Is Saving Good?

For a complete list of Beginners articles, see Financial Crisis for Beginners.

Way back in October, one of our readers sent in a question which can be paraphrased roughly as: “During the boom everyone said we should be saving more. Now people are saying we should be spending more. What gives?” This question has been sitting in my inbox unanswered. Until now.

Two of the leading economics blogs in the world (OK, the English-speaking world) published posts entitled “The Paradox of Thrift” yesterday, solving my problem for me. Tyler Cowen started off with a link to Matthew Yglesias, who wrote a non-technical explanation of the sort I usually do in my Beginners posts. Read that first. (Cowen adds some semi-technical notes that you may or may not understand.) James Hamilton then gives a technical explanation, but by “technical” here I’m only referring to first-year undergraduate macroeconomics, so most people should be able to follow. Read that second, at least through the second paragraph after the second graph.

Yglesias basically says that if you save instead of spending, your bank can lend the money out to someone else to spend instead of you. It might go to your neighbor’s home equity line to buy a new flat-screen TV, in which case the economic impact is the same as if you had bought a flat-screen TV. Or it might go to some entrepreneur who is building a new factory, in which case the short-term GDP impact is the same (the money gets spent), but the long-term economic benefits are arguably higher (because in the long term we need new capital investment for the economy to continue growing). Hamilton shows the same thing with a simple equation. In the immediate term, S (personal savings) and I (private investment) both contribute to GDP, so one is just as good as the other; but in the long term, we need I, so savings are good.

However, it does not necessarily follow that every dollar saved necessarily and magically becomes another dollar invested. There are many reasons why increased savings may result not in increased investment, but simply in the same level of investment, which means total output (GDP) will be lower. Yglesias, Hamilton, and Cowen all point out various examples of why this can happen. In a dismal economic climate like the current one, entrepreneurs may not want to build new factories (put another way, demand for credit may not exist, so the banks have no place to lend the money). Or the savings may be going into zombie banks that are hoarding cash instead of lending it out. Or the economy may simply not be able to adjust fast enough: in order to shift out of cars and into anti-gravity hovercraft, it may just not be possible to retrain the workers fast enough to put all the available capital to use.

So in the long term, there are good things about a higher savings rate, not least that it will reduce the number of people facing poverty in their retirement years. But if we get there too quickly, it could exacerbate the recession we are going through.

11 responses to “Is Saving Good?

  1. My sense is that the average person isn’t thinking of the greater good when he stops spending and starts saving.

    When people are scared, they build walls. The taller and thicker your wall, the safer you are. This has been true for the last 3,000 years.

    I will not be surprised if the US savings rate gets to 10% faster than it ever has before, as families try to construct some rudimentary fence.

  2. I should clarify that even if a rapid increase in saving is hurting our economy, I don’t think that you as an individual should go out and start spending money. You should do what is best given your household financial situation, as I argued in this earlier post.

  3. This is a short term problem that forces us to put off addressing the long term problem: we have operated our economy at production level far above long term demand via debt financing for 20 years now. We are now, unfortunately, in the unenviable position of needing to go through massive, destabilizing changes to our economy precisely because short term problems such as the paradox of thrift have been addressed with fiscal and monetary tools, preventing the earlier (and less painful) corrections from occurring.

    I don’t say that there isn’t a paradox of thrift in crises (although I think in a naturally functioning economy with a growing population and where markets set interest rates, the problem is non-existent) rather I assert, without expertise or evidence, that this mode of economic thinking, this addressing of short term issues at the expense of the long term, is precisely why we are where we are.

    Welcome to the long run.

    (OK, perhaps that’s a bit dramatic…)

    Cheers,
    Carson

  4. I’m just an engineer shooting out ideas. The government wants two knobs to control the economy, (1)control inflation/deflation, and (2) control peoples savings/spending.

    Consider the politically neutral policy of government loans to tax payers. The principal in such loans would be in proportion to taxpayer payment history. Annually, the gvt could offer large or small loans. The interest rate offered now, for example, might be zero. The duration might be short or long. Now maybe payback 10%/year.

    Under this policy, the government has many knobs to adjust to stablize the economy. The entire process could be automated (no bankers!).

  5. How does the money saved in 401k plans, etc fit into the savings picture? That money is “saved”, but if it’s being used to purchase stocks (or stock mutual funds), that money doesn’t get invested in new production — it’s just buying shares in existing production.

    Wouldn’t those funds have to be invested in a money market fund (which is being lent out on the other side) or perhaps bonds funds to contribute to a (potential) increase in GDP?

  6. Gustavo Corral

    Contrary to your post, if people start saving more money and the bank has no good place to put the money, interest rates should drop. Remember there is a continuum of opportunities, each with different ROI.
    However it is also true that as good investment opportunities dry up, the capitalist system seeks more risky opportunities.

    But in fact a rational bank ( btw, should we pack a latern and start looking for these ? ) can always pay off its bonds or invest in corporate bonds or return money to stock holders. The irrationality comes into the picture when banks perceive as riskless that which in fact has a great deal of systemic risk.

  7. 401(k) plans, and stocks in general, count as savings. Even if you’re just buying stock from another individual, then he has money which he will use for either consumption or savings. What matters is the aggregate amount of savings, because that money is not being used for consumption, so eventually it has to find its way to people who will invest it. If everyone wants to buy more stocks and no companies want to issue more, then in the short term the only thing that will happen is stock prices will go up. But when stock prices go up, that means the cost of raising money through equity goes down for companies, which makes them more likely to issue stock and use the proceeds for investment. Things do not adjust instantly, and in the short term you can have sinkholes where money sits and does nothing useful. (We may be in one now.) But over the longer term it does go somewhere useful.

  8. A very interesting article. It is truly dreadful that the government are trying to force people to spend their savings (e.g. my 6 month salary buffer which I have painstakingly built up over the years).

    The government really need two interest rates to try to encourage asset price stability.

    The first interest rate will be very low and will apply to all assets bought before the current collapse (starting about July 2007). The second interest rate will be much higher and apply to new assets to encourage a general asset price decline to reasonable and stable levels.

    As a practical example, suppose you are a family and you bought a house at the height of the boom because you needed a family home and could afford the low repayments.

    Now, one year later a similar family, with similar personal needs buys a similar house and gets it for half the price.

    Now, it does not benefit the economy to make the first family suffer and become destitute and become a burden. They will both be equally productive if given an equal footing.

    Both families have identical properties and the values are effectively identical. Therefore it is reasonable and beneficial to the economy if they can be helped to pay the same amount in interest rates.

    This may not be deemed a fair solution (to the second family who are paying for the ‘so called’ mistakes of the first) but everyone will benefit in the end. It is up to the government to make this happen as only they have control over the interest rates.

  9. I still think that saving in “normal” times is good for the economy. Right now we’re in a depression. There is a steep reduction in output, that has been causing deflation and widespread public anxiety. There is this strong sense of crisis, which makes me think that we may have entered a depression — this definition of a depression is probably not an agreed upon one. I hope that James can clarify this dismal term for us.

  10. Retired LCDR, USN

    One can only ‘save’ if a person HAS:

    1. The INCOME over & above OUTGO, i.e., necessary expenses for shelter, food & transportation.
    2. The self-discipline to do so! (Does the phrase ‘burning a hole in one’s pocket’ ring a bell?)

    But even IF conditions #1 & #2 above ARE met, the question STILL remains WHERE to ‘save/spend’ any surplus (remember THAT word?) dollars one might have. In other words, ‘saving’ vs ‘spending’ depends on each & every individual’s personal situation. There IS no one ‘correct’ answer.

    (Q: What did YOU do with that 2008 tax ‘rebate’ check?)

    Simply putting xtra funds under one’s mattress ‘for a future rainy day’ allows inflation, no matter how slight, to eat away at the ‘real’ worth of those funds.

    Purchasing ‘safe’ (allegedly) govt securities &/or money market funds returning less than 1-2% leads to a net loss as well once purchasing costs & fed/state/local income taxes are subtracted.

    Fortunately, both my wife & I are at least somewhat protected with our retired military pay, i.e., deferred compensation for our combined 50+ years of ACTIVE military service! (Q for ‘dubya’: Ever think of actually fulfilling your military svc commitment?)

    Also, we continue to ‘invest’ in maintaining our ’95 & ’96 Hondas, each running quite well with just under 120K miles each!

    So as we continue to see even our ‘index’ mutual funds drop by 40% in just over a year (sigh!), we use any extra dollars to PAY DOWN OUR PERSONAL DEBT, i.e., home mortage, as all other bills are paid off in full each month.

    Our efforts, in spite of our ‘diversified’ portfolio remain true to the all-too-simple economic equation: NET WORTH = ASSETS – LIABILITIES

    Unfortunately for the generationS following us, is that THEY will be forever paying for the liabilities OUR generation has left for them to inherit. I only hope they get their wheelbarrows now that they’ll need to cart the dollars needed to buy their loaves of bread.
    s/R.W. Koch, Arlington, VA

  11. Hi, nice blog. I like the “guide for beginners”, and this here is an interesting issue.

    I recently came across an article (by NYTimes reporter David Leonhardt) suggesting a new way of thinking about personal savings, and offering an solution to the paradox of thrift. This strategy compliments my own attitudes towards money, so I was happy to see it, but would like to hear additional thoughts on the issue.

    http://www.nytimes.com/2009/02/11/business/economy/11leonhardt.html?_r=1

    The basic idea is that at this moment (recession) individuals need to think about their long-term economic stability, but as a society we need to maintain demand for labor. Leonhardt’s solution is for “little guys” to take responsibility for investing on our own behalf, rather than just handing money over to the financial system. For instance, I could remodel my house to increase energy efficiency — this would increase my future personal economic stability by reducing energy costs (or increasing the resale value of the house), but it would still create demand for labor in my community and reduce the risk that we enter a cycle of reduced aggregate demand.

    I see two issues here:
    1) Would this actually work?
    2) Is it reasonable for individuals to consider social welfare when making their personal financial decisions?

    For the second issue, I think the answer can probably be “yes”. First, a functioning society depends on the willingness of individuals to make small sacrifices for the common good — so as long as the cost of these “personal investments” is small, they are fair game. Second, a shift towards “personal investments” may not actually cost individuals anything — it may be more of a change of attitude, or just a recognition that economic conditions have changed. For instance, when the stock markets were booming, it made sense to contribute our savings to the financial system, but now that we seem to be in a bear market, we need to look for alternative investments. Furthermore, economists have pointed to many situations where Americans have failed to take advantage of high-return investments in energy efficiency, suggesting that people simply haven’t been paying attention to the opportunities that surround them, and have been stuck in a mental rut where they equate “investment” with “buying complicated financial products”. By turning our collective attention (i.e. public discourse) to these local, personal investment opportunities we may actually help ourselves to find good investment opportunities even as we lift our economy out of a recession.

    Any thoughts?