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Are savings overrated?
Here is another good exam question for my macro class:
Let's do the calculations. Over the past 10 years, the U.S. has run up an accumulated goods and services trade deficit of roughly $3 trillion. Sounds like a lot of money, doesn't it?
Now let's suppose those dollars had been used for good rather than evil. That is, rather than buying imported cars, toys, and handbags, thrifty Americans would have saved their money. It's reasonable to believe that about half of that $3 trillion would have gone into financing productive purchases here in the U.S.--new factories, power plants, office computers and the like--$1.5 trillion worth.
So what would be the payoff from all that thriftiness? A reasonable rate of return on investment, after depreciation, is roughly 7%. So $1.5 trillion in extra assets would have a return of about $100 billion a year.
That $100 billion is roughly 1% of an $11 trillion economy. Over ten years, then, complete elimination of the trade deficit might--might--have added a tenth of a percentage point to growth.
That's a good measure of the size of the virtues of savings--roughly a tenth of a percentage point on growth. That's 0.1 percentage points.
To put that in perspective, the estimates of long-term productivity growth have risen roughly a full percentage point over the past decade. The effects of technology more than swamp the effects of savings.
That's Michael Mandel, from Business Week. True, false, or uncertain? Dig in, comments are open, and you don't have to be in my class to offer an opinion.
Posted by Tyler Cowen on October 13, 2005 at 05:52 AM in Economics | Permalink
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A $1.5 trillion inflow in the U.S. capital markets would drive prices of assets sky-high. P/Es of the U.S. companies would fluctuate in the orders of hundreds, such as by the end of the 1980's in Japan. Similarly, banks overflowing with cash would lend to anybody at ridiculously low rates. You may guess what would most likely follow then.
Posted by: Pavel at Oct 13, 2005 8:05:36 AM
Doesn't investment drive technology development?
Posted by: Blancandrin at Oct 13, 2005 8:48:24 AM
False. The verb should be put in the past tense ... "DID swamp". Continued productivity gains with relatively low investment rates *could* continue, but this isn't guaranteed, and as a previous commentator notes, could be endogenous.
There is no "good" or "evil" with regard to spending decisions; we can only evaluate the consequences of those decisions. Here, saving $3 trillion delays consumption. In the meantime that money earns an investment return that Mandel calls inconsequential. Low saving rates suggest that this view is likely shared by a large number of consumers in this country.
On a technical but important point, the tenth of a percent higher growth he discusses is off a higher GDP base since the current account deficit is presumably much smaller, with half of the money spent on imports redirected to domestic consumption and the other half to domestic investment.
As an aside, if technological improvements also result in superior products, then the cost of the foregone future consumption is much higher than indicated. Alternatively, if people were driven to reduce imports by an external requirement, welfare may be reduced; by revealed preference, the imports are preferred by consumers. I really dislike normative judgments based upon macro accounting changes. Without knowing the underlying cause for the change in behavior, evaluating the welfare consequences are problematic. The level of GDP *may* be a good proxy for the level welfare, but I see no reason to assume that changes in GDP accurately mirror changes in welfare in hypotheticals like this one.
Oh well, I'm not a macro guy. But these macro questions you ask make me jealous; your students are lucky (or perhaps they chose wisely). If I had had your class, maybe my answer would be better. ;)
Posted by: Victor at Oct 13, 2005 9:19:11 AM
He is making at least 4 mistakes, one in logic, two in economics, and one in math.
Re: logic, notice he is simultaneously claiming that "technology swamps the effect of savings" and that "savings funds new factories, power plants, and office computers." This is a contradiction -- if savings is what funds technology, then the effect of technology is an effect of savings.
Re: economics, he is also ignoring the fact that a lot of the money we send overseas to pay for imports returns to the U.S. as FDI. If profitable opportunities exist for investment in the U.S., those opportunities will be exploited no matter who owns the investable dollars.
Re: economics, he is also ignoring the fact that many of the imported goods are necessary ingredients for the investments to pay off -- the office computers and some of the factory equipment are imported, and the power plants need oil. Removing these inputs might not only prevent new investment but reduce the productivity and profit margins of existing investments.
Re: math, the claim that a 1% increase over 10 years == 0.1 percentage point increase in annual growth is nonsense. This is true if the base growth rate is 0 and there is no compounding of the additional growth. A higher base growth rate will make the percentage-point difference smaller, while compounding will make both the $100 billion and the percentage-point difference higher.
Posted by: DK at Oct 13, 2005 9:23:07 AM
False. They're talking about -saving- money, not hiding it in your mattresses. 'Saved' money gets spent on goods and services, just not by the people who save it.
Posted by: neil at Oct 13, 2005 9:37:04 AM
Is savings all about GDP growth?
Savings isn't just for investment--it's also for future consumption. It provides insurance against unexpected future expenses (or loss of income).
If very few people are saving, is there the chance that they won't be ready for some future shock, and will have to take drastic measures in response? What if the shock hits a large portion of Americans, and then they all suddenly have to drastically cut consumption or sell their houses because they have no savings.
Also, it matters who is doing the savings/investing. If all the savings is by the rich, then the poor will likely stay poor.
Posted by: Adam at Oct 13, 2005 9:37:40 AM
It could be that the average return to investment in technology is large, but the marginal return to investment in technology is small. For instance, the major returns could be from making straightforward advances on the current state of the art. As resources going to investment increase, there could be fewer and fewer viable points in current technology to advance from.
Posted by: Alex J. at Oct 13, 2005 9:50:39 AM
In my mind, the low savings rate is connected to the low numbers of Americans studying science and engineering. Both trends demonstrate a decreased willingness to prepare for the future and maintain our wealth.
Posted by: Adam at Oct 13, 2005 9:56:29 AM
This is total crap. To begin with, students in my Principles class know the difference between
"deficit" and "debt" -- budget or trade. So, "running up a deficit" is a misnomer and therefore makes the rest of the argument at best a strain on logic.
Even ignoring this bit, what's the last sentence all about? So savings do matter theoretically, but not ruantitatively when compared to the effect of technology? What's the overall point then?
Posted by: MK at Oct 13, 2005 10:10:10 AM
Don't follow the math but maybe I am just stupid. If you are earning a net 1% additional GDP per year in investment earnings, then that (not 0.1%) is the net effect, no?
And the additional, or foregone, income is a perpetuity going forward.
Posted by: Martin at Oct 13, 2005 10:26:57 AM
The problem is misstated. What we are doing is substituting foreign
savings for domestic savings. The current account deficit is equal to
the domestic savings investment gap. So his assumption that we save half of
the difference has no basis in fact. The reason we have a trade deficit is that
we need the foreign savings to finance our level of consumption and/or investments.
To the extent that we use the foreign capital to finance consumption we are
selling our assets to finance consumption -- at some point it will have to be repaid.
If, as in the 1990s we were using it to finance capital spending we are creating capital that will make us better off and allow the foreign capital to be repaid.
The inflow of foreign capital is now equivalent to about one-third of gross private investments. During the 1990s boom the sum of foreign capial inflows and the government surplus was equivalent to almost half of capital spending. So the contribution of the foreign savings is massively greater then the numbers he uses to reach his conclusions.
Posted by: spencer at Oct 13, 2005 11:34:09 AM
It's a bit misleading to compare an amount (not) saved over ten years with an annual return. A better way to say it: after saving $300 billion for each of 10 years, Americans would receive annual income of $100 billion. And all these decisions are made at the margin, so to turn around and compare just one of the figures to total GDP is definitely misleading: if the $100 billion income is 0.1% of GDP, so is the 0.3% of spending or saving every year. Part of his point is that the $3 trillion over 10 years is not a lot, and he's right about that. But it's not true that the gain in growth from savings is utterly dwarfed by the marginal gain in happiness from having spent the money. One-tenth of a percentage point in annually compounding growth, coming as it does from a small investment, is nothing to sneeze at...regardless of technological growth.
That said, it's uncertain that domestic investment in American industry will economically trump consumption of foreign goods. It depends on consumer preferences. If consumers really prefer having the goods that American companies will crank out ten years from now to having the goods that Chinese companies make now, then they should save, by all means. But if they are ignoring true preferences simply to save, they are actually making a poor investment decision. If what we want (at the margin) is handbags, we had better support the companies that build them - otherwise we are sending a counterproductive signal. China makes handbags because it has cheap labor available, while America doesn't so much. It's wasteful if a Chinese handbag company goes out of business because Americans saved up to the point where it appeared profitable to build an American handbag concern. Furthermore, it's a matter of debate whether interest rates even have much to do with the investment decision -- so all that might be achieved is harming the Chinese handbag factory.
Posted by: Jason Briggeman at Oct 13, 2005 12:15:40 PM
The comment that we have been substituting foreign savings for domestic is accurate. This has been part of Ben Bernanke's gripe, that global savings is excessive, and that is why we have run such large current account deficits. Here we are propping up the rest of the world's economy with our low savings!
The real mystery in all this is why the now more than $3 trillion net indebtedness of the US as a nation has not yet shown up in the investment income flows portion of the US balance of payments. It is only mildly negative. Is this a matter of foreigners being suckers to buy our bonds at such low interest rates while our investors abroad demand high returns? Is it that we are such a safe haven that they are willing to forego such returns? Is it that some central banks are now buying our bonds to keep the dollar high so that they can sell us stuff to keep their unemployment down (China in particular)?
It is pretty amazing that foreigners now own 53% of the US national debt, but the net outflow of income remains so low. At some point that continuing accumulation of net indebtedness is going to tilt the scale on the investment income portion of the account. Then the dollar will really fall into difficulty, and things will become very far from amusing all the way around. Hey, those foreigners do not want this particular game to stop any more than our voracious consumers do!
Posted by: Barkley Rosser at Oct 13, 2005 1:22:12 PM
Capital's share of GDP is about 1/3. Therefore, the long run growth of GDP per capita is roughly the increase in the Solow residual (total factor productivity, if you will) plus 1/3 times the growth of capital (per capita). That is to say that as a matter of accounting, the growth effect from capital (savings) is considerably less than the growth effect from "technology" (Solow residual). It says nothing about endogenous growth (that increased capital spending on R&D might lead to better technology down the road). And it has nothing whatsoever to do with his hypothetical 7%.
Posted by: William Polley at Oct 13, 2005 2:14:11 PM
Mandel's analysis is worse than Krugman's. Aside from the many good points already made, he is taking a cumulative number and using it at t=0. Our current trade imbalance for August is 60B and 460B for the year. Ten years ago it was 100B for the whole year. You can't take the full 3T and roll it back ten years; you could only use the 1994 imbalance for 1994.
Another Krugman is that he is taking the consumer part of the imbalance and ignoring the producer part. In other words, he believes that consumers who buy imported cars, toys and handbags are the sole cause of the imbalance. I guess he forgot about those insignificant companies like Wal-Mart who is China's 6th largest trading partner.
Another Krugman is that for some reason if we stop all consumers and producers from using the rest of the planet that somehow we will still be and 11T economy. I guess in his world, prices would not rise and if they did, it would not matter because all prices are inelastic.
Another Krugman is his attempt to bring in a final point that has nothing to do with his analysis. Up until his last two sentences, he had only talked about savings and growth and used numbers (although dubious) to flesh out his points. Then he throws us productivity and technology out of the blue without anything to back up his claim.
Fact - it has rained a lot this summer
Analysis - more rain is better than less rain as long as there is not flooding
Mendel Conclusion - the Colorado Rockies should play in the rain so they can win more games.
Posted by: Patinator at Oct 13, 2005 2:43:31 PM
I think of imported money as how we finance investment in homes and fast food restaurants and such for immigrants. If we had not imported those twenty million immigrants we would not have needed to import the capital at all.
Importing immigrants is not necessarily a bad thing as long as you accept that someone has to pay for them.
Posted by: wkwillis at Oct 13, 2005 5:31:57 PM
Patinator,
Good lord. Do you really need to drag in false allegations about Krugman to score your points? I have lots of disagreements with Krugman, but I do not think he said or would agree with most of the things that you attribute to him. Can you back this stuff up?
It is not the accumulation of the trade deficits that gives us the net indebtedness but the accumulation of the current account deficits. Until quite recently the US current account was performing better than the trade account thanks to our receiving net inflows of capital income. That is now turning around.
Walmart is not a producer but a distributor of produced goods. It is the main conduit through which consumer imports from China are distributed in the US. No doubt Walmart does import a few producer goods, but they are a small part of its business.
Krugman is strongly for free trade. He is one of the last people around who would argue that the economy would not decline if the rest of the world's economy shut down. This is the worst sort of rank ignorance or smarmy misrepresentation on your part.
Krugman does worry about technology and growth and deserves credit for being among the first to notice that the rapid East Asian growth in the 80s and early 90s was fragile due to not being as firmly based on productivity improvements as many thought, thus providing analytical understanding for part of what happened in the East Asian financial crisis of 1997. I am not aware that Krugman engages in bringing up important arguments at the last minute (or paragraph) as a general practice.
I can only presume that you have only been reading Krugman's columns in the New York Times rather than any of his serious writings in economics. If you want to ding Krugman for his politics, go right ahead. If you want to ding him for his economic analysis, well, it would help if you knew what you were talking about.
Posted by: Barkley Rosser at Oct 13, 2005 5:42:55 PM
Good question, Tyler...thanks for asking it.
I will just address one of the comments here. One of the comments asks "Doesn't investment drive technology development?" If it did, then we would have expected the technology boom of the 1990s to have been driven by a great increase in the share of GDP going to investment.
Uh huh. Nonresidential investment was 11.9% of GDP in the boom period 1996-2000. It was the same 11.9% in the ten years ending in 1990, and 11.4% in the 10 years ending in 1980.
And let's not talk about the last five years, where productivity growth has skyrocketed but nonres investment has only been 10.7% of GDP.
The link between investment and productivity growth is not strong..people really need to understand that.
Posted by: Mike Mandel at Oct 13, 2005 5:55:07 PM
Pop quiz: Did Tyler just come up with an ingenius way to test the economic training of typical MR readers? ;)
Posted by: Scott Bardsley at Oct 14, 2005 1:03:07 AM
Pop quiz: Did Tyler just come up with an ingenius way to test the economic training of typical MR readers? ;)http://www.marginalrevolution.com/marginalrevolution/2005/10/are_savings_ove.html#comment-10299564
Posted by: Scott Bardsley at Oct 14, 2005 1:13:44 AM
"A reasonable rate of return on investment, after depreciation, is roughly 7%." Is that so? If it were reasonable to expect a REAL return of 7% (nominal doesn't make sense in this context), then I expect we'd see a lot more saving in the US. Save for ten years and double your money, in real terms. As far as I know, few people have that privilege. Besides, what does "reasonable" mean in this context? If it describes some average degree of risk aversion/planning horizon, then 7% really sounds a bit hefty. Note that this is not a minor detail: it's what defines the payoff to thriftiness (essentially, the opportunity cost of not deferring consumption) in his analysis.
Posted by: Johan at Oct 14, 2005 5:31:04 AM
"A reasonable rate of return on investment, after depreciation, is roughly 7%." Is that so? If it were reasonable to expect a REAL return of 7% (nominal doesn't make sense in this context), then I expect we'd see a lot more saving in the US. Save for ten years and double your money, in real terms. As far as I know, few people have that privilege. Besides, what does "reasonable" mean in this context? If it describes some average degree of risk aversion/planning horizon, then 7% really sounds a bit hefty. Note that this is not a minor detail: it's what defines the payoff to thriftiness (essentially, the opportunity cost of not deferring consumption) in his analysis.
Posted by: Johan at Oct 14, 2005 5:31:58 AM
Just one small point:
"A reasonable rate of return on investment, after depreciation, is roughly 7%."
Is this a pre-tax or post-tax rate, or doesn't Mandel care?
Posted by: dsquared at Oct 14, 2005 8:53:23 AM
Don't foreign companies invest in the US? Why assume the entire 1.5 trillion won't be part of US savings/investment. Furthermore, if technology is at least partly endogenous, don't we benefit from foreign technology growth in the form of lower prices (if trade is sufficiently free)? Why assume you can predict US growth isloated from those that, by definition in this problem, are part of our market for goods and services?
Posted by: joshg at Oct 14, 2005 8:57:04 AM
Barkley,
I did not mean to imply that Krugman argued what I was saying. He is widely recognized as having done a lot of fine work in free trade, so fair point. It certainly would be wrong for me to put words in his mouth like that. I was refering to his work at the Times in which mistakes are retracted or just left in hoping that no one will notice. This piece was generally Krugmanesque in relation to his articles in the Times not his work on free trade. I used Krugman the same way you would use "got Borked".
I hope you agree that you cannot use the cumulative number at t=0.
Posted by: Patinator at Oct 14, 2005 1:42:08 PM
