Theories of the trade cycle

Consumer spending is (finally) slowing in the UK, according to an article today in The Times.

The article indirectly references two theories of the economic cycle: inventories (stocks) and the interplay between consumption and investment via the multiplier.

City economists pointed to the scale of the slowdown in consumer demand as a further omen that a severe downturn probably lies ahead, perhaps the worst since the last recession in the early Nineties. “Consumption looks like it hit the wall,” Alan Clarke, of BNP Paribas, said.

The vulnerability of the economy to a setback… was underlined by fourth-quarter growth having depended so heavily on accumulating stocks, economists cautioned. The huge £3.1 billion Q4 rise in stocks shown by the official data was the biggest since 1988 and accounted for a fifth of growth in the quarter. Over 2007 as a whole, estimated growth in stocks was the biggest since 1973, according to the estimates.

Once stocks begin to accumulate in the supply chain as demand falls, retailers, wholesalers and producers cut orders drastically in turn.

December output in the retail and wholesale industries fell by 1.4 per cent, from hotels and restaurants by 1.3 per cent, in transport by 1.2 per cent, in post and telecoms by 2.1 per cent, and in the financial sector by 1.2 per cent, the data showed.

More up-to-date official figures on the service sector for December alone suggested that it endured a brutal month in which its activity collapsed, with output dropping by 0.5 per cent in its worst performance since June 2002.

This 0.5% fall in demand for services will be magnified back through the supply chain (services as well as physical goods depend on supplies) and job losses could be inevitable - and a serious slowdown can result.

Investment data, too, gives cause for concern.

Consumer spending in the fourth quarter (Q4) rose by a meagre 0.2 per cent, less than a third of the pace in the previous three months and the weakest since the autumn of 2006.

With the final quarter’s business investment also tumbling by 0.5 per cent, total domestic demand - spending across the economy by consumers, companies and the public sector - eked out a gain of only 0.3 per cent, its weakest for 2 years.

The multiplier-accelerator model proposes that investment behaves with greater volatility than consumption. Consumption is linked to income, but investment is linked to economic growth (changes in income). Since the rate of economic growth is more volatile than the level of national income, changes in investment are subject to an accelerator effect, magnifying changes in aggregate demand which in turn affecting consumption.

Households, after all, have basic needs which have to be met (autonomous consumption) whereas firms have greater choice over whether to invest or not. This is reflected in the data: consumption is slowing whilst investment is falling. In theory, this fall in investment then feeds into even slower (or negative) growth consumption via the multiplier effect.

A third theory of the cycle stresses the importance of exogenous shocks. At the moment you can take your pick of external factors: rising oil prices, food price inflation, financial crises, rising metal prices, inflation in NICs…..