The Misunderstood Relationship Between Savings & Investment
by James Kroeger
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If you ask an economist to explain the relationship between savings and investment, she will likely refer you to the model of the loanable funds market that classical theorists put together long ago. She’d mention that there is a supply of loanable funds and a demand for those funds and that the market price of those funds (the interest rate) is ultimately determined by the changes that occur in those two key variables. If, for example, supply increases relative to demand, the interest rate will drop. If demand increases relative to supply, then the price will go up.
In the classical model, the demand for loanable funds comes from firms that want to use them for economic investments that will improve economic efficiency. The supply of loanable funds comes from the savings of households. With this model in mind, economists have typically pointed out that an increase in savings will increase the supply of money available for lending relative to demand, forcing interest rates down, which makes borrowed money more affordable for firms. Conversely, a reduction in savings when demand is constant or growing would force interest rates up, making funds for firm investments prohibitively expensive.
When they are taught this conceptualization of the money/capital market, economists are [implicitly] asked to embrace several key assumptions:
Firms always have economic efficiency projects they would invest in if only there were enough loanable funds available at an affordable price.
All money borrowed by firms is used for economic investments
All economic investments by firms are financed by borrowed money and therefore by savings
All saved money is borrowed by firms
All money borrowed by firms comes from saved money
These assumptions are said to be “close enough” to the truth that we can rely on them to give us an accurate understanding of the money market and the crucial role that savings plays in our economy. Unfortunately, nearly all of these assumptions are flawed.
Empirical evidence reveals that:
1) Between 1988 & 1997, an average of nearly 85% of the money that corporations spent on investment came from retained earnings or other internally generated funds.1
This empirical fact would seem to strongly refute the assumption that firms are desperately dependent upon borrowed money (and therefore upon savings) when they want to make investments. What is the ultimate source of the internally generated funds? It would be the expenditures of consumers and firms and government, not savings.
2) Between 1998 & 2001 (years that included cyclically high levels of business investment) the combined borrowing of non-financial corporations and all non-corporate businesses varied between 20-34% of total borrowing nationwide.2 During the same period, the household sector of the economy accounted for 20-30% of total borrowing.
These statistics tell us that only a fraction of total savings is directed, ultimately, to the noble purpose of improving economic efficiency. Much of the money that is saved is ultimately spent on consumption (e.g., credit card and installment purchases). If firms find that interest rates are too high, is it necessarily because there is a shortage of savings, or is it perhaps because lending institutions are quite happy to starve the supply-side of the economy if they can get higher yields by lending to people for their consumption desires?
3) Savings are not the only source of loanable funds
The ultimate determinant of the supply of loanable funds in the U.S. economy is the Federal Open Market Committee of the Federal Reserve System. Whenever The Fed buys securities in the open market, it pays for them with money that it creates out of thin air with a keystroke. It does not draw the money from some reserve account that is limited in size.3 It is “new money” that did not exist prior to the keystroke that created it. With any of its purchases of securities, The Fed provides loanable funds to banks that were not saved by any saver.
This gives us a profoundly different investment equation. Instead of the equality Investment = Savings that is taught in most economics classrooms, a more accurate description of the loanable funds market would be Investment = (some % of Savings not used for Consumption) + (the corporate earnings that finance 85% of Corporate Investment) + (newly created money by the Fed deposited in banks).
There is no limit to the amount of money The Fed can inject into the loanable funds market.4 If savers were to suddenly pull most of their money out of banks and put it under their mattresses instead (equivalent to a dramatic reduction in savings), The Fed would still be able to easily maintain the supply of loanable funds or even increase it by simply buying every sort of debt instrument offered in the credit markets. Even if The Fed bought up all of the nation’s debt---something that would never happen---and there was still a shortage of loanable funds, it could maintain/increase the money supply by buying buildings or land or anything else it fancies.
In a booming economy, at some point The Fed will begin to panic about the prospect of inflation as unemployment approaches zero. It will want interest rates to increase to discourage the spending of borrowed money. That is something we would expect would happen if people started to save less. But The Fed does not want people to save less in this situation because that would mean that they are spending more, which is the very thing that The Fed does not want. This is not a conundrum for The Fed, however, because it can withdraw loanable funds from the market by either selling securities or by increasing the Reserve Ratio. These actions will drive up interest rates no matter what happens to the savings habits of households.
In light of these facts, it is quite irrational for economists to insist that interest rates are influenced in any significant way by savings levels given The Fed’s known capabilities and its proven ability to control the money supply (interest rates) no matter what the level of savings. Changes in savings do nothing more than simply determine how many securities The Fed is going to buy or sell to maintain the supply of loanable funds at the level it desires. Firms never face a shortage of loanable funds in the U.S. unless that is what The Fed wants. We can be absolutely certain that The Fed will cheerfully reduce the supply of loanable funds available to firms any time it believes inflation is threatening.
A correct, empirically-based understanding of The Fed’s role in credit markets leads one logically to the conclusion that the primary argument Supply-Siders have always used to justify tax cuts for wealthy citizens is actually quite spurious. If interest rates are ever too high, it isn’t because there is too little money being saved in the economy; it’s because The Fed has intentionally reduced the supply of loanable funds in the economy to ensure that interest rates will be “too high.” If savings levels are dropping, but the Fed still wants interest rates to remain low, it would simply buy Treasuries in the bond market---increasing the supply of loanable funds---until interest rates are as low as it desires.
One thing we need to try to remember is that it is ECONOMIC INVESTMENT that is sacred in our economy, not the practice of saving money. They are not the same thing. Many economists frequently refer to Saving as a pure good that the economy can never get too much of, but they are mistaken. The simple economic truth that should be apparent to all is that there are certain times (full-employment economy) when greater aggregate savings is a virtue and other times (unemployed resources) when it is quite the opposite. No, we are not saying that saving money is a great evil that needs to be stamped out. We are simply saying that policy makers need to be aware of the serious damage that excessive saving can inflict on the economy and be prepared to reduce those excesses when they occur.
1 Brealey & Myers, Principles of Corporate Finance, 2000, pp. 383-384.
2 Flow of Funds Accounts, The Board of Governors of the Federal Reserve System, www.federalreserve.gov
3Confirmed by a spokesman for the Fed Board of Governors.
4Many have argued that international capital flows have been even more important than domestic savings rates in determining America's recent, historically low short-term interest rates. It must be kept in mind, however, that foreign investors paid for their purchases of America's financial assets (U.S. Treasuries, e.g.) with U.S. dollars. Where did these dollars come from? Primarily from U.S. bank reserves (the size of foreign bank reserves of U.S. dollars is ultimately determined by the size of domestic bank reserves). When a foreign investor buys an American asset, she "activates" unused reserves of dollars, injecting them into our economy's money supply. Ultimately, however, the Fed's unlimited control of the money supply is so profound, it can easily compensate for any fluctuations in international capital flows. If, for example, foreign owners of U.S. Treasuries (typically, foreign banks) were to try to sell all of their holdings, The Fed could easily maintain the money supply and the interest rates it desires by buying all of them.
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