The question has been one of the main drivers of economic thought for centuries.  And for centuries, governments have been getting the answer completely wrong and then undertaking actions that were ultimately detrimental.

Initially, it was believed that economic growth was a myth – that it was impossible for any one actor in the marketplace to experience a gain (profit) unless some other actor in the marketplace experienced a corresponding loss.  This misconception has been the basis for wrong-headed economic policies for hundreds of years.  It was, in fact, the basis for the non-capitalistic construction of mercantilism so completely exploded by Adam Smith’s “An Inquiry into the Nature and Causes of the Wealth of Nations”.

Sadly, this gross misperception refuses to die.  It is the cornerstone of beliefs behind modern protectionism, many variants of Christian socialism and the all-too-common fable that the wealth of the capitalistic West is nothing more than the stolen plunder of the third world at the expense of exploited workers.  That basic mathematics demonstrates such a conclusion to be absurd is merely written off as “capitalist propaganda”.  But simple logic demonstrates that the doctor who sets a broken leg for a fee has directly benefited the patient while generating income for himself.  Transactions do not take place unless each party to the transaction benefits.  Thus, the notion that someone must lose in order for someone else to “win” cannot survive the examination of any of the countless transactions that occur every day in a capitalist economy.

But the logical error regarding economic performance most relevant today is the myth that economic growth is overwhelmingly driven by … consumers.  It is the glaring misconception behind “stimulus” measures that endeavor to put “money in the hands of those who will spend it” and the same one that fuels the Keynesian and neo-Keynesian method of advocating government spending – such as extended unemployment insurance benefits and/or public projects – as a means of economic stimulus.  Such conclusions fly in the face of both logic and the empirical data indicating that such spending and “targeted” handouts have no stimulative effect whatsoever.

So where did this error come from?

Much of it stems from errors in assessing the size of the economy.  A common calculation used to determine economic strength is gross domestic product (GDP).  It is an attempt to assess the overall economic productivity of a country or nation-state over the course of a given time period – typically a year.  But it is impossible to correctly capture all of the disparate activities that take place in a dynamic economy in a single measure.  GDP is merely a flawed substitute for total economic strength even if it is the best measure we currently have available.

One of the major flaws with the GDP measure is that it includes government spending as a component comparable to that of private sector activities.  This tends to support the fallacy that economic growth can be stimulated or maintained by increased governmental expenditure.  But no allowance is then made for the difference in market driven spending to meet the needs of consumers which is overwhelmingly efficient and beneficial and spending by governmental mandate which rarely takes into account the needs of consumers and is, as a consequence, incredibly wasteful.  It is not spending, per se, that is economically advantageous, but rather investment in productive activities that creates wealth and prosperity in society.  As a matter of economic logic and historical evidence, the notion (most notably endorsed by Lord Keynes and pursued by the Roosevelt administration) that spending by the state generates wealth has been thoroughly discredited.

The second major flaw is methodological.  In an effort to avoid double-counting of wealth at various stages of production in the GDP calculation, intermediate goods and transitory capital goods are discounted in favor of final consumer goods.  While there is value in this methodology in determining a gross domestic product that does not count each stage of production and finished goods simultaneously, the shorthand method of avoiding a double count renders attempts to examine the components of the economy from a total GDP figure completely useless.  A commonly repeated fallacy is that consumer spending represents two-thirds of GDP, but that is only because the intermediate producer’s goods (which, arguably, are significantly more valuable) have been removed from the calculation.

Unfortunately, this belief in the primacy of the consumer in economic strength is behind efforts to “target” stimulus to those individuals most likely to spend whatever largesse the state dishes out.  No recourse to empirical data – such as the study of previous targeted expenditures – can dissuade the true believers from the defense of such methods because consumers are the most visible actors in the marketplace, so they must be the drivers.  But the fallacy of this position is the same.  One cannot spend oneself to prosperity either at the societal or the individual level.  In the absence of production, consumer action yields only scarcity and economic stagnation.

So who drives the economy?  Entrepreneurs.  Economists have understood this for decades but the general public reels.  How, it is asked, can a handful of big business types be of greater importance to the economy than all the “average Joes” buying goods and services?  The problem is that the function and definition of entrepreneurial action has been misunderstood.

Entrepreneurial action takes place whenever anyone in the marketplace, in anticipation of future demand, invests time, capital or resources in an attempt to meet those future needs.  It is not restricted to “big business” or even “business” at all in the sense of an incorporated entity.  The “average Joe” who undertakes action in the marketplace can be part of the entrepreneurial function.  Such action to meet future demands funnels capital to productive means increasing the demand for further inputs – more capital, other resources and labor.

This is the engine that creates jobs.  It is the entrepreneur who, in an effort to meet customer needs and improve his own situation, determines that those goals can be achieved by applying additional labor to his productive endeavors.  This is, in fact, the only activity that ultimately creates jobs.  Subsequently, this greater investment puts more resources in the hands of those “average Joes” in the form of “permanent” (in the relative sense) changes in their income stream and their supportable standard of living.  Attributing the driving force of the economy to the consumptive activities of the consumer simply fails to examine that which must happen first before the consumer activity can change.

Production – not consumption – yields economic growth.  It is the actions of the entrepreneur that drive the economy and it is only those policies that place more capital in the hands of those entrepreneurs – whether they be CEOs of Fortune 500 companies or small business owners or “average Joes” undertaking action to meet future consumer demand – that succeed in generating continued (or accelerated) economic growth.  Policies that ignore this dynamic – as politically popular as they may be – are doomed to inevitable failure.