Saving and Investing: Equilibrium at Work
During of the second quarter of 2020, the personal savings rate in the United States jumped to 25.6 percent; the annual average for 2019 was 7.9 percent. So people saved slightly more than a quarter of their disposable personal income in Q2 2020 compared to about one-thirteenth the previous year. Consumers responded to COVID-19 by increasing their savings and reducing their spending. Some of it was unintentional, as some types of spending were virtually eliminated, like travel and dining out. But people also cut back intentionally out of concern over layoffs and furloughs and getting through uncertain times. Those savings then made their way into some form of investment.
Investment takes many forms. There are investments in tangible items, like plant equipment or government and nongovernment infrastructure projects, or inventories. Or intangibles, such as research and development and the resulting intellectual property, or human capital, including time and money spent on education and training. Regardless of the form it takes, most investing is intended to make the economy more productive, to make us better off than we would be without it—even if it doesn’t always work out that way.
Investment is made possible by savings, which, by definition, means abstaining from consuming some of your, or a business’s, after-tax income. We know that we need to save to invest, and we want to be rewarded for investing to the benefit of the economy. But since the financial crisis in 2008, interest rates have been at or near zero, and the reward for saving has been small. An entire generation has gone unrewarded for abstaining from consumption, which is likely to have long-term implications for savings and investment in the United States and around the world.
But there are still strong motives for setting something aside. Simple precautionary balances—a rainy day fund—are a prudent part of planning for life, as is the prospect of retirement and being able to sustain a lifestyle similar to how you live before you stop earning.
When you save, the money you put aside is financial capital. You take money from your earnings and deposit it in some financial intermediary, like a bank. In turn the bank lends it to someone or some organization that is part of the larger system of financial markets, thereby matching up your savings with borrowers. The markets transform those monetary savings into “real investment” that firms convert into tangible and intangible products and services, or pass along to others interested in investing in some form of capital or needing to borrow money for some period of time.
What Do People, Governments, and Businesses Invest In?
Governments invest in tangible assets like infrastructure and intangible assets like educating their populations. Individuals might invest in their own education or form public–private partnerships to invest in infrastructure. They might also directly invest in business by buying stocks or bonds, or indirectly invest by giving their savings to a financial intermediary like a bank or a mutual fund to manage for them. Businesses invest in tangible assets like offices and machines to become more productive, and in intangible assets like technology, employees, and training.
The decision to invest must consider two dimensions: what to invest in and when to invest in it. For example, a manufacturing firm’s state-ofthe-art technology could be rendered obsolete by a new invention, so it might want to hold off investing in the new technology until its capacity to improve productivity and its role in its industry are clarified. Or the manufacturer might want to invest in existing technology to better serve its current market.
Many emerging nations don’t invest in cutting-edge technology because it is expensive and they are growing rapidly with a less current and less expensive technology. They are willing to wait until their economies require the cutting-edge technology to remain competitive and continue growing. Coordinating those decisions over time is difficult yet necessary for long-term growth and productivity.
Socially Responsible Investing
In principle, people want the highest possible return on their savings, adjusted for risk and other factors. But the “highest return” has many dimensions, not only dollars. Investors invest in order to maximize what economists call expected utility, essentially a multi-dimensional measure of happiness or well-being. Surely, more money is a big part of that, but there are other rewards that are just as or more important to investors than nominal returns. It’s why dollar returns on tobacco, firearms and oil have to be higher to attract investors, because they are often viewed as repugnant industries. On the other hand, green energy companies have attracted investors despite a lower financial yield because people are willing to take less money in exchange for the satisfaction they get for doing what they feel is the right thing. People don’t want to buy cars that pollute, and Elon Musk and Tesla have had no problem attracting investors and buyers.
Economist Milton Friedman, who won the Nobel Prize for Economics in 1976, has been roundly criticized for proposing that companies should be concerned about nothing but shareholder value, that they aren’t in business to effect social change. But as prone as he was to such unfiltered pronouncements, there’s more subtlety in his argument than meets the ear. He often argued that socially superior goods offer superior returns because they do better in the market, and that the market ultimately will not reward a producer for making something socially repugnant.
Investing in goods and services you believe in won’t be rewarding if the market disagrees with your preferences. You might hold squid in high regard, but if your taste isn’t shared, you probably shouldn’t invest in Squid Lovers International, Inc.
More than Meets the Eye
Investment returns are also affected by things the company you are investing in has little control over. Agricultural businesses face multiple inherent global risks. ConAgra has a major stake in grain production in the United States but is also affected by the volume of grain being produced in Brazil. Global weather patterns are also a major agribusiness risk factor. Solar panel production seems like a growth industry, and therefore a good investment. But manufacturers in the United States face formidable competition from abroad, particularly from China where extreme pollution has heightened the need for and substantially advanced clean energy production. Investors weigh all these issues—financial, moral, and ethical—to determine a risk-adjusted rate of return.
While money is fungible and can flow easily across borders, it often doesn’t. Savings can remain in a particular economy at unduly high levels, a phenomenon known as “home country bias.” Investors physically located in economies tend to keep savings produced there at home as opposed to financing activities in other countries, even though those investments may offer higher risk-adjusted returns. Home country bias is not always the most effective practice, but it happens, even when an investor can generate a higher rate of return elsewhere.
In the next three chapters we will examine in greater depth the key beneficiaries of modern investment, real estate, intellectual capital, and inventory, and how the principle of equilibrium works in intended and unintended ways.
Takeaways
• Investments take many forms and are made possible by savings, the portion of your after-tax income you don’t dedicate to consumption.
• Investors must consider two dimensions in their decisionmaking: what to invest and when to invest.
• People want the highest possible return on their savings, but “highest return” has many dimensions and should be thought of as “expected utility,” a measure of happiness or well-being. People may be willing to take less money in exchange for the satisfaction they get for doing what they feel is the right thing.
• Some investors practice “home country bias” investing, keeping their money invested in their home country, even though they can get higher risk-adjusted financial returns investing elsewhere.
Savings and investment is where the concept of equilibrium gains real traction. People receive income for producing GDP and, if they don’t consume that income, they save it or pay it in taxes. Firms plan for investment, but it may or may not be equal to what people save. And what the government spends may not be equal to what they take in through taxation. Still, it all has to add up in the end. If savings are more than firms want to invest—that is, if consumption is not as high as firms planned—build-ups in inventories will affect future production decisions. If taxes fall short of government spending, the government must sell bonds that compete with and can impact private sector bonds. A disturbance in consumption is usually compensated for by a change in savings. An increase in government bond sales may decrease the investment made by the private sector. Equilibrium means that as changes become evident in one sector of the economy, there will be compensating changes elsewhere.