by Dirk Ehnts, Econoblog101
German blog Nachdenkseiten comments on the crisis of the French government by saying that the vocabulary needs to be rethought. The German Sparpolitik could be translated as policy of thrift. Whatever its name, in Europe it does not seem to work well as an economic policy. The self-equilibrating forces of the market seem not come to the rescue, and the cuts in government spending imposed on the European periphery largely translated into reductions of income and a subsequent rise in unemployment.
Let’s revisit the idea of Sparpolitik, which is the idea of a rise in savings being somehow good for the economy. Trichet, former president of the ECB, is on the record with this:
“It is an error to think that fiscal austerity is a threat to growth and job creation. At present, a major problem is the lack of confidence on the part of households, firms, savers and investors who feel that fiscal policies are not sound and sustainable”
But how do you increase the savings of an economy? I mean, in real life, not in some high theory macroeconomic model. Well, we have a set of identities, and it should not be that hard to find out how to increase savings of an economy. Let’s start by defining income (GDP) as consumption plus investment plus government spending:
Y = C + I + G
We omit foreign countries, because we don’t want to increase the savings of our economy so that the savings of some other economy comes down. So, we have income Y and now we need to define savings as income not spend by neither private sector (C) nor public sector (G):
S = Y – C – G
Obviously, the difference between the two equations is the omission of investment (I), but let’s not take that short cut now. In order to run a proper Sparpolitik, you would want to increase savings. That only works if income rises or government spending or consumption are reduced. There is a slight complication with the latter two: consumption and government spending feature in our equation (1). If these two segments of demand go down, than income will also go down and hence savings will not go up. The fall in consumption (C) or government spending (G) will be exactly matched by a fall in income (Y). So, the only road open to us leads through an increase in income Y. How is this going to happen?
Looking back at equation (1), we see that a rise in income could come about trough a rise in consumption, investment or government spending. Keeping in mind that equation (2) has Y-C and Y-G on the right sight respectively, an increase in consumption (C) or government spending (G) cannot lead to a rise in saving, since income (Y) rises simultaneously only with C and G.
Hence, there is only one way to increase the savings of a single national economy and that leads through an increase in investment! Only with an increase in investment would income rise in equation (1) and savings in equation (2), since investment is not part of the right hand side of equation (2)!
Sparpolitik is then not the proper name of any policy intended to raise savings – it should be called Investitionspolitik!
Why is investment not on the rise in the European Union? Interest rates are close to zero (or below), but still investment doesn’t seem to jump upwards. What can be done to increase private investment is to increase public investment. An increase in government spending shrinks public saving but increases private savings since the private sector will have more government bonds, which constitute income not spend. So, there is no rise in savings, but if as a result of this policy private investment will pick up then an expansionary private sector can drive investment and with it savings up.
This is just a small exercise in national income accounting. The two equations from above are identities, which means that they cannot be ‘wrong’. Either you define savings and income like we did above or we don’t. Since the Great Depression economists use these identities, and it should be crystal clear that there is no Sparpolitik without Investitionspolitik – actually, they are two sides of the same euro.