Friday, June 8, 2012

Taking a minor exception to Lord Keynes

Over the last month or so, I have been reviewing The General Theory of Employment, Interest, and Money by Lord John Maynard Keynes. So far, I have discussed involuntary unemployment in an my article "The master teaches us about involuntary unemployment", the distinction between nominal and real wages in "Are workers employed for nominal or real wages", my own thoughts in "Labor reallocation in a depressed economy" and aggregate demand in "Keynes' lesson on aggregate demand". Generally, my positions have been favorable to Lord Keynes, who deserves much respect, but, as I promised in my last post, I found an area where I am unsure whether Professor Keynes was correct, which I want to bring into focus.

The issue is that Professor Keynes said:

[T]he richer the community, the wider will tend to be the gap between its actual and its potential production, and therefore the more obvious and outrageous the defects of the economic system.  For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment, whereas a wealthy community will have to discover much ampler opportunities for investment if the savings propensities of its wealthier members are to be compatible with the employment of its poorer members.  If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual input, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.

To my mind, this sorry state of events has not been a feature of societies as they grow richer. Just to avoid needless discussion of the "facts on the ground", the following graph is offered which contains the personal savings rate and the real output gap, scaled to the population.

It seems that, as the United States has grown richer (has a higher per capita income), the personal savings rate has actually declined. This is especially strange because since the early 1970s, from my understanding, inequality has been increasing, meaning that the rich have been getting richer much faster than the middle and lower ends of the income distribution. Thus, Keynes would have expected the inequality to result in a higher savings rate. And, if one notices, there does not seem to be a strong tendency for a persistent output gap, except recently.

Okay, I have a few questions that leap to mind. First, we notice that the savings rate was highest during the stagflation of the later 1970s and early 1980s, which would be interesting. Presumably during periods of increasing inflation, there would be greater desire to bring spending "into the present, from the future", but this does not seem to be the case.  Perhaps what was really occurring was that consumers were saving more so that they could afford more goods in the future, when the price level had increased considerably.  And the savings rate seems to decline throughout the period where inflation was declining, which may add credence to this "best guess".  This makes my presumptions about Keynes being wrong less certain. If there is something that explains systematic deviations, then we could just be talking about multiple causes, possibly pushing in different directions.  As for the more recent rise of the personal savings rate, that has a lot to do with what seems to be debt deflation connected with the value of underlying assets (housing), but I digress.

That issue aside, could the phenomena that Lord Keynes describes be masked by policy? The most familiar monetary regime in the 1930s was still the gold standard, not inflation targeting or demand management (or some mix of the two).  As for fiscal policy, Keynesian economics had not really been tried and certainly weren't the dominant policy, so that may affect the savings rate and the tendency for insufficient aggregate demand. These could also be affected by the larger scale redistribution which is undertaken by the government and automatic counter-cyclical policies, like food stamps, welfare programs and unemployment insurance.  Admittedly, some policies similar to these were in place already, but Lord Keynes probably understood that they were incomplete and not all that generous.

Since there are some explanations which could help grant credence to Lord Keynes' suggestions about the savings rate and output, I can only suggest that this could call for greater research to come to firmer conclusions.  On the surface, it seems that Keynes might have been wrong, but it could also be that there were intervening factors, such as those mentioned above.


  1. My experience has been that fast jumps in savings rates are usually coupled with tightening of credit markets. It's not that consumers are saving out of preference; they are paying off debts at rates proscribed by credit agreements while being unable to acquire new credit.

    OTOH, when I worked in financial sales in the late aughts, I frequently had customers whose 30-year treasuries they'd bought during the inflationary years were maturing. Some of them had rates as high as 15%--not bad as a risk-free return. I'd tell them I had neither risk-free nor 15% to offer and we'd all get a good laugh.

  2. It's interesting that the personal savings rate rises during recessions and falls during expansions, then falls afterwards. However, notice how (in the past) this had been roughly proportionate to the severity of the recession e.g. the 1982 and 1974 recessions seem to have had a big impact on savings, whereas the Great Recession saw a major fall in GDP and a very weak recovery in private consumption, which suggests that a strong recovery is important as well (1983-1984 and 1976-1977 were years of rapid recovery).

    Secular trends are harder to explain because of the number of confounding factors: for instance, to what degree were personal savings rates kept artifically high in the US due to financial repression? To what degree do tax incentives affect the long-run savings rate? What about long-run fiscal trends?

    Keynes's consumption function has long (since Kuznets's work) been regarded as inadequate to explain long-run behaviour. The problem with the US is NOT secular stagnation. Quite the opposite: a higher savings rate should be encouraged by changing the tax incidence of consumption and investment.

  3. @Cameron,

    Good point. Although I clearly have the feeling that there is a process of repairing balance sheets following the latest crisis, perhaps that could also be a factor of the rise in the savings rate in the 1970s... I was a bit suspicious of my own explanation, anyway, as it's the OPPOSITE of what I'd been reading about the relationship between spending and inflation (i.e., that a rise in inflation would make consumers choose to spend more in the present).

    W. Peden,

    My intuition is that, as Cameron pointed out, that there is generally a lot of balance sheet repair to be undertaken during periods of recession (for whoever is sharing on the downside), which could explain the rise in the savings rate. I'm not sure that I am a huge cheerleader for additional savings, at least at this point. In the short run, the economy could really use additional spending rather than additional savings. After recovery comes, I would be very enthusiastic about that idea and especially any serious private and public sector capital investments.

    Thanks for the comments: they are always appreciated.