Sunday, July 13, 2014

Money Myth 11: We must save more to restore our economy

It seems so right doesn't it? Fiscal responsibility. Working hard. Saving. If only everyone would do it then they would all prosper and our economy would get back on it's feet. (Some even go so far as saying that reason the poor are poor is that they simply lack these qualities). 

Like so many of our money myths, the basis of this viewpoint hearkens back to the gold standard days. The general idea is as follows:

  • productivity creates an excess (e.g. the farmer/business sells more than is needed to pay bills and satisfy wants/needs);
  • this excess leads to savings (i.e. in money/gold);
  • these savings create a pool of funds which can be drawn upon for investment;
  • investment in capital goods increases productivity again (e.g. farmer buys new combine harvester; business upgrades to robotic assembly).

Now don't misunderstand the point - of course saving, hard work, and fiscal responsibility are good things for the individual or business. However, looking for them to save our economy is a problem. There are two flaws with this understanding:

  1. We don’t need savings in order to invest: in modern economies, most investment is done via credit, not savings;
  2. When everyone saves, the economy suffers: for every person that spends less than their income (saves) someone else has to spend more than their income to make up the difference (dis-save, add debt, government runs deficits), otherwise the economy contracts.

FACT 1: Investment creates savings, not the other way around.

How? When a bank finances an investment, the bank takes the promise of repayment as its asset and simultaneously credits a bank account with newly created money (literally numbers in a computer). No savings or existing deposits were needed to fund this investment.

Credit is based on the ability to pay (banks call this underwriting). If creditworthiness exists, loans are granted. When a loan is granted the bank makes a deposit in the borrower’s bank account (or the borrower may directly purchase something so the credit is to the seller’s bank account).

There is NO pool of savings needed to fund most investments (although some savings are needed for down payments or to maintain equity ratios). However, when investment occurs, a new financial asset has been created out of thin air and a new real asset has been purchased or constructed.

Why does this matter?
Loans create deposits. Contrary to popular belief, lending is never constrained by deposits or pools of money saved (or bank reserves). Banks can and will always lend if there is an ability to pay and an opportunity for profit. Businesses borrow and invest when they see a forecast of increasing demand for their goods and services. Consumers borrow when they are confident their income will be sustained long term so they can make their loan payments.

Lowering interest rates when there is no spending/demand (i.e. insufficient employment & incomes) doesn’t lead to investment nor does it stimulate the economy, yet this is what the central bank keeps trying to do. This was the lesson of the Great Depression and it is a lesson for central banks today. Both then and now we have low interest rates but low investment and high unemployment. Monetary policy (managing interest rates and buying/selling government bonds) can’t do the trick.

As long as our collective desire to save is high, fiscal policy is needed to fill the gap in demand (lowering taxes and/or increasing spending so the private sector has more capacity to spend while also saving). Perhaps one day we will also see significant dis-saving (households and businesses investing/spending their stores on money) which could also help restore growth, but we shouldn’t shrink back from using fiscal policy when it is needed.

FACT 2: Saving money is a classic example of the “fallacy of composition”: what may be good at the individual level isn’t necessarily good at the aggregate level. 

The only way everyone can save is if the government runs deficits or the balance of trade is positive.

Here’s why. All income is someone else’s expense. In order to make a profit, businesses must sell what they make for more than it costs to produce. If one person saves money, someone else has to “dis-save” or increase debt. If everyone seeks to save more, businesses (if you add them all up) will be collectively spending more money on wages than they receive from customers buying their goods and services. What will businesses do in this situation? Reduce production, cut costs, and lay off workers. The economy will contract.

Keynes called this the “paradox of thrift”. Collectively trying to save money will probably result is less overall saving because it will cause the economy to shrink, incomes to fall (or go away via unemployment!), and reduced savings.

Is there any way we can all save? Yes! The government can run persistent and sufficient deficits to match the level of our collective savings desires so that the economy as a whole can save money without triggering a recession. And if such deficits were so directed as to increase employment and incomes then the resulting savings and benefits would be more broadly distributed rather than concentrate at the top.

If you’ve been paying attention, you will recognize that we just explained a critical shift in how we should understand government deficits and “debt”. They are exactly equal to the private sector net financial savings! The so-called national debt is actually a record of the amount of money we all desire to save … and that’s nothing to be afraid of.