What’s Savings Got to Do With it? Not much really.

I want to piggy-back very briefly on Marc’s post from Tuesday (and update yesterday) which suggested that the proposed Tax-Free Savings Account won’t “promote investment” like the government says it will (see page 76 of Budget). The empirical literature I’ve seen certainly supports his argument — most corporate investment is financed from retained earnings, which in turn suggests that consumption, not savings, is the most effective way of stimulating investment for the simple reason that consumption juices corporate profits and provides a powerful signal to corporations that more supply is needed. Put differently, it emboldens their animal spirits, which again, is what investment decisions ultimately come down to.

I think, however, it is important to add that there are also strong theoretical reasons to question the savings generates investment argument. These theoretical points revolve around the nature of money. There is a well developed Post-Keynesian literature that argues — and I think demonstrates — that money is endogenous, a fancy term that means simply that money supply in a modern economy responds to demand.

Banks don’t run around looking for savings when they decide to make a loan. Rather, they create money ex nihilo (out of thin air) and then, if prudence dictates, seek out reserves (high powered money) either from other banks or the Bank of Canada — the textbook money multiplier story has it wrong in other words.

This insight has tremendous implications for the way we think about the whole savings-investment nexus (investment creates savings rather than vice-versa) as well as fiscal (balanced budget rules are worse than pointless at the sovereign level) and monetary policy (control over price of money but nothing else).

For a nice summary of what endogenous money theory implies for fiscal and monetary policy, I strongly recommend Scott Fullwiler’s longish article in the December 2007 issue of the Journal of Economic Issues (the JEI isn’t free but anyone with access to a university library should be able to get a copy).

So, if endogenous money theory is correct and aggregate savings don’t matter from an investment perspective, then what really is at stake with these kinds of tax-exempt savings plans is distributional matters, a point made abundantly clear by the rest of the PEF blogging team.


  • First, I think progressives should be worried about the distribution of savings. Clearly this plan favors those with a high enough disposable income to save. In general, even if I agree that in some sense investment drives savings the question becomes for whom does it drive savings?

    Second concern: I think as is implicitly argued here, that it is rather reckless to argue that stimulating effective demand which is augmented by negative savings –consumer credit– is the way to go for blue and white collar workers regardless of the link between consumption and investment. This is because the more in debt workers are, the more they have to work and the higher the level of flexibility in wages and working conditions which can itself have a deleterious effect on aggregate demand unless augmented by further consumer debt. And then around we go. This is the last twenty years of off-loading the public debt (and macro-economic stimulus) onto to the backs of workers.

    Third, I am not sure how increasing the propensity of higher income earners to save helps as a hedge against a possible downturn; as high income earners are likely to have a greater propensity to consume in the face of an economic slowdown. This plan could become a negative drag on effective demand. Even if the plan does not kick in until 2009, why would I not start saving money now in the expectation of making a deposit in 2009?

    Fourth, and finally I can only conclude that this savings plan was an ideologically driven program with the usual distributional implications. In short more of the same.

  • Great post. This misconception is hanging tough… I’ve just spent two months trying to convince my students to stop obsessing with savings and still have mixed results. (Same with a few important myths, such as the impact of national debt – we should run a whole series of myth busters).

    Anyway, on this note, I wanted to say that retained earnings are still a form of savings, and as such are not “necessary” for investment. The difference here is more in terms of where the money comes from and who the corporation will have to deal with. If it borrows, it’ll have to negociate with a bank and will have future commitments in terms of interest payments, going to the stock market (a net drain on corporate resources these days, with all the options et al.), brings up a different set of issues.

    Retained earnings, by contrast, comes free of commitments, allowing managers a greater degree of freedom and more margin of manoeuvre should any investment project go sour. So firm managers like them, of course. But ultimately, realised profits (and thus the ability to retain earnings and invest them), are not a guarantee either. Investment has to be enticed, as you point out quite wel (though whether it is profit or demand-led is another question).

    Briefly put: Yes, these measures are completely silly. Now the question is: Is there an ulterior motive or are we just witnessing a theoretical discrepancy?

  • Oupss. Cross-posting. Well, that answers somewhat the ulterior motive question.

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