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
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
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
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
In the next part we'll
deal with savings, liquidity and the inevitability of bubbles.