Saturday, March 26, 2011

Savings and investment

I'm trying to wrap my head around the concept of savings and investment. The best way I have of understanding something is trying to explain it. Keep in mind that I'm a very junior economist; take what I say with a considerable grain of salt.

We want to first look at things in real terms: what's physically happening in an economy. Since money isn't real (i.e. you can't eat it and it won't protect you from the rain) it doesn't count at this level of analysis. In real terms, we can look at the production side of the economy abstractly as One Big Machine that constantly produces a stream of goods and services: cans of food, ears of fresh corn, automobiles, gasoline, airplanes, computers, shoes, hats, furniture, beer, pizza, computer programs, as well as massages, accounting, toilet cleaning, car washes, etc.

There is a maximum rate the abstract One Big Machine can run efficiently and sustainably. We might be able to go a little over the maximum in times of extreme emergency, but we do so at the cost of getting enough sleep and sex; we really want to reserve going over the maximum for when the Germans really are on the march. More importantly, if we go under the maximum for a time, we can't later go over the maximum to make up for it. We can't turn the dial to 11 this month just because we turned it to 9 last month. If we produce less than the maximum for a time, then what we could have produced but did not is just lost.

Everything we produce needs to be more-or-less immediately consumed. It's very expensive to store a lot of stuff. We need to allocate land, build buildings, use transportation to move stuff to and from the buildings, employ clerks to keep track of it and security guards to watch it. Even with the best of storage, food spoils, cars rust, computers become obsolete. And we can't store services at all. If we as a society decide we don't want to consume all that we could in theory produce, then it's most efficient to just produce less — change the maximum rate of production — and all get more sleep and sex.

Given that we want to run the economy (viewed as the One Big Machine) at some maximum*, how do we look at "savings"? What does it mean to "save"?

Each individual puts a certain amount of labor into the economy, and receives the right to consume a certain amount. We know from the above that the sum of what is produced must always be equal to the sum of what is consumed. (This equality is true for any kind of modern economic relations, capitalist, socialist, even communist.) We also can restrict our economic consideration to the production and consumption of rival goods and services* and say that the allocation of consumption is a zero-sum game: one person consumption always comes at the expense of everyone else's: if I eat a particular can of food, no one else can eat it. We thus cannot physically store the "right" to consume in the future; a right is not a physical thing. All we can do physically is trade one person's consumption for another's in the present.

The economics of non-rival goods is interesting and valuable, but it's a topic for another day.

So, if I have worked for a month (or I've received this month's dividend check), I have received the social right to consume a certain amount of goods and services. (Presumably in the short term the total right to consume in a society is exactly equal to the total amount produced.) I can independently choose (i.e. choose without anyone else's specific consent) to either consume that much, or I can choose to consume less; I cannot independently choose to consume more; there isn't anything more to consume. If I choose to consume the total amount I have a right to consume, everything's good: the amount actually consumed is equal to the amount produced, and everything hums along happily.

But what happens if I independently decide I want to consume less than what I have a right to consume? As we've seen above, it doesn't really make sense to obtain the stuff and store it, either socially or individually. Since consumption and production have to balance in the short term, we could just produce less, but then the foregone production is just poof gone. If I just want to trade stuff for sleep and sex, then that's all right, but what if I want to do more?

I could invest the extra right to consume. Instead of using my right to consume to obtain beer and pizza, I might give that right to consume to a company to obtain economic capital: factories and machines, trained workers, etc. In this case, production and consumption are still in balance; all I've done is switch what is produced, i.e. lathes instead of pizza, conveyor belts instead of beer. All is good. In return, I'll get a share of the revenue, the stuff people give to the company in return for whatever it is they produce. And because I'm actually increasing the capital stock, that should cause real economic growth; I expect on average to receive a real increase in my right to consume in the future for my investment now.

But economic capital is illiquid. If I choose to consume 1,000 fewer abstract units of stuff and instead choose to allow a company to obtain 1,000 more abstract units of machines and training, I can't then go back to the company and get those units back any time I feel like it. Even if we wanted to permit such a thing as a society, what am I going to do with a whole lathe, much less a hundredth part of that lathe? The actual value of the capital I've provided does not inhere in the actual machines, but rather in what those machines can produce. I don't own (or even want to own) the machines themselves, I own what those machines can produce, which requires that they be in a certain place, operated, managed, and integrated into the larger economy. So what I own is pretty abstract and subjective. If I want to get my right to consume back, I can't just walk in and get it back; I have to find a buyer: a specific person who subjectively values that future revenue stream. And economic capital is not just illiquid, it's fundamentally risky. What if people decide they don't want what the machines produce? What if the company is organized inefficiently or perversely? What if a tornado wrecks the factory? Investment is great when I don't need certainty and liquidity, but if I want my money reliably at a very specific time in the future, I need another option.

Another option is to just trade current consumption for future consumption, without physically committing the right to consume into investment goods (machines, factories, etc.). Since I'm depending on the economy as a whole, which I already know can regularly produce a certain amount of goods and services, I can be much more confident that the economy will produce at least the same amount in two years as it does now. All we have to do is make sure that today someone else consumes what I'm not going to consume, and in two years they don't consume what I expect to consume. It's important that total consumption in every given month stays constant; the economy produces at maximum the whole time, and everything produced is consumed.

To recap, there are two primary macroeconomic trade-offs: between current consumption and current investment, and between current consumption and future consumption. It's important to note that these are physical trade-offs, and thus largely independent of any particular set of social, political and economic relations. Our economic relations determine how we make the trade-offs, and who benefits, but they do not affect the physical nature of what these trade-offs actually are. Any set of economic relations — hunter-gatherer, polis, slave-owning, feudalist, capitalist, socialist and communist — will have to determine some trade-off between present consumption and present investment as well as present and future consumption.

I'll explore some of the implications of these trade-offs in a future post.

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