Over the last 2 weeks I have been exploring this central idea:
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 week I am going to show you how this idea could explain the current lack of productivity in the economy, a phenomenon considered something of a conumdrum at this time.
But first, and at the risk of hammering the theme to death, I want to get under the skin of what saving is. Being clear on this will really help you avoid making errors of thinking when we get stuck into the detail of current financial markets. I’m afraid this will be a slightly longer post again, but the pay-off comes at the end when I relate what we’ve been discussing in the last few weeks to the latest news on the state of the economy.
Five weeks ago I quoted the definition of saving from the System of National Accounts (paragraph 9.28, page 182):
“Saving represents that part of disposable income (adjusted for the change in pension entitlements) that is not spent on final consumption goods and services.”
The guidance also states that saving is a “balancing item” in the accounts. Paragraph 9.26, page 182, states:
“Saving is the balancing item in the two use of income accounts. Its value is the same whether it is derived as disposable income less final consumption expenditure or as adjusted disposable income less actual final consumption (in both cases, after making the adjustment for the change in pension entitlements just described).”
By “balancing item” they mean that they don’t collect data on how much people are actually saving, they simply deduct expenditure on final consumption goods and services from disposable income. They insert whatever figure causes the accounts to balance.
This is the critical point: national saving is not the sum of all the individual acts of saving – this is not how it is defined and this data is not collected. Saving is the difference between disposable income and consumption expenditure, which at national level always equals expenditure on investment.
For an individual or company saving is still defined as the difference between their disposable income and consumption expenditure, but they can save by increasing their bank balance. But this act of saving does not necessarily contribute to national saving. As highlighted last week, a single act of saving may be balanced by dissaving elsewhere in the economy, or it could simply cause asset price inflation. Individual saving only leads to an national saving if that act of saving is channelled to investment. Indeed, the saving-investment identity should be telling us to look at the impact of individual saving that isn’t channelled to investment (as we did last week), rather than glibly state that this identity holds because financial markets intermediate all saving to investment (the claim of economics textbooks, which is demonstrably false).
In a few weeks I will start sharing fascinating articles about the current state of financial markets, and I found those articles because my understanding of this identity was telling me where to look. As I’ve said before, “shadow banking” was never actually in the shadows, it’s just that mainstream economists weren’t paying attention to what matters because the models they use are so flawed.
If I’ve been a bit repetitive over the last few weeks it’s to make sure that the concept of saving is absolutely clear, to stop you falling into the lazy intellectual errors so common among economists and journalists. For economists have another definition of saving: they will sometimes define it along the lines of being a decision to defer consumption from now to the future.
What they are introducing here is an idea of intention: that saving represents a choice people are making between consuming now and consuming in the future. But intention plays no part in the definition used in the GDP model, and this second definition by economists can be unhelpful. In particular, it can be taken to imply that national saving is the sum of all of these intentional acts of saving. Individual acts of saving only contribute if they are channelled to investment expenditure.
However, the concept of a choice between consumption now and consumption in the future is central to the functioning of economies – in fact, I referred to this trade off in the 3rd week of the blog. But the choice that matters is the decision by businesses of whether to they use their resources to produce the maximum amount possible this year, or whether they invest some of those resources in maintaining and improving all their equipment, their know-how etc, so that they can sustain and increase their levels of production in the future. In other words, how much they spend on investment.
These decisions then impact on our future wealth: when an individual saves, the value of their savings in the future depends on the level of productivity of that future society. And therefore how those savings are put to use – whether or not they do actually fund investment in future productivity – is critically important.
Don’t gloss over that last paragraph, it’s central to understanding how we create an economy that provides enough for everyone. Let me explain what I mean. At present in the West we’ve had the phenomenon of a surge in population known as the “baby boomers”. This generation has then lived through a period of rapidly increasing life-expectancy, while at the same time birth rates have fallen. Hence, in the next few decades a declining working-age population will be caring for a significantly increased retired population. Those retired people can only consume what the working are producing.
The value of their savings therefore depends on the productivity of economy – those savings simply represent a way to apportion them a share of what has been produced. And that productivity, of course, depends on the level of investment.
Unlike the nation as a whole, you can save personally by accumulating money. Your savings will give you a greater share of the production of the country than you would have had if you had not saved. But if that saving isn’t channelled into investment the country will not sustain its productive capacity – you will have a larger share of a smaller pot. You will be better off than those who do not save, even if a failure to channel those savings into investment causes the economy to be weaker.
This is exactly what has been happening to our economy over many years. Productivity has been declining over recent decades, a decline that has significantly intensified since the financial crash. This is seen as a critical economic issue of this time, and something of a conundrum. This recent article in The Independent discusses the problem, and concludes that it has something to do with investment but no-one is sure why investment is falling.
The model outlined in this blog would suggest that investment is falling because saving is not being channelled to investment efficiently by the financial markets. The increasing demand for assets is simply inflating the price of existing assets, instead of purchasing new assets that channel funds to new investment. The result is not just the asset price boom that caused the 2008 financial crash, but also the current asset price boom that will cause the next financial crash (see this post and this post). All the pain of these crashes hides an even worse underlying problem – the long-term failure to invest in the capacity of the economy to provide enough when we are retired, because our savings (our pensions) are not being efficiently channelled into investment.
I hope you are starting to see how the detail given on the blog is essential to grasp if we are to begin understanding how to create an economy that provides enough for everyone.
It’s now time to unpack this idea of “inefficiency” in financial markets. I’m saying that assets deviate from their “fundamental value”, and next week I will explain what that means.