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posted on 14 September 2016

Investment Equals Savings: Keynes In The General Theory 1936

from Dirk Ehnts, Econoblog101

In his 1936 "The General Theory of Employment, Interest and Money", John Maynard Keynes already recognized that the idea that savings finance investments is wrong.

Savings equal investment indeed, which is written as S=I. However, the way that this identity (roughly: definition in the form of an equation) holds is exactly the opposite. Here are two paragraphs from his chapter 6 (source) with my highlighting:

Income is created by the value in excess of user cost which the producer obtains for the output he has sold; but the whole of this output must obviously have been sold either to a consumer or to another entrepreneur; and each entrepreneur's current investment is equal to the excess of the equipment which he has purchased from other entrepreneurs over his own user cost. Hence, in the aggregate the excess of income over consumption, which we call saving, cannot differ from the addition to capital equipment which we call investment. And similarly with net saving and net investment. Saving, in fact, is a mere residual. The decisions to consume and the decisions to invest between them determine incomes. Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income. Thus the act of investment in itself cannot help causing the residual or margin, which we call saving, to increase by a corresponding amount.

[..]

Clearness of mind on this matter is best reached, perhaps, by thinking in terms of decisions to consume (or to refrain from consuming) rather than of decisions to save. A decision to consume or not to consume truly lies within the power of the individual; so does a decision to invest or not to invest. The amounts of aggregate income and of aggregate saving are the results of the free choices of individuals whether or not to consume and whether or not to invest; but they are neither of them capable of assuming an independent value resulting from a separate set of decisions taken irrespective of the decisions concerning consumption and investment. In accordance with this principle, the conception of the propensity to consume will, in what follows, take the place of the propensity or disposition to save.

This means that investment is financed by credit. When banks create new loans, new deposits are credited to the borrower's account. These deposits are additional deposits that did not exist before. When spending, the investment takes place (and rises by some amount) and the seller of the goods are services that constitute the investment will received bank deposits. This is income not spend, which means that savings go up (by the same amount). Hence savings equal investment, but not because savings finance investment! Before Keynes, Wicksell and Schumpeter wrote about this as well, so it was common knowledge that loans finance investment and not savings. Today, we live in a dark age of macroeconomics and monetary theory since this insight has been forgotten by most of the discipline.

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