Sunday, February 08, 2015

Savings and Investment

It is a trope of neoclassical economics that we have to trade off present consumption for investment, to increase future consumption. While this trope has some value, in conceals as much as it explains.

In (still way oversimplified) real terms, we consume the real (physical, tangible) goods and services created by the previous production cycle. There's no point in not consuming those goods: at best we can put some in storage; at worst we just waste them.

The choice between consumption and investment is not a choice between today's consumption and tomorrow's consumption, it is a choice between tomorrow's consumption and the day after tomorrow's consumption.

At the beginning of each production cycle*, we decide what to produce, which will be available (and must be consumed or employed in production) at the end of the production cycle and the beginning of the next cycle. Furthermore, each production cycle inherits the choices made at the beginning of the previous cycle, less depreciation.

*I am making the obviously unrealistic assumption that all production has the same cycle, and all production is synchronized in this cycle. The analysis, however, still holds if for multiple, heterogeneous overlapping production cycles. We just make more decisions more often, but all the decisions are still production-cycle-lagged.

So, on January 1st, we (the members of a national economy) have a warehouse full of consumer goods, and a lot of capital, human and physical. On Jan 1, we decide what to produce in the coming year, and we can choose between:
  1. producing consumer goods to fill up the warehouse at the end of the cycle
  2. maintaining our existing capital stock (repairing buildings, factories, physical infrastructure, and machinery)
  3. creating new physical capital (new buildings etc.)
  4. creating new human capital (training workers and professionals)
  5. researching new technology (both scientific research as well as new forms of industrial and professional organization)

And, of course, we have to decide in detail precisely what consumer goods to create, what capital to maintain, what new capital to create, what new technologies to produce.

These are not all-or-nothing or mutually exclusive choices; instead, we have to decide how many resources (labor, land, and existing capital) to allocate to these broad tasks. Our choices are constrained (or at least influenced) by the choices made in the previous cycle, since both physical and human capital persists (less depreciation) persists across production cycles.

The point here is that we have to choose not between present and future, but between different futures. It is completely irrational to choose in the aggregate not to consume what we want and has already been produced; not consuming what has already been produced does not add one iota to our future consumption, and, in fact, is a "signal" that we should produce not more but less; it's irrational to produce things people appear to not want to consume.

The money system fethishizes this decision: it makes a decision that in reality is a decision between different futures into a decision that falsely appears to be between the present and the future. When I get my paycheck, I appear to have to decide if I want to consume right now the goods and services I can buy with my entire paycheck, or consume less right now and put some of the money in the bank, where it will (ideally) be allocated to investment for future consumption.

But by choosing consuming less right now, what I am really doing, ideally, is allowing someone else to choose consume more right now. It must be so: in the non-ideal case, if no one consumes what I forego, we are actually wasting the last cycle's production and beginning a paradox of thrift, with disasterous consequences. Present savings (foregoing consumption) is at best just zero-sum game (and at worst a negative-sum game).

Thus, the real mechanism, what the money system is concealing is thus: Alice consumes less today of what we produced yesterday, and Alice (implicitly) allows Bob to consume more. This exchange of present consumption has exactly zero real effect on what is produced in the coming cycle: what we produce in the coming cycle has nothing to do with who consumes what we have already produced. Since the exchange has no real effect, it must therefore have moral effect: Alice is "virtuous" (abstemious), and Bob is "vicious" (profligate). Because of her moral superiority, Alice gets to decide how many of society's resources are allocated to new investment, and she gets to consume more of what will be produced at the end of the current cycle; actually, at the end of the cycle she gets to say that because she has more moral entitlement to consume, she is more virtuous by foregoing even more than she is entitled to consume, and morally deserves more decision-making power about what to produce in the next cycle, and, she will receive even more entitlement to consume what is produced at the end of that cycle. Nassau Senior makes this argument explicit.

Put so plainly, it is obvious why this social arrangement has to be fetishized. No one would stand for it if they knew the truth: Alice's present "virtuous" abstemiousness has absolutely no real effect on future production, so her abstemiousness does not materially entitle her to anything. Even worse, the whole system falls apart if everyone is "virtuously" abstemious; this system fundamentally requires that Bob be "viciously" profligate. A moral system that requires vice to avoid catastrophic failure is no moral system at all.

(I am not talking about the choice between working a lot vs. a little, or working on more vs. less socially desirable production, or working more vs. less efficiently, during the current production cycle. All of these choices have an obvious real effect on the amount produced at the end of the current cycle, and the it there's a rational material justification for differential allocation of consumption at the end of the cycle. We might still not want to actually create differences of allocation, but if we did, I think we could do so out in the open without fetishization.

Of course, decisions about how hard or effectively we work during the cycle occur after we have made decisions about how to allocate resources to production. These kinds of decisions do not affect our earlier decisions, which is the problem at hand. Expectations about these decisions can affect the beginning-of-cycle allocation decisions, but expectations are not actual reality.)

So if this system is fundamentally irrational, what could we do instead?

Suppose we are at the beginning of a production cycle, with a lot of stuff to consume in the warehouse and a capital base. The best minds of science (i.e. not economists) give us the following choices, in percentages of available labor and percentage increase over the last cycle's production:

New Investment
% of available labor
Net Additional
0% 0% 6%
20% 3% 3%
40% 6% 0%

(We can also choose values in between these points, assuming some more-or-less continuous functions.)

I'll assume (just to simplify the model) that we're close to the optimal mix of consumer goods and service; we just might want more of everything. I won't distinguish between new human and physical capital. I'll ignore the government.

Additional Productivity compounds: our total productive capability increases at the end of the cycle; which means that we can produce even more in the following cycle. Additional Production does not compound; it just means we have that much more stuff in the warehouse, but no change in our inherited capital.

The "capitalist" way is that each person (household) begins the cycle with some amount of money which varies by person. We follow this procedure:

  1. We auction off all the consumer goods in the warehouse, which people will consume during the period. This money goes to consumer firms. Some people don't spend all of their money.
  2. The consumer firms pay the amount invested, plus a premium, to their investors from the previous cycle. Since all the goods in the warehouse have been sold (except for those nobody wants), this money has to be reinvested or "saved" (stuffed in the mattress).
  3. Each person with money left over allocates that money to new investment: They give the money to producers of consumer goods, who (hopefully) spend it on producers of new machinery or human capital.
  4. People auction off their labor to producers; producers of consumer goods compete for labor with producers of capital goods. The money received from auctioning off consumption goods (less payments to previous-cycle investors) and from investment is used to purchase labor. Firms can "save" money if they choose.
  5. The money is paid to workers at the end of the cycle. Note that in this model, production of new capital (unrealistically) requires only labor.
  6. Based on the allocation of labor, we end up with some mix of production of consumer goods and capital.
  7. Producers of consumer goods who have investment money for new capital pay the producers of capital goods for that labor. All of this money goes to the workers creating capital goods.
  8. Companies use the labor to create new capital and consumer goods, and fill the warehouse back up, and we go back to step 1.

One defect in this procedure is that the supply of money is fixed. This means either that people bid less and less money for any given consumer good (because, assuming we're using some labor to create new capital, the quantity of stuff in the warehouse keeps increasing. However, since people can "save" money from one cycle to the next, neither spending nor investing it, there's an incentive to hold onto money to buy goods more cheaply in the next cycle. But if too many people "save" like this, there's no money for investment, productivity doesn't grow (or can fall, if existing capital isn't maintained), and prices will rise.

We have at best a chicken game, where people who "save" their money benefit from those who invest their money. The best outcome is if no one "saves" at all, but what will actually happen is that some people will "save", and we will allocate an inefficiently low amount of labor to create new capital.

To be more efficient, we should introduce new money into the system. But where? How much? Who decides?

Again, the capitalist way is to insert a step between step 3 and 4 above. We create a special type of institution, the bank, which can create new money. Based on their judgment about how much people want to invest directly (by direct investment in step 3), and how popular products are (based on the auction in step 1), they create new money and give it to producers of consumer goods to buy new capital. Firms give investment money back to the bank in step 2 just as they give money to individuals.

This has a two-fold effect. First, it directly stimulates additional investment. Second, if the bank creates enough new money, there will be just enough inflation (prices rise for consumer goods overall in the step 1 auction, even though there is more stuff in the warehouse than the previous cycle) that no one has an incentive to "save" money, i.e. stuff it in the mattress, until the next cycle's auction. (The right amount of money to create is expected compounding economic growth plus 2 percent inflation plus or minus adjustment for errors in previous cycles' expectations.) With enough legal and social controls (bank regulations, examiners, a central bank, etc.) this system more or less works.

But the defect noted above still exists: there is absolutely no material reason why holding back some money from the auction for goods in step 1, and thus consuming less stuff relative to people who don't hold back money, should give individuals power to decide how much investment happens in the present cycle, nor a material reason to receive extra money in the next cycle. People who consume less from the previous cycle are not, by virtue of consuming less, materially affecting the consumer goods or investment goods we can produce in the next cycle. That production is constrained only by the existing capital stock and the availability of labor.

The capitalist system tends to magnify even initially small differences in wealth. People with less wealth need to spend more of it in step 1 just to get the basic necessities of life; people with more wealth can afford to save more for investment, which gives them even more money in the next cycle. It is possible, with different kinds of government action to correct wealth inequality. However, the government does not really stand "outside" the system: people with wealth have disproportionate power not only over the economy, but the government as well, and they can and will (rationally) resist correcting wealth inequality.

The communist (transitional communist, or "true" socialist) way is simply to dispense with individual investment, which has no material effect anyway; it's just an arbitrary method to socialize investment. All of the investment happens through the bank, and the bank is run democratically, with everyone having an equal voice on how new money is allocated, advised by experts who will inform the people of the material consequences of investment. We still keep the auction for goods in step 1, but we expect people to spend all of their money at that step (except for money they want to keep in the mattress just in case). There's no incentive to invest individually. We still keep the auction for labor in step 4, but we expect everyone who can work to work at least a little. (There are extra mechanisms to make this happen.)

The only wealth and income inequality comes from people who choose to work more, or work in more socially desirable activities, or work more efficiently. This sort of inequality does not get magnified. If someone works extra hard in one cycle and gets more money, that extra money doesn't translate to forever getting more money; it's a one-shot deal. If someone wants to get extra money in every cycle, she has to work extra hard in every cycle.

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