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Murray Rothbard, in 'America's Great Depression' said:

In short, what can help a depression is not more consumption, but, on the contrary, less consumption and more savings (and, concomitantly, more investment).

We hear a lot about the need to encourage saving. This was relevant to our situation five years ago, but right now that thinking is positively dangerous. Now we need to sustain a fragile recovery, while global stimulus is reduced.

Some, like Rothbard, think that investment and saving are always equal, so increased saving will mean greater investment. This is a popular view, but totally misunderstands the real relationship between saving and investment.

To get a better understanding, you have to dig deeper. When you do that, you discover that you can't create investment by saving. In fact, attempts at saving will reduce investment. To understand why, you have to understand what saving really is.

The True Meaning of Saving

If we use their commonly understood meanings, saving does NOT equal investment. That's to say, what goes in to saving accounts does NOT equal investments in things like manufacturing plants or new software. Saving only equals investment for economists, because of the way we its defined.

In economic terms, saving is “income not consumed.” For you as an individual, that means that you “save” as soon as you get your wages. Later, you may spend your wages on consumption. When you do, you will reduce your saving. But at the moment that you receive your wages, you save. Likewise, a business “saves” as soon as it receives revenue.

That means that a lot of saving is simply transferred between us and nets out to zero. You save when you receive your wages, but your employer reduces saving (dissaves) the same amount. The same happens when you consume. When you buy a movie ticket, you dissave, but the movie theater saves the same amount.

Note that none of this “saving” means that anything has to end up in a savings account. If it does, for example if you deposit $100 in your savings account, you have not actually increased your saving in economic terms. All that you have done is to swap one kind of saving for another. You made the saving when you received the income. Until you spend it on consumption, it remains your saving.

Why Saving Really Equals Investment

The only reason that saving equals investment, is because only investment creates saving. Let me say that again, only investment creates saving. It works like this.

In the example above when you bought a movie ticket, you dissaved because you were spending on consumption. When the spending relates to investment, there is no dissaving. Let's imagine that A Inc. invests in new software from B Inc. What happens at A is that, instead of reducing saving by charging the cost against income, an asset is created on their balance sheet. This increase in asset value represents an increase in investment. Meanwhile, A's spending represents income for B, so B's saving is increased. This gives us an increase in both saving and investment. An increase in investment at A is matched by an increase in saving at B. Investment has created saving.

The bad news is that it only works this way round. You can not create investment by saving. No amount of saving, will cause any investment. Actually, it's even worse than that. If you and millions of others stop consuming, then the companies that sell to you will stop investing. If they stop investing, then they will stop creating savings, because only investment creates saving. Ironically, your attempt to stop consuming and save, has prevented an increase in saving. It's the paradox of thrift.

Worse even than that, you can not create net saving by saving. You can not increase net saving through individual attempts at saving. If one individual attempts to save more, it necessarily reduces saving somewhere else. For example, if you save on your movie ticket, the movie theater just saves less. Their income is reduced, so their saving is also.

Because of this, the final nail in the coffin is that you can not even influence investment by saving. People like Rothbard believed that if we increased saving, that would “concomitantly” mean more investment. That's false. The causality is the other way round. Others also believe that if we encourage more saving, interest rates will fall and that will facilitate investment. But as we've seen, you can't even create net saving by saving. At best, one individual's saving will be canceled out by another's dissaving. At worst, the fall in consumption demand will lead to reductions in investment.

The Danger for the Recovery

Austrian economists and others, misunderstand the causality in saving and investment. Their misunderstanding leads to a focus on increasing saving. This is misguided and potentially disastrous.

Calls to increase saving lead to reductions in consumption. This means lower corporate profits, less investment and so back to less saving. This could be the downward spiral to the next Great Depression.

Instead, we need to focus on two things: increasing investment and reducing the trade deficit. That is the key to a sustained recovery. Only by increasing investment can we increase saving and create a virtuous circle. Reducing the trade deficit is also vital because otherwise, the benefits of our investment are felt by other countries and not us.

To encourage productive investment, we have to create the right investment climate. In the past I have chosen to invest outside of the US. All around me, I see evidence that others have chosen to do the same. We need to change that. That's partly to do with regulation and a lot to do with competitiveness. Competitiveness is also the key issue for our balance of trade.

That outlook leads to a policy mix of low interest rates, moderate inflation and a lower dollar. That would not be pain free, but it's what we need. It would give us lower unemployment, increasing GDP, good corporate earnings and a strong stock market.

Disclosure: Author long stocks

Source: Would Attempts to Increase Saving Damage Recovery?