The art of economics consists in looking not merely at the immediate, but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group, but for all groups.
This is an ongoing series of posts on Henry Hazlitt’s Economics in One Lesson. You can access the Table of Contents here. Although written in 1946, it still touches on many of the issues we face in 2017, particularly the fallacies government economic programs are built upon.
From time immemorial proverbial wisdom has taught the virtues of saving, and warned against the consequences of prodigality and waste. This proverbial wisdom has reflected the common ethical as well as the merely prudential judgments of mankind. But there have always been squanderers, and there have apparently always been theorists
to rationalize their squandering.
The classical economists, refuting the fallacies of their own day, showed that the saving policy that was in the best interests of the individual was also in the best interests of the nation. They understood that economics does not change from micro to macro scale. They offered evidence that the rational saver, in making provision for his own future, was not hurting, but helping, the whole community.
In 1946 and in 2017, you won’t find a lot of “mainstream” economists who embrace the ancient virtue of thrift. The Keyesenians claim they have new reasons for opposing savings and encouraging government spending, but Hazlitt recognized that there was nothing particularly new in their foolishness.
He asked his readers to return to the classical example offered by Bastiat nearly 100 years before. Imagine two brothers – one a spendthrift and
the other a prudent man. Both inherit an income of $50,000 a year. Disregard the income tax and don’t ask if either brother works for a living because such questions are irrelevant in this thought experiment.
Alvin is a lavish spender. He spends not only by temperament, but on principle. He is a disciple of Rodbertus, who declared in the middle of the 19th century that capitalists “must expend their income to the last penny in comforts and luxuries,” for if they “determine to save . . . goods accumulate, and part of the workmen will have no work.”
Alvin lives the high life and doesn’t stint himself on luxuries or staff to take care of those baubles and his wife and friends glitter with his presents. This means his savings account is dwindling, but savings is a sin, so not saving must be a virtue. Plus, he’s balancing out the economic harm being done by his miserly brother, Ben. It’s obvious to anyone with eyes that Alvin is stimulating employment wherever he spreads his money.
Ben is much less popular with tradesmen, restaurants and nightclub owners because he lives much more modestly and spends only about $25,000 of his annual income. For those people who only see the obvious, he is providing less than half as much employment as Alvin, and the other $25,000 is as useless as if it did not exist.
But with Bastiat as with Hazlitt, there was the unseen effect as well to be considered. What does Ben do with the other $25,000? He gives about $5,000 a year to charitable causes and to friends in need. These families then spend these funds on groceries, clothing or rent. So Ben’s funds create as much employment as if Ben had spent them directly on himself, but he has actually made more people happy as consumers, and that production is going more into essential goods and less into luxuries and superfluities.
So, what happens to the $20,000 Ben neither spends nor gives away? He doesn’t hide it under a matteress. He deposits it in a bank or he invests it. If deposited in a bank, the bank either lends it to businesses on short term for working capital, or uses it to buy securities. Ben is, therefore, investing his money either directly or indirectly and that money is invested to buy capital goods—houses, office buildings, factories, ships, trucks or machines. Any one of these projects puts as much money into circulation and gives
as much employment as the same amount of money spent directly on consumption.
“Saving,” in short, in the modern world, is only another form of spending. The usual difference is that the money is turned over to someone else to spend on means to increase production. So far as giving employment is concerned, Ben’s “saving” and spending combined give as much as Alvin’s spending alone, and put as much money in circulation.
The chief difference is that the employment provided by Alvin’s spending can be seen by anyone with one eye; but it is necessary to look a little more carefully, to recognize that every dollar of Ben’s saving gives as much employment as every dollar that Alvin throws around.
So time flies and a decade later, Alvin is broke and is no longer spending lavishly. He’s begging Ben for money. Ben continues with about the same ratio of spending to saving, provides more jobs than ever, because his income, through investment, has grown. His
capital wealth is greater. Moreover, because of his investments, the national wealth and income are greater; there are more factories and more production.
Of course, by 1946 and certainly in 2017, there are far more fallacies in play than in Bastiat’s time. Some stem from logical leaps that make no sense, especially coming from men who claim to be educated.
The word “saving” … is used sometimes to mean mere hoarding of money, and
sometimes to mean investment, with no clear distinction, consistently maintained, between the two uses.
Hoarding without purpose, especially on a large scale, would probably harm the economy, but the money-in-the-strongbox-in-the-basement sort of hoarding is extremely rare. There is a distinct form of this that occurs after a recession has commenced. We saw this (and are still seeing it) in 2009. Consumptive spending and investment contract as consumers reduce their buying, partly because they fear job loss, so they want to conserve their resources. They are planning for the future — spending less on luxuries now so they can continue to consume necessities if they lose their jobs.
Consumers also sometimes hedge their bets, assuming prices will fall and continue falling, so they hold money for a later time when they expect their money to have more value. This pattern does not spring from the same motives as normal saving, but it is still ridiculous to say that this sort of “saving” is the cause of depressions. It’s actually a CONSEQUENCE of depressions.
Hazlitt noted that sometimes “capricious government intervention in business” creates uncertainty, so profits are not reinvested and firms and individuals allow cash balances to accumulate in their banks. They keep larger reserves against contingencies. This cash hoarding may appear at casual glance to the cause of a subsequent slowdown in business activity, but the real cause is uncertainty created by government policies.
The larger cash balances of firms and individuals are merely one link in the chain of consequences from that uncertainty. To blame “excessive saving” for the business decline would be like blaming a fall in the price of apples not on a bumper crop but on the people who refuse to pay more for apples.
When people embrace a fallacy, sometimes they refuse to listen to any good argument against it. They will argue that consumers’ goods industries are built on the expectation of a certain demand, and that if people take to saving they will disappoint this expectation and start a depression. This neglects the reality that what is saved on consumers’ goods is spent on capital goods, and that “saving” does not necessarily mean even a dollar’s contraction in total spending. Yes, sudden changes can upset the economy, but the same unsettling without occur if consumers suddenly switched their demand from one consumers’ good to another.
Another objection against savings is to deride the 19th century with its supposed doctrine that mankind can grow a larger economy through saving and thrift. Hazlitt felt it necessary to address this objection with a more realistic picture of what actually happened.
There is a difference between savings and investment, but the enemies of savings tries to make these two independent variables. They create a picture where you have savers automatically, pointlessly, stupidly continuing to save while on the other hand, there are limited “investment opportunities” that cannot absorb this saving. The result, they claim, is stagnation. The only solution, they declare, is for the government to expropriate these stupid and harmful savings and to invent its own projects to use up the money and provide employment.
There is so much that is false in this picture and “solution” that we can here point only to some of the main fallacies. “Savings” can exceed “investment” only by the amounts that are actually hoarded in cash. Few people nowadays, in a modern industrial community like the United States, hoard coins and bills in stockings or under mattresses. To the small extent that this may occur, it has already been reflected in the production plans of business and in the price level. It is not ordinarily even cumulative: dishoarding, as eccentric recluses die and their hoards are discovered and dissipated, probably offsets new
hoarding. In fact, the whole amount involved is probably insignificant in its effect on business activity.
Most of us keep our money, if we have any savings, in the bank, and banks are eager to lend and invest it. They cannot afford to have idle funds. The only thing that will cause people generally to increase their holdings of cash, or that will cause banks to hold funds idle and lose the interest on them, is either fear that prices of goods are going to fall or the fear of banks that they will be taking too great a risk with their principal. That only happens AFTER signs of a depression, when it is prudent to hold some cash reserves.
“Savings” and “investment” are brought into equilibrium in the same way that the supply of and demand for any commodity are brought into equilibrium. In fact, they are analogolous. Just as the supply of and demand for any other commodity are equalized by price, so the supply of and demand for capital are equalized by interest rates.
The interest rate is merely the special name for the price of loaned capital. It is a price like any other.
Hazlitt might have been writing to people in 2017 instead of 1946 as he laughed into explaining interest rates.
This whole subject has been so appallingly confused in recent years by complicated sophistries and disastrous governmental policies based upon them that one almost despairs of getting back to common sense and sanity about it.
There’s an almost pathological fear of “excessive” interest rates. The argument goes that if interest rates are too high it will not be profitable for industry to borrow and invest in new plants and machines. This argument has caused governments everywhere to pursue artificial “cheap money” policies that overlook the effect of these policies on the supply of capital.
Yes, once again, government is looking at the effects of a policy only one one group and forgetting to look at the rest of the economy. If interest rates are artificially kept too low in relation to risks, funds will neither be saved nor lent. The cheap-money proponents
believe that saving goes on automatically regardless of interest rate. Rich people can only spend so much money, right? But what about the middle class? Savings has been virtually useless for 30 years and the savings rate in the United States is abysmal. Most of us live paycheck to paycheck and think Dave Ramsey is crazy. The argument overlooks the marginal saver, who is representative of the great majority of savers.
The effect of keeping interest rates artificially low … is eventually the same as that of keeping any other price below the natural market. It increases demand and reduces supply. It increases the demand for capital and reduces the supply of real capital. It brings
about a scarcity. It creates economic distortions.
The artificial reduction in the interest rate encourages increased borrowing, which encourages highly speculative ventures that cannot continue except under the artificial conditions that gave them birth. On the supply side, the artificial reduction of interest rates discourages normal thrift and saving, brings about a comparative shortage of real capital.
Constant new injections of currency or bank credit is necessary to take the place of real savings.
This can create the illusion of more capital just as the addition of water can create the illusion of more milk.
This creates continuous inflation, leading to cumulative danger. The money rate will rise and a crisis will develop if the inflation. Cheap money policies eventually lead to more violent oscillations in business than those they are designed to remedy. If government doesn’t tamper with money rates through inflationary policies, increased savings create their own demand by lowering interest rates in a natural manner. The greater supply of savings seeking investment forces savers to accept lower rates. Equilibrium is achieved without government intervention.
Hazlitt also dealt with the fallacy that there is a limited amount of new capital that can be absorbed. He seems to shake his head sadly in his writing because this was believed not just by the uneducated, but by those claiming to be trained economists.
Almost the whole wealth of the modern world, nearly everything that distinguishes it from the pre-industrial world of the 17th century, consists of its accumulated
This capital consists of “durable goods” like automobiles, refrigerators, furniture,
schools, colleges, churches, libraries, hospitals, and private homes.
Never in the history of the world has there been enough of these. There is still, with the postponed building and outright destruction of World War II, a desperate shortage of them. But even if there were enough homes from a purely numerical point of view,
qualitative improvements are possible and desirable without definite limit in all but the very best houses.
The second part of capital consists of the tools of production, from crudest axe to amazing electronics. Similarly, there is no limit to the expansion that is possible and desirable in this area.
There will not be a “surplus” of capital until the most backward country is as well-equipped technologically as the most advanced, until the most inefficient factory in America is brought abreast of the factory with the latest and most elaborate equipment, and until the most modern tools of production have reached a point where human ingenuity is at a dead end, and can improve them no further. As long as any of these conditions remain unfulfilled, there will be indefinite room for more capital.
But how can the additional capital be “absorbed”? If it is set aside and saved, it will absorb itself and pay for itself. Producers invest in new capital goods by buying new and more ingenious tools because these tools reduce cost of production, by creating goods completely unaided by hand labor or they increase the quantities in which these can be produced or by reducing unit costs of production.
It should not be difficult to decide, after our analysis, with whom the real folly lies.