I’ve pointed out over the last 2 weeks that orthodox economists conclude from the saving-investment identity that national saving equals investment because savings are used to fund investment through financial markets. And I’ve demonstrated that this cannot be the reason, because financial markets are not part of the model by which the identity is derived. Even if financial markets did not exist, national saving would still equal investment.
In fact, this identity is pointing us to a causality that flows in the opposite direction – it is the value of investment that determines the value of our savings.
If saving is not channelled to investment the value of all our savings falls. But this fall in value is not necessarily reflected in financial markets – financial assets can be overvalued.
This short, simple paragraph above is the central idea I want to explain in this section of the blog. It will then become the lens through which we look at financial markets in the next section.
In the opening section of this blog I presented a series of very simple models to introduce different elements of the economy. With each new model, I considered the impact of saving on that model, in the posts Saving Part 1, Part 2, Part 3 and Part 4. I first showed the impact of saving using a very simple model where these dynamics could be easily understood, and then highlighted that these dynamics were still at work in increasingly complex models.
There were two repeated patterns. First of all, the act of one individual saving did not necessarily increase national saving – it could be balanced by dissaving elsewhere in the economy, often caused by the paradox of thrift. And secondly, in every case I highlighted that the nation as a whole could only save by an accumulation of physical goods, not an accumulation of money or financial assets.
In this, I was pointing towards the saving-investment identity, though I never formally proved that the value of saving had to be confined to the value of accumulation of physical goods. The saving-investment identity is that proof.
National saving must equal investment because the only way a nation as a whole can save is through the accumulation of physical goods – an increase in inventory or an increase in fixed capital (the two components of investment)*. This is actually all the saving-investment identity is telling us, and in one sense this isn’t that significant an insight. But the insight into the economy comes when we consider what happens to the value of individual savings that are not channelled into investment.
When this happens, saving will either be channelled to consumer spending (which can have various effects which we will discuss next week), or it will fuel asset price inflation. Asset price inflation is how the paradox of thrift manifests itself in the modern economy, again something we will discuss next week. Those early models were designed to help you see these dynamics.
And this brings me back to the statement above:
If saving is not channelled to investment the value of all our savings falls. But this fall in value is not necessarily reflected in financial markets – financial assets can be overvalued.
It may seem seem simple, but it is horrendously complicated to unpack – I’ve been having nightmares trying to draft the next few weeks of posts in a clear and straightforward way.
The statement that financial markets can be over-valued implies that financial markets are not “efficient”. This would be hotly contested by many economists, so it will be necessary to spend a bit of time clarifying and justifying this statement. This is not that complicated to do – probably one week explaining the concept of fundamental value, and one looking briefly at the concept of efficiency in financial markets.
More challenging to explain is the statement that if saving is not channelled to investment, the value of all our savings falls. This is what the saving-investment identity is telling us. If we don’t use our savings wisely, all savings lose their value.
The first thing I need to clarify is the difference in meaning between saving and savings. Saving is a verb – it refers to the act of saving. When we talk about national saving we mean the amount saved by a nation in a year. (In fact, we mean the difference between the national disposable income and consumption expenditure, but we’ll go into the significance of this next week.) We are not talking about the level of national savings (with an s). Savings is a noun – it refers to the stock of savings. Obviously, the value of saving in a year will increase the value of the stock of savings by the same amount, but the value of savings will also change with changes in value of the assets in which those savings are “stored”.
It is important to understand the difference between saving and savings and use the terms accurately and consistently. If you search through the blog, I am almost always talking about saving rather than savings. Where I use the phrase savings I specifically mean the stock of savings. To summarise, saving refers to the act of saving – the value saved in a year. Savings refers to the stock of savings – the total value of all savings held. (Just as savings is a stock, you will sometimes see saving referred to as a flow variable.)
So in my statement above, when I say that if we don’t channel saving into investment then the value of all our savings falls, I mean that if we don’t channel individual acts of saving into investment, the value of the stock of savings held in total will fall. Why should the value of everyone’s savings fall, just because some individual acts of saving are not channelled to investment? This is what I will unpack next week.
