Why do neoclassical economists want the budget to be balanced and people to save more? Because they believe that “saving finances investment”. They believe that in order to finance investment, somebody has to have saved beforehand. This might sound intuitive, but it is one of the biggest (and unfortunately oldest) fallacies in economics. Saving never finances anything – money and credit do; and nobody has to save for anybody else to have credit and thus to invest.
According to the “saving-finances-investment”-theory (often called the loanable funds theory), households have to save first, bring their money to the bank so that firms can borrow and invest – as long as government deficits have not taken away the precious savings from firms. From this it follows that more household saving and lower government deficits are the best way to promote investment: More saving leads to a higher supply of credit and thus more investment. Zero government deficits avoid crowding out private investment. And so if investment is not high enough, both households and the government should save more by cutting their spending and thus allow banks to increase credit.
Credit in the real world – a simple booking procedure
At first sight, the theory seems to be intuitively appealing. But once you look how credit is actually created in the real world, the theory quickly becomes utter nonsense (find more on this in my recent working paper). Nobody has to save before a credit can be created. A bank (either a commercial bank or the central bank) creates credit and money out of thin air by a stroke on a computer keyboard: a bank creates a deposit for its debtor which the debtor can withdraw to pay for something. Later on, the debtor has to repay its debt – if he can’t, the bank has a problem. Giving credit is a simple booking procedure. No bank has ever denied a credit to a potential borrower because of a lack of prior saving.
But if banks can create money out of thin air, why do they need deposits? Banks create bank money, but not central bank money – which only the central bank can do. But central bank money – coins, banknotes, deposits at the central bank – is what people need to make payments. So banks somehow have to get hold of central bank money, either directly from the central bank, from other banks via the interbank market or via deposits.
But if banks want to get money from depositors, this does not necessitate in any way that depositors save. Money does not disappear when it is spent and not saved – it is not “used up” by government deficits or investment. If everybody would always spend all of their income and not save at all, the money would not disappear but flow to firms and back to households: it is transferred from the customer’s bank account to the firm’s bank account; from the firm’s bank account in the form of wages and interest to the household’s bank account and so on. The money is not lost at all to the banking system whatever it is spent on and whatever amount people save. When people do not spend all of their income but save, this is money that the business sector does not get in the form of sales.
In general, as long as people keep their money at the banks – whatever their amount of saving – the banking system has no problem refinancing itself with deposits. And if people were less willing to keep their money at the bank (which today happens for instance in Europe’s crisis countries), banks can refinance themselves at the central bank. So, no saving has to take place either for deposits to be a source of bank credit or for credit to be created.
Financial saving is a zero-sum game
Anybody with sufficient collateral who wants to finance a physical investment (produce or buy a machine or a house) can get this credit, use the money so obtained and invest (with the caveat that banking regulation can of course restrict credit creation, but again, this has nothing to do with saving). Most adherents of the view that saving finances investment seem not to know that investment itself is saving. Normally, we tend to identify saving with financial saving – i.e. to have more money, more bonds or more equity. However, accountants have defined saving as increases in all kinds of wealth, both financial and non-financial.
While the production of new capital goods always increases saving in an economy, financial saving is a zero-sum game. One can only increase net financial assets (financial assets minus financial liabilities) by spending less than one earns. The problem is that your spending is my earning. So if anybody cuts his spending to increase his net financial assets, somebody else will see his earnings cut by the same amount – and thus his ability to save money. Since earning and spending are necessarily equal in the whole economy, the whole economy cannot save financially – net financial assets are zero in the aggregate.
On the other hand, investment creates spending – if a firm builds new machines and houses, it spends money on wages which are income for wage earners; firms that buy machines and households that buy houses spend money – which sellers earn. In contrast to financial saving, increasing production of physical capital goods – investment – is not a zero-sum game.
The paradox of thrift
So what would really happen if people save more money believing that this leads to a higher availability of credit and more investment? Since households mostly spend their money on goods sold by firms, cutting spending in order to increase saving automatically reduces firms’ revenues. Will that incite firms to build more machines?
This seems unlikely. Even if they take out more debts when they see their revenues fall, they would probably not use it to increase their investment. If they would like to continue spending the same amount of money on their employees which they did before households had cut their spending in order to save, they would have to borrow the money which they had earned before by their sales.
But is it even likely that they will take out more credit when they see their earnings fall? That depends on their expectations of future household spending. If households firmly believe in loanable funds theory, they will try to keep their saving up in the long-term – and in consequence firms’ revenues will be permanently reduced. If firms still kept up their former level of spending, their higher credits would lead to higher interest commitments in the future. Thus, rational businesspeople are more likely to cut spending themselves than to increase future spending by taking out new credits. What kind of spending are they likely to cut? Probably they will reduce the wage bill by either reducing wages or firing people. Unfortunately, those are the private households’ revenues, out of which households had planned to save.
Thus, if firms reduced their payrolls households would have shot themselves in the foot with their decision to save: they wanted to save but what they actually achieved is to cut their own revenues. If they would then again reduce their expenditures, firmly believing in the merits of thrift, firms would again face lower revenues etc.
This is the paradox of thrift: households’ plans to save more leads to a decrease in aggregate revenues and expenditures – and no financial saving has actually taken place. Since firms are also likely to cut back their investment, overall saving will have fallen. The government could of course counteract the whole process by spending more where households spend less – but if the government also believes in loanable funds theory, it will cut spending itself and consequently the private sector’s revenues – welcome in recession-land. Or rather: welcome in euro-land.
Those are the economic costs if people who firmly believe in “saving finances investment” rule or advise the rulers. This is not just theory, the fallacies of loanable funds theory are what makes millions of unemployed in the euro zone suffer every day. Economic theory has real world consequences – sometimes for the better, often for the worse.
The text was first published in 2012 on the Social Europe Blog.