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Keynesian economics basically considers two major economic aggregates while checking the health of an economy: the income-output scale, and the savings-investment scale of the economy. The total income must necessarily equal total output, but savings need not always equal investments unless the economy is in a equilibrium. When people decide to save too much for any reason, Keynes argues, the economy would dive into a recession because businesses would have unsold inventories (which in turn induces them to cut jobs and halt expansion). The government could actually play an important role in this situation by encouraging people to spend, or even take the initiative itself and start disposing huge public public spending–all this to get rid off the lack of demand and make businesses sell their products.
This reasoning forms the policy advise of journalists and economists who advise government spending to remedy recessions. Some even go further and say while savings of an individual could mean that she has an essential safety buffer to sustain herself through a gloomy future, on the larger scale however, as in the case of an entire economy savings have unfavorable effects since the economy is spending based. This was called by Keynes as the “Paradox of thrift” or the “Paradox
of Savings”.
Keynes’ proposition could be right if we are to consider ourselves to live in an extremely simple economy, where consumers like us can get our products ready in a very short span of time. Like for example, how we could order water from the stream and the workers would get it for us in no time at all. In such a simple economy where ends are met in a very short span of time with very little complications involved in the process Keynes’ proposition that spending keeps our economies running could work. (It would pay here to notice that we have not accounted capital goods in this very simple example. This will turn out to be the key point when we enter into a complex economy.)
There is fundamentally everything wrong with Keynes’ proposition when we place ourselves in a complex economy. Keynes’ fallacious argument roots from the basic lack of understanding of the `structure of production’ which is very complex in a division-of-labor society. Any product we use in today’s extremely complex economy is provided after complex levels of processes which happen at different points of time, and at different pace. This is called the economy’s `inter-temporal
structure of production’. So there is essentially a time lag involved in the production process. This basic understanding can travel us long forward in understanding the economy and refuting arguments of economists like Keynes.
Now we consider ourselves to be in a complex economy, and so, we have extensive division of labor using capital goods to produce products which serve as inputs to subsequent levels of production before arriving at the consumer market as finished consumer goods. The introduction of capital goods into our economy also brings to our purview the importance of savings. The most important function of savings is that they render capital construction, as the following example will explain.
does, from an economic point of view, is to annul 4 fishes from his present consumption to save the time equivalent of catching 4 fishes to concentrate on building a net which could boost his future catch of fishes. In simple words, the fisherman forgoes present consumption to fund his future. He simply saves.
Anybody who hears this example should now be able to understand the importance of savings to genuine growth of any economy. But it is this very foundational principle which most economists have done away with.
Now getting back to the issue in hand, excessive savings can actually in no way, as Keynes fears, affect the economy. When people decide to save more of their income, that is when people decide to cut down on their present consumption, they effectively provide a signal (through low interest rates) that they do it to fund their hefty future needs (perhaps a boost in production). This requires investment in capital equipments construction. The entrepreneurs in the economy are those who receive this signal (again the low interest rates). Sensing the availability of loans at low rates entrepreneurs would decide to invest in capital equipments construction projects which essentially require a lot of time lag before the final product reaches the consumer.
The reader must now be able to guess what would happen if people don’t want to save. It essentially means that people don’t wish to cut down their present consumption to fund their hefty future needs. So that would mean higher interest rates, and discourage entrepreneurs to take up loans for capital equipments construction. The economy would essentially, however, keep producing consumer goods with the present amount of capital equipments available at its’ disposal, without any boost in production.
What we see here essentially, and that’s exactly what is pertinent to the issue in hand, is that high savings by people only lengthens the `inter-temporal structure of production’. It would not lead the economy into recession as Keynes fears. It is not that people never spend, only that they decide to save now to spend it at a future date. The bonus consumers get is a boosted future production because of investment in capital goods.
The next question that arises is how then does this model explain recessions that happen so often in modern economies? I will deal with it in the next article I write. Till then people could try to guess it from the alleged mismatch between savings and investments in the economy.
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1 views10 Responses to “Are savings bad for the economy?”
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GP Says:
March 13th, 2009 at 9:33 amWhat we see here essentially, and that’s exactly what is pertinent to the issue in hand, is that high savings by people only lengthens the `inter-temporal structure of production’. It would not lead the economy into recession as Keynes fears.
The reader must now be able to guess what would happen if people don’t want to save. It essentially means that people don’t wish to cut down their present consumption to fund their hefty future needs.
<<<<<<What if people don’t spend their savings in investing is capital goods? will you still think it will boost economy?
Also, I think its quite unlikely that all ppl will decide to spend their savings at same time in future and I guess you will also agree to the fact that - One individual’s spending in future will hardly do any good in terms of boosting economy i.e. by increasing demand-supply chain. Now if you analyse mind of people who saves money, yo will find that -Most of them are middleclass ppl who prefer to put their money in fixed deposits/LIC eyeing on long terms benefits with low risk involved and now lets assume such ppl bought an house for them after say -10 or 15 yrs through their savings without taking home loan….do u think its reasonable for construction businessman to wait for them so that they can buy their constructed houses/flats? and what abt increasing property value at that time?…do you really think it will boost economy?
Ill give you simple example of US economy - Americans do not having saving mentality like we indians do have so their logic is simple - spend on your needs now(take loans if u dont have enough money)and forget abt savings . This is helping - banks as well as commodity and construction business. In short, economy boosted.>>>>>>>>
Unpretentious Diva Says:
March 13th, 2009 at 12:21 pmSo what will they do?
Let’s say someone saved his earnings by buying a land piece.
Now he owns property, it is his saving. He further saves money to make a house on that land or a building to let it go on rent. After saving, he invests it at appropriate time according to his needs, and do not waste his hard earned money.
he gains on it.
Taking unprecedented loans and then failing to pay them back not only harms economy, it also causes harm to the individual who took loans.
As a matter of fact, that is the main reason of global economic meltdown.
Governments whole round the world following the keynesian model forces common man to spend more than what he can earn “Aamdani Atthanni Kharcha Rupaiya” Even governments do so by taking foreign loans. They forget that a loan taken need to be paid back.
Now when government takes extreme high loans and increases fiscal deficit, whole economy of nation goes down at the end.
And that is the major reason why no economic stimulus by any government has helped any nation to calm down the hussles of economic meltdown.
Even indian government has wasted 6000 crores Rupees till now to provide economic stimulus and the total planning of India to waste in economic stimulus is 37,000 crore rupees, Indian economy and market is still suffering since last 6 months and it will keep suffering the slow down till more 5-7 years.
Unpretentious Diva Says:
March 13th, 2009 at 12:27 pmAnyways, it sounds like a joke.
Consider what GP is saying.
If you are earning Rs 100 per month, than obviously, one will suggest that you may spend Rs50 or Rs60 per day, but save atleast Rs 40 for bad times.
GP think different. he suggests if you earn Rs 100, than spend Rs200, take loan of Rs100 to increase your spending.
Lol Seems like money grows on trees. Everyone want to spend, who will produce?
Even if money grows on trees, it takes hard work to grow the trees.
prashanthguevara Says:
March 13th, 2009 at 3:22 pm“What if people don’t spend their savings in investing is capital goods? will you still think it will boost economy?”
People save only to fund some future needs which are comparatively expensive than present consumer goods. Capital goods does not mean just those crude machines at some factory, a father who saves to fund his daughter’s education too is saving to invest in some kind of a capital good, namely education which can boost productivity of his son.
“This is helping - banks as well as commodity and construction business. In short, economy boosted.”
Actually, as Diva said, this is the cause of economic recessions. The only way what you say could happen is when government can produce money by itself — that is approval of fiat money system, and give it to businessmen as loans. That’s what exists worldwide today. I will explain how this causes depressions in my next article, as I’ve promised already. Thanks!
prashanthguevara Says:
March 22nd, 2009 at 11:11 amGP, check this out: http://prashanthguevara.wordpress.com/2009/03/13/its-recession-time/
Art Shipman Says:
June 28th, 2009 at 1:27 pmHey I like your background image. Unless you object, maybe I will use it on my blog also!
RE the above article, my only comment is there must be a “best range” for the balance of saving and spending, and that should we drift out of that range it must hurt economic performance.
However, there is something else. You say: “Now getting back to the issue in hand, excessive savings can actually in no way, as Keynes fears, affect the economy. When people decide to save more of their income, that is when people decide to cut down on their present consumption, they effectively provide a signal (through low interest rates) that they do it to fund their hefty future needs (perhaps a boost in production). This requires investment in capital equipments construction. The entrepreneurs in the economy are those who receive this signal (again the low interest rates). Sensing the availability of loans at low rates entrepreneurs would decide to invest in capital equipments construction projects which essentially require a lot of time lag before the final product reaches the consumer.”
Lord Keynes replies: “It is natural to suppose that an act of an individual, by which he enriches himself without apparently taking anything from anyone else, must also enrich the community as a whole; so that… an act of individual saving inevitably leads to a parallel act of investment….
“Those who think this way are deceived, nevertheless, by an optical illusion, which makes two essentially different activities appear to be the same. They are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption… [But] the motives which determine the latter are not linked in any simple way with the motives which determine the former.”
The General Theory, Chapter 2.
Perhaps your “signal” (low interest rates) is the simple link that Keynes could not see… But interest rates are low in the U.S. now. And the savings rate has suddenly increased. Do you think entrepreneurs are boosting their investment in capital equipment now? But GDP is down and sales are down!
renegade_division Says:
June 29th, 2009 at 5:35 am@Art Shipman
No problem, knock yourself out. Although I will highly appreciate if you could link us in your blog.
renegade_division Says:
June 30th, 2009 at 1:38 am@Art said
Well then I am sorry my friend but you don’t understand the article.
See Albert Einstein can walk into a market and look at the prices of Apples($5 per lb) and say “Hey according to my super brain, I don’t think the prices of apple are right. There should be a “best range” for demand of apples and supply of apples, and if we drift out of that range then it will hurt the economy.
But the truth is, that the price of apples DO reflect the best balance of supply and demand. Just because Einstein here thinks that it is not the best balance according to his belief, it doesn’t mean it is not the best balance.
Lets say for example that Einstein is finally convinced that $5 per lbs reflects the optimum value for both the sides. One day People start falling sick because of weather and that leads to an increase in demand of apples and the prices skyrocket to $10 per lb. Einstein says “Well look, $10 per lb is too much, its hurting the consumer, we must lower the price to bring it to the optimum balance which was $5 per lbs, you said it yourself!”. The problem here again is that the demand has increased, therefore to satisfy the demand only the limited amount of people can be satisfied. Yes that harms the consumer, but high price has nothing to do with it, it is the increased demand which has hurt the consumer.
Finally Einstein understands that idea too, but he stresses on a centrally planned economy, or stresses on the fact that yes the price of apples must go high, but only government should do this manipulation, not the Market. So when there is an increased demand of apples, the govt raises the price of apples to $8-$12(could be any number), but unless the price is $10 per lbs(market determined price) the market will not be cleared. If govt fixes the price lower than $10 then there will be more consumers left than producers. The producers have less capital than optimally they would have, to produce more apples. If govt fixes price higher than $10 then there will be more producers left than consumers, and it would be a waste of apples(resources), and producers will produce less apples now despite of the fact that there is a higher need of apples.
Therefore you must understand that Market adjust itself to the demand and supply much better than an individual would. Just because someone BELIEVES(with whatever reasoning) that the prices of something should be higher/lower doesn’t mean that the reasoning is correct.
The same goes for saving and spending. Saving and Spending are Demand and Supply of capital, and Interest rates are the price of capital. If suddenly there is an increase in demand of capital, then interest rates will skyrocket. Similarly if there is a decrease in demand of capital then the interest rates will fall, the production of capital(saving) will decrease by itself.
IF there is an increase in the demand of capital(during a boom) then the interest rates will go up, therefore resulting in an increase in production of capital(savings). The Market’s interest rate reflects the best possible adjustment of savings and spending, and no central planner can be that good to put it highly synchronized with market’s interest rates.
kannadian1 Says:
March 2nd, 2010 at 1:49 pm@Diva
Government spending certainly does help the economy. If you have ever seen a graph of economic growth through history you will notice that when ever we have war, the economy grows. Saving is good for individuals but if everyone saves the GDP will constrict. If you make the lowly wage of 1000 INR a year, and wait for 10 years to buy a house, you realize that the due to inflation the total amount of money would be no where near Rs. 10,000? In fact, the first 1000 INR you made would be worth less than half what it was worth when you first earned it. Saving is good for the ideas that Indians most enjoy, stability, but with the welfare economics of the west, people enjoy taking risks and those risks raise consumption. If Steve Jobs and Steve Wozniak had never taken out loans to start Apple, the world would have never enjoyed the smartphone revolution that ensued after the release of the iPhone. Income=Consumption and so if you consume less by saving, the economy will constrict.
In the perfect world where there is no inflation, savings would have more weight.
Renegade Division Says:
March 2nd, 2010 at 3:00 pm@Kannadian said:
Graphs! If you ever ask people if they were better off at the time of war or at a peacetime, they will answer no.
Similarly if you look at the graph of GDP when the world war 2 got over you will see MASSIVE drop in GDP, yet people claimed that they have never been richer. How is that possible?(Even in this recession American GDP hasn’t fallen as much as it fell in 1945-46 period). A 10% drop in real GDP must mean massive poverty, massive recession, then why don’t we hear about it?
My suggestion to you is that you stop looking at numbers to explain reality, and look at the logic.
That’s like saying if everyone gets married then our population will explode. Well forget the consequences, tell me this, what if everyone does want to get married and want to have a lot of children.
Similarly if everyone saves then that clearly means that they want to prefer things later than sooner, I don’t understand you dilemma here. The interest rates will fall, and businesses will find it easier to borrow more money and invest in the market, and over a few years economy will be more prosperous than ever.
This Keynesian viewpoint of the world you hold will never take you anywhere, my suggestion is that you try and understand Austrian Capital theory.
Dude you are using words, but you have no idea what they mean.
You cannot be more wrong, if you understand Capital theory, you will understand why in India products like iPhone and iPads are not produced and created in India.
When you say stupid keynesian idioms like Income = consumption, you fail the same place where Keynes failed and that is having a Capital theory.
Let me explain you how. Lets say you are a rice farmer who wants to eat wheat(and rice), and I am a wheat farmer who wants to eat rice(and wheat). We both generally trade with each other, but
Keynesian World:
one season you suddenly started saving more and because you bought less wheat from me so I am not able to buy more rice from you, and therefore we both seem to have hit a recession. You don’t spend your savings because you are scared of the recession, and I don’t increase my spending because you are just going to save more. This is termed as ‘paradox of saving’ by Keynesians. The Keynesian solution is that only if someone (like the govt) gives them more money to buy each other’s products everything will be fine.
So govt throws money at both of them and they both start to buy each other’s products and economy becomes better and they both live happily ever after.
EXCEPT, there is no idea of capital in the above picture. There is no entrepreneurship anywhere. You talk about Steve Jobs and Woz, you will never be able to see them in the above model.
Capital is when someone delays their present consumption for future more consumption. IF your savings are 0%, then you have NO capital in that society, that economy is IMPOSSIBLE to grow. Keynes was so wrong about everything that he makes Karl Marx look good.
According to Capital theory:
All these things happen because of voluntary rise in savings. A product like iPhone has a longer production structure(that is iPhone is built using something which itself is built using something which itself is built using something else and so on).
A product with short production cycle is like say hand made clothes, to produce that you need cotton, cotton processing tools, and a thread and a needle. When the voluntary savings rise and that enables creation of products with lengthier production structure a sewing machine will be built.
Anyways, one last thing, inflation is not a natural phenomenon, get rid of RBI and liberalize the money(or as you might call it privatize it), and you will get rid of all this artificial inflation.