June 26, 2012

Frank Newman's Six Myths - #3: If everyone tries to save more, the nation will save more, and investment, GDP, and employment will increase

Charles Perrottet

Today we examine the third “myth” from Frank Newman’s book Six Myths That Are Holding Back America – the presumption that increased saving will drive increased investment.

Friedrich Hayek published an article titled the “Paradox of Saving” in 1929.  This concept was later popularized by John Maynard Keynes who discussed the “paradox of thrift”.  The paradox rests in the observation that, while saving by a single individual increases that individual’s wealth, if everyone in a nation increases their saving, this must necessarily decrease spending.  With less spending national output must decrease and there will be less demand for investment, lower GDP, and a decline in employment.  Current data illustrate this.  Personal Saving in the U.S. was 2.4% in 2007, but increased to 5.1% by 2009, while investment and employment plummeted.

The critical point here, however, is that “Savings,” as we understand them in everyday life (funds individual Americans hold in bank accounts or mattresses or other investment vehicles), are not the “Savings” as economists understand them in “National Accounts.” “Savings” at the national level corresponds to the following equation: governmental borrowing plus private investment must equal private savings plus foreign investment. In other words, “Savings” in the economic sense is a residual amount you get from subtracting foreign investment in the U.S. from the sum of government borrowing and private investment (by businesses).

It also helps to understand the difference between an individual’s “investment”, which is to take a financial interest in something, and “Investment” in the national accounts, which is private sector money spent on new productive assets such as equipment or buildings.  Saving is a decision to not spend so, at the national level, to increase saving means to reduce spending.

In summary, the only way for GDP and employment to grow is for spending to increase.  A decrease in spending (at the national level) does not and cannot cause increased investment.  The causality actually works in the opposite direction from the popular conception: investment opportunities create opportunities for saving, but saving does not automatically result in investment.  If there is one huge issue that cries out for a scenario planning approach, it is the macro-level future of this relationship between savings and investment: will spending in the economy as a whole come back anytime soon, and if so, where will it come from? If it does not come back, what happens then to the U.S. and the world? 

Next myth: “If the deficit is reduced, then national saving and investment will increase.”