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.