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Wednesday, November 24, 2010

Does Saving Reduce GDP?

Warren C. Gibson’s article, “GDP: Who Needs It?” in the May 2010 edition of the Freeman, asserts an inconsistency. He correctly denigrates the Keynesian notion of promoting consumption spending as a means of promoting GDP growth: “The predominance of consumption seems to have spawned the bizarre notion that if we can only get consumer spending up, GDP will rise and everything will be fine” (p. 28, my italics). Two sentences after this statement he asserts an erroneous claim: “If people believe they need to save more they will have to forgo some present consumption, and this may lower GDP temporarily. Savings, wisely invested, boost future consumption. But the future may not arrive until after the next election” (p. 28, my italics).

Why would increased saving reduce GDP? Saving, correctly understood or defined, is the acquisition of interest- or dividend-earning financial assets, such as bank deposits, certificates of deposit, mutual fund shares, bonds, and stocks. Thus saving is not cash hoarding but the transfer of funds from income earners to borrowers who spend the funds. Savings are the source of loanable capital sought by businesses, as Adam Smith in the Wealth of Nations well explains: “By what a frugal man saves, he not only affords maintenance to an additional number of productive hands, but like the founder of a public workhouse, he establishes as it were a perpetual fund for the maintenance of an equal number in times to come.” Also, “Capitals are increased by parsimony. . . . Whatever a person saves from his revenue he adds to his capital, and either employs it himself in maintaining an additional number of productive hands or enables some other person to do so, by lending it to him for an interest, that is, for a share of the profits.” Indeed, increased savings make increased borrowing at lower interest rates possible.

In his concluding paragraph, Gibson also quotes an explanation from Ludwig von Mises that is in accord with Smith’s argument and in contradiction to his earlier income-lowering claim: “There is but one means to improve the material well-being of men, viz., to accelerate the increase in capital accumulation as against population.” Gibson goes on to state: “Capital accumulation requires saving, saving requires confidence. . . .” I think he needs to acknowledge the error of attributing an income-lowering effect to savings or else explain the contradiction in the two paragraphs. We cannot get rid of the Keynesian nonsense that increased saving causes poverty—the so-called paradox-of-thrift proposition—by continuing to employ Keynes’s misconceived definition of saving to mean cash hoarding.

James C. W. Ahiakpor
Professor of economics, California State University, East Bay

Warren Gibson replies:

Professor Ahiakpor quite reasonably questions my assertion that an increase in saving could temporarily suppress GDP. I lacked the space (and inclination) to explain this assertion in the article, but here it is: I agree with him that savings are invested in real assets, and I am willing to stipulate no growth in cash balances. And of course new investments do add to GDP. So it looks like a wash: some consumption is simply shifted to capital goods. But I suggest that if we consider the time structure of production we see a difference. Capital goods are priced at the estimated discounted value of the final products they are intended to produce, and because of this discounting the present value of new investments could well be lower than the consumption goods they replace. Only in the fullness of time will the productivity of the new capital work its way down to consumption, at which time we would expect increased GDP, other things being equal.

  • James Ahiakpor is a Professor of Economics at California State University, East Bay. He received his Ph.D. in economics from the University of Toronto and he has taught at Saint Mary's University and the University of Ghana.

    He is a member of the FEE Faculty Network

  • Warren Gibson teaches engineering at Santa Clara University and economics at San Jose State University.