I’ve spent the last 3 months writing about investment and how it is funded, from a purely theoretical perspective.
That might seem pretty sad (and I didn’t know it would take so long when I started), but there is a purpose to this, and now I’ve finished I thought I’d summarise it all.
To provide enough for everyone, we need to be able to produce goods and services. And production requires infrastructure to be in place – factories, machines, shops, transport systems… We call this fixed capital, and we call expenditure on this investment.
Once businesses exist, any innovation or development requires further investment, and we also need to maintain and replace the existing fixed capital, so investment expenditure is an on-going need of our economy. In fact, investment is critical to maintaining and increasing our productivity so that we can provide enough for everyone. And hence, this section of the blog has come under the heading of “productivity” rather than “investment”, because this is the only reason all this matters.
The next section of the blog will be about what actually happens in financial markets in the real world right now – it will be much more interesting and dramatic, and you might wonder why I didn’t just jump into this. But to identify what is interesting and significant amongst all the complexity of those markets you need to understand certain core principles.
So the opening posts in this section covered what is known as the saving-investment identity: the total national saving of a country is always equal to its expenditure on investment plus its trade surplus (or minus its trade deficit). If there is balanced trade, then national saving always equals total investment expenditure.
The saving-investment identity is a well-known part of economics theory and would feature in any introductory course on macroeconomics. It is not controversial – it is widely accepted, if little understood.
The identity is derived from the equations used to calculate Gross Domestic Product (the value of everything produced in a country in a year). These equations include values for household expenditure, government expenditure, taxation, investment, consumption, saving, exports and imports, and so each of these terms is clearly and precisely defined. Applying simple algebra to the equations using these terms then leads us to the saving-investment identity, which means that this result is true by definition. It doesn’t need to be proven by scientific observation – given the definitions of the terms listed above it must always be true that national saving equals investment plus the trade surplus. This is not something that is up for debate (although occasionally people who don’t understand the identity will try to argue against it).
So the next question is, “So What?” – what is this telling us?
Mainstream economics has long drawn the conclusion that national saving equals investment because savings are placed with banks and financial markets which then lend them to businesses that want to invest – they say that banks intermediate saving to investment. And this implies that saving is necessary for investment. This is completely wrong. It is obviously wrong. It is boneheadedly-stupid. I don’t use these phrases emotionally – I strive on this blog always to write in sober and dispassionate terms – but I feel it is a fair and dispassionate analysis to say that mainstream economics texts are completely wrong in obvious ways that are basically very stupid. And it’s important to be clear on this so that you are not drawn into making the same mistakes. I make my case for this here and here, so you can read it and tell me if you feel I’m being fair or not.
So if it’s not the case that national saving equals investment because saving is used to pay for investment, what is the saving-investment identity telling us? There are 7 weeks of posts exploring this (starting here), based around the following proposition:
If saving is not channeled 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.
What I’m saying with the first sentence is that national saving equals investment not because saving is needed for investment, but because it is the level of investment that determines what our savings are worth. If individual acts of saving are not channeled through to investment, we do not maintain and improve our productivity, and thus the value of our economy is less than it would have been otherwise, and thus our individual savings are worth less.
This should then be reflected in the value of financial assets, but it isn’t because financial markets are not efficient. This is the second sentence of the statement above, and is dealt with in 3 posts starting here. You might think you have a certain amount of savings (e.g. your pension fund), but if financial markets crash all that wealth vanishes – the value of all our savings falls. We think the prices in financial markets represents the value of our savings, but in fact it just represents the wild and irrational behaviour of those markets, fuelled by constantly increasing demand. You might get lucky and retire at the peak of a bubble, or you might have the tragedy of retiring at the bottom of a crash (the difference in the size of your pension could be phenomenal). But the key point is that those asset prices don’t represent the fundamental value of your savings – that value is dependent on the productivity of the economy, which in turn depends on fixed capital investment.
At present all financial assets (including property) are dangerously overvalued compared to the actual productivity of the economy. We are in a bubble that is waiting to burst. In fact, we are in a bubble that has been slowly expanding since the early ‘80s. All the crashes since then, global and national, did not return prices to their fundamental level – prices just dipped a little then we slapped a patch on the balloon and started blowing again. Right now we’re seriously running out of breath, and hence the anaemic performance of the economy since the last crash. And this “lack of breath” is actually inadequate growth in productivity caused by inadequate investment.
The final post, last week, highlighted how saving could in fact be intermediated to investment. I used a set of business accounts to show you the undistributed profits of the firm, which are (by definition) business saving. Such saving can naturally be used as the source of funding for fixed capital investment, and very often is by businesses. So when we look at financial markets we will be very interested to see how business saving is actually being used.
This completes a brief overview of the concepts covered in the last 3 months, but there are two features of the functioning of financial markets that I want to repeat in slightly more detail, as they are so important to understanding what is going on right now.
If one person saves by buying a financial asset, someone else is receiving that payment. If they then spend that money in the real economy the act of saving is balanced by the spending of the seller. For this reason, many economists ignore the study of financial markets, and they also believe that levels of private debt are irrelevant to the economy because all debts and credits balance out across the economy.
There are several reasons why this belief is wrong, but the relevant one here is that not everyone selling a financial asset then spends the money in the real economy. Often, they simply buy a different asset. Traders are constantly moving from one asset to the other, looking for small profit opportunities. If more money flows from the real economy into financial markets than flows the other way (which seems to be the case right now) this reduces the amount of money flowing in the real economy (known as the velocity of money). This will cause a slowdown in the economy through what is known as the “paradox of thrift” (the term is explained here, and the exact dynamic I’ve just described is explained in detail here).
This is why acts of saving that are not channelled to investment can end up slowing down the economy. This is exactly what has been happening to our economy for many years, so it’s a very important dynamic to emphasise.
Secondly, each month there are new flows from the real economy to the financial economy – pension funds, for example. These funds are going to buy financial assets no matter what. If the supply of desired financial assets at current prices is insufficient to meet that demand, prices will simply rise. This is also a dynamic that has been going in financial markets for years, driving the giant bubble we are in. Every so often the bubble becomes unsustainable and bursts, but after a period of stabilisation the relentless, unthinking purchase of financial assets pushes prices up again. When a pension fund buys an asset they are rarely buying it off a company and thereby funding investment. They are typically buying it off a dealer (such as an investment bank). The financial market is primarily a market in second-hand assets (to borrow a wonderfully accurate phrase from Steve Keen).
The inflation of asset prices makes it cheaper for firms to borrow to fund investment (which is one reason why current monetary policy, such as quantitative easing, sought to push asset prices up following the crash). But it also means that savers are over-paying for assets – savings are soaked up into overpriced assets rather being intermediated through to investment.
I first came across the saving-investment identity 5 years ago. I could instantly see that the reasoning of mainstream economics was wrong, but working out what a more accurate model would be was no easy task. This section of the blog has essentially been a summary of those 5 years of study and analysis. It suggests that we need to look closely at the flow of funds from the real economy into financial markets, the flows inside those markets, and the flow back to the real economy, with a special attention on business saving.
So I looked around for relevant empirical studies and I discovered papers that confirmed my suspicions more dramatically than I ever would have dared expect. This is what we will start looking at in the next section of the blog – the seismic shifts in financial markets in this century and the implications for the economy.
If I could start the blog again, I would start with the material that is coming up next. But I only discovered these papers after I’d started the blog. And I only discovered them because of the ideas that I’ve spent the last year writing about, and that is the power of a good theory. I never realised the material covered in the last year would take so much time or be such a slog (sorry about that). If it helps you understand the significance of what we will go on to look at next, then it will have served one purpose, but mainly I think writing the blog was the only way I could clarify these thoughts in my own head.
Now we will get on to the exciting stuff, so we are reaching a somewhat pivotal moment in the blog just as we reach its first anniversary. To mark that anniversary the next post will be an overview of everything so far, to distill all the detail over the year and as an aid to any new readers, before launching into the next section.