Investment in Capital Needed To Save The Economy (Part One)

The government and the Central Bank are doing all they can, but the cost of living is rising. Can we really expect the economy to turn around if the wages paid to consumers cannot suffice for consumers to increase spending? My answer is yes, but it will come with a cost. That cost is time.

One of the major concerns of some economists is the level of savings within a country. Usually countries with lower levels of savings have lower levels of productivity. Low levels of productivity have a root in investment in capital– when investment in capital is low, productivity is low. When we talk about capital, we are not just talking about heavy machinery, buildings, and tools. We are also talking about education, technology, and research and development that contribute to both education and technology.

Hold on a minute, you might be saying just about now. How does spending less cause more productivity? Well, savings is the source for investments in many cases. This is true because many businesses and individuals do not have the money needed to preform at their fullest potential. That is where banks come in. Banks allow those who have extra money on hand to deposit their money for a chance to earn a return. Banks then redistribute this money in the form of loans to those who need it at a cost. The cost would is the interest rate. When there is a low level of savings there is limited funds for banks to loan to those who need it, hence banks will make less loans. If less loans are not made, the cost of a loan is much higher.

This correlation between savings, investments and productivity can be seen today. Many banks that had made risky mortgages ended up facing defaults. These defaults then reduced the cash on hand held by these banks– they lost their depositors savings (remember these banks were able to make the risky mortgages loans because of the savings deposits that they received; read more here). Now, as you might have guessed, these banks have very little cash on hand. With such little cash on hand, they really can’t make loans as they use to due to the required reserve ratio (the amount of cash that a bank is required to hold under our central banking system).

What would then happen if people don’t choose to save, you might wonder. Wouldn’t we just be better off if consumers just consumed with all of their money on goods and services now? Wouldn’t increased spending create more jobs now, after all, that is what the media believes? That is true, but it’s not the whole story. Increased spending will only help in the short run. However, in the long run productivity may worsen because of the lack of availability of credit due to diminishing saving levels. In other words, because banks cannot make as many loans, there will be lessening investments made in technological advances, education, and machinery, all of which would have otherwise increased productivity.

This role of savings is stressed in the well known Solow growth model, which states that maximum productivity is reached when we have the right amount of investment in capital. This right amount of investment in capital should also make up for loses in productivity due to depreciation. The name that we use for this right amount of capital is steady state level of capital. At the steady state level, we produce the most output. Keep in mind this interprets into the most possible income, and this means more people are employed, and those who are already employed may be seeing an increase in their income. For this reason, I strongly believe that investment in capital is needed to save the economy.

In that case, looking for instant increase in consumer confidence when it comes to spending habits after a year of attempted recovery from a recession by the Federal Government makes no sense. We should also be looking increases in savings and investments, because it is something that is needed in order to have a healthy and long lasting recovery. Like I said before, there is limited liquidity in the markets, and we will have to get rid of that problem in order to make room for increased consumer confidence, increased spending and investments, etc.

While the purpose of the Stimulus Package was to increase the marginal propensity to consume so that more people will be employed again, it’s not the only issue that the general public faces. Many have also lost their savings, as I stated earlier, and it is reasonable to believe that they will try to recoup as much as they can in the coming years. To our luck, it does seem that this is happening right now. Now we just have to accept the fact that the market is correcting itself in this sense, and there is little that we can do. Moreover, there is little that we should do.

(to be continued…)

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