Economic textbooks tell us that investment and saving are equal, and often go on to say that this is because people save money in a bank and then the bank lends that money to a business for investment purposes. Right and wrong! Investment and saving are equal provided that the sense in which the words are used make them so, but banks don't use our saved money to lend to businesses - see chapter 39. We'll return to the sense in which investment and saving are equal later.
Unfortunately there are in common use widespread differences in meaning for the terms 'investment' and 'saving', and trying to understand their use in one context while thinking that a definition holds that was made in a different context is a major source of confusion - it confused me no end!
In finance and in plain English 'saving' means putting money aside for future use, and 'investment' means buying something that will give a return in the future. These meanings are easy to understand but are not the ones normally used in economics or in national accounting (accounts drawn up for the country as a whole). To understand the economic use of these terms and for the associated analyses to make sense we have to forget the above definitions and use the economic definitions instead.
The sense in which these terms are used by economists and in national accounting are as follows:
'Investment' is the value of new and replacement capital wealth that is bought from home or abroad during a particular time period for utilisation in the domestic economy, together with changes in the value of domestic company inventories (wherever produced) at the end of the period from their value at the beginning of the period.
This is a complicated and very precise definition, but precision is necessary in order to allow subsequent mathematical analysis to derive relationships between savings, investment, consumption, imports, exports and gross domestic product. The time period is usually a quarter or a year. Changes in inventories reflect the extent to which quantities of goods in course of assembly and finished goods differ at the end of the time period from the quantities that were held at the beginning of the period, expressed in terms of monetary value.[98] 'Inventories' and 'finished goods' are formally defined in the next chapter.
'Investment' as defined above is also known as gross investment, where net investment is gross investment less replacement capital wealth - i.e. replacing that which no longer works or maintaining that which is still working. Net investment therefore reflects investment in new wealth-creating capacity.
'Saving' consists of private saving, which is after-tax income not spent on consumption; and public saving, which is government receipts less government expenditure.
In connection with this definition it should be noted that all non-government income in an economy is allocated to individuals. Incomes of companies are paid out to individuals as wages, interest, distributed as profits, spent on purchases and so on, and retained profits accrue to shareholders as equity. Although company purchases are largely from other companies, which form part of other company income, this again finds its way to individuals eventually, often passing through many other companies in the process. Therefore in the above definition 'private saving' represents saving by private individuals, often also referred to as households.
Note also that both definitions relate to the economy as a whole - i.e. aggregate quantities, so exchanges of existing wealth don't count. Two people who trade a second-hand car don't alter the total wealth in the economy and also don't alter the total private income - the person buying the car in effect allocates part of his or her income to the person selling it.
The sense in which investment and saving are equal can be expressed as follows: from a wealth point of view everything that isn't consumed is invested, and from an income point of view everything that isn't spent on consumption is saved. Therefore since the income that is spent on consumption is equal to the value of wealth consumed, the wealth that is not consumed - investment - must equal the income that is saved. Note that this equality only applies for the economy as a whole. Any individual or firm can invest more than they save and vice versa. Note also that the equality only holds in the form in which it is usually stated if we regard all government expenditure as consumption, which is very questionable - see the next chapter.
A common source of confusion is that saving in this sense includes hoarding. How can money hidden in a mattress or anywhere else contribute to investment? It seems impossible yet it is true, but only because of the way investment is defined. In this case the money hoarded causes domestic inventories to accumulate - stock and services remain unsold. The investment represented by hoarded money is in increased inventories and unbought services. In other words the money hoarded is equal to the product value of the unsold wealth that the money would have bought if it had been spent. It is because the money isn't spent that wealth remains unsold, and the inventory increases by the amount that isn't spent. The same thing applies whenever money becomes unavailable to spend by leaking out of the economy, for example:
i. when money is held up rather than spent such as remaining idle in bank accounts (idle bank account money really is idle, it is commonly believed that this money is used by the bank for productive purposes, and banks like people to think that, but to the bank it is merely a record of a debt, which the bank can't use for anything - see chapter 39).
ii. when taxation exceeds government spending, perhaps because money used to pay off government debt exceeds that raised by new government borrowing, or money is held up in government bank accounts;
iii. when income used to buy imports exceeds income earned from exports; or
iv. when income used to pay off bank loans exceeds new bank borrowing.
Unsold wealth, provided that it isn't perishable, can be sold later, but services and perishable products are lost. Nevertheless they still represent investment in that they have been produced or made available for sale, at cost to the owners, and the value of the investment is the product or service value, although the market value rapidly diminishes to nothing.
This form of saving - where income is taken out of economic circulation - is unstable in that it can't continue indefinitely as was shown for the simple and real economies in chapters 13 and 15. It represents a transitional state where the economy is contracting to a new lower output equilibrium. The only way that income can be taken out of circulation and not shrink the economy is if money is added from elsewhere to compensate.
When many people in an economy try to save part of their income, they find that production drops and their incomes also drop, until as a group they are no longer able to save. They can keep what they have already saved, but as a direct result production has dropped to a lower level.
Investment in unsold wealth, if it is imposed on suppliers by lack of sales rather than being intended by them (perhaps in anticipation of higher impending demand) is bad investment. If only the equilibrium state is considered then the harm that can be done in the transitional state is not seen. In Keynes' time - the Great Depression - neoclassical economists were only interested in equilibrium states (i.e. the long run), and because of their faith in labour markets always reaching equilibrium at full employment (see the 'real-wage paradox' in chapter 35), they didn't understand why unemployment could be a problem. No wonder Keynes was so angered by the neoclassical view. It is worth repeating his famous quotation mentioned earlier:
But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean will be flat again. (Keynes 1924 Chapter 3 p80)
His remark 'in the long run we are all dead' is often quoted out of context with the aim of showing Keynes as flippant and not taking economics seriously. It was anything but flippant. It reflected his genuine anger and exasperation at neoclassical economists' detachment from the real world.
Other than hoarding and its equivalents that cause unsold wealth, saving consists of spending on things that are intended to create wealth in the future - capital wealth - rather than spending on things that are for consumption in the present. This is good investment.[99]
It is noteworthy that if we exclude unsold stocks the bulk of investment (i.e. good investment) is undertaken by firms themselves, from profits, rather than from external investors (Kay 2015 p164), and since firms' profits come from consumption purchases by the public the bulk of investment comes from consumption spending. This also applies for capital goods manufacturers, since their profits come from other firms' savings (i.e. money spent by firms on investment), and those savings come from their customers' consumption spending. Hence the traditional view that saving is better than consumption is again seen not to be true for the economy as a whole. In fact maintaining consumption is essential for the economy to continue to function properly.
Saving by adding money to a bank account deserves special mention. The thing that is of interest here is what happens to the totality of bank money - does it expand or contract? If people take out new loans faster than they repay existing loans then it expands; if the other way round it contracts - see chapter 39. People who add to accounts either by transferring existing bank money from someone else's account or another account of their own neither expand nor contract the totality of bank money. Also people who add to accounts by transferring cash have only a tiny effect on the totality of bank money because cash is moving in and out of bank accounts all the time. In any case nowadays cash can only enter the economy by someone exchanging bank money for it, so to get it in the first place the equivalent amount of bank money is destroyed, but is recreated again as soon as it is redeposited, usually by the owner or a staff member of the shop where it is spent.
If the totality of bank money expands then the additional money is used for consumption, wealth creation, purchase of existing assets (property, shares, bonds, derivatives etc), or remains idle in bank current and savings accounts. Spending on consumption and wealth creation represents MNW and is good for the economy, but the others represent MEA and MNU respectively, and this money often stays out of circulation for prolonged periods because the borrower is usually an investor, and investors buy existing assets from other investors who do the same, and also keep idle money in holding accounts awaiting opportunities to buy. These activities do nothing for the economy as was shown in chapter 24.
If the totality of bank money contracts, then income has been used to pay down loans, and the effect is the same as hoarding.