No: Less Consumption Does Not Cause More Investment
At risk of stating the obvious, in this post I’d like to highlight a pernicious misunderstanding that I find to be widespread out there in the world.
This is not new thinking. You’ll find a more sophisticated historical account, stated very clearly though in somewhat different terms, in the first few pages of this PDF. Still, despite decades of debunking, this misconception remains ubiquitous. I’d like to explain it in the simplest and clearest terms I can.
Start here:
GDP = Consumption Spending + Investment Spending
Consumption Spending = Spending on goods that will be consumed within the period.
Investment Spending = Spending on goods that will endure beyond the period.
Looking back at a period, from an accounting perspective, it’s obvious that if there’s less consumption spending, there’s more investment spending. This must be true, because that’s how we tally things up, once they’ve happened. There are two types of spending; every dollar spent last year must be one or the other. If there’s less of one, there’s more of the other.
But people conclude: if there is less consumption spending, there will be more investment spending. (So we’ll increase our stock of real stuff, and we’ll all be richer!)
They’re confusing (and confuting) a backward-looking, historical, accounting statement with a forward-looking, causal, predictive statement. Because looking back, GDP is fixed. It has to be; it’s already happened! But in that very instant of thought, people abandon that fixed, historical perspective and think: if one component is smaller, the other will be larger.
This makes no sense at all. Think about it: If people spend more on consumption goods next year, that will cause more production — including production of long-lived goods to increase production capacity. Investment won’t go down because people spend more on consumption. GDP will go up. Next year’s GDP (obviously) isn’t fixed.
Likewise, people tend to think that less consumption spending means there will be a higher proportion of investment spending (so, relatively, more real-wealth production). Wrong again. The backward-looking Y = C + I accounting identity tells us exactly nothing about why people will make their spending decisions — what causes them to choose consumption vs. investment spending. They might choose to increase or decrease either or both, for myriad reasons. One doesn’t cause the other in some kind of simple arithmetic manner.
This seems very obvious. But if you hold this firmly in your head as you peruse people’s statements out there in the world, I think that you will find that many of them do not have it fixed very firmly in their heads.
Cross-posted at Asymptosis.
Another example of this are those who say debt doesn’t matter because for each borrower there is a lender, for much the same reason. There is a borrower for each lender and a lender for each borrower in retrospect, but not in prospect. In prospect, increased borrowing can increase gdp and decreased borrowing can decrease it.
This is lcosely related to somthing that has been bothering me for a couple of weeks now.
Adrew Biggs at,
http://www.american.com/archive/2013/april/why-expanding-social-security-is-a-bad-idea,
writes “Let’s assume that, in the absence of Social Security, individuals would have saved around half of that $24 trillion on their own. If the return to capital is around 8 percent, then the current Social Security program reduces annual GDP by almost $1 trillion.”
Does he really believe that saving more will increase GDP faster (than some baseline)? Even outside a liquidity trap producing things that no one wants to buy is not productive. I was starting to think the error is that if consumption is reduced and savings is increased, then you MUST have a decreased return on capital. but if Keen is representing things correctly, then Keynes found that conclusion “unsuccessful”.
Is there a theory to deal with Biggs’ assertion? (Or is the problem that there are competing theries and no consensus?)
Arne
the only theory that i know of that deals with Andrew Biggs is
The sin against the holy spirit is the one sin that cannot be forgiven.
Near as I could tell from the context, the sin against the holy spirit is “lying for political reasons.”
Andrew Biggs is a paid liar. He used to be better at it.
In the first place Social Security IS savings. what SS does is give ordinary workers a way to save their own money protected from inflation and the risks of market losses. There is no “the” return to capital, and Biggs knows it. Even the State cannot get 8% on it’s “capital.” That’s why it is cutting my pension.
Social Security, because it is pay as you go always returns an “interest” at least as high as inflation plus the growth in the economy.
That might “average” 2% real return (about 5% nominal over the past twenty or thirty years). Moreover, because Social Security is insurance, low wage workers can end up getting 10% or better real “return on investment.”
Let Biggs try that in his Magical Present Value Bank.
Steve Roth
you are right, the folks who think that an accounting identity is “predictive” are idiots, or whatever it is that Andrew Biggs is.
But, I remember sometime in the last century reading in Econ 101 about a “production possibility curve”… or something like that.
The idea was that you could either consume all resources today, or invest them all in future production, or some combination of the two.
That would lead to the idea “less consumption today leads to more investment and therefore more future production.”
And that would be true if all the resources you didn’t consume were put to work creating productivity improving “investments.” Which hasn’t been the case since at least 1752… and certainly not since 1922, or 1982, or 2002. or …
The whole notion that this accounting identity could accurately model investment in the real world could only be advanced by someone who has never owned his own business. Any small business owner knows that if consumption is down — if people aren’t spending money on your cookies or widgets or whatever — the *last* thing you want to do is invest money in increasing production. Instead you’re going to tighten your belt, cut spending as far as you can without hurting your remaining customers, and in general wait for consumption to turn up before investing more money into your business.
But perhaps the real problem is that this accounting identity doesn’t actually account for real investment (that is, investment in the means of production). An asset bubble such as the current oil price bubble caused by too much investment money and too few good places to invest it is accounted as “investment” even though the money going into oil futures has produced not a single barrel of oil (the oil companies were already awash in money before this, with more money than places to drill) and has otherwise not at all created goods or services or the means to create goods or services. The accounting identity is needed in order to make the debits and credits balance, but debits and credits are not an economy — goods and services are an economy. This points to the fundamental disconnect between accounting identities and economies — accounting identities are about making two columns of numbers match, economies are about production of goods and services or acquisition of the means of production of goods and services. Attempting to make a statement about economies based upon accounting identities is thus like attempting to make a statement about the taste of oranges by biting into an apple. It just doesn’t work.
-BT
The single overarching point is that you do not do economics by accounting identity.
Not now.
Not ever.
When you try to, you get pretty, balanced equations which then have nothing to do with economics, accounting, or any other aspect of the real world.
Past vs forward thinking is one way to look at it. Another is that accounting is a static snapshot, while economics is dynamic.
Your para beginning: “Looking back at a period . . .” does not state this fact explicitly. But you cannot shift the balance between spending and investment because each is now just as much a chiseled-in-stone constant as is their sum.
Niklas Blanchard hit on the econ as accounting identity fallacy a couple of years ago, and I believe his included links (which I have not read recently) are also relevant to the topic. I think this is the post I’m remembering.
http://modeledbehavior.com/2011/04/21/steven-landsburg-is-he-crazy/
There’s an application of Occam’s razor that suggests that you shouldn’t assume evil when something can be explained by simple stupidity. I think we are living in one of those rare historical periods when it’s more sensible to do the opposite.
lo siento
JzB
JzB, the whole point of accounting identities is to identify theft of money — one side of the equation won’t add up to the same thing as the other side of the equation if someone is somehow siphoning money out of the accounts “off the books”. As such they say nothing about economies, and as identities, nothing about the health of companies for that matter. For example, using $11B to purchase a company in London decreases the left side by $11B, then increases the left side by $11B, and the identity remains true… but if the balance sheet is that of HP, and the company is called Autonomy, the result says nothing about the health of the company. The accounting identity remains true while the company becomes sicker. (Google “HP Autonomy writedown” for the sad details).
If accounting identities say nothing about the health of an individual company, why would anybody assume that they say something about the health of an economy as a whole? It doesn’t make sense. Thus you’re likely right — rather than assuming stupidity, perhaps it’s time to assume evil whenever someone makes this apples to oranges comparison of pretending that accounting identities have any relationship to the health of an economy.
-BT
well, here is an accounting identity, sort of, that maybe someone can help me with.
in a “mature economy” when someone cashes in his “investment” he is subtracting that money from future investment and “consuming.”
the money comes out of the “current” economy…and comes either from part of the purchase price of the goods-and-services the investment arguably increased over time, or comes from new investment being made by new decisions to “invest” rather than consume… in other words part of new investment goes directly into new consumption… or part of potential new investment goes directly into the consumption of (by) old investors… or part of “present consumption” (by the “young”) toes directly into present consumption by the “old.”
note that social security has nothing to do with any of this so far.
but when you put your money into social security, and the same day some takes an amount of money out of social securtiy (receive benefits) that is, in the aggregate, what they put in plus “interest” equal to the general increase in the ecnomy (including inflation)…
where is the difference to the economy as a whole between the “transfer” represented by social security, and the transfer represented by that part of investment that goes to pay off old investors?
i may not have said that as clearly as could be hoped.
on any given day an amount of money is being withdrawn from “investments” that is equivalent to the amount of money that Biggs says is not being “saved” because of SS.
still not clear.
@Arne
Biggs basically has zero understanding of how the monetary system works. Many moving parts that he doesn’t consider. Bond issuance, velocity of money, market and Fed reaction functions, etc. etc. etc. Basically he’s engaged in a childishly simplistic partial-equilibrium analysis, which tells us exactly nothing about how the game might play out when the total system is considered.
@Lord: “In prospect, increased borrowing can increase gdp and decreased borrowing can decrease it.”
Exactly right. I’m working on a post that addresses this, current title:
Income ≠ Inflows. Spending ≠ Outflows
As is my wont, thinking of it in terms of the “real” sector: households and nonfinacial businesses.
@Badtux
Right. As I said over at Asymptosis,
Accounting identities can only, and only sometimes, prove that a given prediction, or assertion of cause and effect, is illogical hence false. i.e. that all countries can reduce their import/export ratios simultaneously.
“When you get to the end and look back, you will never see that result. It’s impossible.”
But there are an infinite number of predictions, assertions of cause and effect, that are not impossible, that conform to the accounting identities. Since they all conform, those identities tell us exactly nothing about which are true or even probable.
The Famas and Cochranes of this world are basically saying, “Look, it conforms to the accounting identities. That proves that it’s true.”
Sheesh.
I think self-delusion is as much of a driver as stupidity or evil. People will believe what they want to believe.
People who own capital want to believe that the world is better because they own capital. Supply-side models support that view.
Arne
there is normal human stupidity in which both you and i are cheerful participators. human beings are nowhere near as smart as they think they are. sometimes a great deal of experience can enable us to be reasonably competent in limited ways.
self deception enables us to live with what we don’t know.
dishonesty… often driven by evil… manipulates the ignorance and self deception of others as well as oneself.
coberly,
You have totally missed the point. Biggs is asserting that the existance of more savings is the same as the existance of more investment is the same as the existance of more productive capital which leads to a larger economy. While SS works as savings for the individual, it certainly is NOT savings as Biggs has defined it, so your refutation does not help the point.
A more pertinent mathematical refutation of Biggs is that if people would save 50 percent of what would be needed to replace SS (or expand SS) then they are unequivocally better off having SS. If the larger economy part of his analysis is correct, then it is clearly producing an even more unequal economy.
Arne, among other problems, I believe the Biggs analysis leaves out one factor: consumption by the elderly/retired. His analysis works as long as you assume it’s zero. If you add this factor (arithmetic), the purported additional savings/investments by wage earners will disappear, now and forever.
PJR
thank you. i believe that was the point i was trying to make that Arne says I totally missed.
Arne
it would not be unheard of for me to miss the point. but Biggs’ analysis is bogus exactly because in the larger economy “investors” will ultimately subtract from the investment stream, by cashing in their “return,” exactly as much money as Social Security “fails to save.”
now, i could be wrong. or i may not have explained it very well. but telling me that i “totally missed the point” doesn’t tell me anything.
try again… at any given point investors are taking as much (or more) money OUT of their investments, as retired people are taking out of Social Security. For the total “savings” (investment) to remain constant, new investors have to replace that money… that is, there is no new net savings. this is exactly what social security does when it “transfers” money from what would otherwise be “savings” to benefits for retired people.
or try again… if i put ten dollars into Social Security today and some old person gets a ten dollar benefit OUT of Social Security today
that has the same effect on society as some investor putting ten dollars into “investment” today and some prior investor cashing out ten dollars from his investments today.
so what happens to the actual investment that grows the economy… well, i think someone (everyone in aggregate) has to be “investing” more money than is being cashed out every day. Since people paying their Social Security do not use up ALL of the money available for investment every day, i would expect the amount of money available for investment (“savings”) is exactly the same with or without Social Security.
except probably people are more inclined to “invest” at risk if they have the SS safety net behind them.
again, i could be wrong, but it would take a few more details to convince me.
Coberly yes, I just tried to say it differently. Arne said ” Biggs is asserting that the existance of more savings is the same as . . . ” but this accepts the premise that more savings exist, which is not true. The posited increase in savings has to come from someplace. Perhaps Arne’s question is answerable if we assume that the added money in savings accounts magically appears from heaven, or the Fed, or as gifts from foreign oligarchs and royal families–either once or every year forever. If Biggs is saying this, then I guess I’d agree that such an increase translates into more money available for investment, which potentially has economic benefits. But Social Security has nothing to do with it–it’s the money that magically appears that would be the cause of any benefits to the economy.
PJR
thanks.