Savings and Investment

posted by Nima

December 26, 2008 · Posted in General Economics 

The following scenario shall explain the significance of savings on any market system:

  • P1 produces A, P2 produces B, P3 produces C, all 3 produce these goods by transforming previously untouched land
  • Each of them can produce 3 units of their respective goods within 1 time unit
  • The period of exchanging goods is 1 time unit
  • Each of them trade 2 units against the other two goods and keeps one unit to himself
  • Each of them can last 2 time units without consumption after consuming 2 unis of any good

As long as they produce for immediate consumption only, the cycle would look like this:

Period Person 1 Person 2 Person 3 Event
1 AAA BBB CCC Production
2 ABC ABC ABC Exchange
3 - - - Consumption
4 AAA BBB CCC Production
5 ABC ABC ABC Exchange
6 - - - Consumption

After producing, exchanging, and consuming the goods obtained, the 3 individuals return to their initial state and produce the same amounts again over the next production cycles. No raise of anyone’s standard of living occurs.

If, however, P1 decides to save good A and only consumes B and C he will hold good A after the first consumption cycle is over. He can repeat the cycle twice and then hold three units of A. This will now enable him to last over 2 time periods during the first of which he can produce a machine M, a factor of production that enables him to produce twice the amount of A within 1 time unit. During the next time unit he can again exchange two units of A and consume all thee goods A, B, and C which leaves him with M. He has invested his savings in capital. From hereon he will be able to produce 6 units of A per time unit. He can now afford to consume more units of A or exchange more. His real income rises. He has accumulated capital:

Period Person 1 Person 2 Person 3 Event
1 AAA BBB CCC Production
2 ABC ABC ABC Exchange
3 A - - P1 only consumes B & C, saves A throughout next steps
4 A AAA BBB CCC Production
5 A ABC ABC ABC Exchange
6 AA - - P1 only consumes B & C, saves another unit of A throughout next steps
7 AA AAA BBB CCC Production
8 AA ABC ABC ABC Exchange
9 AAA - - P1 only consumes B & C, saves another unit of A
10 M AAA BBB CCC Production, P1 this time produces M instead of 3xA
11 M ABC ABC ABC Exchange
12 M - - Consumption
13 M AAAAAA BBB CCC Production, P1 uses M which doubles production output
14 M AAA ABC ABC ABC Exchange
15 M AAA - - Consumption, P1’s output per time has increased

Instead of producing M himself, P1 could also have provided the goods to P2 or P3 in a credit transaction if one of those had had a better investment idea, have one of them build a machine that increases their output, and then get his goods back plus interest which could be financed out of higher production output. However this is arranged, the concept of savings and investment is not changed in the slightest.

If P2 and P3 do the same thing, their real income rises as well and as a result the society’s standard of living rises as a whole.

This is the essence of all wealth generation. If some countries enjoy a higher standard of living than others it is precisely due to the fact that the amount of capital per individual is higher than in others and as a result the output per unit of labor is higher. Thus savings are indispensable to an increase in everyone’s standard of living. Without savings, there would be no investment and hence no capital accumulation. Without capital accumulation the output per unit of labor remains the same.

But all capital that has been accumulated requires maintenance. The machinery, tools, computers, and other productive factors require repair, replacements of parts, and routine checkups, lest their output per unit of labor shrink. Hence, even in order to just maintain an existing stock of capital, continuous savings on the part of individuals on the market are necessary. If the government discourages people from saving, the necessary uphold of existing capital will fall short, what ensues is called capital consumption. The productivity of existing capital will diminish rapidly and the workers’ real income will drop. Thus capital consumption is the inevitable result of policies such as credit expansion or taxation of incomes derived from interest, dividends, and capital gains. The business cycle irrefutably shows how credit expansion precipitates capital consumption.

History has shown that no one single country is ever safeguarded against the blunder of capital consumption. It has lead to the decay and demise of the most powerful and wealthiest empires, and plunged their inhabitants into decades if not centuries of pauperism. On the flip side, rapid capital accumulation has helped the poorest and most underdeveloped nations rise to the ranks of industrialized nations within a matter of years.

Hence there is only one way to continuously and progressively raise the standard of living for the common man. If politicians are truly interested in attaining this objective, they need to encourage savings, capital accumulation, and investments inside the country. The best means to this end are an unconditional abandonment of the policy of credit expansion, a sound monetary policy, and a significant lowering if not an outright abolition of the taxes levied on incomes derived from interest, dividends, and capital gains. Any policy that aims at the opposite, is bound to progressively lower the standards of living of working men and women.

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