How Savings and Investment Increase an Economy's Output

Everyone who has held a job and a bank account understands the potential benefit of postponing consumption today in order to enjoy greater consumption in the future. However, many people — if pressed — would explain this increase in saver’s income by an offsetting reduction in the income of a borrower in the economy.

This is certainly a possibility. For example, if Bill (the borrower) forgets his lunch money on Monday, he might ask his coworker Sally (the saver), “Can you lend me $10 and I’ll pay you back $11 tomorrow?”  If Sally agrees, then it is clear that her $1 in interest on the personal loan was paid out of Bill’s reduced income for that month. In other words, if Bill’s take-home pay that month were $5,000, then he would actually only have $4,999 to work with, because of his $1 expenditure in “buying a loan” from Sally. At the same time, if Sally’s normal paycheck were also $5,000, then this particular month she would actually have $5,001 to work with, after earning $1 in providing “lending services” to Bill.

In the scenario above, what basically happened is that Bill financed his consumption with an “advance” made by Sally. On the Monday morning is question, when Bill left his wallet at home, Sally had to have in her pocket enough spare cash to lend $10 to Bill. Perhaps this made her rearrange her planned spending that day, or perhaps it simply meant that Sally carried less cash in her own purse than she originally had desired. In any event, Sally provided a definite service to Bill. Given his mistake, both parties benefited. In a sense Bill’s total monthly consumption was lower, but he preferred having $1 less in order to obtain his usual $10 lunch on the particular Monday. There is nothing irrational or “uneconomical” about Bill’s decision to pay $1 for Sally’s loan.

Making loans so that borrowers can finance their present consumption (at the expense of future consumption) is certainly part of what happens in a market economy on a grand scheme; it constitutes a large portion of the credit card industry. However, you should not conclude that all savings and investments are of this nature. When we consider the lifetime savings plan (outlined in a previous section), there doesn’t need to be one or more borrowers who grow deeper in debt as the decades roll on. In fact, it is possible that every single person in a market economy provides for a comfortable retirement through saving and investment during his or her working career.

[This is a point worth pondering more. It is essential and its misunderstanding is the root cause of much of a lot of misery. To read more explanations about basic economics, make sure to read Robert Murphy’s book Lessons for the Young Economist — Ed.]

How is this possible? For every Sally who saves and earns ever-growing streams of interest income, doesn’t there have to be a Bill somewhere who borrows and pays ever-growing streams of income? Yes and no. The key is that the loans or investments can be made in productive enterprise, rather than simply being lent to an individual who increases his consumption in the present. Is the savings are channeled into expanding production (rather than merely financing consumption), then “total output” grows over time, in principle allowing every member of society to enjoy larger incomes.

In Lesson 12 we will go over the mechanics of credit card and debt more carefully, but for now we just need to understand that the big picture of what would happen if everyone in society suddenly decided to save a large fraction of his or her income. In order to save more, each person would cut back on consumption. That means people would spend less on fancy restaurant, sports cars, electronic gadgets, and designer clothes. At the same time, people would increase the amount of money they lent and invested in businesses, either directly (through buying corporate stock or bonds) or indirectly (by depositing the money with banks which then advanced loans to businesses).

These large swings in how people spent their incomes — diverting it away from consumption and toward investments — would ultimately steer workers and other resources out of the industries catering to immediate consumption, and toward industries catering to long-range production. For, example, high-end retail and jewelry stores would see their sales plummet, and they would lay off workers and cut back on their inventory. Fancy restaurant too would lay off workers and close down some of their locations.

The laid-off workers would look for jobs in other industries, and this extra compensation would push down wage rates in those sectors. At the lower wage rates, businesses in these other industries would be willing to hire displaced workers. Other resources besides laid-off workers would be redirected to new uses, as well. For example, the owners of now-vacant buildings (which used to house clothing stores and other retailers) would lower their asking price for rents, making it easier for other businesses to expand their operations by filling the buildings.

If we ignore the real-world disruptions that would occur during the transition, even a large and sudden increase in the savings rate wouldn’t affect “total spending.” It’s true that consumption spending would (initially) be much lower, but investment spending by businesses would be correspondingly higher. The total number of jobs (eventually) would also be the same, because the laid-off waiters and mall employees would now be working in factories producing drill presses and backhoe loaders.

The essential insight is that a sudden increase in savings allows the economy’s output to shift away from consumption goods and into capital goods. Just as Robinson Crusoe was able to enhance the power of his bare hand through the wise use of saving and investment — even though he had nobody to “lend to” on the island — so too can the whole population enhance each other’s labor productivity by channeling more resources into the production of machinery and tools. There is no “cheating” going on here; everyone’s income can grow larger over the years when everyone is more physically productive because of the growing stockpile of capital goods.

Regards,
Robert P. Murphy
Whiskey & Gunpowder

February 14, 2011