14 Nov 2008

## Deep Thoughts: Saving vs. Consumption

Back in October, I posted a link to my article “The Importance of Capital Theory.” In the comments, reader randallsquared (RS) was confused by this passage from the article:

As for Cowen, he seems to be assuming that “real income” is equivalent to “real consumption.” I don’t know what to say except, “No it isn’t.” If a worker gets a job in a silver mine and gets paid in ounces of silver that he stores in his basement, he can have very high “real wages” even if his consumption is very low.

So RS was confused by this, and asked why that wasn’t an example of the worker consuming silver. I replied by asking (paraphrasing here), “What if he had been paid in dollar bills and stuck them in his piggy bank? Would you agree with me that that was saving? So how is it different if he gets paid in silver ounces and stores them in his basement?”

RS could see the logic in that, but was still uncomfortable. He then gave me a different example, where a person buys gems and places them all over his house as decorations. This is similar–physically–to my example of a worker taking ounces of silver and putting them in his basement, but clearly we will call the gem story an example of consumption. To explain the difference, I explained in my reply:

The criterion is your subjective intention. If you are buying something with the intention of using it down the road to get something else, then it is saving. (E.g. the guy is holding the silver in his basement, planning to sell it later on and buy cars or whatever.)

[Now] if I fear roving looting bands, and turn my cash into gems, and then strategically hide the gems in the walls etc. around my house, then that is [also] savings. It’s not the physical act per se, it is the intention behind it. If you are deriving direct pleasure from it, [like putting the gems around your house because they look pretty, then it] is consumption. But if you are doing it as a means to consumption in the future, then it is saving.

So then RS finally asked the big question in reply to all of this:

See, this is what I don’t understand. How can my subjective intention (assuming exactly the same outward actions) make any difference to the economy? If it’s the inner life of the actor that makes the difference between consuming and saving, then how can they be different in terms of their effects (given the same action)?

Now this is a great question. I was totally confident in my answers to the hypothetical scenarios of the worker getting paid in silver or dollar bills, or the homeowner placing gems around his house. But RS’s question tries to link these definitive “micro” answers to how economists talk about “macro” things. In other words, economists–especially classical or Austrian types, as opposed to Keynesian nuts like Krugman–often stress how important savings are to economic growth. It certainly seems like there is a physical difference between the two activities (saving vs. consumption). So how can it all just be “in your head”?

Now this is really an interesting issue, and I bet even many professional Austrian economists (all 16 of us) haven’t considered before. I think in order to reconcile the two seemingly obvious positions–namely, that (1) subjective preferences determine the difference between saving and consumption, and (2) others can be affected by one’s decision to save vs. consume–some weird things need to happen to make everything “balance.” It’s sort of like pushing the implications of special relativity onto unusual thought experiments; you get surprising results but if you still believe in the axioms (e.g. speed of light is the same measured by all observers) then you have to endorse the conclusions (e.g. length depends on the observer).

OK the “trick” I suggest, in order to resolve these apparent paradoxes, is that real output increases based on the switch in someone’s subjective preferences. This seems weird at first, because you want to say that “real output is real output,” regardless of how much utility people get from things. E.g. if all of a sudden I decide that I really love my Barry Manilow collection, whereas yesterday I only enjoyed it, I’m not really wealthier. I’m just happier. But despite this observation, I think we have to conclude that real output increases in at least some of these weird cases.

Let’s switch away from silver and into fiat currency, because I think my position will be clearer. OK in scenario one, a worker gets paid \$1000 per week in cash at his job in the factory assembling cars. He spends \$900 of it on consumption goods (including his rent to his landlord), and every week he puts \$100 under his mattress. At the end of 2 months, he spends the \$900 on a fancy new TV. The analysis here is straightforward: he was basically selling some of his current labor for a future TV. By saving during the two months, he freed up factors of production that could have gone into more immediate consumption goods, and allowed them instead to be devoted to the production of an additional TV set available in two months’ time. (Naturally we are assuming entrepreneurs correctly forecast everything.)

OK now scenario two: Here, a worker at the same factory gets paid \$1000 per week in cash for the same type of labor that the other guy does. This second worker also spends \$900 in the community every week on consumption goods, including his rental payments. But every week, he takes a crisp \$100 bill, puts it on his garage floor, douses it with lighter fluid, and burns it. Nobody knows why he does it; the guy’s kind of a nutjob. But there is no doubt that he enjoys doing this, and never regrets it. He is quite literally consuming this portion of his income, there’s no doubt about that.

Now this is odd. The first guy every week put the \$100 bill under his mattress, and economists classified that as savings. By refraining from potential consumption, his farsighted behavior freed up physical resources and allowed for the production of an additional TV in two months time.

But with the second guy, he is not saving at all. He consumes his whole paycheck week after week. And yet, he is drawing on the community’s output of consumption goods no more than the first guy, and on top of that, he has no cash with which to purchase a TV in two months. So it would seem that the community is richer in the second scenario, even though there was less saving occurring!

OK first thing: There was actually no net saving in the first example, over the whole period. What the guy accumulated in his mattress, he ultimately spent on the TV. (Even if he deposits the money at a bank earning interest, so long as he blows the whole balance when he buys the TV, there is no net saving.) So in both scenarios, there is zero saving over the whole period in question. The issue is really, how can the community be richer in the second scenario?

And I think the answer is obvious: There is more real production in the second scenario; real output is higher. Not only is the factory producing cars, but in addition that guy is getting \$100 per week in cash-burning entertainment. If he paid \$100 to a juggler to come perform every week in his garage, that would clearly be an example of real output. So if he “pays himself” \$100 to put on a show of burning cash, he is enjoying real output (of a service). It just so happens that in his capacity as producer of that service, his wages are zero. His cost of production (ignoring the lighter fluid and match) is just equal to his revenue.

Of course you can tweak these examples all you want. The reason I had the guy burn the money, instead of (say) framing the bills and putting them up on his wall as fine art, is that I wanted to make sure he couldn’t change his mind down the road and try to exchange them for other goods and services.

My overall point is that in these odd cases, where savings can rise or fall apparently at whim with someone’s change in subjective preferences or intentions, I think the way you balance the accounts is that total output (and hence real income) changes too.