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Thursday, December 14, 2006

It's Magic!

One of the primary reasons that many people lament the supposedly low savings rate in the United States is that they erroneously believe that "savings" and "investment" are the same thing or that "savings" causes "investment". Saving does not automatically lead to investment. At best, saving can reduce the cost of investment. But, as I wrote in "Is Savings Always Good?", saving beyond a certain level can actually reduce investment.

Let's start with our hypothetical static economy (HSE) as described in "Selfish Savings":
This hypothetical economy is completely stable with no loans or debt, constant population, constant demographics, constant (and moderately low) unemployment rate, constant GDP output consisting of the same products, etc.
One specific aspect that needs to be clear is that the net savings in the HSE is zero. For each dollar that goes into savings there is a corresponding dollar that comes out of savings.

But, as I described in "Money's Inherent Value", since fiat currency issued by an authority that collects taxes has inherent value just like gold, let's use the currency instead of gold. In addition, since it's usually important for the control of the money supply for the government to have some debt, let's say the government has some small amount of debt, say 10% of GDP. The fiat currency in turn enables borrowing as described in "Paying off the National Debt". Also, assume that there is intergenerational borrowing as described in "Barn-Raising Borrowing". Let's denote the HSE with all these modifications as HSEb. We'll keep coming back to HSEb in future posts.

Now let's consider the story of Bob the bonbon maker in our hypothetical static economy. Bob has just thought of an ingenious way to double his production of bonbons. Unfortunately, to do so, Bob will have to build some bonbon making machines and it will take someone a year to do so.

There are many ways that this endeavor can be financed, all of which will slightly alter the hypothetical stable economy (innovations tend do that). But let's start with the simplest. Bob borrows bucks directly from the central bank and pays someone (call him Sam) who was unemployed to build the machines. In the real world, private entities don't usually borrow directly from the central bank, but a similar thing happens via the central bank's agents. Those agents are private banks within the banking system. But let's not get into those details right now.

Sam takes a year to build the bonbon making machines and after a year goes back to the trajectory he would've been on in HSEb. Assume for now that Sam didn't alter his consumption at all relative to his original trajectory in HSEb, either while employed building bonbon machines or afterward.

So let's take a look at the balance of savings at the end of that year. In the private sector, the net savings is still zero. Bob has borrowed, but Sam has saved an equal amount relative to what he would've since he hasn't changed his consumption. Nobody else has changed their consumption (or production) during that year either. Nobody had to save any more money. Yet the economy now has bonbon making machines. Investment and wealth has been created out of thin air. It's Magic!

Again, as shown by this example, savings is not necessary for investment. Admittedly, there are a few minor caveats. It is true that the central bank does now have a positive entry on the balance sheet (what Bob owes them). But the central bank has literally an infinite positive entry (since there is no limit to the amount of money that they can create) so this entry really changes nothing. When Bob pays back the loan, the payoff just goes back into the infinite pool.

It's also true that the unemployed can be thought of figuratively as "savings" as in we're saving them for later. So in this case, by employing Joe, we're using a previously "saved" resource. The concept here is that anytime we do something that increases employment, we pretty much get something for nothing, even if we have to "borrow" to do so. For example, when unemployment is high, the government should generally borrow more and tax less because that generally increases the demand for labor and ends up employing people who would otherwise been unproductive. In this case, the borrowing is very inexpensive per unit of created well being and productivity. Next time you're unemployed (if ever), you can consider yourself a saved resource. Rest up!

So what if there was nobody who was unemployed available to build the bonbon machines? We'll look at that in the next post in this series.


Susan's Husband said...

But Sam can't build the bonbon machine without changing his consumption by buying the parts for the machines. Where do those come from?

Bret said...

Assume that the parts were laying around from scrap and that it was mostly a labor intensive thing anyway.

And yes, there are other slight distortions to HSEb as well.

Hey Skipper said...

I'm not sure I should be banging on about savings as a means of storing time, but your example does require there to be some underutilized time available.

Presuming the bonbon machine is more productive than existing techniques, how does the model incorporate consuming fewer inputs per unit of output?

I'm guessing that part of the answer is that technical innovation has the effect of creating time with respect to the pre-innovation baseline.

But there I go again, banging on about time.

Bret said...

Well, they say "time is money" so I guess that even though many of us look at this from a monetary standpoint, there's nothing wrong with translating money to time. Yes, this particular example required an under utilized resource who had, yes, free time. I'm intending to do another example with full employment as well, but one step at a time.

I'll get to what happens when the bonbon machine comes on line in a near term post. We'll see that it'll cause a slight deflation. That's why the central bank has to continually increase the money supply as productivity rises.

Susan's Husband said...

Wouldn't those spare parts count as savings, then?

Bret said...

Yes, the spare parts could count as savings.

We can do one of two things here. Either we can say that even the spare parts were created with Sam's labor from digging up rock in the back yard and keep the example pure. Or, we can simply say that the spare parts are worth maybe $1,000 while Sam's labor is worth $100,000 so the gist is correct with a tiny change not accounted for.

In either case, investment and wealth has been created out of thin air since the end result ends up having far greater value than the spare parts no matter how you slice it. It's still magic!