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Should we be concerned with the US economy’s falling savings rate?
Dr Frank Shostak
According to the latest US Government report the personal savings rate has plunged to a negative 0.7 percent in December from negative 0.2 percent in November. This was the seventh consecutive negative savings rate. Note that the average of the savings rate since 1959 stood at 7.2 percent.
Many experts are of the view that the falling savings rate points to a growing dependence on the inflow of foreign capital to keep the economy going. This growing dependence is manifested through the massive current account deficit. A fall in the savings rate, it is held, means that the underlying bottom line of the economy is deteriorating.
Some economists disagree with this pessimistic assessment. They are of the view that the fall in savings is in response to the increase in financial wealth. More financial wealth reduces the need for additional saving out of current income. Historically this argument seems to be credible given the very good visual correlation between the saving rate and the consumer financial wealth-to-disposable income ratio (see chart). As the ratio rises i.e., as people become wealthier, they tend to save less. (Milt Marquis, What’s Behind the Low U.S. Personal Saving Rate?, FRBSF Economic Letter, Number 2002-09, March 29,2002.)
For many economists whilst a fall in the savings rate may be indicative of good economic conditions they nevertheless remain unsettled with its visible decline. These economists are concerned with the possibility that a sudden rebound in the savings rate could plunge the economy into recession. An increase in savings is regarded as less expenditure on consumption. Since consumption expenditure is the main driving force of the economy, obviously a rebound in savings, which implies less consumption, cannot be good for economic activity, so it is held.
Saving and wealth — what is the relation?
What allows an increase in the production of consumer goods is the maintenance and the enhancement of the infrastructure of an economy. With better infrastructure a greater quantity and a better quality of consumer goods could be generated — more real wealth can be produced.
The enhancement and the maintenance of the infrastructure becomes possible as a result of the availability of final consumer goods that sustain the life and well being of the various individuals that are busy expanding and maintaining the infrastructure. It is the producers of final consumer goods that pay various individuals that are engaged in the maintenance and the enhancement of the infrastructure. The producers of final consumer goods pay to these individuals i.e. the intermediary producers, out of the saved or unconsumed production of final consumer goods.
Note that when a producer of final consumer goods decides to save more i.e. to consume less, the fall in his consumption is offset by the increase in the consumption of individuals that are engaged in the intermediary stages of production. This means that overall consumption is not falling on account of an increase in saving — as popular thinking has it.
What keeps the flow of economic activity going is the fact that the producers of final consumer goods — the wealth generators — invest the part of their wealth in the expansion and the maintenance of the production structure. It is this that permits the increase in the production of consumer goods, which in turn makes it possible to increase the consumption of these goods. Out of a greater production of wealth more can be now consumed. So the motor of the economy is actually not consumption but rather savings.
Does government data make sense?
In the National Income and Product Accounts (NIPA) the saving rate is established as the ratio of personal saving to disposable income. Disposable income is defined as the summation of all personal money income less tax and non-tax money payments to the government. Personal income includes wages and salaries, transfer payments, income from interest and dividends, and rental income.
Once we deduct personal monetary outlays from disposable money income we get the personal saving. Personal saving then is determined as a residual. It is however, questionable to add all the incomes in an economy in order to establish the so-called national income. Let us explore this point.
The nature of the market economy is such that it allows various individuals to specialise. We have seen that some individuals engage in the production of final consumer goods while other individuals are engaged in the maintenance and the enhancement of the production structure that permits the production of final consumer goods.
We have also seen that it is the producers of final consumer goods that fund i.e. sustain, the producers in the intermediary stages of production. In other words, individuals that are employed in the intermediary stages are paid from the present output of consumer goods. The present effort of these individuals is likely to contribute to the future flow of consumer goods. Their present effort however, does not make any contribution to the present flow of the production of these goods.
The producers of final consumer goods pay the intermediary producers out of the existing production of final consumer goods. Consequently, the income that intermediary producers receive shouldn’t be counted as part of the overall national income. The only relevant income here is that which is produced by the producers of final consumer goods.
For instance, John the baker has produced ten loaves of bread and consumes two loaves. The income here is ten loaves of bread. Now, he exchanges eight loaves of bread for the products of a toolmaker. It is then tempting to conclude that the overall income is the ten loaves that were produced by the baker plus the eight loaves that were earned by the toolmaker.
In reality however, only ten loaves of bread were produced and this is the income. The eight loaves is the saving of the baker that was transferred to the toolmaker in return for the tools. Or we can say that the baker has invested eight loaves of bread. The tools in turn will assist sometimes in the future to lift the production of bread. These tools however, have nothing to do with the present production of bread.
Again the key here, as far as the contribution to the present flow of savings is concerned, is the producer of present wealth.
Whilst the producers of final consumer goods determine the present flow of savings other producers do have a say with respect to the use of real savings. For instance, the toolmaker can decide to consume only six loaves of bread and use the other two loaves to purchase some materials from material producers.
This however, will not alter the fact that the total income is still ten loaves of bread and the total saving is still eight loaves. These eight loaves support the toolmaker (six loaves) and the producer of materials (two loaves). Observe that the decision of the toolmaker to allocate the two loaves of bread towards the purchase of materials is likely to have a positive contribution towards the production of future consumer goods.
The introduction of money is not going to alter what we have said. For instance, the baker exchanges his eight saved loaves of bread for eight dollars. (The price of a loaf of bread is $1). The eight dollars is a receipt so to speak or a claim on eight loaves of bread. (Note that he has already consumed $2 out of his overall $10 generated income).
Now, the baker decides to exchange the eight dollars for tools. This means that the baker transfers his claims on final consumer goods to the toolmaker. What we have here is an investment in tools by the baker, which some time in the future will contribute towards the production of bread.
Note that the eight dollars that the toolmaker receives is on account of the baker’s decision to make an investment in tools to the tune of eight dollars – the transfer of claims on eight loaves of bread. Also note that the tools the toolmaker sold to the baker didn’t make any contribution towards present income i.e. the production of the present ten loaves of bread.
Likewise there is no contribution to overall present income from the fact that the toolmaker exchanges two dollars for the materials of some other producers. All that we have here is the transfer of claims on present consumer goods to the tune of two dollars to the producers of materials.
Obviously then counting the amount of dollars received by intermediary producers as part of the total national income provides a misleading picture as far as total income is concerned. This is, however, what the NIPA framework does. Consequently, savings data as calculated by the NIPA is questionable.
The NIPA framework is based on the Keynesian view that spending by one individual becomes part of the earnings of another individual, and vice versa. Each payment transaction has two aspects: the spending of the purchaser is the income of the seller. From this it follows that Spending = Income. So if people maintain their spending this keeps overall income going – hence this is why consumer spending is the motor of the economy.
The increase in money supply on account of central bank policies and fractional reserve banking makes the entire calculation of the total income even more questionable. The total amount of money spent is driven by the increase in the supply of money. Consequently, the more money is created out of “thin air” the more of it will be spent and therefore the greater the NIPA’s national income is going to be.
Moreover, is it valid to say that individuals save a portion of their money income? Out of a given money income an individual can do the following: he can exchange part of the money for consumer goods, or he can invest, or lend the money i.e. transfer his claims to another party in return for interest. He can also keep some of the money i.e. exercise a demand for money. At no stage therefore do people actually save money. Furthermore, storing or hoarding money is not saving of money but just exercising demand for money.
Now, if money could have been saved then it would also mean that the more saved money the better, after all doesn’t more saving permit more economic growth? We have, however, seen that what supports i.e. sustains economic growth is the flow of production of final consumer goods. Money as such cannot grow anything and therefore cannot be a part of saving — it is only the medium of exchange.
Is it possible to quantify the total real saving?
Now even if there was any compelling reason to establish what the status of saving is then the relevant saving measure should be the real one — after all it is the real saving that grow the economy. To be able to calculate real saving one must first establish total real income and total real personal outlays. However, this cannot be done since it is not possible to add potatoes and tomatoes into a meaningful total. All that one can establish is the amount of money spent, or total monetary expenditure.
However it is tempting to say that we should be able to extract the real part out of the total monetary expenditure if we could somehow establish an average price paid for various goods and services. Once we know what the average price is, we could then extract the total of real goods and services out of total monetary expenditure. Such an average however, cannot be established — try and establish an average out of dollars per one litre of milk and dollars per one tonne of iron.
Various mathematical methods employed by government statisticians that supposedly provide the solution for separating the real total from total monetary expenditure is an exercise in wishful thinking. Thus to make this fiction possible government statisticians employ two types of indexes. The first index operates under the assumption that past and present transactions were conducted in accordance with past prices.
The other index assumes that past and present transactions were conducted in accordance with present prices. To overcome various supposed biases that these indexes are generating, statisticians form a geometrical average out of the indices. The outcome is the Fisher ideal index — invented by the famous American economist Irving Fisher.
Finally the information on monetary expenditure and the various prices of goods and services are fed into a modified Fisher index, which in turn generates the estimate of percentage changes of the total of real goods and services. Note that the percentage changes obtained are regarded as estimates of true percentage changes. In other words, the underlying assumption here that the real total exists and all that we have to do is to devise a better mathematical tool to discover what this total is. On this Rothbard has commented,
All sorts of index numbers have been spawned in a vain attempt to surmount these difficulties ……arithmetical, geometrical, and harmonic averages have been taken at variable and fixed weights; “ideal” formulas have been explored – all with no realization of the futility of these endeavours. No such index number, no attempt to separate and measure prices and quantities, can be valid. (Murray N. Rothbard, Man, Economy, and State, p 744.)
According to Mises,
In the field of praxeology and economics no sense can be given to the notion of measurement. In the hypothetical state of rigid conditions there are no changes to be measured. In the actual world of change there are no fixed points, dimensions, or relations which could serve as a standard. (Ludwig von Mises, Human Action p 222. BEA Survey of current business July 1995)
Even government statisticians admit that the whole thing is not real. According to J. Steven Landefeld and Robert P. Parker from the BEA:
In particular, it is important to recognize that real GDP is an analytic concept. Despite the name, real GDP is not “real” in the sense that it can, even in principle, be observed or collected directly, in the same sense that current-dollar GDP can in principle be observed or collected as the sum of actual spending on final goods and services in the economy. Quantities of apples and oranges can in principle be collected, but they cannot be added to obtain the total quantity of “fruit” output in the economy. ( Preview of the Comprehensive Revision of the National Income and Product Accounts: BEA’s New Featured Measures of Output and Prices, BEA Survey of Current Business July 1995)
Now, since it is not possible to quantitatively establish the status of the total of real goods and services obviously various data like real income, real personal consumption expenditure, or real GDP that government statisticians generate shouldn’t be taken too seriously. The data that is generated by means of mathematical methods is just a fiction.
Yet this fiction passes as the facts of reality, which allows economists to make comments with a straight face regarding the likely future direction of the real economy. The debate is often confined to the decimal point of the rate of growth. Thus it is debated whether the economy will grow by 3.1 percent or by 3.5 percent.
The fictitious data is served as a benchmark against which various economic theories are validated. Also, once it is accepted that it is “possible” to quantify the state of the real economy then one can also establish another fiction — the price level. This in turn provides the rationale for the importance of keeping the price level stable. And this in turn provides the justification that the central bank ought to navigate the economy towards the path of stable price level and stable real economic growth.
Based on the fictitious data various officials, such as the chairman of the Fed, are assessed. Thus based on historical data the recently retired chairman Alan Greenspan was pronounced as the best ever Chairman of the Federal Reserve Board.
In a market economy no one should be concerned with the so-called national saving rate. Every businessman makes sure that in order to accommodate the requirements of the market he operates in he must have the right infrastructure. If he fails to anticipate future demand and fails to acquire the correct structure of production he will be soon out of business.
So in this sense no one should be worried about the size of national savings. The market, so to speak, makes sure that the correct amount of savings is channelled into the various stages of production. The only thing that we should be concerned about is the various policies of navigating the so-called economy. As a rule all these navigation policies ultimately undermine the true economy, which sporadically generates various unpleasant symptoms that surprise the navigators and most economists.
Conclusion
The prolonged decline in the US savings rate has generated all sorts of views of what it may mean. Some economists believe that the decline is symptomatic of severe erosion in the American bottom line. Some other economists, however, argue that the fall may in fact be indicative of expanding financial wealth, which requires less saving. However, it has been overlooked that the methodology of measuring savings is based on an erroneous framework.
Furthermore, if there are any compelling reasons to establish the status of savings then it should be real saving. However on account of the fact that heterogeneous real goods cannot be added up into a meaningful total such total real savings cannot be established. Various data that government agencies generate by means of mathematical methods that supposedly have resolved the issue of adding potatoes to tomatoes cannot be taken too seriously.
Dr Frank Shostak is a former professor of economics who now works in the private sector
BrookesNews.Com
Monday 27 February 2006
