1.1 Module 56: Savings and Investment Spending

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Matching Up Savings and Investment Spending

We learned in the previous section that two of the essential ingredients in economic growth are increases in the economy’s levels of human capital and physical capital. Human capital is largely provided by governments through public education. But physical capital, with the exception of infrastructure, is mainly created through private investment spending—that is, spending by firms rather than by the government.

Who pays for private investment spending? In some cases it’s the people or corporations that actually do the spending—for example, a family that owns a business might use its own savings to buy new equipment, or a corporation might reinvest some of its profits to build a new factory. In the modern economy, however, individuals and firms that create physical capital often do it with other people’s money—money that they borrow or raise by selling stock.

To understand how investment spending is financed, we need to look first at how savings and investment spending are related for the economy as a whole.

The Savings–Investment Spending Identity

The most basic point to understand about savings and investment spending is that they are always equal. This is not a theory; it’s a fact of accounting called the savings–investment spending identity.

To see why the savings–investment spending identity must be true, let’s look again at the national income accounting that we learned about earlier. Recall that GDP is equal to total spending on domestically produced final goods and services, and that we can write the following equation:

where C is spending by consumers, I is investment spending, G is government purchases of goods and services, X is the value of exports to other countries, and IM is spending on imports from other countries.

The Savings–Investment Spending Identity In A Closed EconomyIn a closed economy, there are no exports or imports. So X = 0 and IM = 0, which makes Equation 20-1 simpler. As we learned, the overall income of this simplified economy would, by definition, equal total spending. Why?

Recall that one person’s spending is another person’s income: the only way people can earn income is by selling something to someone else, and every dollar spent in the economy creates income for somebody. This is represented by Equation 20-2: on the left, GDP represents total income earned in the economy, and on the right, C + I + G represents total spending in the economy:

Now, what can be done with income? It can either be spent on consumption—consumer spending (C) plus government purchases of goods and service (G)—or saved (S). So it must be true that:

where S is savings. Meanwhile, as Equation 20-2 tells us, total spending consists of either consumption spending (C + G) or investment spending (I):

Putting Equations 20-3 and 20-4 together, we get:

Subtract consumption spending (C + G) from both sides, and we get:

As we said, then, it’s a basic accounting fact that savings equals investment spending for the economy as a whole.

Now, let’s take a closer look at savings. Households are not the only parties that can save in an economy. In any given year, the government can save, too, if it collects more tax revenue than it spends. When this occurs, the difference is called a budget surplus and is equivalent to savings by the government.

If, alternatively, government spending exceeds tax revenue, there is a budget deficit—a negative budget surplus. In this case, we often say that the government is “dis-saving”: by spending more than its tax revenues, the government is engaged in the opposite of savings.

We’ll define the term budget balance to refer to both cases, with the understanding that the budget balance can be positive (a budget surplus) or negative (a budget deficit). The budget balance is defined as:

Where T is the value of tax revenues and TR is the value of government transfers. The budget balance is equivalent to savings by government—if it’s positive, the government is saving; if it’s negative, the government is dissaving. National savings, which we just called savings for short, is equal to the sum of the budget balance and private savings, where private savings is disposable income (income after taxes) minus consumption. It is given by:

So Equations 20-6 and 20-8 tell us that, in a closed economy, the savings–investment spending identity has the following form:

The Savings–Investment Spending Identity In An Open EconomyAn open economy is an economy in which goods and money can flow into and out of the country. This changes the savings–investment spending identity because savings need not be spent on investment spending projects in the same country in which the savings are generated. That’s because the savings of people who live in any one country can be used to finance investment spending that takes place in other countries.

So any given country can receive inflows of funds—foreign savings that finance investment spending in that country. Any given country can also generate outflows of funds—domestic savings that finance investment spending in another country.

The net effect of international inflows and outflows of funds on the total savings available for investment spending in any given country is known as the net capital inflow into that country, equal to the total inflow of foreign funds minus the total outflow of domestic funds to other countries. Like the budget balance, a net capital inflow can be negative—that is, more capital can flow out of a country than flows into it.

In recent years, the United States has experienced a consistent positive net capital inflow from foreigners, who view our economy as an attractive place to put their savings. In 2012, for example, net capital inflows into the United States were $432 billion.

It’s important to note that, from a national perspective, a dollar generated by national savings and a dollar generated by capital inflow are not equivalent. Yes, they can both finance the same dollar’s worth of investment spending. But any dollar borrowed from a saver must eventually be repaid with interest.

In recent years, the United States has experienced a consistent positive net capital inflow.

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A dollar that comes from national savings is repaid with interest to someone domestically—either a private party or the government. But a dollar that comes as capital inflow must be repaid with interest to a foreigner. So a dollar of investment spending financed by a capital inflow comes at a higher national cost—the interest that must eventually be paid to a foreigner—than a dollar of investment spending financed by national savings.

The fact that a net capital inflow represents funds borrowed from foreigners is an important aspect of the savings–investment spending identity in an open economy. Consider an individual who spends more than his or her income; that person must borrow the difference from others.

Similarly, a country that spends more on imports than it earns from exports must borrow the difference from foreigners. And that difference, the amount of funds borrowed from foreigners, is the country’s net capital inflow. This means that the net capital inflow into a country is equal to the difference between imports and exports:

Re-arranging Equation 20-1 we get:

Using Equations 20-3 and 20-9 we know that GDP − C − G is equal to national savings, so that:

So the application of the savings–investment spending identity to an economy that is open to inflows or outflows of capital means that investment spending is equal to savings, where savings is equal to national savings plus net capital inflow. That is, in an economy with a positive net capital inflow, some investment spending is funded by the savings of foreigners. And in an economy with a negative net capital inflow (that is, more capital is flowing out than flowing in), some portion of national savings is funding investment spending in other countries.

In the United States in 2012, investment spending totaled $2,475 billion. Private savings totaled $3,015 billion, offset by a government budget deficit of $1,087 billion and supplemented by a net capital inflow of $432 billion. Notice that these numbers don’t quite add up; because data collection isn’t perfect, there is a “statistical discrepancy” of $115 billion. But we know that this is an error in the data, not in the theory, because the savings–investment spending identity must hold in reality.

It’s also worth noting that 2012 was not a normal year. As we have pointed out previously, in 2008 the U.S. economy (along with the economies of many other nations) was struck by a severe financial crisis. This crisis led both to a plunge in investment spending and to large government budget deficits, effects that have continued. By using data from 2007, the last year before the crisis, we get a much better picture of what savings and investment look like in more normal times.

Figure 56-1 shows what the savings–investment spending identity looked like in 2007 for two of the world’s largest economies at the time, those of the United States and Japan. To make the two economies easier to compare, we’ve measured savings and investment spending as percentages of GDP.

U.S. investment spending in 2007 (equal to 18.8% of GDP) was financed by a combination of private savings (15.7% of GDP) and a capital inflow (5.2% of GDP), which was partially offset by a government budget deficit (−1.6% of GDP). Japanese investment spending in 2007 was higher as a percentage of GDP (23.8%). It was financed by a higher level of private savings as a percentage of GDP (32.1%), which was offset by both a capital outflow (−4.9% of GDP) and a relatively high government budget deficit (−3.4% of GDP).

Source: Bureau of Economic Analysis; OECD.

In each panel the orange bars on the left show total investment spending and the multicolored bars on the right show the components of savings. U.S. investment spending was 18.8% of GDP, financed by a combination of private savings (15.7% of GDP) and positive net capital inflow or capital inflow (5.2% of GDP) and partly offset by a government budget deficit (–1.6% of GDP). (These numbers sum to more than 18.8% due to statistical discrepancy.)

Japanese investment spending was higher as a percentage of GDP, at 23.8%. It was financed by a higher level of private savings as a percentage of GDP (32.1%) and was offset by both a negative net capital inflow or capital outflow (–4.9% of GDP) and a budget deficit (–3.4% of GDP).

The economy’s savings finance its investment spending. But how are these funds that are available for investment spending allocated among various projects? That is, what determines which projects get financed (such as Facebook’s server farms) and which don’t? We’ll see shortly that funds get allocated to investment spending projects using a familiar method: by the market, via supply and demand.

!world_eia!AMERICA’S LOW SAVINGS

Figure 56-2 shows national savings as a percentage of GDP for seven wealthy economies in 2007. (Again, we focus on 2007 as the last pre-crisis year). The United States had the lowest savings rate, although the United Kingdom’s savings were only slightly higher.

Source: International Monetary Fund.
Note: IMF data differ slightly from other data sources.

In this respect, 2007 wasn’t unusual. The United States has had consistently low national savings compared with other wealthy countries since the 1980s. The main source of these international differences in national savings lies in low U.S. private savings rather than in large U.S. government budget deficits.

Why do Americans save so little? The short answer is that economists aren’t sure, although there are a number of theories. One is that consumers have easier access to credit in the United States than elsewhere. For example, Japanese lenders have traditionally demanded large down payments from home-buyers; but, until the housing bust, it was possible for Americans to buy homes with little or no money down.

It’s also argued that the U.S. Social Security system, by providing guaranteed income in retirement, may reduce the incentive for private saving. In any case, the United States has been able to maintain high levels of investment spending in spite of its low savings rate because it receives large positive net capital inflows.

Module 56 Review

Check Your Understanding

PITFALLS: INVESTMENT VS. INVESTMENT SPENDING

INVESTMENT VS. INVESTMENT SPENDING

What is the difference between investment and investment spending?

WHEN ECONOMISTS USE THE TERM INVESTMENT SPENDING THEY ALMOST ALWAYS MEAN “SPENDING ON NEW PHYSICAL CAPITAL.” This can be confusing, because in ordinary life we often say that someone who buys stocks or purchases an existing building is “investing.” The important point to keep in mind is that only spending that adds to the economy’s stock of physical capital is “investment spending.” In contrast, the act of purchasing an asset such as a share of stock, a bond, or existing real estate is “making an investment.”

To learn more, see pages 206–207.