This is really quite simple. People choose to save instead of consume. And then people use these savings to invest in new production. With more production, there is more to consume. The economy has grown.
The market is a process that sees entrepreneurs using these savings to invest in what they believe people want. And as they learn more about what people want (or not want) they either invest more into the project or redirect their investment to their new beliefs on what they believe people want. They do not get it right every time, however it is through this process of discovery that capital is best allocated.
It is this process that needs to be preserved and not manipulated or disrupted – whether through the printing of money, artificially lowering interest rates, ‘stimulating’ the economy or any other policy that gets in the way of this process.
A parable
I had often thought of writing a simple story to illustrate through common sense how an economy grows – thankfully someone has already done it in comic book format: Peter Schiff. I am going to paraphrase the first half of his book How an economy grows and why it crashes in the rest of this post. I highly recommend you read the book for yourself.
Here goes:
Imagine 3 men stranded on an island: Able, Baker and Charlie. They have no tools and each can manage to catch one fish a day with their bare hands, which is just enough for each of them to survive.
One day Able has an idea to build a net that will hopefully catch more fish with less effort. To do this will take a number of days and where he will go hungry to build a net that might not even work! Thankfully it does work and Able can now catch two fish a day with his net.
What we see here is Able under-consuming (saving) and taking a risk to build a capital good (net) that will produce for him more fish. He has grown the economy from 3 fish a day to 4 fish a day.
Now that Able can produce more than he needs, he has four things he can do with his savings:
- he can save what he has saved: save for a rainy day
- he can consume what he has saved: become a glutton
- he can lend out what he has saved: so Baker and Charlie don’t have to starve while they try and build their own nets (or other capital goods or consumer goods)
- he can invest what he has saved: he could build a bigger net or invest in producing other capital goods or products, like a basket or a knife or a hut
Able decides to lend out fish that he has saved to Baker and Charlie so they can produce their own nets. Now the economy that was only producing 3 fish a day has doubled to 6 fish a day!
With their extra fish, the islanders can finally eat more than one fish per day. But the economy didn’t grow because they consumed more. They consumed more because the economy grew. This is a simple concept, but it’s amazing what modern economists can do with a simple concept.
Most economists think that demand can be increased by giving people more money to spend. But that doesn’t change real demand, just how much people can spend on items that have been produced. Only by increasing supply can people actually get more of what they demand.
Peter Schiff
Instead of lending his savings to Baker and Charlie, Able could have just given his savings (extra fish) to Baker and Charlie while they built their own nets. If he did that, he would not have been compensated for the risk taking he took in building the net in the first place. That might be fine by him, however for most people, it is not.
As time goes by Able, Baker and Charlie continue to grow the economy by saving (deferring consumption today to some time in the future) and investing in capital goods and consumer goods: these include together building a mega fish catcher that racks up 30 fish per week; Charlie built surfboards, providing a new leisure activity to the island; Able established a clothing company; and Baker spent his time trying to find solutions to transportation, like developing the island’s first canoe and cart.
I’ll say it again, an economy grows through savings and investment.
WHat are we doing?
Although a house is technically an investment, if we intend to live in it forever, then it is really an expense. So if you have a mortgage on a home that you are paying off, or if you are saving for a deposit to get a mortgage for a home, then you are borrowing to spend, not borrowing to invest. 35% of Australians have a mortgage on their home.
When a government borrows money to give back to citizens to ‘stimulate the economy,’ then they are borrowing to spend and therefore are not growing the the economy, contrary to the narrative they push.
When the government borrows money to spend on infrastructure projects, then they are bypassing the market process of entrepreneurial discovery and capital is being mis-allocated. That is, people’s savings are not being used in the best way to grow the economy.
Entrepreneurs will invest savings (or invest borrowed savings) in capital or consumption goods for the betterment of us, as it benefits them. But, who are the savers?
Australian Household Savings Ratio has reduced from around 15% in the 60s and 70s and has gradually fallen to between 0% and 5% over the last decade or so. We are no longer a country of savers, we are a country of consumers.
Spread the word: save.
