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Why only investment creates saving ... and why it matters

I wrote an article last week about how investment drives saving, not the other way round, as most people believe. Based on the comments and messages that followed, it seems that I could have done a better job of explaining the key points. Because this is an important issue, I'm going to do that now.

Part of my problem with the previous piece, was working within the constraints of a published article. So this time, I'm going to do this only as an instablog entry. That gives me a bit more freedom to explain things properly.

Because this is a key issue, I would like to make a request. Please can anyone reading this, tell me (by comment or message) if either, they don't get it, they don't agree with it, or they don't see the significance. Thanks.

Okay, let's get going.

Saving Equals Investment

Let's start with a simple case of a closed economy, with no tax and no government spending. As in any economy, Income = Output. All income is earned by producing output. The total value of everyone's income is equal to the total value of everything produced.

We also know that output may be valued for either its current use (consumption) or its ability to create output in the future (investment). So, we know that:

Income = Output = Consumption + Investment, so
Income – Consumption = Investment

The next step is to define “saving”. Some people think of saving, as putting money in a savings account. That's not the way economists look at it. In economics, saving is deferred consumption, or “income not consumed”. It doesn't have to be in a savings account, it could be under a mattress, or in a wallet, if it is income not yet consumed, then it is saving. So, we can say that:

Saving = Income – Consumption, so
Saving = Investment

This gives us our starting point. It is an economic identity, meaning that it is always true. It doesn't happen by accident and it doesn't only happen at particular times. It is always true, measured over any time frame you choose; a year, a month, a day, even down to a nanosecond. Over any time frame, the value of saving will always equal the value of investment.

A sensible response to that is to ask: how come? How is it possible that someone's choice to save is, always and everywhere, matched up with someone else's choice to invest? Not only that, but how come they save and invest the exact same amounts at exactly the same time, down to the nanosecond? Surely there must be some kind of magic involved?

The answer is that, contrary to popular thinking, only one of them is a choice and the other one is the result of that choice.

What We Can Choose

Saving is income not consumed. That definition means that none of us has any choice about how much saving we actually do.

Think about it. You choose how much you consume, but do you choose how much income you have? We'd all like to choose our income, but unfortunately that will always remain a dream. Consequently, we have no choice over how much saving we do, because saving is income not consumed. Our individual saving will always be affected by other economic events, that we have no control over. If we earn $100 more, or $100 less, that affects our saving as soon as it happens.

That's an important point to grasp. People tend to think of their saving as something they have control over, but saving is not a choice. We may choose where we put our saving e.g. in a bank account, or under the mattress, but we can never choose how much. We may choose how much we consume, but we can't choose how much we save.

The same is true for business saving. Again, saving is income not consumed, and there are few businesses that have any real control over their income. Their income is determined by the buying decisions of their customers.

Investment, on the other hand, is a choice. If a business decides to invest in new equipment or software for example, that is a process that they control. At any moment, they can decide to stop the investment process, or change the amount they invest.

So, we find that investment is a matter of choice while, somewhat counter-intuitively, saving is not. We can control what we invest, but we can not control what we save. That gives us a pretty big clue about which causes which.

Investment Causes Saving

Saving is created by the process of investment. It works like this:

As noted above, all output is either for consumption or investment. In both cases, the seller of the output receives income, and so immediately saves, because saving is income not consumed. What happens to the buyer, depends on what the output is for. If it's for consumption, then the buyer dis-saves, because they have reduced their income not consumed. This means that there is no net change in saving between the buyer and seller. There is no net increase or decrease in saving. All that has happened, is that saving has been passed between buyer and seller.

Alternatively, if the output is to be used for investment, then the buyer is not consuming. Because saving is income not consumed and no consumption has occurred, no dis-saving takes place. The net result is that the buyer records an increase in investment and the seller records an equal increase in saving. The buyer's investment has created the seller's saving.

Attempts To Save Can Be Harmful

The process of creating investment and saving, can only start with investment. No amount of attempted saving will cause any investment to happen. There is no mechanism to allow it to happen.

Some believe that, by trying to save, we can somehow create more savings. This would then support lower interest rates and so more investment. But this is false. Attempts to save do not create more saving. An individual can increase their saving, but this must always be off-set by a reduction in saving elsewhere. If you save on your movie ticket, then the movie theater dis-saves. If your employer saves on labor by firing you, then you dis-save.

Worse, if attempts to save lead to reductions in spending, then investment will fall too. Businesses will be discouraged from investing, due to the declining economy. This reduction in investment causes a reduction in saving. So attempts to save lead to less saving.

Sector Balances

I started out with the simplifying assumption of a closed economy, with no tax and no government spending. So what happens if you add them back in?

The basic answer is that you can now transfer saving between sectors. Saving may be transferred to the government, or foreign sectors. The amount of saving is still determined by the amount of investment, but where the saving ends up, depends on government policy and trade.

The logic of sector balances helps us to understand this. You can get an insight to this theory here, or read up on the advanced stuff at the Levy Institute.

The key sector identity that we will use is:

(S – I) + (T – G) = (X – M)   
Private sector surplus + Government surplus = Trade surplus

or alternatively:
I = S + (T – G) - (X - M)

This means that investment (NYSE:I) will always create an equal amount of private saving (NYSE:S). But that saving can then be reduced by taxes (NYSE:T), added to by government spending (NYSE:G), or moved between countries via exports (NYSE:X) and imports (NYSE:M).

The most important thing to understand, is that a trade surplus will transfer saving in to your country and a trade deficit will transfer it out. That is why a large trade deficit is so damaging.

Why It Matters

This is profoundly important, firstly because it is fundamental to the performance of the economy, and secondly because most people get it wrong.

We are culturally determined to think that saving is good, and we should try to do more of it. You have been subtly taught this since almost the day you were born. This inherent bias is then reinforced by economists who suffer from the same bias. Austrian economists are particularly prone to praise attempts to save. As I quoted Murray Rothbard in my original article:

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

What this quote also demonstrates, is the assumption that saving will engender investment. While this may appear to be common sense, in fact nothing could be further from the truth.

Were the world to follow Rothbard's advice, we would enter a self defeating process of attempts to save, and would experience the resultant destruction of saving.

What we actually need to do instead, is to increase investment. But for that to happen successfully, we need to create viable investment opportunities, and that won't happen while we have a huge trade deficit. Those are the things we really need to get right.