Savings Fallacy

Monies are not what they seem

Economics is a natural first stop for understanding the world of humans. The striking fact about our world is its sheer material abundance, and economics is supposed to explain how we got there.

However, I find the overall state of economic thought to be confused. There are a few extremely useful ideas that help explain the world — supply, demand, and prices interaction, efficient market hypothesis, externalities and Pigouvian taxes, principal-agent problems and market for lemons.

However, these ideas don’t quite add to a coherent, holistic picture of the modern economy. There are many schools of economic thought, with very different interpretations of facts and policy recommendations. I struggle with understanding what we know, what we do not know, what hypotheses do we have, and how our models connect with real world data.

Epistemically, I find most economic texts underwhelming, both because they fail to place ideas in context (are you talking about your favorite model, or how we observed the world to work?), and because there’s a notorious trend to skip, assume, or other simplify the basics. So, let’s start with the basics

Inez And Walter

Here’s an anecdote from the start of Mishkin’s Economics Of Money, Banking and Financial Markets:

Inez the Inventor has designed a low-cost robot that cleans the house (even does the windows!), washes the car, and mows the lawn, but she has no funds to put her wonderful invention into production. Walter the Widower has plenty of savings, which he and his wife accumulated over the years. If Inez and Walter could get together so that Walter could provide funds to Inez, Inez’s robot would see the light of day, and the economy would be better off: We would have cleaner houses, shinier cars, and more beautiful lawns.

I want to argue that this anecdote reinforces an incorrect model of finance, and moves the student away from clear understanding. By the way of analogy, it is as if a physics textbook opened with an experiment where you continuously push on a weight on a desk to make it move, and derive Aristotelean understanding of motion that always requires force instead of Newton’s first law of inertia!

If you don’t think through the above story, it surely seems like Walter has some idle resources that he lends to Inez to create useful goods. But this is not what happens. Walter has just stacks of paper — money. Usable for paper planes, not robots. If Walter was working at a robot-parts plant, was compensated in-kind, and accumulated a large surplus of robot parts in the basement, then the above story would have been representative.

In reality, something way more interesting happens. Walter of course doesn’t have real resources. Instead, he has a magical power to redirect efforts of other people. When Walter gives money to Inez, and she uses it to buy robot parts, a logistics machine comes in motion to deliver the parts from the plant where they are produce to Inez. Moreover, the robot-parts-producing company notices an increase in demand, and hires more workers to produce the parts. On the margin, someone decides to become an assembly line worker rather than a barista.

This is the second big difference between the tale and reality. Not only Walter’s savings are immaterial, we don’t actually get “cleaner houses“ and the rest for free. There’s an opportunity cost here: we do get more of those things, but we get less expressos!

Just how much does this money expenditure lead to re-allocation of existing workers, as opposed to compelling more people to enter the work force? I don’t understand this! Unemployment rate plays a role — if everyone is already employed, we reshuffle work hours; if none works, we increase total hours worked. But unemployment rate itself is target by central bank and government policy. In a counter-factual where Walter didn’t loosen the purse strings, the central bank could decide to pitch in!

It gets yet more interesting. What we’ve seen is the action of money “here and now“, but there are future and past reverberations. Another effect that happens here is risk transfer. Neither Walter nor Inez know if her idea actually works. That will become clear only when the robots start rolling from the assembly line. There’s an element of gambling at the world level — maybe we all are better off if we stick to Starbucks rather than cleaning robots? Locally, the risk is split between Walter and Inez. For Inez, it's mostly the opportunity cost of doing something else, but for Walter the entire investment might turn sour, leaving him in the negative.

Finally, the most interesting part — how come Walter gained the power to command other people without actually doing anything? This is the Time Machine of money, which has two components. First, in the past Walter used to work hard, and “we” all agreed that he actually worked harder than was required to buy all the stuff he used. Many years later, “we” are somehow held accountable, and don’t renege on our promise, allowing Walter to boss us around, while he sits in his rocking chair with a pipe!

In summary, money “stand for“ real resources, but isn’t in itself a material resource. Spending money doesn’t materialize stuff out of thin air, rather, it re-shuffles existing stock of things in the “now“, and also sends a supply/demand/price signal to re-allocate production capacity in the future.

Think about this parable while waiting for part II!