Karl Smith - Assistant Professor of Public Economics at UNC-CH & Blogger at Modeled Behavior
Americans live beyond their means. This is the conventional wisdom among American elites from Washington to Wall Street to Harvard Yard. Our government budget deficit is out of control. Consumer debt is rising and we are living through the aftershock of a rapacious run-up in mortgage debt. When will we ever learn?
This conventional wisdom, however, is missing one seemingly obvious but systemically overlooked stumbling block: If Americans start saving, who will borrow?
We normally think of savings in what economists would call Partial Equilibrium analysis. That is we only look at the piece of the economic puzzle we are directly connected to, rather than thinking about the entire economy as a whole. We think that we save, we put money in the bank or in an investment account and then later we get our money back, with interest.
Yet, where does that money go? Does it just sit in the vault? Is there, as economists joke, some giant money bin on Wall Street that collects everyone's savings?
No. In every case the money is transferred to someone else. The bank uses your deposits to make loans. When you invest in the stock market you or your mutual fund is buying out some existing investor. Your money is effectively transferred to the new borrower in the case of the bank or the old investor in the case of the stock market.
Yet, suppose everyone tries to save or invest in the market at once. What happens?
The simply story that we tell is that as more people save, interest rates will fall. In fact, interest rates are largely set by Federal Reserve policy. As more people try to save, the economy will cool down, since people are spending less. The Federal Reserve will respond to this by lowering interest rates.
Low interest rates should then, in theory, spur investment. However, the majority of actual investment in the United States -- and the rest of the world for that matter -- is in physical structures. That is, the majority of investment is in construction. Of these housing is the largest component. So, as interest rates fall investment in housing and other structures rises.
Yet, as we saw over the 2000s there is a limit to how far this can go. Construction investment in general and housing investment in particular can easily outstrip the point where new investment yields positive rates of return.
In the market case, if everyone tries to invest at once, that is if there are many buyers and no sellers then the price of the stocks goes ever higher. Indeed, there is no theoretical limit on how high stock prices can go. If literally everyone wanted to invest and no one wanted to cash out then the price would sail towards infinity.
That won't happen because as prices go higher some folks will want to get out. They will start selling and the market will land on a price where the number of buyers and sellers match. However, as we say in the 1990s that price can be extremely high.
The key question is, how does this help our nation as a whole save for retirement? Since stock prices are determined by the meeting of buyers and sellers there must be some future buyer who will pay as much as you did, or else you face a capital loss. Is it all a Ponzi scheme?
No, but understanding why not shows us the limits to saving through the market.
It's not a Ponzi scheme because there exists a special class of seller, those who can issue new shares. Sometimes a currently traded company will issue new shares as a way of raising money for new investments. More importantly, however, young firms will issue shares as part of an IPO.
The higher stock prices are, the better deal young firms can get in an IPO. And, the better deal young firms get in an IPO the more likely Venture Capitalists are to take a chance on start-ups.
So, high stock prices encourage start-ups. These start-ups will in theory add to economic production and increase the size of the total pie. It's the return from there being a larger pie which then supports the mass of investors who went into the stock market.
As we saw in the 1990s, however, there is a fundamental limit to how many good start-ups can be created. When stock prices go ever higher it has the predictable effect of encouraging more start-ups but we very quickly run into the problem that many of those start-ups either have bad business propositions, or mutually exclusive ones. In some cases the problem is that there can only be a handful of mega-firms like Google, but 100s of companies are betting on making it in search. This means most of that investment has to have a negative return.
Running up stock prices is a way to grow investment and support retirees, but it's limited.
If we have seen ourselves both run out of new companies to invest in as stock prices rise, and run out of construction to invest in as interest rates fall the question remains: If Americans start saving then who will borrow?
In the next part we'll deal with savings, liquidity and the inevitability of bubbles.