No: Saving Does Not Increase the Supply of Loanable Funds
Or: It’s The Velocity, Stupid.
I got quite a bit of blowback on my recent post suggesting that economists don’t understand accounting.
In response I give you Exhibit A: the almost-ubiquitous notion that more saving increases the supply of “loanable funds” — hence that more saving causes or at least allows more investment. (The absolute classic fallacy of the S=I accounting identity.)
On casual consideration, it seems like it would be right, right? You spend less than your income, so you have more money (stuffed in your mattress?), and you can lend it out.
Or more likely: you “put money in the bank” – deposit more than you withdraw — so the bank has more money; it can lend more.
It’s A Wonderful Life.
Here’s Mankiw in his textbook, saying exactly that:
Saving is the supply of loanable funds — households lend their saving to investors or deposit their saving in a bank that then loans the funds out.
1. A little careful consideration shows that this casual consideration is logically incoherent — just plain wrong, by accounting identity.
2. Economists are not supposed to be thinking, giving their sage advice, or corrupting our youth based on casual consideration.
Think about it:
Is the total stock of loanable funds affected by whether the money is on deposit at your bank, your employer’s bank, or the banks of people you bought stuff from? No.
Meantime, you don’t spend $25,000. You “save” it. The money sits there in your checking account. If the action of spending — transferring money from one account to another — doesn’t change the total stock, how could not transferring money do so? Your bank still has the money, which it can lend out. Other banks still don’t, and can’t.
It may help to think about this as if there was only one bank. (Which is not so far off. Bank deposits all consolidate back to accounts at the Fed.) Every person and business has an account. All the spending/transfers (or non-transfers, a.k.a. “saving”) just shift deposits between accounts, with no change in the (single) bank’s total deposits.
So the saving/spending mix has no effect on the stock of loanable funds. Shifting (or not shifting) those stocks around has no aggregate effect on the total stock.
But what about the flow — new loans from banks? Again: no.
Here’s a behavioral, rather than accounting-based assertion — not a controversial one, I think: In any period, banks in aggregate lend more — “print” more new money and deposit it in people’s/businesses’ accounts — because they think they can make money doing it at current interest rates. They think that for one primary reason: they are confidently optimistic about future prosperity — borrowers’ future income streams. If they’re less confidently optimistic they lend less, or ask for higher interest rates — which has the same effect: less lending.
Likewise borrowers: they borrow because they think future conditions will be good, and they’ll be able to service their loans at the asking rate out of strong income streams (and/including rising financial asset values).
Likewise spenders: they spend (that new) money because they think it will yield good returns from investment, and/or because they think they can consume today and be able to earn more money to pay for it (repay the loans) in the future.
So how does the saving/spending mix affect those expectations? Another behavioral assertion: Those expectations are set, to a great degree, by current conditions, because they’re the best predictor we’ve got. It’s difficult at best to predict future “shocks” that will change those conditions. Or as the Eight Ball says: “The future is … unclear.” Life is uncertain.
So how does a higher proportion of saving to spending affect current conditions?
It makes them worse. GDP is spending. Less spending (as a proportion of either income or wealth) means less economic activity. Less velocity. Less transactions. Less surplus from trade. Lower GDP. People, businesses, and banks, borrowers and lenders, are less prosperous, and less optimistic. So banks lend less, borrowers borrow less, and (in a potential downward spiral) spenders spend less.
Takeaway: An increased saving/spending proportion has no effect on the stock of loanable funds (it can’t), and it has only a second-order, expectation-driven behavioral effect on flows — it decreases them.
You really have to wonder sometimes where economists get this stuff that they put in their textbooks.
Nick Rowe attempted to save this conceptual situation recently in a comment posted hereabouts (emphasis mine):
Suppose there’s an increased demand for financial assets by households (a rightward shift in the demand curve). Will that increased demand lead to an increased quantity of investment by firms and an increased quantity of financial assets sold to households (a movement along a supply curve)? It may do. That depends on the model. It’s a behavioural question, not an accounting question.
His questions in the middle, and the last statement, are completely on the money. But his explanation begins right in the midst of the conceptual confusion, putting the modeling cart before the behavioral horse. The behavior doesn’t “depend on the model”; the model’s accuracy and usefulness depends on its assumed human response to incentives and constraints.
Or perhaps, rather, he’s climbed aboard the wrong behavioral horse — one that is wandering off rather aimlessly.
The “desire to save” is a conceptual representation, a mini-model, if you will, of one aspect of the economic situation. I’m suggesting that that construct is outside of, peripheral and irrelevant to, the behavioral chain of cause and effect.
People might want to save more/spend less in aggregate for various reasons:
• Times are tough — GDP and employment are weak — and they’re worried about future ability to consumption.
• Times are good, and they’re satisfying all their consumption desires.
• Rich people have a larger proportion of income and wealth, and their lower marginal propensity to consume drags down aggregate spending, relative to income and wealth.
Or some other scenario. (As Keynes said — not looking up the exact quote here – all economic activity is driven by the desire to consume.)
In the second scenario banks will want to lend more — but not because people and businesses (want to) save more. If that were true, banks would also want to lend more in the first scenario — which is completely contrary to what actually happens. (The results in the third scenario seem uncertain.)
Here’s a syllogism to make this widespread confusion clearer:
Mankiw’s conceptual confusion is inevitable, and arises from two causes:
1. He’s starting with snaky (and conceptually confused) assumptions about the sources of human behavior, and:
2. New but related subject: He’s trying to think about flows (and get tender young minds to think about flows) using static, of-an-instant models like the standard S/D and IS-LM diagrams. The problem, when you’re trying to think about “supply,” is that a flow can’t exist in an instant (only stocks can); it’s a meaningless, impossible concept. And since stocks in our discussion here are unaffected by saving, he’s in a pickle, cause it’s all about flows. (And no: “comparative-static” methods don’t solve the conceptual confusion; they arguably only contribute to it because they impart the illusion of time and dynamism.)
The only way (that I know of) to model “flow supply” in a conceptually coherent way – or even think or talk about it really, which is mental modeling — is using a dynamic simulation model. Of late I’ve been quite taken with the power grid as a good metaphor for a dynamic model of the economy — one that I’ll expand and expound upon in a future post.
For now I’ll leave you with this: Clower/Burshaw on the difference between “stock supply” and “flow supply,” or peruse the literature here. Nick also talks quite a bit about the largely forgotten old 70s notion of “nominal” (roughly: “potential”) supply and demand — though mainly regarding money, not real goods.
I almost never see any consideration of these seemingly crucial concepts in economic discussions — much less cogent analysis, or incorporation of said concepts.
Which leads me to ask a question of economists:
* I won’t even touch here on the widespread misconception among economists regarding bank lending, except to say that in practice bank lending is not constrained by deposits — banks lend most of their deposits then lend (much) more based on their excess capital (times X) — which, thus, is their effective constraint on lending. Not deposits.
Cross-posted at Asymptosis.
it seems to me you are making a simple mistake.
your employer did not save the money. he “gave” it to you. if you save it, the bank can lend it out.
if instead of giving it to you the employer had saved it, the bank could lend it out.
but it’s not zero sum. one of you has to save the money in order for it to be available to lend.
and that is true anywhere down the line. sure,you spend it and therefore can’t “save” it, but if someone “saves” it it becomes available to lend. if not. not.
so take up all the “saved” money from all the players in the economy, and that becomes “available for investment.” it does not matter that for any pair of players, a transfer from one to the other, reduces the one’s savings in favor of the other’s.
First, you point out how important it is for economists to understand accounting and balance sheets and then you pull a scene from the greatest movie of all time!!!! If I wasn’t married …. 😉
I’m not above using videos to make the point on my blog either: http://www.neweconomicperspectives.org/2011/06/can-sesame-street-help-europes-finance.html
Except that the money your boss paid you that you then save is the same money that was not paid to you that the boss then saved. Either way, the bank sees the same money. No net increase in savings.
I think what Steve is getting at, is there is a set fixed amount of initial money. Unless something happens such that the issuing government needs to print more money to cover all the activity going on in the economy, there is no increase in GDP. And, saving money is not one of the things that can put a demand for more currency being printed.
No. If the boss saves it… it is savings. If he gives it to you and you save it, it is savings. If neither of you saves it, it is NOT savings.
How you distribute the savings between you does not matter, as Steve says, but unless one or both of you saves, there is no savings.
There may be… almost certainly are… other aspects of “savings”… including especially the willingness of someone to “invest” what you are saving… but the simple idea that Steve presents… that either you OR your boss MUST be saving is just not true.
coberly: unless the Fed creates or destroys dollars (real or virtual), or unless financial-system leverage changes, then there is no change in the total amount of “money”. All transactions are merely shifting who holds title to that money at any given time.
Bank lend based on capital; deposits are a liability of the bank (i.e. source of funding akin to their own bonds or repos), and only one small source at that.
Only the Fed can create new dollars, and only the real and shadow banking system can create new money (credit) out of leverage. Everything else is merely moving things around.
“one of you has to save the money in order for it to be available to lend.” Sorry, that’s not how banks really work these days. Banks lend until their various sources of funding (deposits aka your “savings”, overnight repo, their own bonds, their own equity) collectively tell them to stop.
Actually, as I think more about Steve’s position, other than the need for government mandated reserve holdings, I don’t think there really is any money that is “savings”. It is always in flux. Which makes the idea that the rich could go Galt so much foolishness. The only way the rich can go Galt is to liquidate all their non-housing assets and stuff it in their own safe. But then, that would really be foolish on their part because their money real would be doing nothing for them either.
“As Keynes said — not looking up the exact quote here –all economic activity is driven by the desire to consume.”
Or the desire to dominate.
Becker and Hamlin
I agree with what you say. But that is not what Steve said.
The banks can only create money to lend in anticipation of increased product… otherwise you do get “inflation.”
I am very open to the possibility that i am wrong here, but it’s going to take a better explanatioin than I have been hearing to convince me.
I’m hoping Cookie Monster’s closing words apply to me: “You’re right. You’re absolutely right.” 😉 God I used to love watching that show.
My daughters would agree with you on PB. Me, I’ll take The Lion In Winter any day, hands down.
(Considered a long-term affair? Serious, deep, meaningful, and lasting overnight relationship?) 😉 again.
@Min: “Or the desire to dominate.”
Very good point. We could go all economist and call it “consumption of dominance” or some such schmatta, but let’s just not, okay?
It helps to get our definitions straight. IIUC, if my salary after taxes is $50,000 and I spend $40,000 on consumption and $10,000 on old U. S. comic books, I have saved $10,000, right?
She is kind of cute. You might want to see if she is open to cross-posting here as a deeper relationship? Nothing like a great erotic conversation about the numbers!!!
Best Economics Movie??? “Its a Wonderful Life” – The Bank always Get Paid . . . Mr.Potter or Shankshank
@Min: “I have saved…”
Oh dear, here we go… I really and truly hesitate to suggest that you read this seemingly endless (and awesome, thanks to JKH and SRW) comment thread…
The whole philosophical riff at the end reminds me of this in Frum’s takedown of Murray:
“I’m writing about housing, not weather.”
I’m writing about the demand for money, not human behavior.
Steve Roth: “I really and truly hesitate to suggest that you read this seemingly endless (and awesome, thanks to JKH and SRW) comment thread… “
I appreciate the link. 🙂 But really, a definition is all that is required.
Sir, I am not an economist and I am not expert in accounting and financial games. I am an engineer and, maybe, just because of that, I have very clear what is the meaning of the process of saving and investing. It’s not a matter of money being in the bank or the account of my employer, on my account, or on the account of the shop where I go to buy new clothes.
It is a matter of the quality of spending and of the economic activity that will be generated by that spending.
If my company spends to build a nice garden at the entrance, that garden will for sure be very enjoyable by the employees, but will generate very little future economic activity, apart of that coming from the fact that employees will be happier having the garden.
But if my company saves, i.e. does not spend in something that once bought and consumed has completed its life-cycle, and invest making, for example, a new research center to develop new technologies and products, that will make a hell of difference. Because in that research center, maybe, someone will invent the way to make really possible cold fusion and generate almost-free energy for the future.
In term of money the company would have spent the same, building the garden or the research center. Mony will flow fro the company account to the account of someone else and will in any case stay in the bank. But money is just a way to make possible trade. What is important is not the money itself but what has been traded.
I find very interesting the MMT especially because of the fight against banksters. But the big flaw I see in the overall theory is that it never considers the quality of the spending. And, in some way, that is an help to banksters that have generated the current big chaos mostly through the loans thay gave to finance consumptions and not good investments.
From the point of view of those of us with short attention spans, here’s the gist of Steve’s argument so far:
– Economists don’t understand an accounting system that economist created, because they haven’t studied the accounting systems that accountants created.
– Economists don’t understand an accounting system because they don’t understand behavior.
– Economists who look at behavior are wrong about behavior if they disagree with Steve Roth about behavior. (Steve’s further claim that he is not writing about behavior baffles me, given all the space he used in claiming knowledge of behavior, but maybe I’m just dense.)
– Economists don’t understand “loanable funds”.
OK, some issues arise. As I pointed out in the “push back” that Steve has taken as a challenge instead of a learning opportunity, Steve may be of the view that economists don’t understand national accounts because Steve doesn’t understand national accounts. It is not clear from this effort, any more than from the prior one, that Steve is in a position to declare that the whole of the economics profession misunderstands economics.
What I take to be Steve’s second point relies on behavior to justify his position on accounting identities. That suggests a fundamental error in understanding. Acounting identities do not address behavioral issues. Behavioral issues, are represented in economics in what are called “behavioral equations”. Behavioral equations are easy to spot, because they often include Greek letters and involve calculus. S=I is not a behavioral equation. Any critique of one’s understanding of national accounting identies such as S=I based on assertions about human behavior either misses the point, or carries a very heavy burden of proving that the critic hasn’t made the error of confusing behavior with accounting identities. I’d also point out that Steve’s first line asserts that the central issue in the prior post was that economists don’t understand accounting, but the prior post had a very great deal to do with “national accounts” which are not taught in accounting classes, and are a far cry from standard business accounts, though some of the goals are the same. (It’s a good idea to have the accounts “close”, and national accounts are designed to be pretty rigid about that.) If Steve is claiming that national accounts are covered in business accounting classes, well, it’s news to me. If not, then the demand that economists study business accounting before they work with national accounts seems a little shaky.
The third point is, well,…do I need to go into this? Steve declares his own understanding of behavior to be superior to the understanding of another discussant, without one whiff of anything like evidence. We’re all tempted to believe our one views superior, but claiming them to be so doesn’t really stand up to scrutiny.
Now, on the point of “loanable funds” we haven’t seen Steve’s definition, so we don’t even know if he’s discussing the same topic that economists discuss when they talk about loanable funds. We have Steve making an argument which seems to imply a definition of loanable funds, but the definition implied seems in some ways different from the definition that economists use. If this is a debate over definition masquerading as a debate over fundamental understanding, well, what a bore! The world is full of people claiming superior understanding, but who are actually just demanding their own definition.
If Steve wants to claims, as so many others have, that he is just smarter and all those economists (or, in other similar debates, insert “climatologists”, “sociologist” “epidemiologist”, as you like) are just benighted, he has to do more than claim. He has to make an argument that doesn’t rely on […]
“Saving” in the headline is *not* referring to “economists”/national accounts’ “S” saving. (Which is actually investment.)
Rather to individuals/businesses spending less than their income — which is also what Mankiw is referring to in his passage.
They’re completely different things.
“if my salary after taxes is $50,000 and I spend $40,000 on consumption and $10,000 on old U. S. comic books, I have saved $10,000, right?”
No: in either sense.
In the sense used here, you spent all your income. That $10K went from your account to someone else’s with no net change in total stock.
In the NIPA sense, the comic books, and your spending on them, don’t even exist, because they’re not newly-produced goods. It was just an asset swap, like buying a house or some Apple stock, which the NIPAs ignore.
@kharris: “Steve’s further claim that he is not writing about behavior baffles me,”
I realized later that would be taken wrong — should have put quote around it.
That’s an economist speaking, not me.
maybe it’s because i am more of an engineer than an economist that i agree with you. i quite lost track of Steve’s argument, but I am certain he is talking about something different than what you and i mean by saving and investment. i could go to some length to describe what i mean, but my guess is that economists mean something else. the question is whether what they mean means anything.
brace yourself: i agree with you.
is the type of lending institution relevant? it may be a zero sum game as to the supply of money, but it seems to me (a chemist not an economist) that a credit union, for example, is more likely to finance consumer spending, and that the sort of bank a big employer might use is more interested in speculative investments… does consumer spending have a bigger multiplier?
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