Savings the heart of economic activity

It is held by most mainstream economists that spending is the heart of economic activity. Economic activity is depicted as a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and vice versa. In contrast saving is viewed negatively as it weakens the potential demand for goods and services.

If, however, people have become less confident about the future, it is held that they will cut back on their outlays and hoard more money. Therefore, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

A vicious cycle is set in motion. The decline in people’s confidence causes them to spend less and to hoard more money. This lowers economic activity further, thereby causing people to hoard more, etc.

The cure for this, it is argued, is for the central bank to pump money. By putting more cash in people’s hands, consumer confidence will increase, people will then spend more, and the circular flow of money will reassert itself.

All this sounds very appealing. Indeed various surveys show that during a recession, businesses emphasize the lack of consumer demand as the major factor behind their poor performances.

Note that this approach ignores the production of goods and services. Are we to take such production for granted? Is it always there, with just the demand for that output being lacking?

In the real world, one has to become a producer first before one can demand goods and services. It is necessary to produce some useful goods that can be exchanged for other goods.

For instance, when a baker produces bread, not everything he produces is for his own consumption. In fact, most of the bread he produces is exchanged for the goods and services of other producers, implying that through the production of bread, the baker generates an effective demand for other goods. In this sense, his demand is fully backed by the bread that he has produced.

What limits the production of goods and services is the introduction of better tools and machinery (i.e., capital goods), which raises workers productivity. Tools and machinery however are not readily available – they must be produced. In order to make them, people must allocate consumer goods that will sustain those individuals engaged in the production of tools and machinery.

This allocation of consumer goods is what savings is all about.  Since saving enables the production of capital goods, saving is obviously at the heart of the economic growth that raises people’s living standards.

Observe that the saved consumer goods support all the stages of production, from the producers of consumer goods to the producers of raw materials, the producers of tools and machinery, and all the other intermediate stages of production and services.  Also, note that individuals do not want various tools and machinery as such but rather consumer goods. In order to maintain their life and wellbeing people require access to consumer goods.

Introducing money

The introduction of money does not alter the essence of saving. Money fulfills the role of the medium of exchange. It enables the output of one producer to be exchanged for the output of another producer. Note that while money serves as the medium of exchange, it does not produce goods and services.

According to Rothbard,

Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing^[1].

Note also that, in the money economy, ultimate payment is made by exchanging real goods and services for other real goods and services, with this exchange simply being facilitated by money. Thus, a baker exchanges his bread for money and then employs that money to buy other goods and services, implying that he pays for other goods and services with his bread. Money only facilitates this payment.

Contrary to popular thinking, it does not follow that one can lift economic growth via the printing presses. When money is printed—that is, created “out of thin air” by the central bank or through fractional reserve banking—it sets in motion an exchange of nothing for money and then money for something. This results in an exchange of nothing for something.

An exchange of nothing for something amounts to consumption that is not supported by production.

When money “out of thin air” gives rise to consumption that is not supported by preceding production, it lowers the amount of real savings that supports the production of goods of a wealth producer.  This, in turn, undermines his production of goods, thereby weakening his effective demand for the goods of other wealth producers.

The other wealth producers are then forced to curtail their production of goods, thereby weakening their effective demand for the goods of yet other wealth producers. In this way, money “out of thin air” that destroys savings sets up the dynamics of the consequent shrinkage of the production flow.

Observe that what has weakened the demand for goods is not the sudden and capricious behavior of consumers, but the increase in money out of “thin air”. Every dollar that was created out of “thin air” amounts to a corresponding dissaving by that amount.

As long as the pool of real savings is expanding, the central bank and government officials can give the impression that loose monetary and fiscal policies drive the economy. This illusion is shattered once the pool becomes stagnant or starts declining.

To conclude what enables the expansion of the flow of production of goods and services is savings. It is through savings, which give rise to production, that demand for goods can be exercised. No effective demand can take place without prior production. If it were otherwise, then poverty in the world would have been eradicated a long time ago.

Do people save money?

People do not save money. Rather they exchange money for goods and services. Once savings are exchanged for money, the holder of the money can employ it immediately in an exchange for other goods or can hold it temporarily.

Whether he uses it immediately in an exchange for other goods or puts it under the mattress, or keeps it in his pocket will not alter the given pool of savings. How individuals decide to employ their money will only alter their demand for money. This, however, has nothing to do with savings, which are the production of consumer goods in excess of the consumption of these goods.

Also, note that by lending money, individuals in fact lower their demand for money. The act of lending does not alter the existing pool of savings.

Likewise, if the owner of money decides to acquire a financial asset such as a bond or a stock, he simply transfers his money to the seller of that financial asset – no present savings are affected because of these transactions.

Conclusions

Contrary to popular thinking, monetary expansion cannot generate economic growth but rather economic destruction. The heart of economic growth is the expanding pool of real savings. Monetary pumping destroys the flow of real savings and in turn undermines the prospects for economic growth. Any attempt to replace savings with money ends in an economic disaster.

[1] Murray N. Rothbard, Man, Economy and State (Los Angeles: Nash Publishing, 1970), p.670.