at over $US70Bn and $US20Bn, respectively).

However, the analysis does not initially (in the author's opinion) support slower growth economies that are deleveraging, such as many EU countries, and the US. Businesses in the US and certain countries in the EU may not be as confident of future demand increases, due to deleveraging of consumers in these countries, and other factors.

As a final note, this relation of demand and investment explains some rational of John Maynard Keynes insistence on governmental, stimulus spending, which would find its way, through Keynes' multiplier (which is incidentally currently being debated in the economics profession, in terms of its size and impact on the overall economy), which, in turn, would support demand and then support investment, as businesses would be more likely to invest in an expanding economy.