Investment Precedes Saving

One argument sometimes leveled at Modern Monetary Theory that is misplaced is that it puts too much emphasis on the monetary and too little on the real. The charge is misplaced for at least two reasons. On the one hand, it is imperative to integrate money into the analysis of what is a monetary economy. It is the tax basis of the demand for money, for instance, that creates real unemployment. It is the hope of turning a sum of money into a larger sum of money – not real output – that motivates capitalist real investment. Attempts to separate completely the monetary from the real in such an economy fail at the most basic level. But, on the other hand, it is modern monetary theorists, and heterodox economists before them working in Marxian or Keynesian traditions, who attempt to make clear what is going on in terms of the real, while it is the orthodoxy that constructs a mystified view of the world in which the real is allowed to be bound by the monetary, for example by pretending a currency-issuing government is financially constrained in its capacity to boost demand and hence real output.

These differences between the various schools of thought are exemplified in debates over investment and saving. The debates concern causation. In this context, it is the behavior of planned or desired (or ex ante) saving and investment that is at issue, not the identity between actual saving and investment. Accordingly, in what follows saving and investment should always be taken to refer to their planned or ex ante levels.

In a simple two-sector model (see here and here), macroeconomic equilibrium requires saving to equal investment. Whereas the orthodoxy conceives real interest rates as long-run equilibrators of saving and investment and as intertemporal allocators of consumption, Marx and Keynes influenced economists stress the primacy of investment in determining income and saving.

Modern monetary theorists, of course, share the view of the Marx and Keynes influenced economists. The conclusion follows clearly from an understanding of endogenous money. In a credit economy, an increase in investment does not require a prior increase in the desire to save. Indeed, an attempt, starting from equilibrium, to increase the proportion of income saved will simply lead to an unanticipated buildup in firms’ inventories, a cutting back of production and lower income. The income adjustments will continue until saving settles back at the level of investment, a higher proportion of a lower level of income. This is the ‘paradox of thrift’. Any attempt to alter the level of saving independently of decisions to invest will cause income adjustments that defeat the attempt.

Investment is the independent variable. If, starting from equilibrium, investment is stepped up, there will be a multiplied increase in income, the process continuing until desired saving reaches the higher level of investment. If investment is reduced, income will continue to adjust downwards until desired saving equals the new, lower level of investment. In either case, saving passively adjusts to investment via income adjustments until macroeconomic equilibrium is restored.

Neoclassical economists prior to the Keynesian revolution had instead supposed that interest rates play the role of equilibrating saving and investment. The logic relied on the notion of a loanable funds market in which an excess of saving would lower the rate of interest and encourage investment, and vice versa. The loanable funds doctrine is clearly inapplicable to an economy with a modern banking system. In a credit economy, there is not a finite amount of saving available for investment. Banks will extend loans to firms for the purposes of productive investment if it is perceived to be profitable. The subsequent investment creates income. Through a multiplier process, income continues to increase until (desired) saving matches the higher level of investment.

In the aftermath of the Keynesian revolution, neoclassical economists accepted Keynesian causation in the short run, but attempted to retain neoclassical causation, resting ultimately on the inapplicable loanable funds doctrine, in the long run. The orthodox approach was further undermined in the capital debates (see here, here and here).

There is no basis for supposing the price mechanism via interest-rate adjustments can bring about macroeconomic equilibrium, even in the long run. In a simple two-sector model, it is income that adjusts saving to investment. In more elaborate models, the same logic applies except that income adjusts planned leakages (the sum of saving, tax revenue and imports) to injections (the sum of investment, government spending and exports).