Saving and the Purpose of Production

If the purpose of production is consumption, where does that leave saving? To a remarkable degree, saving simply shifts consumption between households so that each household can shift its consumption over time. To focus on this aspect of saving, I will ignore investment. (I will get to that later.) To the degree that saving simply shifts consumption between households, it remains completely consistent with the principle that the purpose of production is consumption.

Saving is disposable income less consumption. Disposable income is income less tax payments. Saving is that part of income not paid in taxes or spent on consumer goods and services. Saving implies an increase in net worth by a household. By convention, saving occurs when consumption is less than disposable income. Negative saving, called dissaving, occurs when consumption is greater than disposable income. Dissaving implies a decrease in net worth.

Income, tax payments, and consumption are all flows that occur over a period of time, and so is saving or dissaving. Net worth--assets minus liabilities--is a stock. What is a household's net worth at a point in time?

For example, Smith earns $50,000 per year, pays $5,000 in taxes, and spends $44,000 on consumer goods and services during the year. Smith's disposable income is $45,000 per year. Since he only consumes $44,000, he saves $1,000 per year. Saving requires that he either accumulate assets or repay debts, so that his net worth rises by $1,000 over the period.

Jones, on the other hand, also earns $50,000 per year. He pays $5,ooo in taxes, and spends $46,000 on consumer goods and services. Jones' disposable income is $45,ooo per year. Since he consumes $46,000, he dissaves $1,000 per year. Jones' net worth decreases by $1000 over the year. His assets decrease or his liabilities increase.

How is it possible to dissave? How can Jones pay $5,000 in taxes and spend $46,000 on consumer goods and services, when he only earns $50,000? One way to dissave is to borrow. Jones can borrow $1,000 and so consume at a rate grater than his disposable income. This increases his liabilities and reduces his net worth over the year.

Suppose Jones borrows from Smith, which is equivalent to Smith lending to Jones. Suppose the interest rate is 5% per year, payable as a coupon, but the principal is due many years in the future. The loan is liability to Jones and an asset to Smith. Jones' has a lower net worth. Smith has a higher net worth.

The loan has allowed Jones to spend more on consumer good and services. Does that mean that total spending on consumer goods and services has risen? No, because Smith is consuming less than he would have if he hadn't lent to Jones. If there was no saving or dissaving, total consumption would have been the sum of their disposable incomes, $45,000 plus $45,000 or $90,000. Because of the saving and dissaving, because of the lending and borrowing, consumption is $44,000 for Smith plus $46,000 for Jones. Consumption remains $90,000 per year.

The following year, Smith has a slightly higher income. He earns $50,050. That is, his initial annual income plus 5 percent of the $1000 he lent to Jones. Suppose his taxes remain $5,000, so that his disposable income is $45,050. And suppose he now spends all of that on consumer goods and services, so that he saves nothing.

Meanwhile, Jones is in debt. He owes Smith $1,000. The total stock of debt is $1000. Using the language of financial investment, some say he is "leveraged." He still earns $50,000 per year and pays $5,000 in taxes. He spends all of his remaining $45,000 in disposable income, but he buys $44,950 in consumer goods and services, and pays $50 to Smith in interest.

Does the fact that Jones is in debt (leveraged and maybe "overly" so,) result in less consumption? He consumes less. He consumes $50 less. However, in total, consumption doesn't change. If there had never been any saving or dissaving, no lending or borrowing, then both households would have continued to consume an amount equal to their disposable incomes, which would total to $90,000. Because Jones is in debt, he consumes $50 per year less, but Smith, with his higher disposable income, consumes $50 more. Total consumption remains $90,000.

There is no saving and no dissaving. However, there is debt and interest payments on that debt, providing income to the creditors. Total consumption remains unchanged. The "leverage" of Jones does not reduced total consumption.

While borrowing is one way to dissave, there is a second method. It is possible to dissave by selling off assets that have been accumulated in the past, and so the flow of consumer expenditure is greater than the flow of disposable income during a particular period. Oddly enough, a second way to save is to pay down existing debts.

Suppose Jones tires of paying $50 per year to Smith. Or, perhaps, Smith wants his $1000 back. Jones repays his debts. Smith collects on the loans he has made. (Jones is deleveraging.)

When this occurs, Smith earns $50,050, and pays $5,000 in taxes. His disposable income is $45,050. However, he spends $46,050 on consumer goods and services. How does he do that? He collects on the $1,000 loan he had made to Jones. Because Smith's consumption of $46,050 is greater than his disposable income of $45,050, he is dissaving. Notice, however, he does so without borrowing or going into debt. Smith's net worth still falls, because when he collects the money he lent to Jones and spends it on consumer goods and services, his assets decrease.

Meanwhile, Jones has a disposable income of $45,000. He makes his regular interest payment to Smith of $50, but also repays the full amount of the loan of $1,000. He spends $43,950 on consumer goods and services. The difference between his disposable income and his total expenditures, both interest and spending on consumer goods and services is $1,000. Jones saves $1,000.

Jones has delevered. What happened to consumption? Jones spent less on consumer goods and services, but total consumption remained unchanged. Smith spent $46,050 and Jones spent $43,950, for a total of $90,000.

The amount that Smith saved and Jones dissaved was quite modest. Suppose that the saving and dissaving was $10,000. Smith would initially consume only $35,000 and Jones would consume $55,000. If the interest rate remained 5 percent, then during the period when Jones was a debtor and Smith a creditor, Smith would be consuming $45,500 per year, while Jones would only be purchasing consumer goods and services worth $44,500. And finally, when Jones "delevers," Smith consumes $55,500, dissaving $10,000, while Jones must reduce his purchases of consumer goods and services to $34,500, saving because he spends much less than his disposable income. Total consumption remains $90,000.

Now, suppose that instead of simply saving and dissaving one year, Smith and Jones repeat year after year. Smith saves $10,000 each year and Jones dissaves $10,000 each year. After 5 years, Jones owes Smith $50,000. Jones' debts are equal to his total $50,000 per year income! Jones pays $2,500 in interest to Smith, and so his consumption expenditure is his $45,000 in disposable income less his $2,500 interest payment, plus the new $10,000 loan from Smith for a total of $52,500. Smith earns the $2500 in interest and so has $47,500 to spend. But he saves and lends $10,00 more to Jones, so his consumption is $37,500. Total consumption remains $90,000.

Now, suppose that they carry on for an additional 5 years. Now, Jones owes Smith $100,000--twice his income. Comparing to the initial total income of the two of $100,000, then total household debt is equal to total household income. Clearly, there is too much leverage! There must have been a massive consumption binge, right? Well, maybe for Jones, but not in aggregate.

Suppose Smith and Jones are going to continue on and bring total household debt to something greater than household income. Jones continues to earn $50,000 and has a disposable income of $45,000. His interest payments are now $5,000 and he borrows an additional $10,000. His spending on consumer goods and services is now $50,000. That is, $45,000 less $5,000 in interest payments, plus a new loan of $10,000. Smith is now earning $55,000, with a disposable income of $50,000. He lends $10,000 to Jones, and spends $40,000 on consumer goods and services. Total spending on consumer goods and services remains $90,000 as it has all along. The huge build of of household consumer debt has occurred without there being any increase in total consumption. Smith has consumed less, and Jones has consumed more.

Now, instead suppose Jones begins to worry about his ability to honor his debts, and so stops additional borrowing. Or, perhaps, Smith begins to worry about collecting the money he is owed, and stops additional lending. Total household debt will remain $100,000.

Smith now earns $55,000, including the interest he collects from Jones. He pays $5,000 in taxes. His disposable income is $50,000, and that is what he spends on consumer goods and services. Smith saves nothing. Jones, on the other hand, earns $50,000. He pays $5000 in taxes. He pays $5000 in interest to Smith. That leaves him $40,000 to spend on consumer goods and services. He no longer dissaves. Total spending on consumer goods and services remains $90,000. The highly leveraged nature of the economy in no way reduces the ability of households in aggregate to spend on consumer goods and services.

Now, let's go with deleveraging. Clearly, there is no way for Jones to repay the entire $100,000 he owes to Smith all in one year. His disposable income, even before the $5000 in interest he owes, is too low. And, of course, while it would be possible for Smith to consume $150,000 in one year, that is a very substantial increase.

However, Jones can pay it off gradually. Suppose he pays $10,000 per year. At first, Smith earns the $55,000, including the interest from Jones, and pays his $5,000 in taxes. His disposable income is $50,000. But he collects an additional $10,000 from Jones, and so spends $60,000 on consumer goods and services. Because he consumes more than his disposable income, he dissaves at a rate of $10,000 per year.

Jones, meanwhile, earns $50,000. He pays $5,000 in taxes, and $5,000 in interest. He pays back Smith $10,000 per year. Jones saves at a rate of $10,000 per year. He purchases $30,000 worth of consumer goods and services.

Total spending on consumer goods and services is $90,000. As Jones gradually repays his debts, Smith earns less and less interest income, and so his spending on consumer goods falls. On the other hand, Jones has more income after paying interest to Smith, and expands his consumption.

After 10 years are up, Jones has repaid his debts. Neither Smith nor Jones save or dissave. Smith's disposable income is $45,000 as is Jones'. They each spend $45,000 on consumer goods and services. Total spending on consumer goods and services is $90,000.

Both Smith and Jones were contributing resources to production all along. Firms were using those resources to produce consumer goods and services. Smith and Jones paid taxes, and that funded government spending. Some resources were used by the government, either directly or used by firms to produce goods and services for sale to the government. While both Smith and Jones mostly contributed resources to production in order to purchase consumer goods and services, during some periods, Smith produced more than he consumed, but in other periods he consumed more than he produced. Jones was the same. He consumed more than he produced sometimes, and produced more than he consumed other times. In aggregate, total consumption matched total production. Because saving and dissaving matched, in aggregate, production was continually directed towards consumption.

The life-cycle approach to saving and dissaving suggests that young people dissave. They borrow and go into debt. To the degree they borrow to purchase durable consumer goods, like cars or even houses, the impact on their net worth is ambiguous since they are accumulating real assets. As people move into middle age, they make payments on their installment debt, and so, save. In their later middle years, they have paid down their debts and accumulate financial assets--they save and lend. Finally, when people reach their senior years, they retire and dissave. They spend the funds they accumulated in their later middle years.

The permanent income hypothesis suggests that households save and dissave to smooth consumption as income fluctuates. If income is more than normal, households save by accumulating assets or paying down debts. if income is less than normal, then households dissave by selling off accumulated assets or paying down debts.

These approaches to saving, income, and consumption are very consistent with the principle that the purpose of production is consumption. Consider instead a "class" approach. Wealthy households earn interest income, and limit their consumption to that income. Dissaving, described as "dipping into capital" or some such, is considered a sin against one's progeny. Successful households save, adding to their net worth, seeking to join the ranks of the wealthy. The working people are the debtors, making these interest payments to the wealthy. Ignoring investment, the situation appears rather bleak, as those saving to accumulate wealth can only do so to the degree others go into debt.

Even here, production is directed towards consumption. The rich hold wealth in order to consume. Those who owe them money must reduce their consumption by their interest payments. Those who save and accumulate wealth to lend reduce their consumption out of current income. The savers lend to poor borrowers who consume an amount greater than their incomes.

Production is directed to consumption as long as saving matches dissaving. How can a market economic system, without any conscious direction, coordinate the decisions of the millions of households so that saving and dissaving match? As usual, the answer is prices. In particular, interest rates.

Suppose that at the current level of "the" interest rate, desired dissaving is greater than desired saving. Clearly, this is a problem. The households are providing resources to firms to produce goods and services. This generates an equal income, which households can spend on consumer goods and services. If desired dissaving is greater than desired saving, then households in aggregate are trying to purchase more consumer goods and services than can be produced with the resources they are willing to provide.

The solution is a higher interest rate. Households who would dissave by borrowing in order consume beyond their income will have to sacrifice more consumption in the future when they repay the loans. They receive a signal and incentive to keep their current levels of consumption closer to their current incomes. Households that are saving by paying down the debts they have incurred have an incentive to speed those repayments, particularly if the interest rates on their debts float. The longer they wait, the more future consumption they must sacrifice. Households saving by accumulating assets are rewarded by the additional future interest income, obtaining even more consumer goods and services in the future. And finally, households dissaving by selling off the assets they have accumulated are motivated by the higher interest to slow the pace of sales and current consumption. All of these incentives to reduce current consumption result in expanded saving and reduced dissaving until they are again in balance.

However, there are income effects that have perverse effects for consumption. Households that hold assets and earn more interest income can afford to consume more. That is offset by the households that are currently indebted whose interest payments make up that interest income. They have less income after interest to fund consumption. Generally, the income effects between borrower and lender (like any buyer and seller) offset, leaving a substitution effect--less current consumption and added future consumption. So the result then is more saving and less dissaving.

While it is natural to focus on the impact of higher interest rates on desired saving and dissaving at a given level of income, it is certainly possible, and even likely, that higher interest rates will elicit more work effort--a higher supply of labor and increased current income. The notion that people will work more hours or obtain an additional job so that they can save the added labor income to earn higher interest rates seems implausible. Similarly, the notion that net creditor households will respond to higher interest income by taking an additional job to maintain consumption with reduced dissaving is very unrealistic.

However, households that are borrowing less and so reducing consumption may well seek added opportunities to work and obtain the desired consumer goods by other means. And, most importantly, those households that are already in debt and whose interest payments are increased, will face a very strong incentive to work additional hours, even to the point of taking another job, to try to maintain consumption.

What about the other type of imbalance? Suppose desired saving is greater than desired dissaving. While trying to consume more goods and services than can be produced with the resources households provide to firms is infeasible, there is nothing impossible about households purchasing fewer consumer goods and services than the resources they provide to firms can produce. Saving certainly is possible. If firms cannot sell the goods, they won't produce them. If firms don't produce the goods, they won't hire labor and other resources to produce them. And so, the result of interest rates being too high, and leaving desired saving greater than desired dissaving will be that households won't be able to sell labor and other resources. Households will earn less income than desired.

In this scenario, the problem is that interest rates are too high too coordinate the decisions of households and the solution is a lower interest rate, signaling households to expand consumption expenditure. While this may include some households borrowing more, going further into debt, and consuming beyond their incomes, it can also involve other households paying down their debts more slowly. They are reducing their "leverage," but less rapidly. Of course, they could go so far as to stop, and leave their total indebtedness the same. Perhaps more importantly, it signals still other households to reduce their saving. They increase consumption but they obtain to money to pay for that consumption from current income. And finally, it signals those households that are dissaving by collecting on old loans to do so at a more rapid rate. These increases in consumption result in less saving and more dissaving, bring the two into balance. The demand for consumer goods expands, and so, firms demand more resources--labor, land, and capital, to produce them. At the new, lower, level of interest rates, households' decisions to provide resources to earn incomes, and then to consume, to save or dissave, are coordinated. Their plans are consistent.

Again, there are complications due to income effects. The lower interest rates reduce the interest incomes of creditor households. The lower incomes likely result in lower consumption. However, debtor households have more income remaining after their interest payments, and so can expand consumption.

Further, the changes in intereset rates may impact work effort. While the notion that households that are saving will work less (and so, enjoy more leisure) because of the lower benefit of saving is implausible. However, less work effort by households who can borrow to obtain consumer goods is plausible. More importantly, the income effect on indebted households whose interest payments are reduced may result in less work effort. On the other hand, that retirees living on interest income might go back to work to maintain consumption is plausible, which would result in greater resource supplies and an increased ability to produce consumer goods.

If there is a situation where households are saving and not borrowing, and consumer expenditures are low, such that households have difficulty in finding employment of resources, like labor, it is quite posssible that the problem is that interest rates are too high and consumption is too low. While it is certainly possible that people could be choosing to save more and dissave less because there is "too much" debt, meaning either debtors are worried about honoring their debts or creditors are worried about collecting, that doesn't mean that consumption in aggregate must fall. Nor does it mean that consumption in aggregate should fall. It simply means that perhaps some households should consume less, and other households consume more.

In conclusion, it is a mistake to ignore the important role of increased consumer expenditure in bringing a depressed economy to recovery. Complaints about excessive consumption and debt in the past "causing" the problem are wrongheaded. Perhaps the market clearing interest rate is lower now than it would have been if no one had borrowed in the past and current levels of consumer debt where lower. But that is hardly an argument for keeping interest rates above market clearing levels. It is the lower market interest rates that keep saving and dissaving in balance, and allow those households that are in debt to earn incomes and pay down their debts. While some households may choose to borrow more, other households can simply save less out of current income. And further, those households that had saved funds in the past, and accumulated wealth, can now use that wealth to fund consumption. Those households can act in a way consistent with the principle that the purpose of production is consumption, if not now, then in the future. And the future is now.

Finally, how does this tie into monetary disequilibrium? It is simple. In the absence of monetary disequilibrium, for a household to save, it must lend (or purchase some other asset.) For a household to dissave, it must somehow obtain the money. It must borrow (or sell some other type of asset.) If saving and dissaving are the same as lending and borrowing, then the interest rate that clears credit markets keeps saving and dissaving equal. (Similarly, the prices of other assets balances the purchases of savers and the sales of dissavers.) However, if households can save by accumulating money balances, or household can dissave by spending down previously accumulated money balances, then market interest rates that clear the market for loans do not necessality keep saving and dissaving in balance.

Further, if banks (and especially a central bank) can fund loans with newly created money, and people will accept that money in exchange for consumer goods even if they do not intend to hold that money but rather spend it, then again, it is possible that the interest rate that keeps the supply and demand for credit in balance will not balance saving and dissaving.

If the quantity of money is equal to the demand to hold money, then the interest rate that clears credit markets keeps desired saving and dissaving in balance. If not, the economy is out of equilibrium. While it is possible to simply say--keep the quantity of money in balance with the demand to hold money, fixing that problem will at some times result in lower interest rates and increased consumer expenditures. Increased consumer expenditures is sometimes what is needed to generate economic recovery. And that should be no surprise. Because the purpose of production is consumption. Or, at least, it should be.