This year we invited extraordinary Professor Peet Strydom to write a series of guest posts about economic theory. In this first post he considers the relationship between savings and investment.
Investment, which refers to capital formation, determines production capacity and long-term economic growth. Conventional wisdom relates investment to saving in the sense that investment is financed by saving. From this true proposition the argument easily jumps to the conclusion that investment is driven by saving. The causation runs from saving to investment. In this sense saving could be a constraint on investment. We argue that this causation is only true under special conditions. In terms of a more general case the causation is reversed so that investment determines saving. Before we elaborate on these topics a few observations on saving behaviour are in order.
1. Saving and saving behaviour in South Africa
As opposed to investment statistics, saving is obtained as a balancing item in the national accounts. This complicates the stability of this variable as well as its interpretation. Empirically the corporate component is the most dominant in terms of size.
Our understanding of household saving behaviour comes primarily through research on personal consumption functions. It is not surprising that saving is also referred to as postponed consumption. Saving, as consumption, is primary a function of income.
Substitution processes appear to be important in household saving behaviour. From time to time we notice a switching out of discretionary in favour of contractual saving and vice versa. Households also switch discretionary saving into assets such as financial and non-financial assets. From 2005 to 2012, for example, the net wealth of South African households expanded by 13% per annum. These substitution processes could be encouraged by taxes on households. In view of the high marginal tax rate on individuals in South Africa in comparison with the corporate tax, it is attractive for households to arbitrage personal saving into corporate saving. The high individual tax rates coupled with a penalising capital gains tax are distorting household saving behaviour.
From this exposition it is evident that statements on the adequacy of saving vis-à-vis investment could easily enter the sphere of nonsensical argument.
2. Saving and investment: a real sector view
The real sector view refers to an exposition on the relation between investment and saving in a world without money. The most prominent example of this is the loanable funds theory, as for instance, discussed by Harberler (1946). This theory maintains that the rate of interest is the variable that equates the supply and demand for loanable funds or credit.
If we elaborate on the supply and demand elements the real sector nature of the exposition becomes evident. The supply of loanable funds is determined by thrift and the demand is for capital destined for production. In this sense the rate of interest has also been referred to as the price of capital. Here, the price of capital is dependent on its marginal productivity. Austrian authors, such as Böhm-Bawerk introduced a time element into the exposition by relating the marginal productivity to the length of the period of production.
The loanable funds theory is characterised by the fact that saving is the driving force behind investment, or formulated differently: saving determines investment. It is in this sense that the loanable funds theory has entered neoclassical economics. In the typical neoclassical growth theory of Solow (1956), investment is determined by saving. In the following section we show that this causation does not hold in a money economy.
3. Saving and investment in a money economy
The real sector approach to interest rates was first challenged in 1898 by Wicksell (1956). He distinguished the natural rate of interest and the money rate of interest. We will follow the literature by referring to the money rate as the market rate of interest. The natural rate refers to the rate of return on real capital goods while the market rate is determined by banks or the financial sector, in accordance with the demand for credit, funding or liquid capital, in the terminology of Wicksell. The natural rate depends on the general economic conditions that determine the efficiency of production.
The two rates are unlikely to be the same and Wicksell explains price movements by a deviation between these rates. When the market rate of interest is relatively low the demand for money loans rises and the supply of money adjusts to accommodate the new demand. As long as the market rate is below the natural rate prices will increase, the demand for goods will be depressed and there will be an adjustment of the market rate towards the natural rate while the demand for money becomes discouraged by a relatively high market rate. Conversely, if the money rate is above the natural rate prices will fall and the adjustment process described above will secure a convergence of the two rates. In terms of Wicksell’s analysis the equality of the two rates is rather an exception than the rule. It is this equality of the two rates that encouraged the concept of monetary equilibrium which claims the neutrality of money. This led Hayek to defend a stable monetary aggregate as has again recently been discussed by Wapshott (2011). This topic falls outside our present interest.
This monetary approach to the rate of interest accepts that the supply of money is an endogenous process. The explicit role of banks in Wicksell’s approach is even more relevant under present institutional arrangements regarding financial sector behaviour. We could describe this in general terms by identifying the modern business model of banks as the originate and distribute model. This has replaced the once well-known model of originate and hold. Whereas the latter model emphasises the banks’ position of trust between lenders and depositors the new business model encourages conventional banks to conduct more active liability management as they fund themselves through the interbank money market. In this framework endogenous money is much easier to explain since the money creation process has become a public affair in the sense that it is a matter of switching less liquid assets into more liquid assets with money the ultimate end of this chain. Following this exposition it is evident that the money creation process is endogenous and demand driven. The extent of the money creation is a function of the cost, as expressed in short-term interest rates that are, in the final instance, determined by the cost of accommodation at the central bank.
In this framework of endogenous money investment determines its financing or saving requirement. In terms our terminology above we could identify reverse causation: saving is determined by investment. It is this framework of thinking that fits the relation between the marginal efficiency of capital and the rate of interest as described by Keynes (1936).
4. The open economy
The argument in favour of endogenous money and reverse causation is strengthened if we extend the analysis to an open economy.
International trade and payments open up the possibility of accessing foreign saving. In this respect we distinguish saving surplus and saving deficit countries. If a country’s domestic demand is in excess of domestic production the excess demand is satisfied by foreign production in the form of imports. This means that a country with excess domestic demand is likely to run a current account deficit. This has to be settled in terms of the country’s foreign exchange reserves and or capital inflows. A country that runs a current account deficit on a sustainable basis is referred to as a saving deficit country since it is availing itself to foreign saving.
Conversely, a country with a sustained current account surplus exports saving and is described as a saving surplus country.
In a similar way as in section 3 the open economy exposition enables us to verify the endogenous nature of money where investment is not constrained by saving. Should domestic saving fall short of required funding, the shortfall is met by accessing international saving.
The debate about the constraint of saving on investment appears to be running out of depth if we consider the measurement of saving in the national accounts together with the various options open to households in respect of saving substitutes. The theoretical debate has two outcomes depending on whether one considers a money economy where the money creation process is endogenous to the system or whether money is excluded in a so-called real economy framework. The open economy exposition stages a strong convincing case for reverse causation.
HABERLER, G. (1946) Prosperity and Depression: A Theoretical Analysis of Cyclical Movements, Third Edition, New York: United Nations.
KEYNES, J.M. (1936) The General Theory of Employment, Interest and Money, London: Macmillan.
SOLOW, R.M. (1956) A Contribution to the Theory of Economic Growth, Quarterly Journal of Economics, 70:65-94.
WAPSHOTT, N. (2011) Keynes Hayek: The Clash that Defined Modern Economics, New York: Norton.
WICKSELL, K. (1965) Interest and Prices: A study in the Causes Regulating the Value of Money, New York: Kelley.