Four weeks ago in this space, I wrote approvingly of research by Fred Block and Robert L. Heilbroner that suggests that America's savings rate is miscalculated. Their most arresting finding is that when you count realized capital gains as part of personal income, the overall rate of private savings in the 1980s did not decline, contrary to widespread belief. Several indignant readers wrote to advise that any freshman economics student knows why capital-gains income shouldn't be counted as savings: By definition, savings are what is left over from income after consumption. And by definition, realized capital gains are not savings (since they don't depress consumption), but are simply an inflation of existing financial assets.
But this is precisely the trouble: These time-honored definitions lead to a misunderstanding of the issue. Suppose, for example, that Smith buys a share of stock for $100. The stock price then goes up to $200. Jones takes $200 out of his savings account and buys the stock from Smith. At this point, Smith's net worth has increased by $100. But Jones is no poorer--the form of his financial asset has simply changed. Meanwhile, Smith can take his $100 gain and invest it in something new or spend some of it. The transaction is analogous to fractional reserve banking, in which banks "create" money by taking in deposits and making loans. The depositor has all his money, while the borrower has new resources.
HOLDING BACK. By reviewing the 1980s in this light, we gain a better understanding of what went wrong with the U.S. economy and what is wrong with the orthodox remedy of increasing the savings rate. For one thing, the supply-side program had perverse results. Affluent investors increased their financial net worth and their share of the nation's wealth, but this increase in their private financial savings did not translate into increased investment. Affluent people failed to fulfill their role as creators of new national productive wealth. Instead, they spent some of their windfall and invested much of the rest in existing financial assets--the shares of existing stocks or in speculative real estate. Conventional accounting of the national income pictures this merely as an inexplicable fall in the savings rate, which misses the point.
In truth, the problem was not on the savings side of the equation, for there was plenty of financial liquidity. The problem was that the people with the money could not discern opportunities to place their savings in new productive investments. One indicator of this reality is the declining interest rates on Treasury securities. Despite the immense public deficit, the Treasury has had no difficulty financing the national debt at relatively moderate interest rates. If there were plenty of opportunities for productive investment in the private sector, the Treasury would be paying more to sell its bonds.
WRONG REWARDS. Several implications flow from this revisionist analysis. First, the deeper problem afflicting the U.S. economy is not a shortage of financial savings but a series of institutional failings. Because of the structure of our financial markets, investors have incentives to invest short term rather than long, and this depresses productive capital formation. Moreover, the banks, one of the key institutions for channeling savings into investment, have been so traumatized by the excesses of the 1980s they are now excessively risk-averse. And they were no match for their German and Japanese counterparts even before the recent real estate blowout. Further, the low global competitiveness of many U.S. industries discourages investors from putting their capital at risk, and the recession intensifies the belief that new investments will not pay off.
Second, we must reconsider economic cause and effect. While investment technically equals savings after the fact, a higher savings rate does not automatically translate into a higher rate of productive investment, particularly when the economy is in recession and beset by institutional problems. Simply increasing the aggregate rate of savings will not cure the institutional defects we've discussed. The conventional recovery strategy is to increase the savings rate and wait for increased investments to follow. But it would be more sensible to cure the institutional problems noted above to make investment more attractive, which in turn would coax out more savings.
Third, the composition of public spending is a key part of the story that is usually left out of the standard analysis. As Heilbroner noted, government spending is not a source of savings or dissavings but rather a use of savings--on either public investment or public consumption. During the 1980s, the composition of public outlay shifted. The federal government spent more money on consumption and on military expenditure and less on civilian investment. If the government had invested more, the deficit would have been more economically useful and less of a drag on performance. One big policy conclusion follows: If very wealthy people are increasing their financial worth but not investing it in productive assets, it would be preferable for the government to tax some of that private windfall and put the proceeds directly into productive public investments.