Consumer saving is bad for the economy. ??

A familiar theme of late is that increased consumer saving is bad for the economy. This is similar to many other mentions in the media that ‘the consumer needs to spend in order to improve the economy’, etc. This is also the dominant theme of government programs such as cash for clunkers and tax credits for new home purchases.

This ‘saving is bad for the economy’ theme is just ridiculous. Savings is the foundation of all economic growth. Savings leads to investment. Investment leads to new capital. Capital results in increased productivity. Increased productivity leads to more, cheaper goods, which are then consumed. Consumption is at the end of the chain, savings is at the beginning. This is a crucial point. In order to consume in the future, one must forgo consumption today. This concept is the same whether for a person or a country. Savings is simply forgone consumption. (On the other hand, borrowing is simply consumption pulled forward to the present at the expense of future consumption.) This increase in savings (and paying down debt) HAS TO result in decreased economic activity in the short-term, but that is a completely necessary outcome from the excessive spending in the past couple of decades. The economy might have to shrink for a few years to work off the previous excesses.

Let’s take every economist’s favorite example – Robinson Crusoe. Robinson Crusoe is able to catch one small fish per every two hours with his bare hands. He fishes for sixteen hours each day, and eats eight fish in order to keep from going hungry. At some point, Robinson wants to build a fishing net (ie capital). In order to build this net he fishes only 12 hours per day and catches six fish, and devotes his other four hours to searching for sticks to make a crude net. Robinson has to forego current consumption and go hungry in order to save up for capital equipment. After he devotes a few weeks to this saving and capital accumulation, he has a net that allows him to catch 1 fish per hour, which gives him much more time for leisure or berry-picking. He has achieved a positive return on investment and is wealthier because he has more food or leisure time or both.

To expand the example somewhat, let’s say that Robinson meets Friday, who has already constructed fishing nets. Robinson and Friday agree to trade one fishing net for 40 fish. In order to make this trade, Robinson has to save some of his fish – say 1 fish per day for 40 days. This means that Robinson has to sacrifice, ie go hungry, for 40 days in order to afford the fishing net. This is the same as investing to accumulate capital. Savings is the necessary first step in sustainable economic growth. One other option that Robinson has is to borrow from Friday. He can take the fishing net today and agree to pay Friday 60 fish next month (due to interest). The fishing net allows him to catch 1 fish per hour, so he can still get his fill of fish each day and set aside fish to pay Friday next month. But, he still will get less leisure time than if he had built the net himself, because he needs to repay his debt. This shows that borrowing and investing in capital equipment can be a positive economic decision if the return on capital is high enough. If this was the position that the US was in, it would be a short recovery process, but unfortunately, this is not the position that US consumers find themselves.

The final example is that Robinson borrows the net from Friday in exchange for 60 fish next month. Instead of using the net for fishing, Robinson uses it to help construct a shelter. This does not help him fish any more productively, so he has to sacrifice much more in the future in order to repay his debt. His future consumption of fish will have to be less than normal because he has to use 60 fish to repay his debt – he might have to go without food for a couple days because he only catches 8 per day with his bare hands. The trade may or may not have been a good decision (maybe his shelter outweighs his hunger), but it is a fact that Robinson’s future consumption has to be less. Borrowing in order to purchase a non-income-producing asset (like cars/TVs/vacations/especially homes) results in a decrease in future consumption. The US consumer is in the stage where he has to defer consumption in order to repay his debt. Consumer spending has to decline, but capital investment should increase.

To sum: savings is the foundation of the economy. If we want the skyscraper to keep reaching for the heavens, we have to solidify the foundation.