The Keynesian Fallacy Of 'Unspent' Money

Keynesians are convinced that if people and businesses would just spend more the economy would be better. They think taking money from rich people and giving it to poor people helps the economy because the poor spend a higher percentage of their income than the rich. They think that businesses with piles of cash they have not invested yet are slowing the economy and policies should encourage them to spend with abandon.
These ideas misunderstand what unspent money does. Keynesians act as if money saved is money vanished. In reality, money saved is money lent and spent.

If Jack saves $100, depositing it in the bank, the money has not vanished from the economy. On the accounts of a bank, deposits are liabilities while loans are the assets. The bank only accepts deposits so that it can lend the money out to somebody. Keeping only a small fraction of the deposits (in case Jack wants to withdraw some from an ATM), the bank lends out the remainder of the money as quickly as it can because collecting loan payments is how the bank earns revenue.

When a company has retained earnings that it has not spent yet, the money does not just get locked up in the corporate vault. Companies have bank accounts, too. When a corporation does not spend its money, it deposits it in a bank which lends out the money the same as if it was in a person's account.

Two simple economic identities are important here. The total size of the economy, as measured by gross domestic product, is given by the sum of consumption, investment, government spending on goods and services, and net exports. In symbols, economists use Y to denote total income which is equal to GDP and write the above identity in equation form as Y = C + I + G + NX where the other letters denote the component of GDP that starts with each respective letter. The second identity is even simpler: I = S which stands for investment equals savings.

The income of every person and every business is divided among three uses. Paying taxes is one option, thereby funding government spending. Consumption is the one that the Keynesians want to see. The third option is to either save the money or invest it. It does not matter if a person or business chooses to save or to invest money because one person's saving simply becomes another person's investment once the bank loans out the money that was saved.

If the rich save and invest a lot instead of spending their income on consumption, that does not mean the economy is harmed by a slump in consumption. Their saving allows somebody else (a person or a business) the opportunity to spend above their income by borrowing the money that was saved. Saving does not destroy money; it simply changes who spends it.

In fact, unless people are hiding their savings in mattresses, saving is actually a net positive for the economy. That is because some of the savings will be borrowed by businesses to make investments in productive capital-factories and machinery that produce goods for us to consume later. Spending on consumption and investment in capital count the same when we measure GDP today, but they have different long-term effects. Raising the level of productive capital in the economy means that the economy will be larger in the long-run because extra capital means companies can make more products for us to consume later.

Robert Solow won a Nobel Prize partly for demonstrating that the ratio of capital to labor determines the long run wealth of a country. The U.S. is below the optimal capital to labor ratio, so more savings now means future generations will be richer. More consumption now may make Keynesians happy but it will leave our children and grandchildren poorer.

We did not have a recession because people suddenly, in large numbers, stopped spending money for no rational reason. The economy had grown partially based on inflated real estate values and financial sector profits that were supporting higher levels of spending both from the income generated by finance, and real estate profits and from the wealth effect. The wealth effect is simple; when people are wealthier, they spend more money.

When the real estate bubble burst, $8 trillion in household wealth vanished. Borrowing from real estate equity that had been supporting $200 billion per year in spending was no longer possible because with equity fast disappearing the banks stopped making home equity loans. Thus began a recession. The problem is not that people saved instead of spending. The problem is there was less spending with no savings in its place.

When saving replaces spending, the economy is unaffected in the short run and future generations will actually be richer due to the resulting investment in long-lasting, productive capital assets.

The recession was not caused by people having money that they did not want to spend. The problem was that when real estate values collapsed, people had less money and wealth, period. The lost wealth was the problem, not what people chose to do with their money.

The road to a stronger economic recovery is not found in boosting spending at the expense of savings. The road will be found in the ongoing recovery of real estate prices and in entrepreneurs who create new products and businesses, thereby generating new wealth to replace what was lost. To help the economy, government policy should support business formation and entrepreneurship rather than worrying about what people and businesses do with their money.