Sunday, 14 May 2017
We don’t need to save in order to fund investment?
Michael Kumhof and Zoltán Jakab wrote an article, published by the IMF, a year or so ago entitled “The Truth about Banks”. The article included the following paragraph, which leaves room for improvement.
“Many policy prescriptions aim to encourage physical investment by promoting saving, which is believed to finance investment. The problem with this idea is that saving does not finance investment, financing and money creation do. Bank financing of investment projects does not require prior saving, but the creation of new purchasing power so that investors can buy new plants and equipment. Once purchases have been made and sellers (or those farther down the chain of transactions) deposit the money, they become savers in the national accounts statistics, but this saving is an accounting consequence—not an economic cause—of lending and investment. To argue otherwise is to confuse the respective macroeconomic roles of real resources (saving) and debt-based money (financing). Again, this point is not new; it goes back at least to Keynes (Keynes, 2012). But it seems to have been forgotten by many economists, and as a result is overlooked in many policy debates.”
The truth is actually as follows.
If extra spending is to take place, assuming the economy is already at capacity, then some reduction in spending must take place to balance that increase, else demand and inflation will become excessive. One possible form of “reduction in spending” is extra saving. Thus, contrary to the suggestion in the above IMF article, saving can fund investment.
However there is no absolute need for the saving to precede the investment spending – by one day, or month or any other relatively short period of time. For example if the entity doing the investment just goes ahead with it, after borrowing money from a bank, and subsequently, a reduction in aggregate spending is brought about somehow or other, e.g. via an increase in interest rates, or increased VAT, that would do equally well.
To summarise, extra spending in the form of extra investment requires reduced spending, i.e. extra saving in some other part of the economy. But whether the extra saving takes place just before or just after the investment spending does not matter.