Thursday, November 19, 2009

Saving is not Investment

There's a long and ultimatily unsatisfying thread over at Nick Rowe's. Sadly, I cannot recommend it.

One clear idea emerged -- the confusion around "savings" and "investment".

If you get some money and don't spend it, then it's clearly savings. If you get some money and you use it to buy something you then consume (like a donut), then it's clearly "consumption". But how about when you spend your money on something that you hope will give you even more money in the future, like a share of Goldman Sachs, or a Treasury Bill, or a lottery ticket, or a house? Is that "consumption", "savings", or "investment"?

When you're thinking about and tracking the movement of money, then all of those "investment" activities should not be thought of as "saving". They should be thought of as "investment", and may, retroactively, be reclassified as "consumption" -- almost certainly in the case of the lottery ticket, and commonly nowadays in the case of the the house. So, you need all three definitions: saving (money in the bank or under the mattress), investment (money spent in the hope of getting it back), and consumption (money spent with no hope of getting it back). They key difference between these is that investment and consumption is money spent, it triggers income for some other party in the sector, while savings is not. If you are looking at demand or money, velocity, aggregate demand, or anything that involves transaction, you must understand that "saving" does not generate a transaction while both forms of "spending" (consumption and investment) do.

In the end, the amount of saving will equal the amount of investment (S=I) but the causality behind this is subtle, and requires complete attention be paid to the difference between real and nominal. That is a post for another time.

(Small note. In the above example, the Treasury Bill would count as "savings" because it does not trigger a spending event. Government spending is independent of anything the private sector does, and treasury bills simple change the term structure of outstanding reserves, as a mechanism to set interest rates, and are not a "funding" source for anything. Similarly, putting money in the bank does not "enable" the bank to make a loan, as bank deposits are CREATED through the act of lending)

6 Comments:

Blogger Nick Rowe said...

Hey, Winterspeak! Read my latest comment on my "Accounting and Economics" post. I've come down (I think, sort of) on your side!

5:10 PM  
OpenID beakburke said...

I think Bryan Caplan's post on money velocity http://econlog.econlib.org/archives/2009/11/what_is_money_v.html also makes this distinction. He says basically that the velocity of money (V in MV=PY) is simply the inverse of savings. In uncertain times, people reduce C and I and increase S; increasing S drives down V (since V is the inverse of S. If V falls and the increase in M doesn't fully offset that, you get falling nominal GDP (PY).

9:35 PM  
Blogger JW Ogden said...

OK so should saving be discouraged? Should Government not sell bonds at all and not insure demand deposits so that people invest more and save less and should currency be only backed by the assets of a bank rather than the full faith and credit of the US gov.? Is it true that the smaller saving is the less its varying can threaten the whole economy?

12:49 PM  
Blogger JW Ogden said...

Addendum to earlier post imagine that people save for retirement rather than invest and so the boomers reach the age of retirement with huge wads of cash and start spending wouldn't this require a significant offsetting adjustment in consumption. That means in their working years extra investment was not made increasing productivity and it their latter years investment will not slow freeing some extra production for consumption. So gov. will need to make the more and bigger adjustments.

BTW A great way to invest today in energy save capital like insulation.

1:01 PM  
Blogger original anon said...

Alas, much error is in the post. Money in the bank is not saving. When I take out a loan, I have money in the bank, initially. I can leave it there if I want. May not make sense economically, but it’s not illegal. When I buy a treasury bill with the money, I still owe the loan. Clearly, neither of things has anything to do with saving. And S = I does not depend on nominal versus real.

4:29 AM  
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