Scott Sumner  

Spending on consumption vs. spending on investment

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Brian Moore asked me the following question:

I have read your site for years, but this is the first time I felt compelled to ask a question: some friends and I were discussing the various benefits to society that would accrue from say, my purchasing a product, vs investing the same amount of money in the stock market. While I know, at a high level, that investment is necessary to grow the economy, I had a more difficult time explaining the specific mechanism by which the action of "I buy 100 bucks of index funds on Vanguard" translates to "investment" in the economy. We were easily able to understand that if I buy a 100 dollar widget from Widget Corp, that benefits that company (and the economy), which now has $100 more to spend on wages or machines, but I am having difficulty coming up with a similar concrete sequence of steps for the 100 dollar stock investment.

On a larger point, I think this reflects part of the skepticism and suspicion that people have towards the stock market, particularly from the crowd that throws around terms like "gambling" and "speculation."

This is a surprisingly confusing subject. Consider the sentence that begins "We were easily able to understand . . . ". In fact, I don't think they do understand, as money spent on wages and machines is not a benefit to the economy, it's a cost. The benefit comes from consuming the widget. In the examples that follow, I'll assume the $100 widget is a meal at a restaurant for the Moore family.

Before considering Brian's stock market question, suppose he were trying to decide between spending the $100 on a meal, or spending it on materials for a new front sidewalk. The meal is considered consumption, and the new sidewalk is investment, because it's durable and yields a flow of services for many years, or even decades. The money spent on the sidewalk is called "saving". In either case, output gets produced and the effect on GDP is roughly the same, in the short run. In the long run, GDP will be a bit higher with the sidewalk investment, as it will continue to produce a flow of services for many years.

Now suppose Brian is trying to decide between the $100 meal and loaning $100 to a neighbor who will install the sidewalk. So far things are the same, at least in the aggregate. But now suppose the neighbor waits 2 weeks to do the sidewalk project. In that case, the restaurant meal may lead to more GDP in the very short run (less than 2 weeks), as compared to loaning the money to the neighbor. Over a three week period, output is the same either way.

Now suppose Brian is trying to decide between spending $100 on a meal, or investing $100 in the stock of a company that will use the money to install sidewalks. This is still pretty much the same as the previous example of the loan to the neighbor, it's just that the financial arrangements are getting steadily more complicated---more reliance on financial intermediaries. It's still true that money saved leads to investment, but the connection gets progressively more difficult to see.

So far we've been assuming full employment, and in the end I'd argue that this is the correct assumption for answering Brians's question. But first I'd like to play the devil's advocate (aka Keynes's advocate). Let's assume that Brian's purchase of stock does not lead to more investment. The company does not respond by building more sidewalks. What then?

My response is that S=I is an identity, and that more saving implies more investment.

The devil would respond that that's true in aggregate, ex post, but also that Brian's extra saving would not cause aggregate saving to rise, for "paradox of thrift" reasons. His decision not to go out to eat would lower AD, pushing the economy into a tiny recession. Consumption would be $100 lower than if he had bought the meal, but investment would not rise, nor would saving, in the aggregate. Instead, the extra $100 in Brian's saving would be offset by $100 less in saving by someone else, perhaps the owner of the restaurant that saw a lower income when Brian did not eat out.

This devil's advocate position explains why people tend to think it's "good for the economy" if consumers spend a lot of money. But is it? That depends on monetary policy. If the Fed targets interest rates, then the devil is correct. An attempt by Brian to save a bit more will put downward pressure on interest rates. To keep them from falling the Fed will reduce the money supply a bit, and NGDP will fall. Instead of Brian's saving leading to more investment, it will lead to lower NGDP.

My response is that over any meaningful time frame the Fed does not target interest rates, they adjust them as needed to keep inflation or NGDP on target. This means the Fed provides enough "aggregate demand" so that when Brian tries to save more, NGDP does not fall. Instead, that $100 boosts investment somewhere in the economy.

I don't mean to suggest that this works perfectly, rather that it works on average. Sometimes the Fed injects a bit too much money, and sometimes not enough. That's because they are not watching Brian as he ponders whether to spend $100 at the restaurant. So his decision not to eat out will cause a drop in NGDP at that very moment, relative to the alternative decision to buy the meal. The Fed tries to guess how people are behaving in the aggregate, and tries to supply enough money so that the classical model is true, that is, enough money to keep aggregate demand growing at the Fed's target rate.

Since monetary policy works on average, it's the default assumption that Brian and his friends should make when thinking about consumption and saving.

Comments and Sharing

COMMENTS (27 to date)
AntiSchiff writes:

Dr. Sumner,

My answer to the original question would have been that $100 added to the stock market would lower the cost of capital, ceteris paribus, hence expanding investment and raising real GDP potential, at least on average. Is this incorrect?

AntiSchiff writes:

Or I should say, real GDP, not potential.

Emerich writes:

An additional complexity is that the $100 added to the stock market, at least the secondary market, is an exchange between investors and doesn't go to the company. But yes, AntiSchiff, I think you're right, the additional buying pressure raises the stock price, reducing the cost of capital (and also increasing liquidity and hence decreasing the cost of trading, which increases willingness to hold stock, which decreases the cost of capital).

Todd Kreider writes:

This is a really good post along the theme of clarifying economic ideas that often confuse people such as the misuse of the identity Y = G + I + C + (X - M).

Brian Moore writes:

Thank you for addressing my question in such detail, Prof. Sumner!

If you have a moment, would you be able to expand upon this statement:

"or investing $100 in the stock of a company that will use the money to install sidewalks. This is still pretty much the same as the previous example of the loan to the neighbor, it's just that the financial arrangements are getting steadily more complicated---more reliance on financial intermediaries. It's still true that money saved leads to investment, but the connection gets progressively more difficult to see."

I think this is the part that, as you point out, I do find difficult to see. When I buy that stock, (other than in an IPO) the money goes to the previous owner/trader of the stock, who now has my money. I get that the stock price rises by a tiny amount as result, but I guess I'm having difficult tracing the actual physical steps that takes my 100$ from my wallet to the transaction of new sidewalk pavement. If it's not an inconvenience, would you be able to walk me through (even a hypothetical) that sequence of connections?

Thank you again,
Brian Moore

Francois writes:

Very interesting post indeed.

I was asking myself the same secondary question as I was reading Mr. Summer's answer.

My guess is that the initial purchase of the stock was based on the confidence that someone would eventually be interested in buying those shares.

I am eager to see if someone who know who is talking about could confirm my assumption. :)

Philo writes:

Good post. In the next-to-last paragraph,"his decision to to eat out" should read "his decision not to eat out."

AntiSchiff writes:

Brian Moore and Francois,

$100 purchase of stock, all else being equal, will slightly raise the price of the stock, allowing the company issuing the stock to issue more stock at a higher price than otherwise. Typically, companies that issue new shares of stock when there are already public shareholders will do so through a rights offering. Current shareholders have the first opportunity to buy new shares at a given price to keep their proportion of ownership constant. In other words, such a rights offering prevents dilution of current shareholders.

Similarly, a stock issuer can also issue convertible bonds, convertible preferred stock, can issue warrants, etc.

Scott Sumner writes:

Antischiff and Emerich, Yes, that sounds right.

Thanks Todd.

Brian, As far as the mechanism, see the comments of Antischiff and Emerich. Of course in an economy that produces many goods, money is fungible. Thus if you buy stock in the secondary market, there is no guarantee that that specific $100 goes for any specific investment project. It's also possible that the person who sells you the stock might dissave at least part of the $100.

I was considering a ceteris paribus case, where the decision to save $100 caused total saving to rise by that amount. In practice, it may rise by less than $100.

Of course that's also true of consumption. If you buy that widget, it might push the price up a tiny bit, and discourage someone else from buying widgets.

Thanks Philo.

BC writes:

When Brian Moore buys $100 of stock, even on the secondary market, the seller receives $100 and, thus, will consume $100 in place of Mr. Moore.

A financial transaction, like trading a share of stock, seems different from a physical investment like building a sidewalk instead of buying a meal. Building a sidewalk and producing a meal both involve allocating economic resources (land, labor, capital) towards production of a good. In one case, the good is classified as a capital good and, in the other, it's classified as a consumption good.

A financial transaction is an exchange of cash flows (claims on consumption) of one timing and risk for another set of cash flows of different timing and risk. When Mr. Moore buys $100 of stock, he trades $100 of immediate risk-free consumption to the seller in exchange for the delayed and risky cash flows associated with the stock. The economic gain here is that both Mr. Moore and the stock seller gain consumption that better matches their timing and risk preferences.

When firms make physical investments like building a sidewalk, the sidewalk produces delayed and uncertain (and hence risky) future consumption flows. To the extent that those flows can be securitized and traded, their risk can be borne by those with the highest propensity to bear such risk. In turn, that should facilitate higher physical investment than would be the case if the risk had to be borne by those with less risk bearing propensity. Financial transactions allow physical investment decisions to be separated from the risk preferences of the people making the decisions. For example, a firm can take on all positive NPV projects, independent of the risk preferences of management or the firm's shareholders, who all have different risk preferences anyways. Risk averse shareholders can simply sell their claims on the project's cash flows to less risk averse investors. So, in addition to higher utility for buyer and seller, financial transactions probably also allow for higher physical investment.

Thomas Hutchesoon writes:

I'd answer that if the Fed were doing its job correctly, the two decisions will have the same short run effect on the economy, zero, and in the long run investing in the stock market will raise real income without affecting the trend in the price level. Unfortunately, the Fed since 2008 has NOT been doing its job well, (David Beckworth's drawing of the consistently under-shot target is perfect) as the price level trend and expectations thereof has not been doing its job well so that investing in the stock market may not translate into an increase in demand for investment goods whereas he direct purchase of goods will.

Francois writes:

Very interesting post indeed.

I was asking myself the same secondary question as I was reading Mr. Summer's answer.

My guess is that the initial purchase of the stock was based on the confidence that someone would eventually be interested in buying those shares.

I am eager to see if someone who know who is talking about could confirm my assumption. :)

Brian Moore writes:

Scott/Antischiff/Emerich, thanks for your (further) comments; it's helped me understand the topic a lot better.

James writes:

If Brian buys a share of stock in a company for $100, he has to buy it from someone else. So while the "Investing by Brian" line goes up, the "Investing by everyone else" line goes down by the same amount because some person among the "everyone else" had to sell. The total amount of investment in the economy is not going to be affected.

If we do not net out the seller's transaction, we come to the odd conclusion that if Brian buys the share, immediately sells it, and then buys it again, each time for $100, then $200 of investment spending has taken place.

Michaer Rulle writes:

Re: Buying stock in the secondary market

Ceterus paribus I believe that at the end of the line the cash used to buy stock ultimately either becomes a deposit, hard investment---sidewalk-- (which still leads to a cash deposit somewhere) or consumption (which also leads to cash deposit somewhere). So the amount of money in the system does not change, but its intermediate use does, regardless of what the initial investor does. I assume that the sum of all these transactions is input for the Fed to determine how it affects its monetary policy which then alters money supply, according to its policies.

Thaomas writes:

It is the Fed's job to make sure that I=S is a behavioral equation, not just and identity, that is that the decision of one person not to consume part of her income -- a shift in the IS curve -- leads to another person consuming or investing.

Bob Murphy writes:

Brian Moore, this is a great topic, and as the answers indicate, I don't think economists know the answer. (Or at least, if you asked 10 economists, you'd get probably at least 3 different classes of answer.)

You could come up with all kinds of different answers depending on the assumptions you're making. For example, imagine stock prices move and two investors want to rebalance their portfolios, so they effectively (through money sales and purchases) swap stocks with each other. Does that cause the companies involved to build more factories? Presumably not.

Or, suppose Smith is more optimistic about the future so he draws down his checking account balance by $1,000 to buy Acme shares, while Jones is now worried about the future so he sells of Acme shares to build up his cash balance by $1,000. This isn't about a flow of saving and investment, this is just rearrangement of assets in two guys' portfolios.

Anyway, if you want, try reading my article on stock speculation and the social function it serves. It won't directly answer the original question you posed, but it might give you more things to think about.

john hare writes:

To me, most of the comments here do not communicate to people outside the academic world. This would be more understandable to some.

You can invest $100.00 in a very nice meal today, or use that same $100.00 to plant a garden that will return a hundred vegetarian meals later. Some of those vegetarian meals can then be traded for the other ingredients of a nice meal as in pot luck community dinners. Add in the use of money and this is the way investment works compared to consumption.

There is a necessity for academic discussion and training. There is also a need to communicate economic reality to people without that background.

John S writes:

Brian Moore, great question. I've wondered the same thing.

This is the best answer I've been able to get so far:

The key step you are referring to occurs between D) and E). (In Step E, "the return they can expect on consumer goods and services" is what JP refers to as "consumption yield," e.g. the benefits you get right now from eating a hamburger or buying a new car.)

The way I understand it, expansionary monetary policy works (even at the zero bound) by altering the balance between expected future yields on financial assets (as prices increase, yield goes down) and consumption yields in the present.

Rising asset prices gradually pull up prices for goods, services, and wages, but that process takes a while (while asset markets respond much very quickly to monetary policy).

John S writes:

The end result is that consumption goes up because it looks more attractive than the yield that can be earned from financial assets. So ultimately $100 of expansionary monetary policy does end up becoming $100 more spent on widgets or sidewalks.

James writes:

john hare:

Suppose you spend $100 to plant a garden. I then buy your garden from you for $105. How much investing has occurred? $100? $105? $205? I think that's the question here.

Johnhare writes:

You have invested $105. I have taken a $5 profit and left the market

Jack Rabuck writes:

I made a brief response to Scott's post that addresses one potential follow-up question -- what happens when we are talking about secondary markets instead of direct investment.

Hazel Meade writes:

Why can't investment spending be viewed as consumption. If I loan a neighbor $100 to install sidewalks, he's going to go to Home Depot and buy some wood and some concrete - he's a consumer of home improvement products. The same goes if the money is invested in a construction company. They are going to buy things with that money in order to build the sidewalk.

Why is it that people assuming that a meal is consumption, but spending on construction materials isn't?

Hazel Meade writes:

I think BC gives the best answer to my question above, but I also think the distinction between capital goods and consumption goods is somewhat arbitrary and nonsensical.

From a Keynesian point of view, it shouldn't make any difference if you spend money on building materials or dinners out. Indeed, Keynesians love spending money on infrastructure projects so as to boost consumption. What difference does it make if the government is doing the spending or if I'm loaning $100 to my neighbor? Either way that $100 gets spent and winds up in someone else's pocket to go spend on something else. At least with the sidewalk you end up with a resource that produces returns in the future.

Johnhare writes:

Would the simple explanation be that investment provides a return but consumption doesn't

David S writes:

The way I would explain it to a "normal" person is this:

When you invest in the stock market, you are not spending money. You are trading US dollars for a different currency. The value of US dollars fluctuates depending on what the government does. The value of stock fluctuates depending on what the business does. The most important point to communicate is that they are not buying pieces of paper, rather they are buying a percentage of the company's future output.

The essential difference between US dollars and stock as currencies is that US dollars are expected to lose value over time. US government decisions almost always devalue the currency (for good reasons). Stock prices are expected to increase over time. Business decisions on average increase their future output, and thereby increase the value of the stock.

In comparing buying a meal, to buying a car, to buying stock: The expectation is that the value of the meal will sharply decrease very quickly, the car will lose value more slowly, and the stock value will increase. None of these actions benefit society to a great extent. The help to society happens when you earn the money.

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