A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Wednesday, August 5, 2009

Savings Equals Investment ... So?

Today on the podcast, the savings rate, savings equals investment, and a look at the leaders in savings -- Japan -- with Richard Koo

Savings Rate

One can get an idea of the confused state of primitive economics when we look at the treatment of the savings rate.

A higher savings rate is a good thing, it is said, long overdue, a necessity for an advanced economy.

Meanwhile Japan with one of the higher savings rates in the world slumps along decade after decade.

The full premise of the savings rate proponents is unspoken and incomplete these days, but is easy to remember. That premise arises from the accounting identity of savings and investment. In a closed economy, savings must equal investment. Algebraically.

The obvious fact is that the American economy is not closed, and it has for many years, decades, been drawing investment quote unquote from the rest of the world, most notably and ironically from the developing world. For a good portion of those many years this flow of capital from developing to highly developed was excused with the explanation, "We should be happy they see the opportunity to invest." I kid you not. Of course, that is on the other side of a housing bubble which distorted the value of those investments. We threaten from time to time to go back and recalculate net U.S. investment in the light of current housing prices.

But the savings rate proponents base their fervor on this truism, because they have carried it on to the fallacy that savings CAUSES investment. This is the fundamental error of the premise, that savings causes investment. If only we had savings, investment would follow.

Looking out the window now as the savings rate skyrockets while investment plummets, it is hard to imagine how profoundly this causal connection has been featured in the minds of primitive economics. It is this superstition of a causal effect that lies at the base of the advocacy of high savings.

We propose, and other demand-siders propose, that the causal arrow actually points in the opposite direction. As in the old days, when you wanted to buy a house, the impetus for savings arose to get the down payment. Expanding this, with the prospect of profit, businesses went out and found the financing. We have only to look into the various bubbles to see that with the prospect, or illusion, of big profits, there is no absence of savings to tap.

Next, let's point out the paradox of thrift. When one person saves, it is a prudential and sober thing. When everybody saves, incomes go down. Since savings are the opposite of spending, and one person's spending is another person's income, the opposite of one person's spending is a reduction in another person's income. A reduction in incomes means a reduction in demand which means a reduction in the prospect of profit for those producing for consumers.

Further, as we pointed out earlier in the year in our discussion of the multiplier, that multiplier also works in the negative direction. A reduction in spending is multiplied to more than the initial amount by its follow-on reductions in incomes to others.

Ultimately an increase in savings absent the investment that will be absent without the prospect of profits leads not to an increase in the absolute level of savings, but to a decrease in incomes and eventual use of those savings to meet expenses.

It can have escaped nobody's notice that just as the savings rate has expanded, so the growth rate has fallen.

It is the role of government to match savings with investment in times like these -- so that incomes don't fall and the paradox of thrift does not enter the liquidity trap of deflation, where buying something tomorrow is less expensive than buying something today and producing something today is more expensive than producing something tomorrow. Thus the cash itself, the liquid securities, become the trap for the economy.

Government can invest, which it is doing. It does not need the prospect of profit. This investment can increase private incomes and keep spending higher, which is happening. And government can reduce the savings of the wealthy by taxation, which it is not doing, funneling them into its investment. Accessing the wealth of the wealthy by borrowing it is not so much more efficient than by taxing. Certainly the claims that the wealthy must be wealthy so the rest can have jobs must weaken a trifle when the rest do not have jobs.

But the word taxes has been given such a stigma by the Right Wing that a proposal that they could be a route out of the current trap sounds almost absurd to most ears.

The bottom line is that there must be investment to ratify savings or incomes will fall. As incomes fall, savings in absolute terms fall, even if the savings rate rises. This is in aggregate. It is analogous to a hot air balloon. The pressure inside and outside the balloon is equalized. Savings equals investment. But it is the height of the balloon -- incomes -- that does the equalizing.

Not understanding this point -- that higher savings in the absence of investment means lower incomes and lower incomes mean lower production and employment in a downward feedback loop -- not understanding this is not understanding economics as it actually manifests. You can have all the stock market recovery in the world, but without incomes beginning to rise again, there will be no recovery in the real economy.

We have a great deal of talk now about the end of the recession and things turning up with a kind of tacit understanding that there is a gyroscope that is automatically re-stabilizing the economy. Things are naturally reverting to the mean, and so on. This is bull. Any stabilization has to come from stabilizing demand, which has not yet happened and which will not happen by simply believing it will. The government is producing a sturdy base with its basic services, some infrastructure spending, the social insurance programs soon to be augmented by -- God willing -- universal health insurance. This is stable enough, but as a base it is too low.

Any bounce off this low is technically a "Recovery," since the growth line is not falling, but is it an economy that will support us?

Now imagine that the savings rate increase is not composed of savings as such, not as the accumulation of liquid assets, but as payments to banks for debt. There is no cash value being built up in the household sector. It is all paying down debt. And it is not as if there is value under even the mortgage payment, since equity has eroded by up to half, leaving a huge debt overhang unsupported by equity value. Banks have continually resisted a New Deal style Home Owners Loan Corporation which would share the pain and give homeowners the needed incentives to stay in their homes. This is a mistake they will come to regret.

The savings rate is an extremely good segue into the experience of Japan.


The lost decade in Japan is the cautionary example of the times. "We can't do this or we'll end up like Japan..." "That's what Japan did and it led to the lost decade." And so on. In a moment we'll check in with Richard Koo, Chief Economist at the Nomura Research Institute in Tokyo, but first let's interject our view that by ratifying the bad bets the banks and shadow banks made, and taking them on the public shoulders, we have set ourselves up for something at least as bad. And it could be worse. Will the U.S. really expand the federal debt as much as Japan has?

But let's continue our digression. Unless we break up the big banks into entities that are not too big to fail and set them on firm financial footing, we are going to have to carry them forward as we try to get out of the collapse they engineered.

Very discouraging is the administration's regulatory scheme being floated on Capitol Hill. A super regulator is proposed to handle so-called Tier One institutions. Tier One is code for too big to fail. Those who present systemic problems should they fail. JP Morgan Chase, Citibank, Goldman Sachs, Morgan Stanley, American Express, Bank of America. These are the Goliaths who are exempt from market discipline because by virtue of their size they get free too big to fail insurance from the American taxpayer. Meanwhile the rest of us need to run around and clear the road so they don't step on us, or heaven forbid, fall down again. They might crush us.

The Demand Side view is that they are more dangerous walking around and looming over us than they would be on the ground. At a minimum, if they are going to exist, they need to be paying too big to fail insurance premiums to take the weight off the taxpayer.

Ironic and really laughable are the free marketeers who say, "Let the market work, stay out of the way..." until they fail. Then it is a sad duty, but a duty nonetheless, for the rest of us to bail them out. This kind of Capitalism is really rule by the powerful, not any kind of logical or internally consistent system.

The breakup of the banks that is necessary for a successful market follows logically from their failure as business enterprises. That is, there should be no excuses or rationale for not breaking them up. They proved they were not up to the task, and continue to prove they are outside the stream of the real economy. It is not a hypothetical to say the banks are too big.

All right. That was only bullet point one on the how to avoid Japan list. We'll dispense with the rest for the moment and get to Mr. Koo and his discussion of the Japanese experience.


So what you heard here, I believe, is that Japan's experience is not necessarily such a complete failure. They did not go into depression, but simply stagnated. This with dramatic increases in public borrowing.

This is what we have to look forward to, if we're lucky.

1 comment: