Save or Spend?

Jeff Stahler - Columbus DispatchJeff Stahler – Columbus Dispatch

In Macro class today we talked about what is really a dual decision. First, should our national policy encourage spending or saving? Second, should government actions favor consumption or investment?

First, some definitions and a smidgen of theory. There is a simple dichotomy over  how a family or a nation uses their income. They can spend it (i.e. consume) – which means purchasing goods and services that provide benefits right now. Or they can save it – by putting it in the bank or paying off debts, or even purchasing stock with it. Presumably the savings will improve things in the future (more on that later in this post.) Personal savings (excluding business and government action) have declined as a percent of income since 1980 and probably longer. The personal savings rate was 3.6 percent as of September 2011 (source: FRED). That meant we spent or consumed 96.4 percent.

Savings fuel investment. When households save, businesses save, and the government runs a surplus, this provides funds which can then be borrowed for investment purposes. Done correctly those investment activities will reap economic benefits in the future. If the government operates with a deficit, this adversely offsets personal and business savings. Government borrowing removes funds from the investment pool – a term called “crowding out.”

So, should we encourage people to spend or save right now? Saving brings up good images of a frugal nation, putting aside current desires for a better future. On the other hand, saving does nothing to stimulate demand right now as we struggle to return to full employment. For an extreme example consider Japan in the 1990s, which suffered what is sometimes called “the lost decade.” A real estate bubble popped, causing a typical recession, but then even with low interest rates businesses and families saved rather than spent. They entered what Paul Krugman calls a liquidity trap. Robust economic growth didn’t return for 10 years.

Were someone to ask me this first, spend or save, question, I would recommend incentives to spend – in the short and medium run. Restoring economic activity to its full potential is our most important priority right now – more important than the national debt and more important than future investment. A program to encourage more personal savings would be counter productive.  As the economy starts growing on its own steam, we could then switch to more emphasis on savings.

Consume or Invest?

Now to our second, related question. As government considers fiscal policy (government spending and taxation) it would be wise to target those efforts strategically. Some government spending and some tax cuts will encourage consumption. This can be an appropriate goal during recessionary times, because the added consumption will add directly to GDP. In econ-jargon we call this shifting aggregate demand higher (to the right). If we were considering tax cuts, then targeting low and middle income families will yield the most effective bang for the buck. Lower income families spend more of new income on consumption. Higher income families, having met many of their day-to-day requirements put proportionately more of that new income to saving (including stock purchases.)

Let’s consider what to do once the economy is starting to grow on its own. Do we continue to encourage consumption, or should we shift to investment? I prefer the latter. Investment means putting off the benefits or happiness of current consumption, and directing resources to a better future. Using our tax cut scenario from above, we could argue that cuts should go to higher income families, since they are more likely to save, which in turn should encourage investment. Unfortunately for the advocates of this position there is theory but not much in the way of verifiable results to support this approach.

So, if the economy is growing or starting to regain its momentum, our other choice is to use government spending on thoughtful investments. Pushing aside some of the political wordsmithing, President Obama’s preference for spending on infrastructure fits with this goal. It asks a lot of Congress and the White House to choose investment projects wisely – the lobbying wolves are seldom at bay. There’s an old saw in the grant funding world, that if money is going to support more pigs, successful applicants learn to become pigs. This makes it difficult to thoughtfully target that spending.

My take on this is to be skeptical of general tax cuts – particularly those that funnel most of the money towards higher income families. Tax cuts will fuel consumption at all levels of income, though more consumption among lower income families. And there is scant evidence that money kept by higher income families truly generate savings that lead to thoughtful investment in our future.

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