A lesson in Economics! :-D

Sometime back Priya had forwarded me the following mail from an IITK newsgroup asking me to explain if it is true.

Newsgroups: iitk.misc
Sent: Wednesday, February 16, 2005 3:05 PM
Subject: Give it a thought…

> Japanese save a lot. They do not spend much. Also Japan exports far more
> than it imports. Has an annual trade surplus of over $100 billions. Yet
> Japanese economy is considered weak, even collapsing.
> Americans spend, save little. Also US imports more than it exports. Has
> an annual trade deficit of over $400 billion. Yet, the American economy
> is considered strong and trusted to get stronger.
> But where from do Americans get money to spend?
> They borrow from Japan, China and even India. Virtually others save
> for the US to spend. Global savings are mostly invested in US, in
> dollars. India itself keeps its foreign currency assets of over $50
> billions in US securities. China has sunk over $160 billion in US
> securities. Japan’s stakes in US securities is in trillions.
> Result:
> The US has taken over $5 trillion from the world. So, as the world
> saves for the US, Americans spend freely. Today, to keep the US
> consumption going, that is for the US economy to work, other countries
> have to remit $180 billion every quarter, which is $2 billion a day, to
> the US! Otherwise the US economy would go for a six.
> So will the global economy. The result will be no different if US
> consumers begin consuming less.
> A Chinese economist asked a neat question. Who has invested more, US
> in China, or China in US? The US has invested in China less than half of
> what China has invested in US. The same is the case with India. We have
> invested in US over $50 billion. But the US has invested less than $20
> billion in India.
> Why the world is after US?
> The secret lies in the American spending, that they hardly save. In
> fact they use their credit cards to spend their future income. That the
> US spends is what makes it attractive to export to the US. So US imports
> more than what it exports year after year.
> The result:
> The world is dependent on US consumption for its growth. By its
> deepening culture of consumption, the US has habituated the world to
> feed on US consumption. But as the US needs money to finance its
> consumption, the world provides the money.
> It’s like a shopkeeper providing the money to a customer so that the
> customer keeps buying from the shop. If the customer will not buy, the
> shop won’t have business, unless the shopkeeper funds him. The US is
> like the lucky customer. And the world is like the helpless shopkeeper
> financier.
> Who is America’s biggest shopkeeper financier?
> Japan of course. Yet it’s Japan which is regarded as weak. Modern
> economists complain that Japanese do not spend, so they do not grow. To
> force the Japanese to spend, the Japanese government exerted it self,
> reduced the savings rates, even charged the savers. Even then the
> Japanese did not spend (habits don’t change, even with taxes, do they?).
> Their traditional postal savings alone is over $1.2 trillions, about
> three times the Indian GDP.
> Thus, savings, far from being the
> Strength of Japan has become its pain.
> Hence, what is the lesson?
> That is, a nation cannot grow unless the people spend, not save. Not
> just spend, but borrow and spend. Dr. Jagdish Bhagwati, the famous
> Indian-born economist in the US, told Manmohan Singh that Indians
> wastefully save. Ask them to spend, on imported cars and, seriously,
> even on cosmetics! This will put India on a growth curve.
> “Saving is sin, and spending is virtue.” Before you follow this neo
> economics, get some fools to save so that you can borrow from them and
> spend.
> This is what US has successfully done in last few decades.

I had sent her back an explanation, which she recently acknowledged ‘made sense’ to her. 🙂 So, I thought I will post that too here. Please note that you would not find anything very profound here. It was written keeping in mind those who might not know anything of Economics and hence basically discusses very simple Economics concepts. Also all the things are explained only conceptual. I have not verified any data about who is saving how much and who is spending how much! Just in case someone is interested. And mind you – read it your own risk. The author does not take any responsibility for any intellectual damage the following piece can cause to the readers. And excuse the informal tone of a presumably serious discussion. I am reproducing the mail verbatim!

The economic growth of a coutnry is largely measured in terms of Gross Domestic Product (GDP), which can be defined, in one way, as follows

GDP = C + I + G + NX

where C = consumption in the economy
I = Investment in the economy
G = Governent Expenditure in the economy
NX = Net Exports in the economy

(At an intuitive level, these are the four purposes for which any productive activity will be undertaken in the country. And hence by
measuring them, productive economic activities can be measured.)

Another term that would be useful in the discussion is S = Savings in the economy.

Let’s understand the relationship and differences between savings and investments in the economy. In this context Investment means “Investment in Physical Capital” like machines/equipments etc. which can be used for production. Investment, in say stock market is not “Investment” in the economic sense. It is “saving” as are our deposits in Banks and other such institutions. Only if a company that gets money through stock market uses it for some capital formation, does the saving gets converted to investment.

This also brings us to the relationship between saving and investment. While saving does not automatically guarantee investment, it is necessary for investment. What someone saves, is what some one else invests. Institutions like Banks, Stock markets etc. facilitate the mobilization of saving and take it from the saver to the investor. This investment then contributes to the economic growth by increasing GDP.

Saving need not automatically translate into investment. As in if I have kept 1 lakh rupee in my wallet, it is not going to be an investment. However, if I keep it in bank, the bank will possibly lend it to someone interested in investing. The interest I get on my saving induces me to save. Of course bank can give me that interest only if the person investing it is getting even more out of it. I am happy with the interest, since I am not interested in taking the pains of investing.

What could be the alternative uses of this money I am saving and the other person is investing. One possibility is that bank does not lend it for investment purposes, but for consumption purposes (e.g. it might give away the money as house/vehicle loan). Then, my saving gets converted into somebody’s consumption. For his/her consumption that person is ready to pay the bank more than the interest I get.

And yet another option is that I do not save at all and use all my money in consumption.

What is the implication of using money in investment vs. consumption (my own or somebody else’s?)? If everyone in the economy goes on consuming and no savings are mobilized towards investment, then with time, the capital in the econmoy will deteriorate. This capital includes the equipment/machinery we are using for the production of what we are consuming. So, after a while (this “a while” can range into decade possibly, but it will happen), we will not be left with the means to produce at all (or at least there will be a deterioration). So, while today, by using all the moeny in consumption (C) I can increase my GDP, tomorrow I will run into trouble if I have not saved and invested in the physical capital! Thus, investment means that we sacrifice some consumption today, so that we can consume enough tomorrow. Of course, the eternal question before all the economies of the world is how much of investment and how much of consumption? We certainly do not want to make life unnecessarily tough/bad for people today by investing too much. But we can’t be too ‘extravagent’ and compromise the consumption of future generations.

Now, we can see the given case in the light of the above framework. Keep in mind that I had ignored the movement of saving across the countries in the above. This will come into picture in this case.

As per this article, Americans are consuming and not saving (much) domestically. Japan is saving, but not investing the whole of it in its own coutry. Rather it is diverting a large part of it to America. Now, question is what are Americans doing with the money. Suppose a Japanese person has put the money in an American Bank. Now, is the American Bank lending the money for a housing loan or to a company for creating capital? If it is for housing loan and not just this bank but all the banks taking money from Japanese are doing the same thing, how long can they sustain it only on consumption. So, long as physical capital is sustaining consumption and hence economy is growing and hence the person is ready to pay the bank more than the interest bank will give to the Japanese person. But how long? Someday they will run out of production resources (capital) and then?

Now, if Japanese are diverting their savings to America, why are they doing it? What are they doing with the returns they are getting? If they are using that return for investment in their country, they are building a better future. If they are using it for consumption, they are enjoying their life without taking the pains of investing in the physical capital. But of course, in the later case, they are also risking their future. What happens when in future Americans run out of physical capital and hence can’t consume and hence have low GDP and can’t pay the Japanese back?

But let me hope that American as well as Japanese economists and governments are at least as intelligent as I am (and now you too :-D). Hence, even while cosuming a lot Americans are taking care of their investments for future; and despite diverting their savings to America, Japanese are consuming and investing enough. And hopefully what they are diverting to America earns them better returns there than it would earn them in their home-country.

So, you see, it depends on where a particular economy is presently there. How much of consumption it can afford and still have enough for investment? Consumption is important. Effect of investment on Economic growth comes with a time-lag and consumption is the best way to ensure
the growth in short-term. But investment is important as well. Short as well as Long term welfare is to be kept in mind. Probably Americans can afford to consume a lot. Can we Indians do it?

Several things would come into picture there. What I have described is obviously a simplistic picture. Very often the actual action of people/government in a country does not solely depend on the economic wisdom. The deficit of America and the fact the it is the largest borrower in the world is indeed a matter of concern. If in future its economy collapses, it will certainly have drastic repurcussions on all the countries. Many a times political considerations over-ride the economic concerns, even in America 🙂

And then, many a times a simple measure like GDP is not enough. That’s where the concepts like Developmental and Welfare economics come into picture. At times even if there is a best way to ensure GDP growth, it may not be the best way for the well-being of a large part of the society. Thus, a simplistic argument can’t be taken just like that. Even if one accepts that consumption is the best way towards Economic Growth, it need be good from the point of view of equity and welfare. At what cost does the consumption come? Who consumes and who suffers?

I must stop before I am labeled as communist 😀

If you have indeed read upto this, questinos are welcome. And also a feedback on how good or bad an Economics teacher I shall make :-p

9 thoughts on “A lesson in Economics! :-D

  1. Never thought about things like this…..good one but I have one question:

    I guess there is an another aspect of this. If you see big American companies like GE, Pepsi or software companies. They are not making any investments (as your definition) in America in self. Like, they make manufacturing plants and development centres in low cost centuries like India, Brazil, Mexico etc. On the other hand they are downsizing people in America. Even though they are borrowing and not investing in their own country they are controlling most part of the world economy.

    If certain nation denies accepting FDI from US (case of Chilli, 1974) or not investing back in US (case of Indonesia, few years back). Americans use all methods to change their decision. They bribe officials (Chilli, 1974 and India, always been like this :-)), They do military attack (Iraq) or create economical crisis (Indonesia).

    Their strategy is to gain control and not to follow certain welfare or visionary economy.

    Have you read “GOOD Muslim, BAD Muslim”??? Above is effect of it.

  2. nice..I had seen this email about two years back. that time I really appreciated the skill of the writer.It was called as ‘neoeconomics’…..ur counter explanation is one of the best possible…
    PS: where are you going for internship this summer?

  3. The issue raised in the original article from which you’ve quoted (available at http://www.econ.ubc.ca/lemche/academic_w04/webfw_04/neo-economics.pdf)

    can be answered in specific using the following approach:


    According to conventional economists (refer Ando and Modigliani, 1963)

    Consumption = f (disposable present income, expected future income, wealth)

    Expected Future Income (EFI) is dependent on:

    1.Current Net Worth: dependent on Disposable Present Income (DPI) [Modigliani’s proxy] and wealth

    2.Consumer credit outstanding (CCO) – because people spend on credit, as they believe they can pay off the debt with future earnings.

    Using the above proxies thus,

    1. C = f (DPI, NW, CCO)

    2. CCO= f (DPI, NW, i, consumer confidence)

    since CCO depends on DPI, Net Worth (NW), interest rates (i) and consumer confidence

    Conventionally, DPI and NW are the drivers of EFI and C, and CCO is of hardly any consequence.

    In fact, if I remember right, in the 1960s in the US,
    Marginal Propensity to Consume (MPC) out of income was around 70%
    and MPC out of wealth was around
    8 %

    But a unique feature of the US economy in recent times has been the rising importance of CCO; in fact, since the late 80s CCO has been the most dominant contributor to consumption. Importantly in tandem with this, Net Tangible Income in US has also been going down steadily.
    Thus the current co-relation between Wealth and Consumption has become transitive:
    People consume on credit but obtain credit based on wealth and confidence in the economy. This transitive dependence has reduced the importance of DPI and NW in determining Consumption in the US (the multiplier). In fact currently in the US, MPC out of wealth is negligible (refer Poterba or Porteba, 2000, I don’t remember the guy’s name exactly).
    Added to that, due to policies in the US, interest rates and consumer confidence have become much more important in determining CCO.

    This is broadly the key to the success of the US consumption saga and many countries have either failed to replicate it, or have been only marginally successful, because one or the other condition has not been fulfilled or the sequence of steps has been different.

    Traditionally in economies like India or Japan, consumption though low, has had a strong co-relation to savings and net wealth (The rich Indian seth spends more than the poor chaprasi though the seth’s spending is much lower than the spending of a comparable US seth). These economies have tried to/managed to a partial extent to unshackle consumption from savings but unlike the US, savings has not gone down (neither has the consumption been funded fully by savings.) Thus the issue of surplus savings and its lending to the hungry US.

    There are more issues as well like the relations between Savings, Consumption and Investment; the relation between Savings and Investment that must be analysed in detail, differently from the conventional approach. Without these, the broad approach which you apply cannot do full justice to the specific issues raised in the article (For eg. your analysis will change if I put in Investment as Consumption in future date after factoring in interest rates or take into account Fisher’s Separation theorem)……. but that’s for later and some other forum :-).

    …good memories of a good subject (ECO-2) and a good Prof and some good learning (4 months and sadly quite a lot of it has rusted) never required for exams…..but time to get back to a subject even better OR :-).

  4. the name ‘Hayek’ somehow wasn’t striking me yesterday……

    the approach which you’ve tried using was proposed by the nobelist Friedrich August Hayek in his seminal essays in the late 1920s (try reading that masterpiece, ‘the paradox of savings’) but many important factors which you’ve overlooked were considered.

    Later economists like Modigliani, in the 60s found the conclusions to be disputable and too generalised and obvious to be of much use when trying to explain specifics like the relation of American spending to its boom and the relation of savings, investment etc. to the strength of an economy… Modigliani wrote some seminal papers on these topics in the 60s and this work was carried on by later economists like Partebo, Robbins etc.

    In the previous comment I tried to summarise the core of Modigliani’s approach, of course with many details deliberately glossed over….they are available in his papers.

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