Saving vs. Spending

John Maynard Keynes once said that saving money is an individual virtue but a societal vice. This has been the stance of mainstream economics for a very long time.

The underlying belief is that demand stimulates all economic activity. Hence, when there is more demand, there is more economic activity. Thus, an economy grows by increasing demand. Demand is another word for increased spending.

Hence, modern-day economists believe that incessant spending by the consumers is what drives the economy. This is the reason why the American government requested the people to go out and spend their money after the 9/11 attack which threatened to slow down the economy.

However, this doctrine which advocated more and more spending is somewhat recent in nature. For many centuries, economics has actually been urging people to save money. This has created a dichotomy of sorts in the minds of the modern student. On the one hand, they know from common sense, that saving is indeed good for the economy. On the other hand, there are these economic gurus who claim that spending is what keeps the economy afloat.

In this article, we will try to resolve this dichotomy.

The Logic behind Increased Spending

The justification for increased consumer spending is generally derived from the “circular flow of economy” model. This model explains that the cash flow in the economy is circular in nature. Hence, the spending of one person becomes the earning of another person. Similarly, the spending by the second person becomes the earning of the first. Thus, according to this model, spending is what keeps the economy alive.

Spending is also seen as the number one reason for increased employment and job creation. Hence, according to this model, when spending is cut down, people will lose their jobs. The overall negative sentiment will lead to few people buying even fewer goods. Many economists like Keynes believe that this leads to a downward spiral which is self-reinforcing. The belief is that it is this downward spiral that causes a recession. Also, since the spiral is self-reinforcing, it is difficult to come out of recession.

The Omission of Capital Goods

The overly simplified version of the circular flow of economy omits many relevant facts. For instance, it overlooks the fact that all spending is not equal. For example, if a baker buys a new oven, he is actually making an investment that will help him earn a higher income in the future. However, on the other hand, if the same baker goes on a vacation and spends money that expense would not reap any returns in the future.

The record of economic history explicitly states that for a country to increase production in the long run, it needs to increase its stock of capital goods. This stock of capital goods can only be increased if money is invested in productive activities. Hence, this philosophy is very different from the spending philosophy since it emphasizes on the need for savings and the correct diversion of those savings to productive activities.

The Problem with the Spending Approach

The spending approach to economic growth can be seen as of the significant reasons behind many economic ills. Firstly, many governments have gone deep into debt in order to stimulate spending and recover from financial setbacks. This approach will only work if the expenditure is done on capital goods. On the other hand, if the money is used to make welfare payments, then the spending would have done more economic harm than good. In the short run, it will help in increasing the GDP. However, in the long term, it will only lead to more indebtedness. Similarly, the spending approach is creating several problems with personal finances. A large number of individuals find themselves in debt because they have been brainwashed into spending money.

Incessant spending does not create prosperity for the individual just like it does not create prosperity for the entire nation. The fact of the matter remains that before individuals consume, they must have produced goods of equal or more value. This is the only way real economic growth can be achieved in the long run.

Effects of Hoarding

The difference between saving and hoarding must be clearly understood. Saving means that the money is entrusted in the hands of people who intend to use it for productive purposes. On the other hand, hoarding would mean storing cash under a mattress or in any other space where others can not access it.

Savings create economic growth whereas hoarding does not. The reasons are self-explanatory. Money kept idle does not multiply or benefit anyone. However, money in the hands of industrious people is a great resource that can spur economic growth.

Effects of Inflation

When a government prints money out of thin air, it creates inflation. This inflation is having a detrimental impact on savings. For instance, the value of the interest generated as a result of savings is reduced by inflation. As a result, it discourages people to save money since the purchasing power of money is depleted in the long run. Also, when a government prints money and spends it, it diverts money from productive activities. This ends up shrinking the production flow.

Hence, the bottom line is that incessant spending by individuals may not necessarily be good for the economy. Instead, the focus should be on saving since it allows countries to achieve higher levels of economic growth.

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Managerial Economics