Wednesday, March 04, 2009

Is Saving Money Bad for the Economy?

One of the things that I never understood about Keynsian economic theory is the issue of spending vs. saving. How's that for an obscure start to a blog post? These days you hear all about government economic stimuli and how the government needs to spend more money to offset declining spending in the private sector. Supposedly, us wretched members of the public are so concerned about our own economic fate that we are spending less and saving more (the savings rate hit 5% in January, up from virtually nil last summer). Government must pick up the slack and get the economy going again, or so the explanation goes. The theoretical economic basis for such government intervention was developed by influential 20th century economist John Maynard Keynes

However, I never understood how and why the fact that members of the public started saving more could be a bad thing. After all, when you save money it goes into a bank, which uses your money to lend to other people who in turn use the cash to invest or spend. Savings equal investment. Yes? I understood the supposed logic behind government stimulus, but I never understood why consumer retrenchment in the form of savings could actually cause an economic downturn.

Well, this weekend I listened to an episode of EconTalk which covered this exact question. This excellent weekly podcast consists of an hour long discussion between two economists, covering a different topic every week. It's an intelligent discussion - not exactly dumbed down, but the conversation is jargon free and largely accessible to anyone with even a basic grasp of subject matter. Consider it econ 101 on your iPod. Anyway, the episode I listened to covered the issue of Keynesian economics with guest Steve Fazzari (you can find it here). The host, Russ Roberts, asked Fazzari the question that has been on my mind all this time but which I never bothered to explore: how can it be that a higher rate of savings causes an economic slowdown? A 30 minute discussion ensued which essentially boiled down to this:

Consider John who eats out every work day at a local restaurant. If John decides to save more and bring a bagged lunch from home, he will reduce his spending by say, $5 a day. His savings will go up by $25 a week. However, the restaurant owner will see his income reduced by $25, and therefore will either need to reduce his own spending by $25 a week or else his savings will be reduced by the same amount. The fact that our protagonist decided to boost his savings by $25 did not raise the total savings in the economic system. All it did was move the savings from the restaurant owner to John. This is like conservation of energy applied to money... maybe we can call it conservation of savings? Since no more savings exist in the system, no more investment exists in the system. All that changed is that the restaurant owner is now seeing a lower income. Interesting...

I don't know if I fully grasp or buy this explanation, but I am very intrigued. I have been thinking about this idea for a couple of days, and it seems to hold water so far. I think I want to learn more about the subject.

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Anonymous said...

Of course, it's much more complicated to that, and the devil is in the details.

The restaurant owner would not have realized $25 in profit, so it is not an even trade. Now, assuming his costs are affected the same way, it may still equal out. But there are taxes as such to factor in as well.

I think the main thing is that there's a good chance that the business owner can make better use of the money than sticking it in a savings account. (Where "better" = "more economically useful".)

plonkee said...

This sort of thing always reminds me of the prisoner's dilemma.

I also understand that if everyone saves a lot all of a sudden, when the economy is expecting people to save then it's a problem. If only a few people do it, or it changes gradually then it's not an issue. Not an economist though, so not sure.

Joel said...

Here is where I think the logic fails. The US is not a self sustained economy. In fact a major part of our consumption goes to either manufacturing (i.e. China), energy (OPEC etc.) or raw materials (Russia, Brazil etc.).

So when we decide to spend our money on say a flat screen TV, only a fraction of the money stays in the US. That is how we exported our recession to China and the Middle East.

Now, in very short term, saving may cause some pain since it keeps the money in the hands of the haves (people who are cash positive) and out of the hands of the have nots (people who lost their minimum wage jobs at say a Circuit City) but long term, these saved funds will serve as one of two great uses:

* A cushion to prevent personal financial collapse if the saver looses his job (keeping him off welfare)

* A major purchase (such as home upgrade) once the recession fears ease.

Of course, there is the best kind of saving which this site prescribes to which putting the money in the stock market. This helps boost company value and may in itself help end the recession by creating a positive psychology.

Shadox said...

Ren - of course, the example I gave is simplified. Naturally, the restaurant owner would not have a 100% margin, but the logic holds if you take the entire supply chain into account (e.g. the waiters, the restaurant owner's suppliers etc.)

Plonkee - I think that parallel is a very good one. The best out come for each individual is to save, and to have the rest of the country continue to spend...

Joel - there is no doubt that saving more helps an individual saver.

As you point out, this recession is global, and I do think that you have a valid point about exporting much of any dollar we spend.

Thanks for the comments guys.

Dana said...

Saving should be a rational reflection of one's ability to do so, subjected to the cost and constraints of current versus future consumption, and also the underlying social welfare structures that either support or discourage you from saving.

Some Asian countries have high saving rates because there's little social safety net. This tradition becomes manifested in the mentality of those cultures over several generations, and somehow, they are known as natural savers.

Germany, France, and a number of European countries also have relatively higher saving rates. But those economies don't go on spending sprees, why is that? Perhaps it's because of the lack of credit creation from thin air, and that people simply cannot get credit to spend what they don't have. But given the chance: the liquidity, the flashy cars, the crazy houses, they would never trade future prosperity for instant pleasures, right?

I don't believe that's true. The same way that I don't believe Americans are natural spendthrifts. Easy credits, media cheer-leading, unscrupulous business practices have equal parts to play in how America got to where it is now. Not just America. What about Iceland and Ireland?

Japan couldn't seem to open its purse string (even before this recession hit) because there was no indication that the fundamental problems of the economy were fixed. By not spending on education, health care, and instead on building roads and bridges, the Japanese sorely lack the confidence needed to go back to its somewhat conspicuous spending days (not to say that's the aspiration here, but ...).

So back to the question of saving and how much, or little, America should do to find that equilibrium. I think that balance will come when the debts are paid down, liquidity is restored, housing prices have come down to a sane level, and people generally believe there is sustainable social security and medicare. Before those problems start to patch up, any bullishness might be sectoral, purely temporary, or government propped.