The truth about savings and consumption
Sunday, May 19, 2013 10:00 PM
We're told over and over the myth that consumption and spending grow the economy. In reality, savings and production make the economy grow, not consumption and spending. The fact is that society wouldn't become wealthier if everyone ran out and bought boats, houses, and cars. If this were true then the larger we all made our credit card bill, the wealthier we would all be.
A healthy economy is made up of goods and services people want. Why does an economy one place have a large amount of goods, but another has a small amount. Well, first you have to ask, "Just how does the amount of goods in an economy grow?" The answer is, "Production!"
Let's take the simplest case, a self-supporting family farm. How much food they produce depends on how much they work. When they work, the total amount of food they have increases. When they eat, their total amount of food decreases. This isn't to say consumption is a bad thing. After all, it's the whole point of working in the first place. But if they want to sustain themselves, their production has to outpace their consumption.
What if they decide to build a plow to increase their productivity? With a new plow they could produce, maybe, twice as much food in half the time. But a plow doesn't just appear out of thin air. It takes time for the farmer to make one. While it is being constructed, the workers building it won't be producing any food. They'll just be consuming it. Therefore, they will have to save enough food beforehand to be able to eat while they work building the plow. Without that saved food, there's no way for them to take time to build the plow. They'd run out of food.
Once the plow is finished they can produce more efficiently, and the total amount of goods will grow. Now, because they no longer have to worry about starving, their time is freed up. They can now choose to produce other goods and services, or just relax and enjoy their free time.
This is the same thing that happens in a large scale economy. Factories and bulldozers don't just pop out of thin air. They have to be constructed with a pool of savings. Here's how it works: First, in a free market when people save money and don't spend it, capital piles up in banks. Next, this money is lent to entrepreneurs who use it to purchase or create equipment, which expands their business and increases their level of production. The more goods that are being produced, the more savings that are becoming available. As the pile of savings grows, even larger loans become available to even more entrepreneurs. Therefore, the economy grows exponentially.
All of this is made possible only by savings. Without it, there wouldn't be any capital available to borrow. Therefore, economic expansion would come to a halt. An economy based on consumption instead of production can only last until there are no more goods left to consume.
All credit for the above explanation goes to the Foundation for Economic Education (fee.org), and the brilliant short video they produced titled, "The Truth About Savings and Consumption." To watch the video, go to http://youtu.be/vj7XExwChwI