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Monday, October 30, 2006

Is Saving Always Good?

There are those who have told me they are sure that saving money is unequivocally good and that the more we save the better, no matter what.

That's an interesting belief, but a quick thought experiment disproves this concept.

Let's say there is a country whose well developed economy is self-contained (i.e. no external trade), with steady GDP per capita growth, an adequate level of savings and investment, and fairly low unemployment. Let's say that suddenly everybody in this country decides to become absolutely as frugal as possible in order to save as much as possible. In other words, everybody minimizes the amount of food they buy (no more chocolate – the horrors, the horrors!), stops buying clothes, switches to walking or using mass-transit to get to work, stops spending money for movies, music, and other entertainment, moves to smaller apartments, does everything for themselves (no maids, gardeners, plumbers, etc.), and so forth. Let's say that on average people were able to cut consumption by 50% and everybody put the money they saved by cutting consumption in a bank.

Would this increased saving increase wealth? Would it increase well-being? Lastly, would the decreased consumption really increase savings?

The answer to all three of these questions is no. Why? Because after a certain point every dollar not spent on goods and services is a dollar that someone else doesn't get paid to produce those goods and services. Those dollars that people aren't getting paid to produce goods and services aggregate into lost jobs. People without jobs have limited income (if any) and usually can't save much. Furthermore, because demand for goods and services has been drastically reduced, investment in capital equipment to produce those goods and services will be slashed to nothing so even those employed producing capital equipment will lose their jobs.

If we all drastically reduced our spending tomorrow, it would be catastrophic for the economy. We would not be wealthier. On average, we would be much poorer. Instead of increasing savings, we would decrease our Gross Domestic Product.

Has this ever actually happened? As far as I know, no, not really, at least not in isolation, but there have been a number of occasions that have shown us a glimpse of this effect. The Great Depression was primarily caused by gross mishandling of the economy by Hoover and FDR, but the great reluctance of people to spend what money they had probably added to the problem. The Japanese are great savers (as individuals). Their economy has been having problems for a long time (decades now), and if they were unable to export, I think those problems might be catastrophic.

The problem is that saving doesn't stimulate demand and without sufficient demand, saving has very limited value (if any). Saving is only useful (in aggregate) when it can be used to make investments to boost production to meet demand more inexpensively. If there's no demand, no investment is needed and saving isn't useful. A balance is required between consumption (demand), production, and saving (investment). If that balance is not present, saving can be counterproductive.

1 comment:

Howard said...

Economist Alfred Marshall likened the interaction of supply and demand to the action of the blades of scissors. An inordinant fixation on savings could indeed interrupt the interaction between production and consumption in a well functioning economy. Savings provides some flexibility in future consumption decisions. A fettish or obsession with savings does not provide added benefit, it just perverts the normal functioning of an economy. There's nothing admirable about a mizer.