Thursday, May 28, 2009

Is Saving Bad for the Economy?

I recently heard a radio ad that was telling everyone to just go out and spend money. There was no advertisement for any particular product. Just - "Go Buy Something. Stimulate the Economy."

I read a post on The Simple Dollar that touched on this issue and thought I would make some additional comments on the subject.

Personally, I find it infuriating when people claim it is our fiduciary duty to spend money to "stimulate the economy." Either that or I hear people make excuses about taking on large amounts of debt or making extravagant purchases by saying, "Well, at least I'm stimulating the economy."

It's an interesting topic. I don't claim to be any financial expert but I think I should at least present a few facts of WHY economists claim spending stimulates the economy.

What do economists mean by "Economy"?

Generally when people refer to the "economy," they are most likely referring to GDP (Gross Domestic Product). GDP is basically just the sum of all economic activity, and this is how economists measure it :

Consumer Spending + Gross Investment + Government Spending + Trade Surplus (Deficit).

Consumer Spending generally makes up around 70% of our GDP. So if GDP is considered to be the measure of our “economy” - then yes, Consumer Spending is one of the biggest factors.

Saving does not contribute directly to GDP but can have an indirect effect. Saving and investment helps provide capital for other businesses and individuals. This capital can then be used to build factories or houses or do something that increases GDP.

Is Saving Hurting the Economy?

A recession is by definition, is negative GDP growth for two consecutive quarters.

The current recession is a result of two very significant changes in GDP.

, consumer spending changed dramatically. When consumers as a whole went from a savings rate of NEGATIVE 2% to POSITIVE 5%, that net change in such a short amount of time is what caused such a sharp decrease in GDP. So yes, saving instead of spending has caused a sharp drop in GDP, but I don't think that means it has been "bad for the economy."

Second, two of the largest inventories in United States (Houses and Cars) have fallen in demand/price - and no amount of credit or loans is going to fix it. These relate to the "gross investment" portion of GDP. We have been seeing a lowering of inventories and gross investment because of the fallen demand.

These are the two fundamental reasons for negative GDP growth. And GDP is what economists are referring to when they claim that spending stimulates the economy.

So, Spend or Save?

The good news is that now the savings rate is at a healthy level, we will most likely only see increases in future consumer spending. As soon as the housing market corrects itself and we can get rid of the excess waste in the auto industry, we should only see increases in the gross investment portion of GDP.

I personally believe that saving is incredibly important, and the lack of saving in the last decade is one of the reasons why this recession was necessary. Honestly I think that the debate of spending vs. saving is pointless. This is a personal decision that should be decided by individual needs, not by macroeconomics. My only advice is to spend less than you earn and don't think that "stimulating the economy" should give you carte blanche to spend whatever you want.


  1. Excellent article Eric. I didn't know you had a financial blog! You write very well.

  2. Yeah I just started. I figure I need somewhere to get all my crazy ideas out of my head.

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