Demand Side, the Book

Chapter 17:

Investment Explained - The Rule 0f 70

BOLD INCLUDED IN CHAPTER 11

Investment


Demand Side as expressed here profoundly diverges from Classical or Conservative economics on the issue of investment.  Investment in productive forward-looking capital is vital.  Investment in the public's infrastructure and human capital accounts have to be included along with private capital investment.  Currently they are ignored in any effective form.  Public investment in roads and infrastructure and so-called "human capital" - education and social services - can be best understood in the terms used in the previous discussion of Public Goods.  The challenges of the future will require more Public Goods, but since the market cannot effectively produce Public Goods, the mechanism of demand will need to be collected under a public agency.


The following discussion leaves some of these issues for another debate another day and refers to investment in conventional terms of private investment in plant and equipment and housing.  Understanding private investment from the Demand Side exposes the shaky underpinnings of Classical Supply Side.


Under Supply Side private investment has been the raison d'etre  for virtually all economic development schemes for the past century.  Attracting such investment and the attendant (often ephemeral) high-paying jobs has excused many fiscal extravagances and has engendered a fierce competition between states and nations.


Supply Side and Classical economists assume that private investment is a function of the savings rate.  This is a misreading of an algebraic identity which simplifies into Savings = Investment.  From this equation and the fact that it reflects, that investment is financed by savings, it assumed that savings produces or causes investment, that the causal arrow runs from savings to investment.  This sparks much excitement from bankers and amateur economists about encouraging savings and raising the savings rate and so on.


Two test cases ought to give us pause.  One is the Great Depression, where saving (or hoarding) was seen to be a cause for economic stagnation, since spending produces income and income produces spending.  The other case is that of modern Japan, which had an enormous savings rate of 14 percent of household income at the start of the 1990s and a national savings rate (includes corporate savings and government deficits) of 25% in 2005  (FN: but which has been mired in stagnation for two decades.


The causal arrow, in fact, runs in the opposite direction, from investment to savings.  This will perhaps be easier for the lay reader than for the expert to understand.  Ask the question, "What causes an individual investor or entrepreneur to invest?"  The answer is, of course, "The prospect of making a profit."  The investor sees a need or unmet demand and moves to fill it.  He then goes and finds the capital.  If the financing is too dear, it may scuttle the project, no doubt.  But much more often the prospect of profit brings forth financing.  That is, it is the strength and nature of demand that elicits investment.


This is empirically verifiable.  In times of strong demand investment has flourished, the stock of plant and equipment has increased, and financing has been available.  We will see that in Chapter 4, which displays economic performance under different presidents.  The coincidence of high GDP growth, high employment and strong investment is marked.  Which is the cause?  They go hand in hand.  The contrast again is Japan with its enormous savings rate and its low economic performance.


How is it, then, that savings and investment equate?  The example of a hot air balloon may be helpful.  A balloon rises to the point at which the pressure inside is roughly equivalent to the pressure outside.  Does the pressure outside cause the pressure inside?  No.  They equate.  The balloon has risen to the altitude where they equate.  It is the altitude that is the dynamic factor.  This altitude is the income level.  The savings rate and the investment rate both depend on income.  The higher the income, the higher both savings and investment.  From this we can predict that strong demand for new energy and transportation technology will only improve investment, income and savings.


Again, the lay observer will have less difficulty with the concept that strong demand elicits more investment than slack demand.  It may even seem natural.  The Supply Side bias that prefers tax breaks for the wealthy and investment incentives to corporate producers has not worked because it cannot work.  This is pushing on a string.  As the historical record of the Reagan administration shows, the Supply Side incentives are routinely pocketed and produce no net new investment.
Savings and investment.

Savings will be drawn down in a recession. People have to live.

From the Prudent Bear, October 26, 2009

Where have all the savers gone?

    * by Martin Hutchinson
    * October 26, 2009

In the recent unpleasantness, the United States made some progress towards solving its biggest economic problem of recent years: the lack of U.S. savings. Regrettably, in the latest figures, the beginnings of economic recovery have brought backsliding, with the savings rate dropping back from 6% to 4.3%. Without more savings, as global liquidity declines, the United States will quickly become a capital-starved economy, losing investment to capital surplus countries where savings are plentiful. The difficult questions are: what caused the savings decline, and what can be done to reverse it?

During the halcyon years of the 1950s and 1960s, the U.S. savings rate – the percentage of disposable personal income that is saved – was consistently over 10%. That is nowhere near as high as the 40% savings rates consistently seen in China (though questions remain over the quality of Chinese statistics), nor the 25% to 30% of the other major East Asian economies during their takeoff phases. The United States was always a culture not particularly given to saving, and 10% is not a brilliant savings rate – it is for example lower than Germany's level even in today's culture, of a solid 11% – but it was sufficient to allow the great economic growth of the 1950s and 1960s to be financed domestically.

The U.S. savings rate began to decline during the 1970s. That was not surprising; during that decade the stock market went nowhere (declining heavily in real terms) while interest rates were steadily negative in real terms, even lower when you take account of the fact that savers had to pay tax on gains and interest income that was eaten away by inflation.

After the 1970s, one would have expected the savings rate to rebound. Real interest rates were very high in the 1980s, inflation came down from 1982, and the stock market embarked on a generation-long bull market that was to raise the Dow Jones Industrial Average to 10 times its 1982 level. Yet instead of rising, the savings rate fell. From an average level of 10.8% in the 1960s and 8.6% in the 1970s, the savings rate declined to an average of 5.8% in the 1980s. The deep 1981-82 reduced it, as one would have expected (the savings rate went negative during the worst years of the Great Depression), but it never recovered thereafter.

The savings rate declined somewhat further, to 4.9%, during the 1990s; again it dipped during the early 1990s recession, then recovered in that later 1990s, when real interest rates were low but stock market investment was uniquely appealing.

Then from a peak of 6% to 7% in 2000, the savings rate declined to depths not plumbed since the bottom of the Great Depression, reaching 1.8% in 2003, near the bottom of that relatively mild recession, then failing to recover significantly, before plunging again in 2007-08 to a level currently assessed at exactly zero.

There appear at first glance to be three factors that may have affected the trend in savings rates:

The first and most important is the return available to saving. If as at present or in the 1970s, deposits and fixed-income investments provide savers with a return that is less than the rate of inflation, then savings rates are bound to decline. People won't save because they are being penalized for doing so. This is why the expansive monetary policies favored by Greenspan, Bernanke and others are so misguided. A capitalist economy cannot survive if its risk-free rate of return is below or close to zero for prolonged periods, because people will have no incentive to defer consumption and so capital will disappear. You only have to look at the unhappy fate suffered by the German Weimar Republic and various Latin American countries in bouts of hyperinflation to see the result of de-capitalizing the economy in this way.

Argentina is no longer a rich country for this reason. Its people are perfectly industrious and 97.2% are literate, its education system is adequate, its natural resources are abundant, its climate is healthy, yet through bouts of hyperinflation, its governments have de-capitalized its economy. Without a recovery in the savings rate, the United States is heading down the Argentine route to perdition.

The second reason why the savings rate may have declined is the revolution in consumer finance since the 1960s. This supposition is reinforced by the higher savings rate in Germany, a country with a more generous pensions and healthcare safety net than the United States (which should depress private savings), but with less overwhelmingly available consumer finance. This factor may explain a large part of the savings rate's 1980s' decline. The first unsolicited credit card offers were sent out by Citigroup in 1978, and by the middle 1980s, cards were proliferating and it was perfectly possible to carry several of them. Total consumer debt outstanding remained constant as a percentage of Gross Domestic Product (GDP) in the 1970s, falling from 12.5% of GDP to 12.4%; it then took off around 1980, rising to 13.8% of GDP in 1990, 16.3% of GDP in 2000 and 17.7% of GDP by its 2008 peak. Thus from 1980 to 2008, consumer debt rose annually by an average of 0.19% of GDP (in addition to its natural rise from economic growth) – about 0.3% of personal consumption. That's a significant albeit modest contribution to the savings rate's decline.

The third reason, impossible to quantify, is the attitude to saving of the U.S. population itself. The generation who were adults in the 1950s and 1960s had experienced the Great Depression. That did not simply make them cautious; it also gave them a high regard for the value of substantial savings – which had after all increased in real value by 25% in the first years of the Depression. Conversely, the baby boomers and their successors, the adults of the 1980s or today, have not experienced real financial hardship and, in the 1970s, saw inflation eat away inexorably at the value of savings. One need not grind one's teeth at the moral inferiority of the baby boomers to realize that their different life histories might reasonably have given them different attitudes to saving. The same effect seems to have occurred in Japan, where savings rates dropped from 25-30% in the 1970s to around 5% today; the stock market slump and economic stagnation are unlikely to provide a sufficient explanation for this change.

To restore the U.S. savings rate, we thus need three things: higher savings rates (painful, but easy, and necessary in other respects), tighter consumer finance availability (tricky), and reversion to the pro-savings attitudes of the 1950s and 1960s (very difficult.) Nevertheless, the goal is sufficiently worthwhile to the long-term future of the U.S. economy that a number of policies leading in its direction might be tried, as follows:

    * Prolonged period of interest rates at least 3% above inflation, together with tax changes allowing the elimination of inflationary erosion of capital from investment income.
    * Elimination of tax-deductibility of mortgage and other interest, and of all government subsidies to home ownership, including in particular Fannie Mae and Freddie Mac guarantee programs. In today's private market, 20% downpayments for home mortgages would be required by banks forced to hold mortgages themselves. This would force massive saving.
    * Rapid elimination of federal deficit, reducing government's contribution to national de-capitalization.
    * "Tobin tax" on securities transactions, primarily affecting Wall Street trading operations, but also removing the percentage of national wealth acquired through short-term speculation.
    * Heavy excise on casinos, hotels and transportation to casino destinations, and abolition of state lotteries, reducing the gambling propensities in U.S. society. "Get rich quick" methodologies of all kinds must be discouraged.
    * Full funding by government of the requirement that indigent patients receive treatment in hospital emergency rooms. Also tight limits on medial liability damages and removal of restrictions on inter-state purchase of health care. Apart from making medical care affordable, this would reduce the truly exorbitant charges by urban hospitals, eliminating much of the medical bankruptcy risk and making savings more attractive through reducing the risk of some leech hospital seizing them.
    * Elimination or drastic reduction of the "death tax" to encourage capital accumulations in families.
    * Elimination of the double taxation of corporate dividends, by making them deductible at the corporate level (while fully taxable at the individual level.)
    * Prohibitions against unsolicited mass credit card mailings and their e-commerce equivalents.
    * If necessary, a credit tax on all purchases not paid for in cash or by debit card or check. This would have the effect of a limited value-added-tax, but applied to credit transactions only.

As you can see, there are innumerable unpopular but fairly easy steps that could be taken towards raising the savings rate. We can't recreate the psychology of the 1950s, but these changes taken as a whole would push society in that direction.

If the alternative is an Argentine future, the pain would be worth it.

The Bears Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005). Details can be found on the Web site www.greatconservatives.com