Savings ≠ Investment: Keynes's Peculiar Economic Theory from Peculiar Economic Times

“An act of individual savings means – so to speak – a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, – it is a net diminution of such demand.” (Keynes, The General Theory, 211)

Keynes’s proposition implicitly includes two circumstances where the supply of savings cannot be aligned with demand for loanable funds – i.e., S ≠ I. In one case, individuals who increase their cash balances pull money from the economic system and put it, so to speak, in their pockets. If that money had been in the banking system, then this will also result in a decrease in the supply of loanable funds. The assumption is that, due to liquidity preference – preference to hold cash on hand rather than on deposit – savings is split between cash holdings and money saved in the financial system.

There is another circumstance where savings cannot be aligned with investment. Even where savings is defined classically – as in, money saved in the financial system – under a scenario of severe deflation, the interest rate will fail this task. Imagine that the inflation rate, π, plus the real rate of interest, r sum such that:

π + r < 0

or in other words

π < -r

The nominal rate is approximately defined by the above sum. If the equilibrium nominal rate is negative, than that rate will not be realized. Assuming the actual nominal rate remains positive, there will be an excess supply of savings over the demand for savings.

The first of these cases, where demand to hold cash increases, is unlikely to be very troubling long term. Only in the circumstance where individuals make a substantial shift to holding base money, as opposed to using deposit slips, checking accounts, etc…, will this result in substantial contraction. This happened during the Great Depression and was the result of tight monetary policies under a gold standard, beggar-thy-neighbor tariff policies, and suspicion – a not incorrect suspicion – that gold in banks might be confiscated. We should not be surprised that there was a banking collapse in the U.S. in 1931 and that GDP continued to fall alongside a tidal wave of deflation for another two years.

Which brings us back to the second point. The rate of deflation after 1929 led to a divergence between the equilibrium nominal rate and the actual nominal rate. Within two years, prices of consumer goods in the U.S. had fallen by nearly 30%. Unless the real rate of interest was excessively high, the equilibrium nominal rate had to be negative at the time.

It is under such unusual circumstances that Keynes wrote his treaty. But Keynes pays little attention to the sources of these problems; Again, these were tight monetary policies under the gold standard and the initiation of tariffs. It should be no surprise that Keynes comments at the beginning of The General Theory that “the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience (3).” He was certainly right concerning the economic situation that he had observed. What makes little sense is why he paid such little attention to the actual impediments to economic recovery. I’m tempted to credit his Utopianism, as reflected by his active interest in eugenics and his desire to use fiscal policy “as a deliberate instrument for the more equal distribution of incomes (95).” Keynes was interested in radically changing the discipline and the depression had given him the opportunity.