March 13, 2010

Savings & Trade

The following two posts focus on the importance of savings for improving our long-term standard of living, and how a lack of savings causes trade deficits.

I am glad that you raised the issue of savings. In economics savings means something a little different than simply money is a savings account. Savings is really the portion of the nation's economic production, which does not go to current consumption. In other words it is available to be used for things that will be productive in the future, for example, the portion available for investment in new plants and equipment, infrastructure like roads, telecommunications, equipment, and education.

If we consume everything that we produce, we have nothing left to devote toward the future. It would be like a farmer, who had nothing left for next years seeds. When I was a new economics student in 1978, economists used to say that in an economy investment was equal to savings (I=S). However, with the rise of global finance, this no longer holds true for any particular country. In recent decades, the US has been able to invest despite a low savings rate, primarily because people in high savings countries like China have been willing to lend or invest their excess savings in the US. However, this also makes the US vulnerable to changes in attitude around the world about the wisdom of investing in the US. In addition, a portion of the wealth created in the future, must be returned overseas to investor.

The irony is that in the short-term policies are often implemented to encourage people to spend now to pull the economy out of recession. However, in the long-term such policies can be destructive, because it is savings the ultimately allows us to become better off. What is needed is a strategy that will encourage people to gradually save more and more in the US and long-term rely less on consumer credit.

You make an important point. See my last post on savings. In response to your post, let me expand my comment a little more.

What most effects our overall trade deficit/surplus situation is our savings rate, and not trade practices by other specific countries. Imagine that your home is a country. You do two things. 1) You go to work every five days a week and "export" your services to the rest of the world. 2) You buy goods and services, and thus "import" them into your home.

If people outside your home are willing to lend you some of their savings in the form of credit cards, you can import more than you export. You have more buying power than the value you produce at your job. In other words your home is running a trade deficit.

This is also true for countries. If a country has more buying power than the economic value it produces because people in other countries either lend their savings or use their saving to buy assets of that country, that country will run a trade deficit. It consumes more than it produces. In contrast, a country with excess savings will run a trade surplus because it will lend to other countries or use its excess savings to buy investment assets in other countries, and thus consume less than it produces.

In other words, the US can complain all it wants about unfair trade practices by other countries, but until the US increases its savings rate significantly, we will still be running large trade deficits. (Alternatively, trade deficits could come to an end, if other countries lost faith in the US and stopped lending to the US.)