Compound Interest, the Doctrine of Equivocation, and Social Discount Rates

“In a sense the problem is this: on the assumption that future people are people, too, the wonders of compound interest make it seem insane to do anything but save for five centuries hence.”

Reminiscent of Sir Partha Dasgupta’s critique of Stern’s discount rate as elaborated in the Stern Review.

http://www.econ.cam.ac.uk/faculty/dasgupta/STERN.pdf

“It is an easy calculation to show that the current generation in that model economy ought
to save a full 97.5% of its aggregate output for the future! You should know that the aggregate
savings ratio in the UK is currently about 15% of GDP. A 97.5% saving rate is so patently absurd
that we must reject it out of hand. To accept it would be to claim that the current generation in
the model economy ought literally to starve itself so that future generations are able to enjoy ever
increasing consumption levels.”

Or, since Minkiw is a Bushy, flip the argument over. How long will it take his children to pay off the debt run up during the Bush years?

I think a major problem (and this is the big point on which Taleb is right) is that there is really no such thing at all as a risk free rate over that time horizon. If you’re thinking even a hundred years out, you really aren’t entitled to ignore things like the Russian Revolution, the Second World War or the fall of the Roman Empire, all of which had pretty shocking effects on investment returns. Over that time horizon, something is going to come along and stop your returns from compounding. This is of course particularly relevant when the context is global warming!

Isn’t the confusion here down to forgetting that money isn’t actually a resource itself merely a claim on resources? What we want to bequeath to our children and grandchildren is an expanded stock of actual resources (physical, social, intellectual, technological, methodological etc.) for them to have the claims on. Whatever claims they have will do them no good if there is nothing to claim.

Call this the ‘Real Resources are Real Theory’ or ‘Capitalism with Actual Capital’. What we can do at any given point in time depends on our actual real world non-monetary useful resources. If we want to do more in the future — we usually assume we do — we collectively have to employ the resources we have in the present to develop and build the resource stock that will survive into that future, as some of our existing stock probably won’t. Fidding about with the arrangement of claims, ‘the movements of small, green pieces of paper’ to coin a phrase, is only useful collectively in so far as it improves the total stock of real resources.

The ‘change the world through the power compound interest’ scheme doesn’t work because it’s rather missing the point. It tries to build up a huge stock of mere claims against resources in the far future to make big bang changes also in that far future, without giving any particular consideration to the hard graft of physical and intellectual effort of building up the real resources needed to actually make such changes. We’re leaving that part in the lap of gods and bankers, but every year still expecting our magic bank account to get rewarded with additional claims on current resources for the service of being part of the system that fiddles around with the small green pieces of paper.

When that system is improving the stock of real resources you can argue that this reward is justified. Whats happens to the magic back account when that system is failing to improve the stock of real resources, or even depleting them, likely involves pitchforks and torches.

How this all relates to Mankiw I’m not sure.

Of course this was all just after the France that had been sufficiently forward looking to see massive value in the Mississippi Bubble.

This assumption — that future people are people — is not necessarily true. It will only become true if we reproduce. Not just reproduce, but raise our children in a safe and fulfilling environment so they can reproduce themselves, and on and on, not neglecting your own needs as a caregiver. The admonition to save 100% of your income thus should apply only to net income, after the expenses you incur to make sure that future people actually become people. Seen this way it becomes less absurd and more like what most people actually do.

This assumption—that future people are people—is not necessarily true.

Ah, damn, I expected next you’d be talking about Eloi and Morlocks. That would be funnier.

“As I pointed out at the time”

I didn’t say it was right or wrong John, only that it was reminiscent of it. Which of course it is, given that you’ve identified them both as being wrong for the same reason.

As long as the long-term real rate of return of a riskless investment exceeds the `social discount rate’ (which, one can plausibly argue, should be 0%), there is a very powerful argument for investing almost all your money to benefit future generations. SKapusniak@7 is half-right: money in the bank is not a resource, but rather, a claim on resources. However, the real rate of return on riskless investments should equal the long-term growth-rate of the real economy (because it is this underlying real economic growth which generates these returns in the first place). The mismatch between the nominal long-term growth rate of money-in-the-bank and the long-term growth of the real economy should show up as long-term inflation. But we are talking about real rates-of-return on investment here, so we have already taken inflation into account. So if I invest my money for 100 years and the Magic of Compound Interest causes it to be worth $1 000 000 (in 2010 dollars), then this is not just 1 000 000 `little pieces of green paper’ —it really does represent a claim on the equivalent of $1 000 000 worth of resources in 100 years time.

Of course, DSquared@5 makes a valid argument that, in practice, over multi-century timespans, there is no such thing as a `riskless investment’, because of Black Swan events like world wars, global catastrophes, etc. But that’s a contingent, practical issue. The philosophical problem remains: if you had the option to convert your present consumption (hence, welfare) into exponentially larger levels of consumption (hence, welfare) for future generations, and you are even moderately altruistic or utilitarian in your ethical calculus, then what justifies you in keeping anything for yourself above a subsistence level?

This problem is somewhat similar to a problem often posed by Peter Singer: anyone living at even a modest middle class level in a first-world country could donate a large part of their wealth (say, 80-90%) to help the teeming billions languishing in abject poverty in the world’s poorest countries. If I give $100 of my money to help some children in Africa receive primary education or basic medical care, thereby massively increasing their life prospects, there is virtually no doubt that the welfare they gain from this donation vastly outweighs the welfare I lose. Thus, if I am even moderately altruistic or utilitarian, then I should donate this $100. Now repeat this argument a thousand times; I will rationally and inexorably reduce myself to a pauper.

Of course, one can make `practical’ counter-arguments. For example, Singer suggests that we must keep enough of our money not only to maintain ourself at a subsistence level, but also to enable us to continue earning the money that enabled us to be charitable in the first place. For example, perhaps I need a car and reasonably nice clothes to keep my cushy middle-class job. But I could still afford these job-requirements with maybe 20-30% of my present after-tax income. Also, it isn’t really certain that my donated money will really do that much good in the long-term. It might be wasted by aid agency bureaucrats, or stolen by kleptocrats. Or it might generate unsustainable population growth, or screw up local economies (e.g. food aid undermines local farmers), or promote unsustainable modes of development which actually lead to even larger Malthusian problems down the road. However, you can do some research to find NGOs and aid agencies with excellent reputations for using the money properly (e.g. OxFam, BRAC, Grameen Bank). And unless you believe the entire field of development economics is pure nonsense, there are forms of development aid where the available evidence strongly suggests that expected long-term welfare gains almost certainly exceed the cost (for example: providing girls with education and young women with good job opportunities generates wealth, combats misogyny, and lowers birthrates. It is an excellent investment by any measure).

So, if you’re a utilitarian, why aren’t you donating 70% of your income to OxFam so that they can provide education for girls and job opportunities for young women? Well? I’m waiting….

Don’t worry. I don’t have a good answer either.

The paradox raised by M. Fortune Ricard is similar. Assuming a reasonable riskless rate of return (and no Black Swans), it seems immoral not to invest most of your money into a trust-fund that will start cashing out scholarships, university endowments, etc. in 200 years.

However, as an argument against poor Mr. Mankiw’s insupportable tax-burden, this fails utterly, unless we assume the government simply wastes the money in gratuitous consumption. Why? Because presumably most of Mr. Mankiw’s tax money will go towards either reducing the national debt, or towards investments (e.g. in America’s rapidly decaying infrastructure and education systems).

Now, increasing the national debt (e.g. by perpetuating the Bush tax cuts on the super-rich) simply increases the tax liability of future generations. And the future tax liability generated by each dollar of present-day tax cuts grows precisely at the rate of return on a riskless investment (i.e. the interest rate on long-term government bonds). So someone who claims to be thinking in these terms should be totally indifferent between paying more taxes now and having his grand-children pay (exponentially) more taxes later. This is the doctrine of Ricardian Equivalence*, which Mankiw should be very familiar with.

(* Ricardian equivalence has many flaws when used as a critique of fiscal policy. But Mr. Mankiw seems to think it applies to him, so I will apply it to him.)

On the other hand, if the government intelligently invests the tax money (e.g. in infrastructure and education), and this investment yields the riskless rate of return, then again Mankiw should be indifferent about his marginal tax rate. However, a good argument can be made that many government investments actually exceed the real riskless rate of return —especially during a recession, when real interest rates are infinitesimal, and there is a massive underprovision of certain public goods. In this case, if I were Mr. Mankiw, I would be happy to pay even more taxes.

That is, unless I was instead planning to give the money to OxFam.

justifying any more spending now

The weird thing is that the exact same argument could be used in support of actually higher taxes. And, in fact, if somebody started talking to me about not spending money because the way things are going, our kids are not going to have enough, that is exactly what I’d think.

I wonder whether Mankiw’s column was in response to the survey that showed people don’t understand compound interest (reported in Surowiecki’s New Yorker column in June). I have no idea what they asked–most people really don’t need to understand compound interest in its technical details, in my opinion (though personally I’d rather know why balloon payments are stupid than be an innocent who isn’t tainted by any knowledge of what a discount rate is). Anybody know?

Indeed, if larger sums merit higher interest rates, it’s absolutely in the interests of society as a whole for everyone to send a check to Donald Trump and his peers, resulting in a higher aggregate wealth (even without getting into a sense that if we poor people don’t reproduce, the only people left will be rich, therefore our children will be rich too–which is what the Eloi/Morlock comparison brings to mind in this context).

Although [7] is the key point here, I think we can simply note that the magic of compound interest applies to yourself within your own lifetime, and people save/invest a relatively small amount of their income. They then leave too much (compared to what they want to leave) to the next generation.

A previously unsuspected moral problem — raised, developed, analyzed, and refuted! Pierre Menard would be proud!

testing (

Russian Revolution, the Second World War or the fall of the Roman Empire

Granted, the Russian Revolution was not very predictable, although the more cosmopolitan Russian aristocrats usually had significant property in France and the Continent in general, and in any case it had always been wiser to do your banking, revolution or no revolution, in Switzerland rather than in Russia itself. Russia never was exactly known for security of investments.

But if you did take the right steps, you could preserve your wealth, just as if you want to hedge against American currency depreciation you could do it today. Want to pass down wealth tax-free? Buy rural tracts.

I agree with many commentators: Risk is the reason that returns (interest) happen at all. Nobody can put their resources in a place where they will happily compound forever. There will be perturbations over any arbitrary time scale that will suffice to confiscate the wealth, one way or another; active management can help mitigate that, but active management means mouths to feed off the wealth. Those mouths may not necessarily be good managers, either.

The point has also been made that money may compound, but most other resources don’t, and those that could cannot be converted linearly into other resources. So, if you find a way to produce infinite quantities of, say, grain, there comes a point at which your need for grain is saturated and so is everyone else’s. So the market basket shifts and your abundant resources loses value.

I like M. Ricard’s plan. I like imagining what would happen if everyone in Charles Mathon de la Cour’s day with 23 livres, or 20 pounds sterling, or 20 gold marks, all did the same thing as M. Ricard. That would mean the banks of the future would owe us all not mere trillions but tens of thousands of trillions! Every family with its own trillion! Or would Smith owe Jones his trillion, and Jones owe Smith, and Peter owe Paul, and… It couldn’t be, could it, that this is some kind of pyramid scheme?

Has Mankiw recently watched that old episode of Red Dwarf where Lister is tracked down 3 million years later by NorWEB (the Northwest Electricity Board) for destroying the Earth’s economy by leaving £17.50 in his current account?

“Leaving aside all the people who were unable to move their assets elsewhere”

Oh, me-oh-my! Who might those “left aside people” be?

This is why argumentative agreement provokes suspicion.

Wow, he’s a cock isn’t he?

I particularly like the disingenuous way that his untaxed $1000 earns 8% interest with no corporate tax, but his taxed $523 earns 8% interest but has to pay a 35% corporate tax.

It’s almost as if he was a disingenuous liar. And his plea to us is that if we raise taxes he might write less of this shit?

What better argument can there be for raising taxes?

SKapusniak 10.16.10 at 11:24 am no 7 said:

“Isn’t the confusion here down to forgetting that money isn’t actually a resource itself merely a claim on resources? What we want to bequeath to our children and grandchildren is an expanded stock of actual resources (physical, social, intellectual, technological, methodological etc.) for them to have the claims on. Whatever claims they have will do them no good if there is nothing to claim.”

This could be developed in many ways, but let me just point out a little moral issue. Suppose you invest at 5%, but the economy expands, in real terms, at only 3%. Then the next year, you have a relatively larger share of the (real) economy. Everyone else shares a relatively smaller part. Now suppose enough people invest at 5%, say those who combined own half of everything, and the economy grows at only 3%. Then next year their relatively larger share is so much larger, that not only has the share of the people who own the other half of the economy of the economy declined from half, but their absolute well being has even declined. Not only are they relatively worse off, but they are absolutely worse off. So the moral problem is, are you justified in investing at 5%, knowing that, as a result of your actions and the actions of those who act like you, other people will be worse off? Should you profit at the expense of others?

The reality is that, when the nominal amount of debt becomes great enough, that is that the product of nominal debt times real interest, is greater than the product of real wealth times real growth rate, then not only will there be a relative transfer of wealth from one half to the other, (from the have-nots to the haves,) but such assets as the have-nots already have, will also (gradually, at first) be taken from them.

Are you morally justified in being a part of this, (Republicans think so.) or is this immoral, and an abuse of power.

Another question arises, are you a part of it? Are you of the haves, or the have-nots? After all, the Federal debt is about $14 Trillion, or almost $50,000 per person. Arguably, if you don’t have this much in the bank, you’re one of the have-nots. Or one can argue from total debt, which is about $50 Trillion, which is about equal to the total real wealth of the country. So, if the real interest rate is above the real growth rate, then there is an absolute transfer of assets, from the have-nots to the haves. The have-nots are not only just not gaining wealth more slowly than the haves, they are actually losing what they have, to the haves.

And check out what this guy has to say:

http://www.telegraph.co.uk/comment/personal-view/7273332/Darius-Guppy-our-world-balances-on-a-sea-of-debt.html

Oh, me-oh-my! Who might those “left aside people” be?

That’s a fair point. But what I have found is that generally it’s an absence of actively trying to hedge, rather than the inability to hedge, that accounts for loss of wealth. For example, the family of someone I know, who were rabid European colonialists, refused to hedge against the Japanese invasion of the South Pacific. They actually did fairly well for themselves (off under the garden the jewelry goes), but the result was nonetheless predictable.

Say if you were a Southern slave-owner before the onset of the Civil War. Now what actually happened was that the Southern slave-owners refused to hedge, and so they lost their wealth. But they could hedge if they felt inclined to: most people just, sometimes on account of national or war feeling, were disinclined to hedge. Or take the English genteel bourgeoisie through the First and Second World Wars. Could they hedge if they wanted to? They could. But they felt that they were “above” such forms of hedging, and thought in war there one could not hedge.

Well, if you were the English bourgeoisie in 1947, stuck with bunch of worthless British securities, whether bonds, gilts, or stocks, hedging would have looked mighty wise in retrospect.

I’m not really trying to prove a point: it’s practically speaking impossible to preserve your wealth against multiple revolutions, wars, etc., because the external factors are so much more overwhelming than any rational inclination to hedge or not hedge, or where or how to hedge. I very much doubt that if I had any wealth I could hedge any better than anyone did. It would probably be gone within months of war. But if you were sufficiently inclined, it’s doable, although extremely unlikely. Loss of wealth, unlike Greek tragedies, is not deterministic.

Which is a long-winded of saying: don’t bother. Material wealth comes and goes. Accepting that reality, and instead aiming for something less ephemeral, is the hardest part.

BenK @31 – Risk is the reason that returns (interest) happen at all.

That at least is certainly not true. I would note that the role of risk in getting profit is commonly used as a justification; a kind of substitute for actual work, withthe added bonus of a pleasingly swashbuckling feel to it. Reward for risk sounds much better than reward for having spare cash. In fact I imagine that when it suits him, Mankiw has probably trotted out that particular line of cant himself.

Should probably note though that M’s own claim only really extends to a period of a few decades. Saving for one’s children has a good rhetorical feel to it, the needs of the family being in general quite a good way of presenting selfishness at a household level as altruism at an individual level. This is especially important for Mankiw here because obviously he can’t appeal to impartial altruism, because there’s no reason why we would consider him an especially good custodian of the magic money tree. And in this case he can’t appeal to selfishness (sorry, ‘incentives’) because in the long run he is all dead.

(Though on a not-entirely-random tangent, U Po Kyin might have been quite interested in the opportunities for leverage that this style of argument offers: He would devote his closing years to good works, which would pile up enough merit to outweigh the rest of his life. Probably his good works would take the form of building pagodas. Four pagodas, five, six, seven…)

It also only generalises to the class of high-‘earning’ US taxpayers, rather than everyone in the world. So while addressing an extreme version of his argument is useful for identifying underlying fallacies, it does not immediately apply to his particular claims. (Which is not to say that he is not talking out of his arse of course; he is. In particular I’d mention again that so far as anyone wishes to remedy the laziness that threatens humanity with the prospect of his insights going with him to the grave, they would be well-advised to get him onto the steepest bit of the Laffer curve and keep him there. That or resort to some ticking-time-bomb-style solution.)

By the way, it seems to me that the real upshot of Mankiw’s argument is that we should tax corporate earnings less and tax personal income more. A tax on corporate earnings is passed on through a lower ROI to all of its investors, no matter what the income level of those investors. That’s regressive. Wouldn’t it be better to let the corporation give a higher ROI to its all of its investors, and then to tax away the additional revenue we need from the investors themselves, placing the highest burden on the wealthiest investors? We already do that, but with further readjustment perhaps we could make investment much more profitable for more modest investors, a timy bit more profitable for the wealthiest investors, and still get more revenue.

Dan Kervick 10.17.10 at 1:48 pm:

There’s another side to investment in production, however, which is that there’s no point in a company’s investing in more efficient production of better products if it can’t then sell those products. A producer’s return on investment comes from their customers’ consumption of their products. Which is why it’s good for government to finance consumption in a slump.

SKapusniak 7:
“Isn’t the confusion here down to forgetting that money isn’t actually a resource itself merely a claim on resources?

Yes, it is. Whenever an economist like Mankiw cites the ‘miracle of compounding’, it is clear that he is suffering from a flawed understanding of what wealth really is. It is the same flawed reasoning that regularly inspires Republican economists to extol the presumed virtues of saving money.

Is it fair to describe the practice of saving money a virtue? Well, if it was, then surely we would all be better off if we were all savers and none of us debtors, right? So what kind of world would we be living in if everyone were to henceforth become perfectly devoted to the practice of saving money for all purchases, and none of us ever again took on any level of debt?

Well, we can be sure that one of the most celebrated benefits of saving money—-the opportunity to earn interest income—-would disappear. In a world without borrowers, all saved money would simply be removed from the economy, feeding a deflationary spiral.

It turns out that savers need borrowers. How can anyone, with a straight face, claim that the practice of saving is virtuous if it is actually necessary for some people to dis-save in order for the savers to benefit? The most generous thing that could rationally be said about the practice of saving money is that it is a prudent thing for the individual to do, but only so long as most people are not also doing the same thing. Indeed, it might even be immoral to save money when there is any level of unemployment.

There is a certain ideal that all savers pursue as a sort of ultimate goal: to save a very large amount of money and then retire and live off their accumulated dollar/pound-wealth. Isn’t that what all the financial experts out there are advising us to do? But just ask yourself what the world would be like if it were somehow possible for everyone to become extremely rich in dollars one day, enough so that we all decided to retire and live off our accumulated money wealth.

We’d all be enjoying lives of luxury, right? Well, no. What we would soon discover is that we did not actually possess any real wealth at all because no one would be producing anything of value that we could buy. In order for savers to benefit optimally from the saving of money, they need to have a lot of other people out there who are not able to save like them, but who are forced to work for a living, instead.

The Real Wealth of the economy is its productive output: the real goods and services that are produced by our combined work efforts. The more we collectively produce, the richer we collectively are, in real terms. The only way it is possible for us to optimize our consumption/’possession’ of real wealth, is by optimizing our production of real wealth, and that means eliminating all unemployment.

It ultimately doesn’t make any sense for us to all seek to become millionaires, because we cannot all live off of the productive efforts of “others.” But then, that’s actually the Republican Party’s ‘solution’ to the problem of poverty, isn’t it?

It is because (1) virtually all jobs in the economy are ultimately dependent upon the SPENDING of consumers, firms, and governments, and (2) all money that is not spent is money SAVED, there is an actual limit to the amount of aggregate savings than an economy can safely tolerate (without it costing us jobs). This means that when there is any level of unemployment, it is because aggregate savings levels are excessively high.

Of course, when there is too much saving going on in the economy, it does not mean that everyone is saving too much money. The problem is that some people are saving too much money; even while others are not saving enough. In effect, these Super Savers (generally, the Ultra-Rich) are ‘hogging all of the available savings’ that the economy can safely tolerate.

It really is a zero sum problem. In order for middle-class citizens to save more, it is necessary to limit the amount of money that the richest 10% save. Of course, the best way to accomplish that is through a steeply progressive income tax.

The most generous thing that could rationally be said about the practice of saving money is that it is a prudent thing for the individual to do, but only so long as most people are not also doing the same thing.

In the abstract, savings is not a virtuous activity in itself. But in the concrete case of the pre-recession U.S., savings can be virtuous because of its counterpart — more savings in the U.S. would presumably have been tied to more borrowing and consumption in China and Japan. Which would have been a healthy and would probably have increased sustainable world productive capacity in the long run.

My conclusion, the good professor has spent too much time reading vampire novels, where aristocratic monsters live forever in splendid wealth, preying on humans using money tucked away long ago. Perhaps he is publicly saying this money is for his son, but has other plans?

The government of Canadian province Alberta has billions in the Heritage Fund, started with oil royalties.

The magical thinking dominating contemporary thinking about economic matters couldn’t have been expressed better than in the Mankiw piece.

John Quiggin 2: I’m not sure where you start but at 1.75% p.a., 800 years constitute 20 doubling times, or a multiplier of about 1 million.

John Holbo ,

I hate the Bush Tax cuts but

The dividend tax cut , especially, and the estate tax cut are probably pretty decent tax cuts for the reason’s Mankiw gives. See MY from today.

A Judo move is what is needed. Point out that according to his logic today’s income or consumption taxation has virtually no impact on what his children collect 30 year’s from now. So what is his objection to repealing the income portion of Bush’s tax cuts?

You already have a partial victory. And with objections to consumption and income taxes off the table you have plenty of room to move.

Well, spending money you don’t have without any idea of how you’re ever going to able to pay it back is not particularly virtuous either – in fact, a lot of people doing just that got us into this whole mess in the first place.

For another example of a “generation-skipping trust,” see the case of Attorney Will H. Latta of Indianapolis:

http://cspcs.sanford.duke.edu/blog/varela_22nd_century_philanthropy

Yes, Franklin actually did it – with disappointing results. I believe that the fund left to Philadelphia performed badly over a century, while Boston did somewhat better (and used it to found the Benjamin Franklin Institute of Technology, a worthy though minor institution). After the second century there was an additional amount available, but not enough to do very much.

Kind of, but not exactly. The codicil to Franklin’s will (see http://www.fi.edu/franklin/family/lastwill.html) describes the purpose of the bequests as, in part,

I have considered that, among artisans, good apprentices are most likely to make good citizens, and, having myself been bred to a manual art, printing, in my native town, and afterwards assisted to set up my business in Philadelphia by kind loans of money from two friends there, which was the foundation of my fortune, and all the utility in life that may be ascribed to me, I wish to be useful even after my death, if possible, in forming and advancing other young men, that may be serviceable to their country in both these towns.

After 100 years, Boston was to spend £100,000 on public works of any sort and Philadelphia on the water system and on navigational improvements on the Schuylkill.

Boston (arguably in contradiction of the terms of the will) invested to maximize the return. In 1890, they established a trade school with the income; when the trust ended in 1990, the balance went to the same trade school’s endowment. The total income was $5 million in 1990 dollars.

Philadelphia decided to use the funds for what would now be called “social investing” – essentially small business loans to local “mechanics” and tradesmen through the early 20th century and loans to first time homeowners from the 1940s on, so the total income was less ($2 million in 1990 dollars) but the social benefit arguably greater. In 1990, the balance became the Benjamin Franklin Fund, one of a number of charitable endowments administered by the Board of City Trusts, a city agency, which uses it “to assist recent graduates of Philadelphia high schools to pursue careers in trades, crafts and applied sciences.” Currently, this means scholarships forscholarships for Philadelphia high school students going on to college in the sciences, but is subject to periodic review

James Kroeger @51

As I pointed out @41, there may indeed be conditions where it is immoral to save money, at least with (real) interest, not so much necessarily where there is unemployment, as under conditions where the money saved compounds at a greater rate than the real economy grows.

You go into the “paradox of thrift,” that excess savings may lead to a decrease in economic efficiency. The problem is that this does not explain how the Chinese economy is booming with very high (I have heard as much as 40%) rates of savings.
My conclusion is that where savings goes to investment, that is where it is borrowed to produce real capital, it leads to expansion and an economically virtuous cycle. So whether high degrees of savings is a virtue or a vice depends on the level of investment. In the US we seem to be disinvesting, with results that the rate of savings here is too high.

Were the level of investment higher, it would support more savings. Investment levels are more variable than savings rates. In fact, high levels of investment create their own demand, that is provide market for further investment in a positive feedback loop. Once this investment cycle is established, it feeds on itself, and pulls the economy with it. It is the low levels of investment which have put us in the trap we are in. But these low levels of investment seem justified because the Ultra rich are sucking up the demand of the rest of the country. The income of the top 1%, at 24% of the nation’s total personal income, is equal to the income of the Federal government. The nation’s supine stance wrt Chinese mercantilism is also not productive, discouraging investment in the domestic economy.

I agree the Ultra-Rich are ‘hogging all the available savings,’ though more than the economy can safely tolerate at this current low level of investment. A steeply progressive tax is a necessary component in saving the economy, but with the rich in control, they won’t do it, even to save themselves. It is because they are only in it for themselves. But see:
http://nontrivialpursuits.org/printer_friendly_tax.htm

A payroll tax holiday might, as Warren Mosler and others suggest, also be helpful at stimulating demand. QE was not, and QE2 will not, be helpful, as the money goes to the wrong places, ending up directly in the hands of savers.

Charles St. Pierre, 69:

“The problem is that this does not explain how the Chinese economy is booming with very high (I have heard as much as 40%) rates of savings. My conclusion is that where savings goes to investment, that is where it is borrowed to produce real capital, it leads to expansion and an economically virtuous cycle. So whether high degrees of savings is a virtue or a vice depends on the level of investment. ”

One reason why China has not yet been hurt by its high savings level is the high level of exports to satisfy foreign demand. Generally speaking, export-led economies are insulated from the effects of excessive saving because domestic savers are not being depended upon to provide the major share of aggregate demand. Foreign consumers suffice.

I would just reiterate that it is real economic investment that is a virtue; not savings. It doesn’t matter how that investment is financed—through quantitative easing, or through nickel and dime saving, the economic benefit is going to be the same.

I agree with much of the rest that you said…

Also, how much of the Chinese savings ratio is essentially exogenously determined? The government controls the exchange rate, and exerts significant influence on wages in a downward direction. Exporters therefore build up surpluses which are recycled through the banking sector and specifically the central bank, which reinvests the dollars in US T-bills (i.e. repo assets). State-owned banks are allowed to borrow from the CB in so far as they comply with the investment plan.

Communist economies are known for using various measures to target the national savings ratio and then use this for capital investment – IIRC Dsquared saying that there are probably enough economists in China to give the profession globally an actual Marxist majority.

Absentee landlords and the lack of rational oversight

The basic problem with Ricard’s scheme is that it fails to distinguish “investment” in the stronger sense from the weaker sense. Examining his centuries-old scheme is instructive because we still tend to make the same mistake.

In the strong sense, capital investment includes the concept of supplying not just the money an economic enterprise needs to get up and running, but also rational oversight over the use of that money. At a minimum, the investor has to know which enterprises are likely to give better and/0r safer returns. But even that minimum entails some knowledge of the processes that any candidate enterprise is engaged in.

If, on the other hand, you’re an absentee landlord and don’t know or care anything about the actual process of working the land, you can’t expect your weak investment of only money to yield very much. You’re going to have to get the land actually worked and productive via middlemen to oversee production, and you either invest your time and intelligence finding competent and honest such, or you’re going to be systematically cheated at every turn. And how do you differentiate between honest and competent overseers vs the alternative, unless you know something about the underlying business of working the land, and then put in the effort to find the right overseer for the job?

Ricard’s mistake has become so universal that we have trouble even noticing it when he makes the fatal wrong assumption at the outset. We are willing to accept as if it were an “investment” the purchase of stock on a secondary market. This isn’t even absentee landlordism, as we’re not even capitalising an enterprise, much less actively directing its processes.

Of course it’s going to come to a bad end, because there is no rational oversight, people simply accept without question that something like 5-15% RoI is to be expected, long-term, from stocks, when the really long-term view is that you lose even your prinicpal if you’re not paying the attention that we imagine you magically don’t have to pay, and things will still hum along unattended, producing RoI for you year after year. That thinking leads to a lack of oversight of these “investment” markets, which in turn guarantees that they will follow the natural pull of the money itself to gather itself into pyramids. The pyramids eventually end when they can’t find enough new money to suck in, and everyone but the swift and conscienceless few lose even their principal.

In the end, even the ultimate backstops for the more modest RoI “investments” of the absentee landlord variety, institutions like the FDIC for savings account deposits, will fail. Governments fall, or fall into the wrong hands. There are no exceptions, whatever people in the US, whose short history has spared it many of the unpleasantries more long-lived nations have experienced, may fool themselves into believing about our exceptionalism. The short history is our only exceptional quality, and time will eventually take even that from us. It’s certainly going to do so in much shorter timelines than the more grandiose and longer-term of Ricard’s seven investment packages.

If you have 700 livres lying about doing nothing useful, the best advice for any era has always been to find an actual investment to spend it on. Bettering somebody or even some thing right now will yield greater and more certain dividends for the short, middle, and long term futures. Finding something that can be actually improved with money is the trick, and suggests that accumulating piles of money is not itself a wise investment of your time and attention. Certainly Ricard’s ideas on that score, of what actual good things his imagined vast piles of money would end up doing (God, as if France was ever in need of more clerics! Or more towns of 40,000 than develope on their own!), should serve as a cautionary that the real trick, the thing you should invest in, is knowing how to use money once you’ve gotten it, not how to get it. Get-rich-slowly schemes are as much a folly and distraction from real life as get-rich-quick schemes.

Even if you use a zero% social discount rate (we rate the utiltiy of future generations as equal to our own). there are other inherent discounts in the utility maximization formula.

Under the assumption that one can in fact, earn a risk free return over a long period of time, it is pretty much certain that future generations will be richer than our own, and thus have a correspondingly lower marginal utility of money. So we need to discount for this.

It turns out that via arguments made in this thread, it’s very clear that there can be no risk-less and labor-less return universally available over long time horizons that is greater than real economic growth. In the long run, any return greater than this, represents a moving around of resources, a flow of resource claims from others who have gotten less on their investments, because all investments as a whole cannot grow faster than the stock of the whole economy.

In reality, near-riskless returns will almost always be strictly less than economic growth over any medium to long term, as any mostly-efficient market must provide some extra return to risk.

Already this is enough, if marginal utility of money for an individual is a pure log function, to mean that saving for future generations is no more useful than using the money for your own purposes. On average, we expect our future generations to have roughly the same opportunity we do, plus the economic growth between now and then. But our riskless investments cannot be expected to grow by more than this per capita opportunity does. So my great-great-great-granddaughter will probably find that my compounded savings is worth a bit less to her than the original investment was worth to me. Of course I could be lucky, invest in things with moderate risk and make an extra percent or two per year and she will be rich. But that carries an even greater risk that she will end up with something between nothing and very little.

And that presumes that nothing untoward happened in the intervening 100+ years to preclude the whole of whatever I have invested reaching her. Some discount must be applied for the possibility that my great-great-great-great-grandaughter will not even exist, and another for the possibility that the funds will be plundered or lost due to mass calamity or thievery at some point before they reach her. Perhaps this is a small percentage — .1% per year or so, but over 100 or 200 or 800 years, it adds up.

Let’s take a fairly optimistic case of saving for the future, investing in relatively riskless assets in the US in 1800. Suppose we could in fact guarantee a real rate of return of 2% per year, and that our assets would survive the civil war et. al. That would mean an investment of an inflation adjusted $10,000 in 1800 would be worth 1,280,000 today.

That said, even the inflation adjust equivalent of today’s 10k would be huge by the standards of the times. That would be 643 in 1800$, at a time when the GDP per capita was a mere $89. $10,000 doesn’t seem like a giant sum today, being about 1/5 of per capita GDP, it’s the kind of thing a middle class family could save in a few years. But in 1800, $643 would represent over 7 times the per capita GDP. A median family would have had to be very frugal and investment savvy for many years to save that much money — it’s roughly the equivalent of saving $330K today for a median family.

It’s not impossible for a typical family to save that kind of money over many years, but it’s not something they can do easily.

It’s hard for me to believe that even the 1,280,000 would really mean much more to me today, than the $643 would mean to someone in 1800.

The other side of the “return on savings vs. growth of the economy” coin is that, through the miracle of economic growth, France has achieved the utopian improvements in poor relief, general education, scientific research, entertainment, the arts, public health and hygiene, urban and rural development, drainage of swamps, etc, construction of transport infrastructure, abolition of venal offices, peace with Britain, independent income for married women and many, many other good things, all well ahead of schedule! Still waiting for world peace and an end to the national debt—and the theological essay industry seems to be in the doldrums recently—but you can’t win ’em all.

Piglet @72:

“The only way in which “saving” can take demand away from the economy is through capital export, which has nothing to do with saving per se.”

No. Money which is not spent, is saved. But unless the money goes to real investment, the economy is no better off for the savings.

Money is (among other things) demand. It can be rendered idle. It can be stuffed in mattresses. It can be put in banks. It can be put it into financial investments. (For instance, when the FED sells bonds, it takes money out of circulation.) Or it can be squandered. It can be spent on yachts for the wealthy. It can be spent on excess housing. Or, it can be invested in a factory, or go to accumulate coconuts.

When money is rendered idle, the demand it represents is taken out of the real economy. It is a little more subtle than this, since when money is taken out of the real economy, the money that remains will become a little more valuable. That is, savings which goes to become idle money, or financial investment, whatever, causes deflation. For instance, corporations have recently saved up around $2 Trillion. That is money they are not making real investments with, money they have been taking out of the real economy. If corporations invested it, in factories, say, that would replace demand. (They might even start the economy on a virtuous investment cycle, as I discussed @69.) Neither has much of it been getting into the hands of consumers, so there hasn’t been much to sustain more demand there. (The Chinese have also been taking money out of our economy, and ‘saving’ it to the tune of $500 Billion or so per year. It doesn’t matter that they’re another country. They put it in our banks, but it doesn’t get invested, nor does it get to the consumer. The deflationary pressure is the same.)

Most importantly, savings is money taken away from consumers, who in any economy are the ultimate source of demand. I say taken away because, in today’s economy, savers are the relatively few upper middle class to wealthy individuals, and mostly just the wealthy. With the increasing disparity of wealth, the whole economy’s real demand, and by implication real investment, is just going to decrease. But ‘savings,’ and financial investment, will increase.

piglet @82 said:

“That is all correct but you are forgetting that somebody is selling those shares, and that somebody now has the money that I “invested” by buying the shares. The money has simply changed hands. This shouldn’t have any impact, good or bad, on the real economy at all. “Saving” in this sense doesn’t take any money out of circulation.”

But it doesn’t go to economic investment. Neither does it go to buying goods and (non-financial) services. Suppose you have two banks. One of the banks buys the bonds of the other bank. The money is still in the banks. It’s still held in the financial sector and out of the real economy.

Other than stuffing it into mattresses, what example can you give me for “money rendered idle”?

Hmm. You seem to have the idea that money is always changing hands. It’s not. Sometimes it goes into mattresses. Sometimes it burns holes in people’s pockets. Sometimes it sits idle in banks.

When more of this is going on, the velocity of money slows down. When less, the velocity of money speeds up. It’s only in the moment that money changes hands. Otherwise, it’s sitting somewhere. The less often it changes hands, the more it sits, the lower the velocity.

Also, roughly, for limited periods of time, the quantity of money does not change. Any time you exchange money for a product, the quantity of money in the economy does not change. The quantity of money he gets is the quantity you gave him. Exceptions occur when the FED decides to buy up Treasuries, putting more money into circulation, or sells Treasuries, taking money out of circulation. So yes, the economy as a whole doesn’t ‘save’ money, it just has it. But it’s not always spending it.
When a lower quantity of money is in circulation, when the velocity goes down, you have deflation, even though the total quantity of money has not changed.

See:

http://paul.kedrosky.com/archives/2010/03/mauldin_the_vel.html

for a nice discussion of the velocity of money. Toward the end, he mentions $1.3 Trillion sitting idle in the hands of lenders. This is money not in circulation.

Now what an economy cannot save, is services, and labor. The labor of America’s unemployed is not being saved up for tomorrow. It’s gone. Neither does an economy save much in the way of production. Most inventories, even many basic commodities, are only good to last for a few months. Certainly an economy doesn’t build up a twenty year supply of dishwashers, so it can have them in the future. What it does ‘save’ is real capital: productive capacity, buildings, infrastructure. And I suppose one could say the skill set, and attitude, of its people. And institutions.

“The seller might very well use it to buy goods, in which case demand is created.”

The money can be spent. It merely isn’t being spent. The $1.3 Trillion can be lent. It merely isn’t being lent.

Mankiw’s essay seems to be missing an important factor to me. If there were no taxes on his $1000 pay, there would be no government. The $10,000 garnered on his investment would be eaten up by the cost of paying protection money to the local gangster, hiring a security guard for his house, and trying to buy enough food to feed his children in a collapsed economy where no infrastructure was repaired and no companies could rely on a stable society or any external system of justice. For that matter, where is he going to invest his money at 8% with no government to enforce contracts? Better subtract the capo’s salaries, too. This math is getting hard.