Saving Makes Us Richer

A tiny part of me dies inside when I hear people praising consumption or encouraging people to spend money "because after all, consumption is 2/3 of the economy" or something like that. If we’re going to consume stuff, we first have to produce it. If we’re going to produce stuff, we need tools, skills, and ideas. When we have more tools, skills, and ideas, we can produce more. When we save, we can make more tools, develop more skills, and come up with more ideas.

(Classic Example: Robinson Crusoe) To illustrate the point, consider some of the problems Robinson Crusoe faces when he is shipwrecked on a deserted island.* Suppose he is shipwrecked with nothing but the clothes on his back, and again for simplicity assume he sees a small cave so shelter isn’t really an issue. Feeding himself is the problem that confronts Crusoe, at least until his clothes wear out.

He feeds himself by fishing, but fishing by hand is really difficult. Maybe he only catches one fish per day. He decides, therefore, to go hungry for a day so that he can fashion a net out of branches and vines. The net—a capital good—raises Crusoe’s productivity and helps him catch two fish per day. With his new surfeit of fish, he can then smoke some of the fish and start to stockpile (or save) them. His accumulated savings can then sustain him through even longer and more difficult projects that might not pay off for a few days or weeks but that will allow him to consume even more fish and maybe even other goods. Maybe he devotes a few days to fashioning a ladder that will allow him to reach coconuts in the tops of the trees. Maybe he devotes still a few more days to fashioning a basket so he can gather berries. Each of these capital goods—a net, a ladder, and a basket—raises Crusoe’s productivity and allows him to have a higher standard of living. He is able to enjoy that higher standard of living first because he sacrificed a day’s consumption in order to fashion the net and second because his accumulated saving feeds him while he builds capital goods (a raft, for example) that take a long time to build.

The world we inhabit is much more complex than Robinson Crusoe’s island, but the principles are the same. When we save, we leave unconsumed resources to sustain people while they invest in machines, tools, and skills that will make them more productive in the future. Your bank account might be financing construction of a new factory. The factory’s owners and managers borrow the money and then use it to buy materials and hire workers to build it. Notice that none of the workers are producing anything that will be consumed right now: rather, they are able to use saved and borrowed money to buy food, clothing, and shelter to sustain them until the big payoff happens when the factory starts producing output.

(Modern Example: Student Loans) Student loans are another example, albeit a controversial one at the moment. People go to college to acquire skills and signals that will raise their future productivity and show future employers that they are productive and, therefore, worth hiring. Student loans allow students to feed, clothe, and sustain themselves with others’ savings (or their own) while they invest in signals and productivity-increasing skills. Even if they pay with their own savings (or their parents’), they are able to sustain themselves through a process of productivity-increasing investment.

When we save—that is, leave resources unconsumed—we are able to then use those resources to sustain ourselves while we invest in projects with longer time horizons. Saving allows us to avoid our ancestors’ hand-to-mouth existence because the projects we finance with saved resources make us more productive in the future. We might sacrifice a little bit right now, but it gives us a higher standard of living in the future.

According to some of the standard growth models economists use, there is a limit to the degree to which we can increase our output by simply piling up more capital goods because machines and tools wear out and because of diminishing marginal returns. Under most scenarios, though, an economy in which there is a sudden increase in saving will grow until it reaches a higher level of annual output and (in most cases) higher standards of living for its citizens. I write "in most cases" because there is something called a "golden rule" ratio of capital to labor which maximizes citizens’ annual consumption, and it is possible to save so much that the economy’s capital-to-labor ratio exceeds this.

In 1987, Robert Solow was awarded the Nobel Prize for his work developing the model I just described, and since he developed it the model has been a workhorse in the analysis of economic growth.** He came to a surprising conclusion: that technological change, not just capital accumulation, explains growth over the long run. It isn’t just that we have more capital goods. We have better capital goods. A simple look around shows you that this is the case. You probably don’t raise your productivity every year or two or three (or five, or ten) just by two computers identical to one that wears out. You buy a better computer, or a better machine, or a better car, or a better truck…or a new tool or gadget that didn’t even exist last year.

Innovation comes from a culture that encourages and rewards it, but it can also be encouraged by saving. As explained by Auburn University’s Roger Garrison, research and development occurs in the early stages of the structure of production, which means that a lot of research and development happening now won’t pay off in final consumption goods for years if not decades. The iPhone required a lot of research and development. Planetary Resources requires a lot of research and development if they are going to achieve their goal of harvesting metals and other resources from asteroids. They are able to borrow the funds to pay the R&D department because people are saving.

If you’re reading a website called "DepositAccounts.com," you’re probably not one who struggles with impulse control or who has to fight in order to save. You might take a bit of criticism from friends and family because you save and because you’re looking for the banks offering the best interest rates to depositors. It’s important to note, though, that we are able to enjoy high standards of living in part thanks to people who are willing to abstain from current consumption in order to save for the future. Far from being "unearned income," the interest you’re earning on your savings is earned. How and why? That will be the subject of a future article.

* - These are pretty standard examples. I recall seeing this comic book-style explanation of "How an Economy Grows" that makes a similar point.
** - Tyler Cowen and Alex Tabarrok have produced a few videos that explain a simple version of the Solow model in as part of their "Marginal Revolution University" program.