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Wednesday, August 19, 2009

Saving Is Killing the Economy?

In the midst of the current recession, many of the oldest fallacies in economics are making a comeback. In a column titled “Why Saving is Killing the Economy,” senior writer Chris Isidore repeats one of the oldest: that the key to economic recovery or growth is consumption and that saving retards that process. Isidore states that the increases in savings that accompanied the onset of the recession might make sense to each individual household but are collectively problematic “when what the economy needs most is for consumers to be spending more freely.”

But the view that consumption is “stimulative” while saving is harmful is almost the exact opposite of the truth if the goal is to generate sustainable economic growth. Savings is what makes long-term growth possible. It just ain’t so that more consumption is what is needed in a recession.

An Incomplete View

This particular fallacy is essentially a version of the more general fallacy identified by Frédéric Bastiat in the nineteenth century: an inability or refusal to “see the unseen.” Consumption has easily observable effects on the economy. We see people spending on new cars or televisions, and we understand how that means larger profits for firms and more opportunities for employment. So it comes as no surprise that people would think that an increase in saving, defined as the portion of our income we do not devote to consumption, would be bad for the economy. If we are increasing our saving, we are presumably reducing our consumption, which means lower profits and fewer job opportunities in the places where we used to be spending those consumption dollars.

So far, the analysis is not necessarily wrong, just incomplete. A full analysis would then ask, “What happens to the portion of people’s income no longer being devoted to consumption?” What exactly do we mean by “saving?” If people are “saving” by simply increasing their holdings of currency (say under the storied mattress), then the critics have a point. Those resources are being withdrawn from the larger economy, and to that degree they will reduce conventional measures of economic well-being. Of course, those increased currency holdings will improve the well-being of their owner, as he or she is now holding wealth in the preferred form of currency.

This isn’t how it usually goes, though. Most saving takes the form of financial instruments, including everything from basic checking accounts to the fanciest investment tools. If people are keeping higher checking account balances or putting more in savings accounts or money market mutual funds, then that wealth is not withdrawn from the economy. It is simply channeled elsewhere than into consumer goods. Financial institutions that accept such deposits lend them to customers who invest in their businesses. This is the process of creating the capital that is the sine qua non of sustainable, long-term economic growth.

In Bastiat’s terms, we see the lost expenditures at the retail store, but we mostly don’t see the “backdoor” way the savings are channeled to other businesses. More precisely, an increase in the savings rate represents a change in consumers’ time preferences: They are saying they are less interested in current consumption and more interested in future consumption. The beauty of financial markets is that they translate that change in preferences into a change in the flow of resources. Those investments will take time to become consumption goods, but that’s what consumers want.

Saving Creates Growth

So contrary to Isidore’s arguments, restricting consumption does not hamper economic growth. In the long run, economic growth requires saving and the creation of new capital goods.

For savings to contribute to growth this way, financial intermediaries must function properly. The fallacy that increases in saving will frustrate growth finds its most recent theoretical statement in Keynes, particularly in his assumption that the financial system cannot translate savings into investment. In contrast to the classical and Austrian economists, who believed that interest rates would coordinate the supply of savings and the demand for investible funds, Keynes argued that saving was a function of income, and investment was driven by the “animal spirits”—that is, people’s psychology and expectations. As a result, there was no reason to think that increases in saving would make their way back into the economy as investment. Indeed, savings was a “leakage” from the expenditure stream made up of consumption, investment, and government spending.

But Keynes was wrong about how markets, especially financial markets, work—at least when they are left to themselves. As Isidore’s article points out, if banks are reluctant to lend out the funds that savers are supplying, increases in saving will not get translated into investment spending. He argues that is precisely what is happening right now.

If true, the fault lies not with the saving habits of the public, but with whatever is causing the banks to hesitate. Blaming the public for “saving too much” is wrong, as Isidore himself notes in claiming that “a high savings rate is not a bad thing for the economy.” The problem, he argues, is people doing it now when banks won’t lend. Why then are banks reluctant to lend?

One answer is that at the onset of the crisis the Federal Reserve System decided to pay interest on the reserves banks hold in their accounts at the Fed. Combined with very low rates of return on other assets, this made sitting on both the public’s increased savings and the Fed’s newly injected reserves a better choice than lending.

Moreover, the combination of bailouts, quasi-nationalizations, and policy zig-zagging might be making lenders more uncertain about the future and less likely to lend. What economic historian Robert Higgs has termed “regime uncertainty” was responsible for the length of the Great Depression and might be a key reason why banks might lend less than in the recent past. Isidore and others never consider that, in the words of economist Roger Koppl, “Keynesian policies can create a Keynesian world”—that is, bad policy can break the link between savings and investment. In any case, blaming the savers misses the real problem.

And there might not be a problem anyway: A number of economists have disputed the claim that banks have stopped lending. Even at the height of the crisis in October, economists at the Minnesota Fed found no evidence that banks had stopped lending to individuals or nonbank entities. More recent data from the winter show that while the rate of lending growth had slowed, the total quantity of loans to individuals and firms was steady, if not growing slightly. So theory aside, the empirical reality since September does not support the claim that savings is counterproductive.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.