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.

Originally published at the Baseline Scenario and reproduced here with the author’s permission.