Why Financing is not Saving: Fable of the Breads

by Dirk Ehnts

I must admit that it took me some time to understand this:  financing is not saving. You may finance all sorts of things, and savings are not a necessary part of this story.  The reason why this is so is the existence of a fractional reserve banking system.  While normally it takes a longer time to explain the details and some knowledge of economics is certainly helpful (see this exposition by Randall Wray), I think I have spotted a short story which leads you on the right path. This is Steve Randy Waldman:

Suppose that land to grow wheat is scarce but labor to farm and bake it into bread is abundant. Land-owners and laborers are paid their marginal products, which at the limits of land scarcity and labor abundance means that land-owners receive approximately all the bread and laborers receive approximately none of it. Suppose that people prefer a bite of bread now to a
bite of bread later, but that in each period, no individual can eat more than twice what their share of total output would be if total output were evenly divided.  Land owners at full gluttony can eat no more than a small fraction of potential output, and they cannot store the surplus. Technology and population are stable, but land owners face negative real interest rate. There are laborers who would be glad to borrow the surplus bread, but they have no capacity to repay. The real interest rate on the bread lending market would be -100%.

Now Paul Krugman has picked up the scent:

OK, I like little parables. But I have a problem with this one, for one simple reason: any such story, basically an underconsumptionist story, would seem to depend on the notion that rising inequality has led to rising savings.  And you just don’t see that.

That, I would argue, doesn’t fit with the story. Remember that [l]and owners at full gluttony can eat no more than a small fraction of potential output, and they cannot store the surplus, so there cannot be any saving!  It is impossible to have any saving, not to speak of rising saving, which is absolutely impossible in this story. Nevertheless, laborers can finance their consumption by lending from land owners. What you would expect in this story is a two-step ending. And it is not a happy one:

  1. Rising inequality should lead rising household indebtedness when the poor still seem creditworthy. However, when it is clear to the land-owners that the laborers cannot repay, we come to step
  2. Land-owners lower production until they reach the level where they consume all the output and nothing is left over. Employment will be lower (although GDP might rise as long as productivity is rising).

Let us now see whether data series from FRED2 support the fable of the breads for the US. #1 is about rising indebtedness (NINJA loans, etc.), #2 about a dent in the GDP growth trend through a permanent fall in employment. (In order to show the three data series in a graph with only two scales I decided to index GDP and employment.)

As so often when thinking about the crisis, we are back at Keynes. Here is an excerpt from chapter 23 of the General Theory (quotation by Keynes put in bold italics by me):

But it was by Bernard Mandeville’s Fable of the Bees that Barbon’s opinion was mainly popularised, a book convicted as a nuisance by the grand jury of Middlesex in 1723, which stands out in the history of the moral sciences for its scandalous reputation.  Only one man is recorded as having spoken a good word for it, namely Dr Johnson, who declared that it did not puzzle him, but “opened his eyes into real life very much”.  The nature of the book’s wickedness can be best conveyed by Leslie Stephen’s summary in the Dictionary of National Biography:

Mandeville gave great offence by this book, in which a cynical system of morality was made attractive by ingenious paradoxes. … His doctrine that prosperity was increased by expenditure rather than by saving fell in with many current economic fallacies not yet extinct.[33] Assuming with the ascetics that human desires were essentially evil and therefore produced “private vices” and assuming with the common view that wealth was a “public benefit”, he easily showed that all civilisation implied the development of vicious propensities….

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One reply on “Why Financing is not Saving: Fable of the Breads”

  1. Great quotes, Dirk.
    I like Waldman’s “negative 100% interest”, which is approximately what Germans will earn on their Greek vendor financing loans (:

    Just before the passage that you quote in Keynes book is this gem,

    “Prodigality is a vice that is prejudicial to the Man, but not to trade…Covetousness is a Vice, prejudicial both to Man and Trade.” (Barbon 1690) In 1695 Cary argued that if everybody spent more, all would obtain larger incomes ‘and might then live more plentifully’.”

    Waldman observes that the virtue of saving is an arbitrary value of our culture, not a ‘truth of economics’ or a ‘fact of nature’. Saving that is not reinvested into the economy as fixed capital formation or production costs must necessarily reduce, not increase, the economy’s wealth, as dead saving removes that money from the spending and income stream that drives the real economy.

    So “covetous” misers = ‘prudent’ savers, in their deleterious macro effects on the economy. And it is ‘profligate’ spenders who actually make the economic world go ‘round. So much for the Puritan economic morality of “thrift” which, if practiced generally, yields national “poverty”.

    And as Waldman reiterates Bernanke, it leads to a global “savings glut” that reduces the rent value of the plentiful money to less than zero. Real goods that you want to save up suffer spoilage and carrying costs, a negative rate of return. What god decreed that money savings must always yield a positive return? And who, in a world drowning in excess savings, is obliged to pay that return?

    A few pages further on in Keynes’ book he quotes Thomas Malthus in 1821 making the very case that Kumhof and Ranciere made in their 2010 paper, Inequality, Leverage and Crises,

    “We see in almost every part of the world vast powers of production that are not put into action, and I explain this phenomenon by saying that from the want of a proper distribution of the actual produce adequate motives are not furnished to continued production…I distinctly maintain that an attempt to accumulate very rapidly, which necessarily implies a considerable diminution of unproductive consumption, by greatly impairing the usual motive to production must prematurely check the progress of wealth…But if it be true that an attempt to accumulate very rapidly will occasion such a division between labor and profits as almost to destroy both the motive and the power of future accumulation and consequently the power of maintaining and employing an increasing population, must it not be acknowledged that such an attempt to accumulate, or that saving too much, may be really prejudicial to a country?”

    Kumhof and Ranciere observe that the relative shares of income flowing to workers and investors (“labor and profits” in Malthus’ terms) has been excessively tilted toward investors over the past 30 years of financial deregulation and globalization, which led to the ‘diminution’ of workers’ ability to consume, which investors counteracted (in order to maintain demand and the illusion of profits) by “lending” the workers money to keep up consumption. German capitalists are not the only ones who “accumulated very rapidly”, and who now find their customers broke and unable to keep buying their wares, and unable to repay their consumer loans. Which demonstrates Barbon’s point that,

    “Prodigality is prejudicial to the man, but covetousness is prejudicial to both man and trade.”

    The more things change…

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