Most commentators’ regard savings as harmful to economic growth on the ground that savings are associated with fewer outlays. These commentators portray economic activity as a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings.
If for whatever reason people become less confident about the future, it is held that they are likely to cut back on their outlays and hoard more money. Consequently, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.
A vicious circle emerges—the decline in people’s confidence causes them to spend less and to hoard more money. This depresses 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. It would appear that what hampers economic prosperity is capricious consumer behavior, which manifests as a sudden decline in demand.
However, can demand by itself generate economic growth? Nothing is said here about goods. Are we to take them for granted? Are they always around and all that is required is to have demand for them?
Scarcity of Means Hinders Demand
What impedes individuals’ demand is not their psychological disposition but the availability of means. There can never be a problem with demand as such, but only with the means to accommodate demand. In the real world, one has to become a producer 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, he does not produce everything for his own consumption. Most of the bread he produces is exchanged for the goods of other producers. This means that through the production of bread, the baker exercises his demand for other goods.
Demand cannot stand by itself. It is constrained by prior production—it is the production of bread that permits the baker to acquire various goods. Bread is the baker’s means of payment.
Demand is therefore limited by production. Hence, what drives the economy is not demand as such but the production of goods. In this sense, producers and not consumers are the engine of economic growth. According to James Mill,
When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation that constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation’s power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation…. Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.1
For example, if a population of five individuals produces one hundred potatoes and twenty tomatoes—this is all that they can demand and consume. No government and central bank tricks can make it possible to increase their effective demand. The only way to raise their ability to consume more is to raise their ability to produce more. What limits the production growth of goods is the tools and machinery, i.e., capital goods, available, which raise workers’ productivity. Nor are tools and machinery readily available; they must be made.
In order to make them, people must allocate saved consumer goods that will sustain those individuals engaged in the production of tools and machinery. Note that savings is the amount of consumer goods produced less consumption of these goods by the producers of consumer goods.
Since savings enable the production of capital goods, obviously savings are at the heart of the economic growth that raises people’s living standards. The improvement of the infrastructure because of better capital goods enables the strengthening of economic growth.
The improvement in the infrastructure in turn can take place because of the increase in the pool of savings, i.e., the pool of consumer goods. Hence, anything that weakens the pool of savings undermines the prospects for economic growth.
Money and Saving: What Is the Relationship?
The introduction of money does not alter the essence of what saving is all about. Money fulfills the role of the medium of exchange. It enables the produce of one producer to be exchanged for the produce of another producer. Observe that while money serves as the medium of exchange, it does not produce goods; it only enables goods to be exchanged.
In addition, in the money economy the ultimate payment is goods for other goods. A baker exchanges his bread for money and then employs the obtained money to buy other goods, implying that he pays with his bread. Money only facilitates this payment.
Another important role of money is to facilitate the channeling of savings. When a baker sells his bread to a shoemaker for one dollar, he has in fact supplied the shoemaker with his saved, i.e., unconsumed, bread.
The bread is going to sustain the shoemaker and allow him to continue making shoes. Note that money received by the baker is fully backed by his saved bread. One individual’s exchange of savings for money supports the production of another individual, who by exchanging own his savings for money supports a third individual.
Now, when a company issues stocks or bonds, the money received for these financial instruments enables the company to obtain the savings of various savers, which in turn enable it to pursue its planned objectives.
Is it valid to argue that individuals save money? We do not save money as such but employ it as a medium of exchange and in channeling savings.
Furthermore, when an individual hoards money, he does not save money but rather exercises his demand for money. Exercising demand for money can never be bad news, as popular thinking has it.
Increase in Money and Economic Growth
When money is generated “out of thin air” because of the loose monetary policy of the central bank, it sets in motion an exchange of nothing for money and then money for something, i.e., an exchange of nothing for something.
An exchange of nothing for something amounts to consumption that is not supported by production. An increase in consumption that is not supported by production must divert savings from wealth-generating activities to non-wealth-generating activities.
This weakens the flow of savings to the producers of wealth, which weakens the flow of production, i.e., sets in motion an economic recession. For instance, when money “out of thin air” gives rise to consumption that is not supported by preceding production, it lowers the amount of savings that supports the production of goods of the first wealth producer.
This in turn undermines the wealth producer’s production of goods, thereby weakening his effective demand for the goods of another wealth producer. The other wealth producer is in turn forced to curtail his production of goods, thereby weakening his effective demand for the goods of a third wealth producer, etc.
Observe that what has weakened the demand for goods is not the sudden capricious behavior of consumers, but the monetary injections of the central bank, which have weakened the effective demand.
Every dollar generated “out of thin air” amounts to a corresponding dissaving by that amount. Observe that as long as the pool of savings is expanding, the central bank and government officials can give the impression that loose monetary and fiscal policies drive the economy, but this illusion is shattered once the pool becomes stagnant or starts declining.
It is not possible to remove the dependence of demand on the production of goods by means of monetary pumping and government spending. On the contrary, loose fiscal and monetary policies are likely to impoverish wealth generators and weaken their ability to produce goods—it will weaken the effective demand.
Conclusion
What enables the expansion of the flow of production of goods and services is saving and not demand. 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, poverty in the world would have been eradicated a long time ago. After all, every individual aspires to have a good and comfortable life. What always thwarts these aspirations is the means, which have to be produced.
Any attempt to create an illusion that people’s wishes somehow can be accommodated through the monetary presses is sooner or later shattered by the facts of reality—that it is not possible to create something from nothing.
- 1. James Mill, On the Overproduction and Underconsumption Fallacies, ed. George Reisman (Laguna Hills, CA: Jefferson School of Philosophy, Economics, and Psychology, 2006), pp. 8–9.
THIS ARTICLE ORIGINALLY POSTED HERE.
