The Key To Future Economic Growth
How does a nation grow wealthier over time?
Of course, this question is debated in the field of economics. But I think economists often vastly overcomplicate the matter with all sorts of formulas, models, and theories that may or may not accord with the historical data. Assuming a nation has the fundamental factors of peace and stability, the rule of law, and a system of property rights, one economic factor in particular determines future growth:
Private saving is the engine of economic progress.
When a person lives under their means, consuming less than their income, savings are generated. Typically, the first step for small-dollar savers is to store these savings in some form of depositor institution — a bank, a credit union, a money market, etc. The depositor institutions compete for savers' money, typically offering interest-bearing accounts that coincide with their ultra-short term cost of debt.
These institutions then use those deposits (i.e. savings) to make loans out to home buyers, real estate investors or developers, or businesses, or to purchase securities such as mortgage-backed securities. For large-dollar savers, investment banks exist to act as a conduit between high net worth individuals and institutions and various investments, including but not limited to securities such as stocks and bonds.
In other words, depositor institutions take savers' money and lend it out to borrowers who will, in some form or fashion, use it to grow the economy.
Home buyers support the housing market, which also supports the builders, furniture makers, appliance manufacturers, and a host of other market actors. Commercial real estate investors free up capital for businesses to use for the tasks in which they specialize. Instead of devoting large sums of capital to real estate, they can sell their real estate to investors and devote that money to more useful enterprises. Businesses use loans to upgrade machinery, equipment, or software, to expand inventory, or to develop new products.
All of this, taken together, would be considered private investment. It is the use of funds for the purpose of acquiring capital, which is then used to increase output, efficiency, or productivity. And it started with ordinary workers spending less than they earn and depositing the remainder as savings.
Saving leads to investment, which leads to increased productivity and output capacity, which leads to more valuable workers, which leads to rising wages, which leads to increased consumption, which leads to GDP growth.
In The Wealth of Nations, Adam Smith wrote, "Whatever a person saves from his revenue he adds to his capital, and either employs it himself in maintaining an additional number of productive hands or enables some other person to do so, by lending it to him for an interest, that is, for a share of the profits."
One might scoff at this idea, asserting that since ~70% of GDP is based on consumption, a lower savings rate would lead to higher GDP. But this thinking is short-sighted. Saving less today may push GDP higher in the short term, but it will also leave consumers less able to spend in the future and also starve the market of investable funds for future growth. In other words, a lower savings rate may (or, as we'll see, may not) temporarily juice GDP growth, but it will diminish GDP growth in the long run.
Saving is the accumulation of resources, while consumption is the depletion of resources. Saving increases a nation's productive capacity, while consuming merely shifts money around between various market players.
Unfortunately, the contemporary fixation on GDP places all the emphasis on current economic activity, which is essentially what GDP measures, rather than future growth. GDP is largely agnostic on whether consumers will be in a position to spend more money tomorrow than they did today. The primary reason for this is because GDP essentially treats saving as negative and spending as positive, even if consumers are over-spending and investing nothing for the future.
Private savings, then, is the primary method of societal enrichment. It's how individuals and nations alike grow wealthier over time.
Historical data bears this thesis out.
Below, we can see the tight correlation between net saving as a percentage of gross national income (blue line) and the YoY change in real GDP (red line).
Gross national income is the total amount of money earned by American individuals and businesses, derived both domestically and internationally. Since savings are derived from income, not consumption, it makes sense to measure it against GNI rather than GDP. Of course, the two metrics are similar, but GNI is more expansive and thus acts as a reliable denominator.
As you can see, net saving and GDP growth have both fallen over time roughly in tandem.
Some object to comparing net savings to gross national income, arguing that depreciation has become more rapid for newer technologies in recent decades and thus has distorted the measurements. But it makes little difference. Gross saving as a percentage of GNI (blue line) has likewise fallen from an average of ~22% from 1947 to 1982 to an average of ~18% from 1983 to 2019.
We can see that the correlation between savings and GDP is extremely tight, whether one uses gross or net numbers.
We can see the same trend, beginning in the 1980s, in falling gross domestic savings as a percentage of GDP:
Source: The World Bank
Thus, the falling average GDP growth rate over the last 50 years or so is largely the story of a falling savings rate.
Imagine the virtuous chain of events beginning to weaken. What would happen when savings began to fall? Investment would likewise fall.
Indeed, that is what we see when we look at YoY percent changes of real net private domestic investment (blue line) compared to real GDP (red line):
Real net private domestic investment is the inflation-adjusted private sector investment made by Americans (not considering foreign investment in American assets) with depreciation factored out. A certain percentage of investment is carried out merely to replace old or faulty machinery, equipment, software, tools, or buildings. But this is not a net new investment in the economy; it merely replaces a depreciated investment that is now obsolete.
Real net private domestic investment takes out investment that is meant to replace depreciated assets to show only net new investment in the American economy. As you can see, it correlates quite closely with real GDP growth YoY.
Unfortunately, as a percentage of GDP, net domestic investment has declined significantly over the last half century, hitting 11% in the late 1960s but slumping below 4% since 2015.
Source: Atle Willems
The 5.3% average GDI-to-GDP since the Great Recession is a far cry from the 10.5% average enjoyed from 1956 to 1974. The early 80s seemed to be the crossover point from one trend to the other, with the late 1980s to late 1990s marking the period of steepest decline.
Not surprisingly, the change in trend for net investment occurred around the same time period as the change in trend for gross saving as a percentage of GNI: the late 1970s to early 1980s.
With the fall in investment came a fall in the growth of the capital stock. Notice, for instance, the difference between the average YoY growth of the period from 1940 to 1980 versus the tepid growth thereafter.
The next link in the chain is productivity. Are investment and productivity actually liked in the data?
Yes, they are. At least since the late 1990s, we can see that real net private domestic investment (red line) has correlated closely with the productivity growth of the private business sector (blue line):
Specifically, the above measurement of productivity is multifactor productivity, which combines labor and capital factors. Investment ultimately results in more efficient machines, equipment, software, etc., which in turn results in more effective workers. In other words, investment strongly affects productivity.
And what does productivity affect? Wages.
See, for instance, the correlation between YoY changes in private labor productivity (blue line) and median real wages for full-time employed workers (red line):
Broadly speaking, when labor productivity rises, real wages rise with it. When labor productivity falls, real wages fall as well. Sometimes there is a lag (such as in the early 1990s), while other times the shifts in productivity and wages occur in the same quarter.
Changes in wages affect spending. After all, you can't spend money you don't have (at least not indefinitely!). Hence we find, aside from a few anomalies, a fairly reliable connection between YoY percentage changes in real disposable personal income (blue line) and personal consumption expenditures (red line):
Saving leads to investment. Investment leads to increased productivity and output capacity. These lead to more valuable workers. More valuable workers command higher wages. Higher wages leads to more consumption. More consumption leads to higher GDP growth.
Thus, in the long run, personal saving (blue line) and GDP growth (red line) are positive correlated:
This is not merely my own conclusion. It's also the conclusion of St. Louis Fed researcher and economic advisor Daniel Thornton in a report titled "Personal Saving and Economic Growth." It turns out that, contrary to intuition, a higher savings rate actually correlates with both higher GDP growth several quarters out and also higher GDP in the current quarter.
"All correlations are positive," writes Thornton, "suggesting that a higher saving rate in the current quarter is associated with faster (not slower) economic growth in the current and next few quarters."
Quantitative Easing: A New Source of Private Savings
You might look at the personal saving rate and think that we've hit the low in savings and are back on the upswing.
Indeed, total net private savings has risen noticeably since the Great Recession:
This chart is probably the main reason that many financial pundits claim that we are in a "savings glut." If the trend in net private saving growth from 1970 through 2004 remained the same, the total amount of savings would be 62% lower today. The trend definitely changed during the last recession, around mid-2008.
The standard theory, which bears some merit, is that lower interest rates, stock yields, and real estate cap rates have driven investors to save more in order to keep their investment income stable. There is much to be said for this theory, but does it fully explain the explosion in net private savings? I don't think so. After all, aggregate Treasury yields have been steadily falling since the early 1980s. The trend isn't new.
What's new since 2008 is quantitative easing, the multi-trillion dollar expansion of the money supply used to grow the Federal Reserve's balance sheet with mortgage-backed securities and Treasuries. QE injected cash into the economy which was meant to trickle down into increased lending, consumption, and wages. Unfortunately, however, it mostly remained with recipient banks while boosting the prices of assets primarily owned by corporations and the wealthy.
(For more on this subject, see here.)
Below is the percentage YoY changes of net private savings for households and institutions (blue line) and central bank assets to GDP (red line), suggesting that the spike in private savings since the Great Recession is largely due to the digital money printing of QE:
Besides a few notable periods in the last two decades, both of which occurred during strong bull markets / economic expansions (2004-2005 and 2013-2014), the growth or contraction in net private saving has correlated fairly closely with the expansion of central bank assets. This is especially true during most of the economic recovery after the Great Recession.
The long streak of positive growth in net private savings from 2008 to 2012 coincides with the initiation of QE, and the falloff of net private savings in the last few years aligns with the transition from QE to QT — quantitative tightening, or shrinking the Fed's balance sheet.
The Upshot of Artificial Savings
The boost in private net savings since the Great Recession, then, is largely artificial. It is the product of unconventional monetary policies like holding interest rates at zero for nearly a decade and introducing quantitative easing.
What is the consequence of this artificial boost in savings? Well, if you scroll up and look at the above charts, you will see that it did not result in increased investment, labor productivity, wages, consumption, or GDP growth. Quite the opposite: each of these have been subdued during this economic expansion.
When investable funds are not actually derived from personal savings but rather from an expansion of the money supply, they are mostly used for unproductive purposes rather than productivity-enhancing investment. That's why, in the past decade, we've witnessed faster-than-average dividend growth, record buybacks, skyrocketing asset valuations, an expanded wealth gap, massive debt buildup, and the proliferation of zombie companies.
Generally, those in charge of making investment decisions are too smart to invest in unprofitable ventures. Those that do are quickly punished through market mechanisms. But when real (i.e. derived from disposable income) personal savings are low, investments which would ultimately increase output turn out to be unprofitable because consumers can't afford to buy them. Consumer debt can only go so far before it becomes over-extended. The crucial factor determining the profitability of investments is whether there exists real, widespread demand for the products they would yield. And weak demand is the result, at long last, of an economic system that has gradually pillaged savings.
When private savings are expanded through an expansion of the money supply without an equivalent increase in disposable incomes, those new savings accrue primarily to the rich and thus are more likely to be used to bid up asset prices than purchase new plants or equipment. Why waste money on net new capital stock when it will be producing things that consumers, by and large, can't afford to buy?
What changed to cause the collapse in America's formerly high savings rate?
I think it was a change in the economic and cultural zeitgeist of the age, from saving for the future to spending one's income today. Long ago, in a bygone era, "thrift" was considered a virtue. The word refers to careful and prudent management of one's personal finances, which includes saving. In the 1920s, President Calvin Coolidge said, "Industry, thrift, and self-control are not sought because they create wealth, but because they create character."
It was assumed back then that industry (i.e. hard work), thrift (i.e. careful money management), and self-control (i.e. living below one's means) did ultimately create wealth. But their greater value was to be found in character-building. In other words, society had a high view of saving back then.
Writing in the 1980s, during the transition away from a savings culture, Norwegian-American sociologist Elise Boulding said,
Frugality is one of the most beautiful and joyful words in the English language, and yet one that we are culturally cut off from understanding and enjoying. The consumption society has made us feel that happiness lies in having things, and has failed to teach us the happiness of not having things.
In 1971, when President Richard Nixon took the US off the gold standard, he is quoted as saying, "We are all Keynesians now." What he actually said was, "I am now a Keynesian in economics," but that is neither here nor there. His words marked a shift in prevailing economic thinking, which would aid in bringing about a shift in the cultural mindset as well.
Keynesian thinking, which gives primacy to consumption as an economic driver, helped to fuel a culture change that eventually resulted in sentiments such as, "Do your patriotic duty and spend!" For virtuous citizens, the highest good that one can do for the economy is to "spend, spend, spend." That is how consumption's component of GDP grew from ~60% in the late 1960s to ~70% today.
However, back in the olden days of the late 60s, GDP growth averaged 4.76%, whereas the average of the last five years has been 2.46%.
Unfortunately, both the economic intelligentsia and cultural norms forecast no change in trend anytime soon. Therefore, expect GDP growth to remain correspondingly muted for the foreseeable future.
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"The habit of saving is itself an education; it fosters every virtue, teaches self-denial, cultivates the sense of order, trains to forethought, and so broadens the mind." —Thornton T. Munger
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.