Over the last 3 weeks we’ve rattled through material that would typically be covered in the opening chapters of a macroeconomics textbook (with a number of additional clarifications from myself), until we reached the saving-investment identity. I’m not going to summarise any of this – if you’re not clear (or you’ve not read it), you’ll have to read it again.
What I demonstrated is that, if exports exactly equal imports, then national saving must equal investment. There’s nothing radical or controversial about this, it’s basic macroeconomics.
When I was studying conventional economics I wanted to feel confident that the range of courses and books I had studied was giving me a fair representation of widely held mainstream thought, so I looked up what the best-selling textbook was – there were a few contenders, but Greg Mankiw’s “Principles of Economics” came up most frequently so I bought a secondhand copy (2004 edition).
He starts the macro section by explaining GDP (chapter 23) and in chapter 26 outlines the saving-investment identity. He then asks the questions (page 570):
“What mechanisms lie behind this identity? What coordinates those people who are deciding how much to save and those people who are deciding how much to invest?”
And he gives the following answer:
“The answer is the financial system. The bond market, the stock market, banks, mutual funds, and other financial markets and intermediaries stand between the two sides of the S = I equation. They take in the nation’s savings and direct it to the nation’s investment.”
And a bit later he adds (emphasis in original):
“The supply of loanable funds comes from those people who have some extra income they want to save and lend out. This lending can occur directly, such as when a household buys a bond from a firm, or it can occur indirectly, such as when a household makes a deposit in a bank, which in turn uses the funds to make loans. In both cases, saving is the source of the supply of loanable funds.”
Reading this elicited a somewhat angry reaction from myself, reflected in the notes scrawled in the margin of my book! I’m not going to repeat them here, because I strive to keep the language of the blog sober and dispassionate.
But it is important to be clear that what Mankiw has written is absolutely false, and that this can be clearly and incontrovertibly demonstrated. The error, I would suggest, is blatant and easy to point out, and yet it pervades macroeconomics teaching and media commentary. I am not singling out Mankiw because I perceive him to be particularly at fault, but rather precisely because he is representative as the author of a best-selling economics textbook. I’ve regularly seen and read economists drawing the same conclusion – that the saving-investment identity occurs because savings are intermediated to investment.
In striving to be balanced and fair-minded, we should be careful not to be dismissive or derogatory of different perspectives. But equally, if something is clearly wrong, then it is just plain wrong! And if such an error pervades an entire academic field then it is balanced and fair-minded to be wary of that field.
So what is this terrible error? What is so false about the way that orthodox economics interprets this identity?
First of all, I hope you noticed that Mankiw claims that banks loan out their customers’ deposits. This is a fiction repeated in textbooks that I covered thoroughly in the posts about money. In his chapter on “The Monetary System” Mankiw gives the standard incorrect position of mainstream economics that has been repudiated by the Bank of England and many others, as described here.
The main reason it was necessary for you to gain an understanding of the monetary system was so that you could instantly see what is wrong here. Banks don’t intermediate between savers and borrowers, they create new money every time they make a loan. In the words of the Bank of England:
“Rather than banks receiving deposits and then lending them out, bank lending creates deposits.”
If this isn’t clear to you, you need to go back to the section on money (click money on the menu bar above) – this was the whole point of those 15 weeks of posts!
But it is true that most financial markets do intermediate between savers and borrowers – as Mankiw states, when a saver buys a bond, the firm selling the bond is borrowing from that saver. However, not all funds raised in financial markets are used for investment. Financial assets also channel funds to consumers, for example, so that loans are spent on consumption rather than investment. And increased demand in financial markets (from increased saving) can simply inflate the value of assets, as described here and here.
It is absolutely clear and empirically demonstrable beyond any shadow of doubt that banks and financial markets do not channel all savings into investment, and therefore the reason for the saving-investment identity is not because of these markets and systems.
But there is an even more fundamental, glaring error here, which I will point out next week.