There has been a lot of talk about economic growth over the past few months.  Economic growth is one of the hot-button issues of the 2012 campaign.  Each candidate would like to put in their two cents about what creates economic growth.  Republicans like to say that they are the “pro-growth” party.  President Obama likes to say that his policies have created some economic growth, and we need to re-elect him for all of the growth to be realized.  But what really drives growth?  Saving does.  Saving drives economic growth.  Yes, there are other things that are economic drivers, but saving is a huge economic driver.

Saving Drives Economic Growth

When someone doesn’t spend all that they earn, they save money for later use (deferred consumption).  They either stash under their bed, or put that money in a savings/checking account, or they put it into an investment account of some kind.

If they stash it under their bed, it’s good to no one but themselves, and really not even that.  If they stash it under their bed, it loses its value every day.

If they put it into a checking or savings account, that capital is used by the bank for lending to other people.  Savings lead to greater availability of funds to lend, which leads to lower interest rates, which leads to greater borrowing for business investment, which leads to business expansion, which leads to more employment, which leads to economic growth.

If they put it into an investment account, it has much the same effect as putting it into a savings account, with the exception of who assumes the risk of investment.  If you put your money into a savings account, you are sacrificing great returns for the safety of no risk.  The bank assumes the risk of lending.  However, when you put your money into some investment account/vehicle, you are assuming the risk of that investment, with the possibility of greater return.

But the effect on the economy is the same.  The company or companies in which you invest use that money to invest in their business.  They hire more people, or use that money to replace aging machines, or for one of a hundred other uses.

When a company makes a profit, they can use those profits in a bunch of different ways, too.  They can issue a dividend, which goes directly back to the investors of the company (which can drive consumption or investment in other parts of the economy).  They can reinvest that money back into their company to create more growth, which likely drives the stock price of their company up (which creates gains for their investors as well).  They can use that money to drive acquisitions, which creates growth in their company, and also can drive economic efficiency (if duplications are eliminated as a result of the acquisition).

The fact is, people’s savings are a large driver of economic growth.

Not Saving Hinders Economic Growth

What would happen if people didn’t save some of their money?  Let’s trace it backwards… if people don’t save, then the amount of money in savings accounts and investment accounts go down.  If savings accounts are eliminated, then banks don’t have as much money to lend, which drives interest rates up, which leads to lower borrowing, which leads to business stagnation, which leads to less employment, which leads to economic stagnation.

Now, businesses will still grow, but at a slower pace.  So instead of seeing, say, 5-6% annual growth in an economy, one would expect to see a 2-3% growth in the economy.

What about consumer spending?  Doesn’t that also drive an economy?  Sure it does, to a certain extent.  You can’t grow a company without people that are buying your product.  But without the initial investment, the products wouldn’t be made in the first place.  Consumer spending can support future growth to a certain extent, but cannot make the initial investment.

Furthermore, consumer spending fueled by debt only increases the future cost of an immediate need met.  For example, you can buy a house today for $200,000, but if you finance it, you will end up paying upwards of $400,000 for that purchase.  If you use a credit card to pay for new clothes, you will pay more for those clothes than the sticker price (assuming you don’t pay off your credit card each month).

So, consumer spending either allows you to buy $1 of goods for each $1 that you have now, or forces you to eventually pay a multiple of your dollar down the road to buy something now.  In the second scenario, you are diminishing future growth to finance consumption today.  If you use saving to finance growth, however, then you multiply future growth.  So, for every $1 in saving/investment today, you will have $2 to spend down on consumption down the road.  This point was made in the New York Times in an editorial on November 7, 2010: “Although consumer spending can help an economy emerge from recession in the short run, for long-term prosperity, a higher savings rate is helpful.  More money saved in U.S. banks means more money available for investment, which then leads to higher growth.”

It Works for Government, Too

This bears itself out easily in households (people save money for retirement, invest it in the market, and see their savings compound over time), but we can also see it worked out in government as well, and it has policy implications.  There are two points I’d like to make about government spending in regards to this issue of saving and economic growth.

First, the U.S. government is a massive consumer.  It’s not truly a producer of wealth, because it takes a portion of each producer’s earnings, and uses it to finance spending in other areas of the economy.  Now, this spending can be good or bad; I’m not saying here that it’s one or the other.  But the fact is, when government takes from people, it is necessarily financing its spending at the expense of spending in other areas of the economy.  If government were to spend $100 billion less, then that $100 billion would be spent in other areas of the economy.

Second, the government is a massive consumer that funds much of its consumption through debt.  Our country’s future growth is stunted because of the short-term consumption spending of our government.  The correlation between high government debt and lower economic growth is well documented, and the causation of lower economic growth by high government debt is highly probable.  In a Bloomberg.com article in 2011, Harvard economics professor Kenneth Rogoff and University of Maryland economics professor Carmen Reinhart write,

“At what point does indebtedness become a problem? In our study “Growth in a Time of Debt,” we found relatively little association between public liabilities and growth for debt levels of less than 90 percent of GDP. But burdens above 90 percent are associated with 1 percent lower median growth. Our results are based on a data set of public debt covering 44 countries for up to 200 years. The annual data set incorporates more than 3,700 observations spanning a wide range of political and historical circumstances, legal structures and monetary regimes.

“We aren’t suggesting there is a bright red line at 90 percent; our results don’t imply that 89 percent is a safe debt level, or that 91 percent is necessarily catastrophic. Anyone familiar with doing empirical research understands that vulnerability to crises and anemic growth seldom depends on a single factor such as public debt. However, our study of crises shows that public obligations are often hidden and significantly larger than official figures suggest.”

Tax Policy Implications

If economic growth and wealth as a country are worthy goals that we should have as a nation, creating incentives for saving (rather than incentives for consumption) is something in which the government should be involved.  This has historically been the case.  Government has had lower tax rates on savings and investment.  The government allows people to save for retirement in pre-tax dollars (in a traditional IRA), and then pay taxes on those savings in retirement (when their income is typically lower), which means that they pay lower taxes on those dollars.  The government also created the Roth IRA in 1997, to allow people’s retirement funds to grow tax-free.  The government also taxes investment income and dividend income at a lower rate than earned income, which encourages people to save and invest.

If we want our economy to continue to grow at the pace it has grown at in the last 100 years, we need to continue to create incentives for our people to save their money, and to defer their consumption.

Questions for discussion: What are ways that our government can create incentives for saving?  What can the government do to create an environment in which saving is encouraged?