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Saving Makes Us Richer


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.

Robinson Crusoe

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.

Classroom

(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.

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.

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.

... 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.

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.

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Comments
Anonymous
Anonymous   |     |   Comment #1
I am not sure I have ever heard anyone praising consumption or encouraging someone to spend (except Ronald Reagan who even encouraged using credit cards to get the economy going) but I find it disconcerting that a " part of you dies inside" etc.------  GDP is 2/3rd's consumption. That is a fact and it has been over 70%.  When people do not spend we encourage deflation. If you need something buy it if you have the money. Of course having savings is important also. I try to buy when times are slow because you get better prices and it helps the economy. We built our last home in 2009-2010, bought new furniture ( ours was nearly 40 years old), new appliances also more than 25 years old etc. Two years ago I replaced my 14 year old car. 
When companies build new buildings they put them out for bids when times are slow. Bids come in much lower then. 
Anonymous
Anonymous   |     |   Comment #3
You seem too sensible and well-read to have not ever heard anyone praising consumption or encouraging someone to spend, as referenced in the article (especially considering I think it could be argued that you did that very thing yourself in your comments!).  Having said that, totally agree on making purchases (both big and small) in the slow times when you have more control vs. the hot times when it's a seller's market, and props to you for your wise timing on that purchase list.  We just did the same thing on appliances (I'm still holding out on my 20-year-old car!), and I'm just hoping that the new ones last half as long as the old ones did! 
Anonymous
Anonymous   |     |   Comment #4
Unable to speak regarding other appliances.  But needed to buy a new refrigerator couple of years ago to replace one which had lasted thirty years.  Told to anticipate a six year life for the new one . . . if we were lucky!!
Anonymous
Anonymous   |     |   Comment #6
I always use Consumer Reports and reviews before making any purchases. Pick what you want and they watch for sales. We were able to get 45% off list on ours when we built our home including a 5% off with a credit card. 
Anonymous
Anonymous   |     |   Comment #8
You will notice a big difference with your electric bill. We did build a new home with new appliances but the electric bill went down an average of $70 a month even though we now have 2 refrigerators, a large freezer, air conditioning (never had it before) and underground sprinklers (never had these either and we also have a well).  
Anonymous
Anonymous   |     |   Comment #7
Never have heard anyone praising consumption ever. I watch a lot of news, read a lot of papers, including policy papers and have never heard this except as I said before when President Reagan encouraged even the use of credit cards. With this statement I went ballistic. 
Anonymous
Anonymous   |     |   Comment #5
Compare the amenities enjoyed by the modern college student to a 70's student and you'll understand the student loan debt debacle. Saddling oneself with 20 years of debt at the age of 18 is, for a huge percentage of students, absolutely insane. Without federal and state guarantees most of these loans would never materialize. Student loans are, for many, a terrible investment.

Saving, by itself is not productivity. Investment is the real economic game changer with winners and losers determining outcomes. Free markets do it best, everyone knows it yet few openly embrace it. Tell a class you'll total all grades, compute the average and assign that grade to each student. Even the worst students will OPENLY admit that's not fair; performance should be rewarded accordingly. They understand competition, risk and reward and then they vote for the exact opposite. Until, that is, old age looms and they are forced to become savers!
Anonymous
Anonymous   |     |   Comment #9
Along with a college education, people need some common sense!

When old age looms, it is way too late to become savers.  Smart, not necessarily college educated, people start saving at a very young age, then relax and enjoy spending their savings when old age comes about. 
Anonymous
Anonymous   |     |   Comment #10
Scanning this post I see too little mention of the key role of the banking system. Economic theory for a long time has accepted that savings equals investment and data relating to the banking system clearly supports this theory. Why this is doesn't need to involve some microanalysis focused on productivity, standard of living, technical change, etc. CREDIT is the key element involved in the creation of capital, the basis of investment. The engine of capital basically runs on the resource of credit and not on spending by consumers or from the issuance of stock. banking system is the basic source of credit in our economy and the deposits in the banking system provide the raw material of credit. When there is a low rate of savings in our economy there will simply be less growth than would otherwise occur. Not an easy pill for many to swallow but a pill that needs to be taken for a healthy life.
Anonymous
Anonymous   |     |   Comment #11
CREDIT is what sent our economy into a tailspin.

The banks and other financial institutions are awash with money.  That's why we get so little interest on our savings.  They do not need our money.  

Until this recent last quarter report, our nations GDP had dismal growth.  Being our economy is not booming,  I don't swallow your opinion.
Anonymous
Anonymous   |     |   Comment #12
CREDIT did NOT send our economy into a tailspin--BAD loans to individuals and entities that were basically irresponsible or in some cases, actually FRAUDULENT in nature, sent the economy into a tailspin. It isn't a matter of the banking system "needing" our money. After the financial "crash" the banking system needed to purge itself of weak loans and was prodded by the government to do so. Following your theory of GDP pre-eminence, it would make no difference if we didn't have the savings that are in the banking system now, after all, it's overkill. WRONG. Things would be WORSE than they are now re growth if these deposits were reduced. Regrettably, a great many individuals in this country are in relatively bad shape economically and are simply save anything, or even spend on anything but the bare necessities. Until the country gets a handle on that situation the necessary investment for growth won't be there and you will continue to see production and growth less than it would be otherwise..  
DCGuy
DCGuy (anonymous)   |     |   Comment #13
Education funding has changed since I went to college back in the 1970s.  When I graduated, I had zero debt (all expenses paid through grants).  Tuition costs were reasonable.  Now the majority of the cost of education has shifted to the student as tuition rates go from $3K to near $50K.
Anonymous
Anonymous   |     |   Comment #14
When I was old enough for college, you could work in a paper mill during the summer vacation and make enough for tuition and books. We would walk to college in our town. What a difference today. 
Anonymous
Anonymous   |     |   Comment #15
Exactly, #14.  Back then young people had personal responsibility.  Also "Spring Breaks" were spent working at part time jobs, NOT having "fun in the sun".  Proud young men and women earned their way through college and didn't beg for "student loan forgiveness", expecting taxpayers to pick up their tab. 
Anonymous
Anonymous   |     |   Comment #16
They learned it all from the greedy colleges...what would "you" expect!