When S != I

As Brad DeLong has noted, Tim Geithner believes it is time for “the economy has now recovered sufficiently for government to begin to make way for private business investment.”  In short, he expects “the private sector” to do the heavy lifting in these joyous times of economic recovery.

Cynics among us—why, yes, that might well include me—would note that the private sector has had to do much of the heavy lifting for the past several quarters, in the face of what is varyingly described as “a precipitous decline in Aggregate Demand” or “a rise in unemployment.” (You say overextended credit, I say bankrupt.)  And that its performance has been, not to put too fine a point on it, exemplary in the face of the constraints presented.

Yes, I’m praising the efforts of the private sector.  Not just because small businesses especially are trying to sustain current levels of production and services in the face of tightened credit and the aforementioned AD decline, but also because they, as LBJ once observed in another context, have been put into the position of trying to run a race when the shackles are just being removed from their ankles.

I blame the banks.

Now you know it’s me.  The problem is, the evidence is on my side.  Recall that the alleged reason we needed to “save” the banks is that they are Financial Intermediaries, taking a slice out of the matching between Investors (Savers, in most economics models) and Capitalists, who borrow to recombine Capital (K) and Labor (L) into a new product that presents a better return than the old one.

Call it “creative destruction.” Call it “capitalism.” Call it “economic growth.”

Let us ignore—though it Abides, like Earth or a steaming pile of elephant dung—that the “intermediaries” were making somewhere between 30 and 40% of the total profits in the U.S. for the past decade. We can (1) pretend that those were all payday lenders, (2) be a “first-best economist” and claim that is the way things should be, or (3) realize it’s a problem and leave addressing it for another time.*

But let us not ignore that capital supply is essential to growth possibilities. With labor abundantly available, the limitation on creating new product is essentially The Big K, and it’s “Main Street” proxy, money.

As noted above, in most models of economic growth, we treat Savings as being equal to Investment.  This makes sense: even when the Financial Intermediaries were making $3 or $4 of every $10, they were reinvesting in better systems, better technology, better analysis, and better methods.  Low Latency leads to High-Frequency Trading (HFT) which leads to…well, let’s be nice and just say “greater firm profits.”  Even if only 50% of those profits are being directly reinvested, they are being reinvested, while the rest produces at worst greater paper investments and at best a higher velocity of money and/or a multiplier (“trickle-down”) effect from increased spending.**

Put your money in a Mutual Fund, it’s Invested. Buy a stock, it’s invested.  Put it in a Demand Deposit Account (what used to be a “Savings” or “Checking” account), and it’s invested (“swept”) by the Financial Intermediary, who gives you a share of the profits in the form of interest.

Not to sound like a broken record, but Excess Reserves put a spanner in that last one.  Don’t believe me, ask economists Bruce Bartlett or Joe Gagnon.  Or just look at a graphic of M2 and what I’m calling “Intermediary Private Investment” (M2 minus the Excess Reserves maintained by Financial Intermediaries).



As Excess Reserves are not Seasonally Adjusted, I used the NSA version of M2.  As noted in my previous post, up until September of 2008,  the Fed did not pay interest on Excess Reserves (or Reserves, for that matter), so that excess reserves were essentially a rounding error—funds kept because of the asymmetric risk-reward of a miscalculation, or “precautionary savings.”  They tended to total about $1-2 Billion on average, rather minor in the context of $7-8 Trillion.***

But once you hit September of 2008, the growth in M2 is more than negated by the growth in Excess Reserves. Indeed, the horizontal line on the graphic above is the level of Intermediary Private Investment in August of 2008—nine months into the “Great Recession.”—isn’t exactly reaching for the skies.  But it’s also significantly higher than the current I, as opposed to S.

(Note that the NSA trend is also downward since the alleged beginning-of-recovery months of June-July, 2009. That the performance has been as good as it has been in such a context is amazing.)

When Savings=Investment, there is potential for growth. When savings go into mattresses—for good reason, especially in the pre-FDIC days—intermediaries cannot do their job so efficiently as the models presume.

What are we to call it when Intermediary Private Investment is significantly less than Savings—when not the people, but the intermediaries themselves, are stuffing money into their own, interest-bearing mattress?

I would suggest “bad economics,” but that term seems too applicable to more general conceits.

*I would rather lose what is left of my eyesight and hearing than take the second position; others, from Scott Sumner explicitly to Brad DeLong implicitly, have significantly variant mileages, which is why there’s a horserace for describing economic policies in the past decade or so. They are winning, while I received several decent paychecks over the time.

**It is left as an exercise whether the “trickle-down” effect is positive or significant.

***Another sign of improved technology is that the growth in reserves decelerates—funds are used more efficiently by the intermediaries—after ca. 1990/1991; the trend moves slightly upward in the Oughts, though that is both relatively minor and possibly due to complications related to the expansion of products offered.


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