Savings, Investment & IS-LM: An Answer for Tim

As I noted last week Paul has a good post up on the need for a new  ‘common sense’ economic agenda.  The piece was cross posted over at Liberal Conspiracy.

 The infuriatingly readable Tim Worstall commented upon it.

 Where do you think investment comes from?

The traditional (neo-liberal if you like) answer is that investment comes from savings. So if you reduce savings by taking money that would have been saved (if held by the rich) and make sure that is is spent on current consumption (by giving it to the poor who do not save) then give that there will be fewer savings then there will inevitably be less investment.

Just so you don’t reject this as being only the neo-liberal answer, I think you’ll find that the investment / savings link is the IS in the IS/LM model which is pretty much the basic elucidation of Keynesian thought.

I fear that you’re a little confused in your economics here.

Paul asked yesterday for my thoughts on this.

Interesting that Tim talks about Paul’s (and implicitly my own) argument running against the ‘basic elucidation of Keynesian thought’. It might well do.  But then it’s not a Keynesian argument, it’s a Post Keynesian argument. I.e. it flows from an economic school that believes it follows the true path of Keynes’ ‘General Theory’ rather than from the school which grew up in his name and dominated macroeconomics for decades.

 I take the Post Keynesian line.

 Thus, Post Keynesians and neoclassicists can pretty much agree on definitions of saving and investment, for example. They can also agree that in a simple economy with no government and no foreign trade, savings must equal investment. This is, in fact, a basic national income accounting identity. Where these two schools differ is not here, but in how they see the causal nexus between the two. For neoclassicists, savings cause investment; it provides the funds needed to build new capital equipment. In contrast, Post Keynesians hold that investment determines savings. Investment can be financed by borrowing from banks, which does not require savings because banks create money by lending. Investment, in turn, generates jobs and incomes. Some of this income will be spent, and the rest saved; thus, at the end of the process, savings come to equal investment.

 Empirical Post Keynesian Economics, Holt & Pressman (Emphasis mine).

 

It’s obviously true that ‘savings = investment’ but that is a simple accounting definition. What matters is the causation and here myself and Tim disagree. Interestingly Paul intuitively ‘gets’ the Post Keynesian view in his own line that:

I’ve also written about how the now dominant narrative of neoliberalism and money supply control became so dominant; despite the fact that the fundamental assumption of a finite world money supply is flawed, the ‘good housekeeping’ / ‘you cannot spend what you have not got’ narrative has continued to hold sway over public opinion for a generation and more.

 To quote Holt & Pressman again:

 The neoclassical view sees savings as the answer to the problem of how we get more goods for tomorrow. Savings generates investment, which in turn, increases our productive capabilities. The paradox of thrift is forgotten or ignored on this traditional way of thinking. Post Keynesians see traditional analysis as putting the cart before the horse; they regard investments as the cause of savings,.

 A New Guide to Post Keynesian Economics, Holt & Pressman

 The Paradox of Thrift  is crucial. If savings are very high then spending will be lower and so demand is also smaller , in which case why would anyone invest?

On Tim’s more general point on the IS-LM model… don’t get me started. Remember the IS-LM model is not an invention of Keynes, it’s an attempt by others to formalise his work. I would mention that even John Hicks, its creator, later renounced it.

It has many problems – not least of which being that it is a model of a static economy, it allows no role for path dependency and that it places zero weight on expectations, which are crucial in the General Theory. The Journal of Post Keynesian Economics (not available for free online) is an excellent source for those interested in these issues.