Interest Rates Don't Equalize Savings and Investment

Savings and investment are flow variables in Keynesian models that are brought into balance by the interest rate so that the quantity of dollars saved is equal to the quantity of dollars invested, at any particular level of GDP. That is the orthodoxy and it is well received. It is also flatly wrong, I submit.

Consider sample households, some in the lower half of the income distribution and the others in the upper half. Let us look at how they typically dispose of their income these days. Households in the lower half spend most of their income on consumer goods and services, saving a portion usually to help pay off their debts. How much they save has little if anything to do with any interest rate, except perhaps the onerous ones being charged on a portion of their debt, e.g., credit card debt. These rates, in turn, have little to do with anything but opportunistic usury.

At the other end of the income distribution, the richer households have a lower average propensity to consume and put a much higher proportion of their income into secondary financial markets, also with little regard for interest rates. In fact, if stock prices are high and rising, with lowering returns, they are inclined to invest more in secondary markets in order to ride the trend.

The relationship between savings and interest is then turned on its head for a large portion of the GDP, given the skewed distribution of income in the country. Obviously, income much more determines the levels of savings than interest rates and by a very wide margin at both ends of the income distribution. But worse, savings can increase more, the faster and higher secondary asset prices rise and the lower is the return on them, at least within a broad range and for a lot of the time.

Alternatively, say both sets of households decided to save more in case the recession worsens, i.e., GDP and their incomes fall. Putting a portion of their incomes into bank savings accounts almost guarantees the money will not be loaned out for original investment in bad economic times. It will likely be used directly or indirectly for bank investments in the secondary financial markets as well. Again, interest rates or returns have little to do with it and the relationship can actually be turned on its head again. High and rising prices implying lower returns with even greater secondary market investments, of course, to a point.

The notion that an interest rate has any real bearing here is largely ludicrous. Indeed, moneys that might have been used for original investment are often diverted often into the secondary financial markets in ever larger quantities the lower is the interest rate and the faster financial asset prices are rising, exactly the opposite of what the Keynesian models suggest.

At least in a poor economy, original invest is minimal and substantially interest inelastic. Savings, on the other hand tends to increase as interest rates fall and financial asset prices rise. But is it any different in good economic times?

Original investment may well be higher and more interest elastic in good times, but savings can well have the same inverse relationship to interest rates noted above. There is no reason whatsoever to believe that interest rates will equalize the amount of money originally invested with that saved. None at all.

The Keynesian model supposes people save by either direct original investment or by putting their money in institutions that immediately do so and that they save more, the higher the interest rate. Those making original investments, on the other hand, consider carefully the return on that investment compared to the interest rate they must pay for the money to invest. That is, most simply, Y = C + S and S = I, where Y is income, C is consumption and I is investment. The interest rate equalizes I and S.

Only in these incredibly naive and rarefied circumstances, where everything else is equal, does the Keynesian model have any credibility at all in regard to savings and investment. Too much is patently ignored. Given the collateral affects on the economy of secondary markets (via wealth and other affects) and the impact on those markets of Fed and governmental policies, all savings not directed into original investment cannot simply be chalked up to hoarding. The situation is much more complicated than that, in both good times and bad. The equations above have to be opened up to the secondary financial markets. Once that occurs, trends in those markets and the manner in which they compromise those markets destroy the Keynesian models. See my articles here entitled Good Picks Can Be Clobbered by Trading Trends and How Trend Trading Compromises the Market for further background. Trends occur most of the time that secondary markets are rising or falling, that is, virtually all the time.,

Just as Says Law fails in regard to equalizing production and consumption, the same type of variability destroys any presumed equality of the amount saved and the amount originally invested, interest rates notwithstanding. This is largely rendered true given the existence huge of secondary financial markets, the amount of income going into them and, indeed, the typical inverse relationship between asset returns and the demand for them in those markets much of the time.

Comments

[bob adamson:]

Thank you again, Kimball, for an interesting article on a topic that would not likely appear now in SA if you hadn’t written it.

Much has changed since Lord Keynes wrote his General Theory in 1936. For advanced nations:
1. National economies were closed economies to a much greater degree than at present.
2. Large working class, servant and farm populations essentially consumed their earnings with little left over for savings, certainly savings on a year over year basis.
3. Communications technology and patterns were very different that they are now.
4. Consumer credit as we know it today was not a factor in the lives of the vast majority of people.
5. The rural and small town element formed a much larger portion of the population.
6. The shift from primary production and heavy industry to light industry and skilled and professional services geared to the individual consumer for non-essentials was just beginning to ramp up.
7. Even the very nature of what constitutes capital and capitalism was very different than at present.
8. The forms of money and money like instruments took were much fewer than at present and the means for transactions relating to money were slower, fewer and involved much smaller nominal amounts.
For most of Asia, the Middle East, Africa, Central and South America and Eastern Europe the facts of economic life were only beginning to shift from pre-industrial patterns. It followed that savings, hoarding and investment patterns, even in a uniquely advanced and urbanized country like the UK in the mid 1930s, depended upon a much smaller portion of the population (the urban middle and upper classes and their banks and businesses) and were, as your article suggests, much less complex (or at least very different) than at present.

In today’s economy marked by global and instantaneous shifts of money internationally, massive use of consumer credit across all classes, inclusion (or at least rapidly growing inclusion) of all classes and regions of the world in the money and credit economy and complex world wide financing, production, purchase and consumption patterns for many goods and services it is difficult to trace savings and investment correlations let alone determine whether savings equals investment (or are being brought into alignment by interest rate adjustments) in the sense that Keynes understood. In short, the relationship today of savings patterns to patterns of hoarding and investment is infinitely broader but more tightly interwoven than Keynes could have envisaged. This relationship today flows through time, space and social patterns that we, let alone him, dimly understand.

Mention is made of hoarding along with investment above because Keynes himself (and certainly many of those influenced by his work) recognized that, particularly at times of economic, social or political crisis, potential capital was simply left idle. He proposed that various combinations of fiscal and monetary policy be used to diminish hoarding and maintain or return the economy at full employment equilibrium assuming that ‘animal spirits’ (i.e. the entrepreneurial motive) then would efficiently cause investment to meet the demands of a well balanced and stable economy.

The question you ask, Kimball, is whether interest rate adjustment remains an effective tool in today’s environment (or was even so in the 1930s) to bring investment into equilibrium with savings. The rather long preamble above hopefully serves to illustrate that interest rate adjustment within one economy alone, even within an economy as large that of the US, will in this carry trade world be unlikely to achieve the desired balance. Coordinated adjustments of interest rates by central banks across the globe are an obvious modernization of the Keynesian approach that is being tried but, while there is a global economy that theoretically can be addressed today by such an approach, there are still significant national and regional needs that may run at cross current to the perceived needs of the global economy generally. In short, whatever its theoretical merits as a tool for balancing savings and investment, it has become very difficult and not very effective to manage an interest rate policy nationally of internationally for this purpose.

The real question now therefore is what tools are available.

Nov 11 02:20 PM

[Kimball Corson:]

Harvard_ trader. What can stop this bull market, you ask. Some really bad news for the longer run, coupled with much higher interest rates from an abandonment by the Fed of its policies of zero interest rates and quantitivative easing, along with a huge chorus of many bears arguing cogently why the market stinks, just might do it, but it is foolish to bet against this market now, even if you are a permabear. It pays to be trend friendly even if trend trading does damage operation of the market per se, as I have explained in a couple of recent articles I cite in the article above.

Nov 11 08:53 PM

[flow5:]

Keynes didn't make a distinction between financial intermediaries and commercial banks. I.e., there is a fundamental LEAKAGE in the national income accounting procedures S=I+(G-T):

In The General Theory of Interest, Employment & Money, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

I.e., In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. This is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Reg Q, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, etc.

I.e., "the utilization of bank credit to finance real investment or government deficits does not constitute a utilization of savings, since bank financing is accomplished through the creation of new money" see: LELAND J. PRITCHARD, Ph.D, Economics, Chicago, 1933, MS Statistics, Syracuse.

I.e., the collapse of the non-banks (financial intermediaries) is primarily responsible for the collapse in real-gdp & the high rates of unemployment and underemployment.

Nov 13 09:37 AM