Arnold Kling  

Saving and Investment: My (Keynesian) Take

An Optimist's Take on Charles ... Moneyball...

I am going to try to stick to substance, and not do name-calling. But I think I am articulating a model that is in the spirit of Keynes, which probably puts me on the Brad DeLong and Paul Krugman side of the debate.

The basic idea is this: On the one hand, if I stop going to Chinese restaurants and start going to Mexican restaurants, we know that workers laid off by the Chinese restaurants can be hired by the Mexican restaurants. Not a problem. But on the other hand, if I stop going to Chinese restaurants because I want to save more, how does my saving get translated into specific demand for future goods? Perhaps nobody knows what I want to consume in the future, so that my saving does not create effective demand.

I do not want to take the Nick Rowe route, which is to say that I hold my savings as money, and since nobody produces money, that reduces demand. I have never liked that story. Similarly, I don't like Krugman's babysitting co-op model.

Instead, I am going to put together a story that has no financial assets or banks at all. It is my version of "what Keynes really meant." The rest below the fold.

There are four industries:

consumer goods
raw materials for construction
cheap construction (strip malls in New Jersey)
expensive construction (skyscrapers in Manhattan)

When workers want to save more, they buy fewer consumer goods and more raw materials. They invest these raw materials with entrepreneurs, who allocate them between cheap construction and expensive construction.

At the margin, it takes less labor to produce one unit of raw materials than one unit of consumer goods. Thus, if workers shift from consumption to saving, then this creates excess labor that can be employed in construction.

Labor in the cheap construction industry is fixed. All you need in order to produce more strip malls is to allocate more raw materials to producing them. Raw materials put into cheap construction this period will yield a risk-free one percent return, received next period. In this model, I do not care what happens next period. I am focused on this period.

Labor in the expensive construction industry is variable. The more skyscrapers we build this period, the more labor gets used. A skyscraper yields an uncertain return. It will either be + or - 10 percent. Everyone is risk neutral. The probability of success is entirely subjective. Obviously, if the probability of success is estimated at 0.5, you would rather build strip malls. If the probability of success is .6, you would build the skyscraper instead. The border line is a probability of success of .55.

The probability of success of a skyscraper declines with the number of skyscrapers we build this period. Other things equal, entrepreneurs view the first skyscraper as more likely to succeed than the second, and so on. Thus, there is a schedule of subjective probabilities of success.

The subjective probability of success also depends on animal spirits. Nobody knows the objective probability of success. If animal spirits are high, then entrepreneurs think that the tenth skyscraper will have a probability of success of .55. If animal spirits are low, then entrepreneurs think that only the third skyscraper will have a probability of success of .55.

The first point to note is that if animal spirits shift down, then employment will decrease. Raw materials will be shifted from skyscrapers to strip malls, and by assumption this reduces labor employed in skyscrapers without increasing labor employed in strip malls.*

The second point to note is that an increase in savings can reduce employment. More labor is now available for construction. However, the subjective probability of success for skyscrapers has not changed. Therefore, the labor is not employed.**

I could argue that these are PSST stories. There is a full-employment equilibrium embedded in the system somewhere, but it will require changes in prices, reallocation and retraining of labor, and so forth. In these stories, the shocks that require adjustment are changes in entrepreneurs' subjective probabilities or changes in workers' propensity to save. But there are many other phenomena that can require adjustments. We do not need to fit every period of macroeconomic history into a single model.

*In theory, wages could fall, this could reduce the cost of producing consumer goods, and demand for consumer goods could rise. But in the spirit of Keynes, we treat the share of income spent on consumer goods as constant.

**In theory, wages could fall, this could reduce the cost of building skyscrapers, and in theory this could increase the subjective estimate of the probability of success of the skyscraper. But these adjustments do not take place instantly. So along the way, you get lower employment, which means lower income and lower consumption, which causes multiplier effects, and so on.

Possibly related: Skyscrapers predict financial crises.

Comments and Sharing

CATEGORIES: Macroeconomics

COMMENTS (11 to date)
david writes:

So where does saved money go? Endogenous money?

Mark Michael writes:

In my scenario, I stop going out to eat and save more. I live in Ohio. My savings accumulate in my brokerage account and my local Dayton checking account. They invest it as efficiently as they can, and find exciting new prospects right here in Ohio! We're in the middle of exploiting a large find of shale natural gas. Thousands of leases have been let for drilling. A new steel mill is being constructed for $650 million to make pipe for all of the new pipelines that will be needed. There's a new natural gas refinery announced; it's in the billion dollar range of investment.

I then decide, "Why leave it up to my stupid bank to invest my saved restaurant consumption dollars? I'll do it myself!" And I use those dollars to buy stock in a natural gas pipeline company that will benefit from this natural gas discovery. (I paid $23.17/share for the natural gas pipeline company com. stock in 2006; it's at $31.42 today, a 37% total capital gain. It pays 3.6% dividend, so the modest 6.4%/year capital gain + 3.6% div. = 10.0%/year ROI. That beats 0.25% in a MMF or 2% in a CD.)

So, instead of employing low-skill restaurant waiters, busboys, and medium-skill cooks, Ohio is hiring workers for the natural gas-related plants. In fact, at least one Ohio university has started new courses to train workers for various jobs in the natural gas "fracking" business. They're working closely with the companies involved. (It may be a community college, I forget.)

Natural gas prices in Ohio have dropped to $4 per million BTU, thanks to this prospect of lots more natural gas. That is raw material for a whole range of products from fertilizer, to plastics, to other petrochemicals.

Hmm. So maybe I should look into investing some of that saved restaurant consumption into Dow Chemical, DuPont, fertilizer making companies, etc.

But wait...

Unlike oil, which is highly fungible, natural gas, not so much. The price of oil does not differ as widely around the world as natural gas does. For example, I believe the Japanese pay $16 per million BTU for their natural gas. Europe also pays a much higher price for their natural gas.

American natural gas companies, seeing those very high prices would like to sell some American natural gas overseas. (Make it more fungible.) But to do that, they need the infrastructure to get the gas to a port and the plant that can liquify it. They have proposed a pipeline to ship some gas to the Gulf area - TX or LA, I forget - but the environmentalists and customers of natural gas are teaming up to block them politically. If you own shares in a natural gas company, you'd view them as an unholy alliance between crony capitalists, government, and environmentalists.

But I digress.

Let's see, back to the original premises of the toy problem. If I stop eating in restaurants and save the money....I invest in Manhattan skyscrapers...Hmm. Why would any sane investor do that? Wall Street is laying off thousands of people, thanks to a beautiful business model called "investing in the housing & real estate boom...until it goes 'caboom!'" So now there are lots of empty skyscrapers. The incomes of those former one percenters has plunged up to 50% How many skyscrapers can Donald Trump build before he goes bankrupt and decides to run for President...again?

Maybe we can train those laid-off Wall Street bean-counters to work in the natural gas fracking industry! Have a government jobs training program to ship them to Ohio to attend those courses to make pipelines, drill wells, work in steel plants,.. Oh, wait. They're high-powered mathematicians. They could do seismic computer modeling for doing the exploration work! You know, those experts who figure out where the gas is.

Okay, I keep running off the rails of the toy problem. I better quit while I'm behind.

Richard W. Fulmer writes:

When consumer spending patterns change (e.g., from slide rules to calculators), unemployment will result since labor cannot instantly shift out of one area of production and into another. Similarly, unemployment may rise when a significant number of people stop consuming and start saving. This raises some questions:
1. What led people to increase their savings?
2. Should government offset the shift by confiscating savings (either through taxes or inflation) and spending “for” consumers?

It seems to me that if a lot of consumers suddenly want to save, something significant must have occurred: war fears, rising oil prices, expectation that taxes will rise, etc. If the shift is caused by government policy, should the reaction be to change the policies or should it be to confiscate people’s savings?

fundamentalist writes:
how does my saving get translated into specific demand for future goods?

It’s difficult to see unless you understand Hayek’s Ricardo effect. Essentially, the Ricardo effect is the PPF for labor and capital taught in micro econ applied to the whole economy. Assume two sectors in the economy – capital goods and consumer goods makers. When demand for consumer goods falls because saving increases, revenue for consumer goods makers falls; profits fall; the marginal price of labor rises; the marginal price of capital falls. Consumer goods makers will employ more capital and less labor. The demand for more capital to save labor costs translates into increased demand for capital goods.

At the same time, lower interest rates due to rising savings will shift profits from consumer goods to capital goods industries. It’s all in Hayek’s “Profits, Interest and Investment” and “Pure Theory of Capital”.

david writes:

The Ricardo effect has the unfortunate characteristic of implying that capital investment should be countercylical, when in fact it is procyclical. Of course the effect can still exist, but it does not appear to dominate a standard Hicksian characterization of what happens in a recession (namely, excess supply of everything that isn't money).

There are elaborate ways to dance around the basic flaw (comovement between investment and consumption in the data), but I think the Cowenian thesis that these attempts are dis-satisfactory is still basically correct.

Hunter writes:

@Richard, What if the change is the looming retirement of millions of people?

roystgnr writes:
how does my saving get translated into specific demand for future goods?

When I buy a car, how does that get translated into specific demand for future goods? I'm clearly not going to buy another car next year, yet "mothball the factories for a decade" isn't a good plan. When I do buy my next car, I'm probably going to insist on ten years worth of improvements in it; how does my current purchase provide that information? Can you even predict whether I'll want a larger or smaller vehicle due to changing family circumstances?

The answer is the same as the answer to the "saving" question: everybody tries to predict the future, and the ones who act on better predictions get rewarded. It's similar but critically different from the answer to the socialist calculation problem, where people try to predict the future and the ones who make more popular predictions get rewarded.

Nathan Smith writes:

I've been working on a paper called "Start From Here: Aggregate Demand is a Function of the Present Value of Permanent Income" or the AD-PVPI model for short. When the present value of permanent income (PVPI) is high, which occurs because of some combination of (a) low interest rates and (b) optimistic about the time path of future income, consumption is higher; when PVPI is low, consumption falls. I use "consumption" and "aggregate demand" interchangeably; investment is a different story.

A key insight, which seems to be more original than I would like (I was kind of planning it to be a more distilling-others'-views paper), is that markets never clear. Markets clear implies empty store shelves. Store shelves are never empty. The thing is that suppliers double as market makers. Markets couldn't clear, because it would require an impossible kind of exact coordination, where the buyers show up at the store at the exact moment when goods arrive from the factory. Market makers are needed. In the stock market, buyers and sellers can both make either "market orders" or "limit orders" and market makers are in the middle, with buffer stocks to trade with both sides. But in the rest of the economy, suppliers double as market makers. Consequently, aggregate supply always exceeds aggregate demand. (You could try to be a stickler and insist that I really mean "aggregate quantity demanded" exceeds "aggregate quantity supplied." But I would argue the demand vs. quantity demanded distinction should stay in micro.)

So a rise in AD boosts consumption; AS has slack and is passive until PVPI, which is an independent variable for now, pushes near to the place where AD=AS. At that point, some demand is frustrated and you get "too much money chasing too few goods"-- inflation.

The other part of the model is the market for "claims to future purchasing power" (CFPP). It's similar to the market for loanable funds, except that it tries to put everything in real terms, with the real interest rate on the vertical axis and capital/CFPP on the horizontal axis. This determines a Wicksellian equilibrium interest rate. The economy has some self-equilibrating tendencies, because optimistic expectations for the future will reduce demand for claims to future purchasing power, pushing up interest rates and causing future periods to be discounted more, thus putting a check on surges in PVPI and restraining aggregate demand. Money/zero lower bound can get in the way. AD is *not* a function of the price level, because the effect of changes in the price level have an ambiguous effect on what really matters, PVPI. If they're expected to be temporary, that has the opposite effect of when they're interpreted as a signal of rising inflation. The whole thing is kind of in the spirit of Scott Sumner's NGDP targeting.

Bryan Willman writes:

Most of this is too simple.

It's rare that people switch from cheap strip malls in NJ to skyscrapers in NY - they are more likely to switch to building web service vendors that make going to the strip mall or the skyscraper less or totaly unnecessary.

And it's an odd case that everybody in the state of Ohio all stop eating out and start buying natural gas investments at the exact same time - especially since some of the people hired by the gas companies will eat out...

Another question that sometimes keeps me up at night...

Both investment and consumption are largely perishable. And in particular, when dollars are not spent on consumption (are "saved") but don't get used for timely investment, that particular time-period of money is wasted.

AND Since money can really only buy from current capacity, money I have for the future will only be useful then if there is adequate capacity to sell me what I want. So unless investment (savings) grow or maintain capacity, savings don't assure me of a happy retirement in any economy that isn't very slack.

This leads me to the conclusion that unless the economy is growing in real terms, saving for the future may be an ineffective exercise.

(Nathan Smith - some "markets" DO clear, but the ones I know of aren't repeating. Jo Old puts his welding table up for sale, and keeps dropping the price until Sara New buys it. The market for Jo's table has cleared. It is also now closed.)

Alex Godofsky writes:

In his footnote Arnold obviates the entire post. Any story of sticky nominal prices is a story of improper money supply/demand.

Prices clear markets. If a market doesn't clear then the prices are wrong. If all of the prices are wrong then you can fix the problem by altering the quantity of money.

fundamentalist writes:

David, I don’t understand how the The Ricardo effect implies that capital spending is countercyclical. The effect says that capital goods investment is the cycle. As an example, take the investment categories of cyclical and secular stocks. Cyclical stocks tend to be those companies in capital goods production. Secular tend to be consumer goods. High beta stocks tend to be capitals goods and low beta tend to be consumer goods.
Capital goods industries tend to lead the recovery. Is that what you meant?

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