Last week I compared the economy to an engine, and gave you an overview of a few components particularly relevant to the question of how we can produce enough for everyone, highlighting the importance of investment and saving. I then promised that from this week we would take this engine apart piece by piece so that we can examine each component carefully, starting with saving.
Saving is simply the difference between our disposable income and what we spend on consumption. It is sometimes described as a decision to put off consumption until the future. Its opposite is “dissaving”: when we spend more than our income, either by spending our savings or by going into debt. Households, businesses and governments can all either save or dissave, and from all of these separate, individual decisions you get national saving – the saving of the economy as a whole.
So how am I going to achieve this feat of separating saving off from the other components of the economy? With the well-used economics technique of imagining an economy in which those other components don’t exist!
So bear with me, and imagine a land in which everyone has a job doing something they enjoy, earning a wage that keeps them satisfied. Everyone is pretty much happy and content with what they have, so demand for products is stable, and there is no need to innovate. Every month and year, expenditure remains more or less the same. Welcome to Orderlyland.
This economy is in equilibrium, ticking along in a steady state. To facilitate trade, the Government has printed money. Things are simple in Orderlyland – there are no banks, cheques or electronic money, only cash. There’s enough in circulation to cover one month of expenditure in the whole economy. In other words, people get paid at the end of the month, spend it the following month, and this circulating money becomes the salaries paid to everyone as that month ends. So each banknote is spent 12 times each year (this rate at which money circulates is known as the velocity of money). The money that some save for retirement (in shoeboxes under their bed) exactly balances the amount that the retired are currently spending out of their savings.
Each year everyone earns about the same amount, and spends about the same amount. There is no inflation.
Then one day, Bob decides that actually he’d quite like to be able to buy some slightly nicer, more expensive things, so he decides to forego some of things he usually buys and save up for the bigger, nicer things. What impact does this have on this economy? In the first month he saves, some people are going to experience a drop in income as Bob spends less. But that means that the following month, these people have less money to spend. So in the second month they spend less, so a new group of people find their income falling, while once again Bob saves some more. Each month, his saving from all previous months is passed around the economy, as people find their income falling so spend less themselves, causing someone else’s income to fall. Bob saving £100 in the first month of the year alone will become a drop in expenditure in the whole economy of £1200 by the end of the year. As this keeps snowballing around the economy, and Bob keeps adding to the effect by saving more every month, it could eventually come about that Bob actually sees his own income fall as the slowdown in the economy eventually hits his own business. So paradoxically, the act of saving so that he could afford nicer things in future could make him poorer in the long-run.
The famous economist Keynes called this “the paradox of thrift”. While of course the mechanisms in the real-world economy are far more complicated, this simple model enables us to grasp this concept: individuals saving money can slow the economy down, theoretically to the point that they actually end up poorer themselves. But last week we said that we need our saving to contribute to increasing productivity of the economy. As we add more to this model, we will want to keep an eye on what happens to this paradox of thrift – when it applies, and how it is avoided.
There’s another interesting feature about saving we can notice when we examine it in isolation like this. Orderlyland has a fixed money supply, so when Bob ends the year with more cash than he started (because of his saving), others must be ending the year with less than they started – dissaving. In Orderlyland there are no assets for people to “invest” their savings in (that’s the point of this simplified model), so all saving has to be in the form of cash – and we just said that the total amount of cash available is fixed, so if some people end the year with more money than they started (because they saved), others are forced to dissave the same amount. Mathematically, it always has to balance out.
Does this mean that national saving in Orderlyland will always be zero? No, because the economic slowdown caused by Bob’s saving means that that some firms end up with unsold stock at the end of the year, so there will be national saving in the form of unsold goods. And in this model, the only way the nation as a whole can save is by stockpiling goods. So while you may think that an individual saving is going to increase the level of national saving, what this model shows us is that this is not necessarily the case. An individual saving could simply be balanced by someone else dissaving (reducing their wealth). This is another feature we will want to look out for over the coming weeks. And in particular, we will want to avoid the mistake that economists frequently make, of assuming that any individual act of saving simply adds to national saving.
If you’re not sure why this matters, don’t worry. Next week, we’re going to plug productivity increases into our model and see what happens, and as we add more components over the following weeks we will see how this affects the dynamics of saving, and the relevance will become apparent. If you have any questions, feel free to ask them in the comments.
So you’re saying that because I spend less than my income each year, I am causing the economy to be depressed. Somehow I don’t believe it.
You’ve badly misunderstood the point here, so I apologise that I didn’t make it clearer. I knew it was going to be challenging to gradually develop these concepts in a clear way, and I can see I’m going to have to try harder.
Firstly, I’m asking the reader to imagine a very unrealistic economy – cash only, no banks or financial assets, and in particular no growth or innovation. The economy just ticks along the same each year. Imagining such an extreme form of equilibrium enables us then to isolate the impact of household monetary saving (and by monetary I mean holding money, rather than saving by purchasing an asset). In this highly simplified, unrealistic scenario we can see clearly how the paradox of thrift works. I am at pains to point out the real-world economy is much more complicated, but I just want the reader to be able to clearly understand this one concept.
I will be using this technique over the next few posts, so it’s really important to be clear that this is what I’m doing, or else you will repeatedly miss the point. Do not draw inferences to the real world yet, we need to add more to the model and then see how the dynamics we are identifying now change as more components are added.
Think of the paradox of thrift as one dynamic interaction that occurs in the economy. The real-world economy has far more elements, so there are other dynamic interactions occurring. The effects of these obscure the effect of the paradox of thrift, but this effect still occurs. I’m using this model to isolate and thus clearly identify this one dynamic so that we find it easier to spot when we have built up to a model that more fully reflects the complexity of the real-world economy.
Secondly, for simplicity I ask the reader to imagine just one person saving. In reality, one person saving could never have any impact on the economy whatsoever! (Unless, perhaps, we think in terms of a small village economy in which much trading happens locally.) I could have asked the reader to imagine that saving suddenly becomes a trend and thousands of people start saving, but felt many people might find it simplest to think in the concrete terms of one individual (and then in future models I will re-introduce Bob, to see what the effect of household saving is this time). Maybe I was mistaken that this would make it clearer.
So don’t infer from this post that I am describing what happens if you personally save, (a) because this model in no way reflects the real-world economy and (b) the actions of one individual make no difference whatsoever.
Thirdly, it’s important to be clear that the model I describe is in an extreme form of equilibrium. We are imagining a land with full employment, everyone is happy with what they have, and it just stays in this steady state year after year. In such a scenario, a single action can have a dramatic effect (and that, of course, is the whole point pedagogically of imagining such a scenario, so that we can isolate the effect of this action). In the real world, even if household monetary saving suddenly became a hugely popular fad, there would be so many other knock-on effects and responses in the financial system that it is very hard to predict what the result would be. So again, don’t draw conclusions about the real-world from this first post – we are going on a journey together, and you’re going to have to be patient!
Finally, the most important concept to observe from this post is the second one (not paradox of thrift, which is the first). In this model, the act of of individual monetary saving does not lead directly to national saving because it is balanced by dissaving elsewhere (it does lead indirectly to national saving through increases in inventory – and these increases are magnified through the paradox of thrift which is why it was necessary to explain it). We will keep coming back to re-examine this effect in subsequent models, because economics textbooks typically teach that household savings are loaned out by banks and thereby fund investment, with an assumption that household saving is directly leading to national saving. This assumption will be tested in model after model, and sometimes will be found to hold, and sometimes not. I felt it was important, therefore, to use a very simple model to show how it can be the case that individual saving does not necessarily automatically increase national saving.
I’m sorry that this wasn’t all clear from the original post. However, explaining all this has taken more than the length of a typical post, and I’m in a constant quest for brevity as well as clarity! Hopefully these comments will also be helpful to anyone else who was similarly confused.
You described it clearly enough but clearly we cannot draw any conclusions like the first comment because the model is so simple and there are many other dynamics going on in the real world.
Exactly, it’s just introducing the concept. If you’re catching up on the blog, you’ll see that I revisit the concept in another post on savings after introducing productivity, investment, prices and variable money supply to the model. Next week I’ll introduce banking, and then we’ll revisit it again.
Fascinating stuff!