I left off yesterday arguing that consumer spending is the result of economic prosperity instead of the cause. The misunderstandings surrounding this issue are like most in economics: people are short-sighted and only tend focus on what is seen in the immediate sense, not on what is unseen. This is why it's not immediately apparent how savings are what fuel greater economic prosperity that later allows for more spending and higher living standards.
To illustrate, let us consider the story of two friends: one is named Hank, the other Snuffy. Snuffy and Hank must both be blessed by the luck of the Irish because an anonymous wealthy benefactor at Blessed Sacrament School has passed away and left both with an annuity of $100,000 in dedication for their lifelong service and support of that renowned institution.
Snuffy is a lavish spender with the new income. And he spends not only based on desire, but on principle. He is a firm believer in the theory that every penny must be spent or else goods will accumulate and people will be out of work. So he goes all out in redecorating his home, and buys a few luxury sports cars and a yacht. He dines at the finest restaurants, drinks top-shelf liquor at elite establishments, and goes on numerous vacations at exotic locales. He buys the finest diamonds and jewelry for his girlfriend. He tips very handsomely and keeps a large staff of chauffeurs and servants.
In this way, Snuffy feels he is not only serving his own immediate wants and desires, but is helping others through his generous spending. And it certainly appears this way, because Snuffy is extremely popular with the Lexus car dealers, the bartenders at the Mansion, the bellhops at the Westin, the strippers at Temptations, the wait staff at Ruth's Chris and the Yacht Club, and the entourage he keeps. Everyone around Snuffy see him as a public benefactor for his liberal indulgences. His extravagance keeps these people fat, happy, and employed because he pays for their services; that is what is seen.
Hank, on the other hand, is an entirely different story. His spending habits are quite austere. Unlike Snuffy, Hank decides to only spend half ($50,000) the income each year. Sure, Hank splurges on the occasional Outback steak or Captain's Platter at Hilliard's, but for the most part his spending habits remain the same as before the bequest. He lives a much more modest lifestyle and is rarely seen making it rain at the jewelers, the nightclubs, and the strip clubs. He still eats bologne sandwiches, sneaks peanuts and Sam's cola into the movie theatres, and brings flasks into bars. For this reason, many view Hank as overly stern and stingy. With Snuffy being the city's Santa, Hank is seen as its Scrooge. By withholding potential spending dollars, he deprives retail and services sector additional income or employment; that is what is seen.
But what of the $50,000 Hank chooses not to spend? Where does it go? Does he just stuff it under his mattress or allow it to pile up in his closet? What happens to it? This is the part of the equation this is not seen. Hank decides to take his cash and deposit it into a savings account at First Chatham Bank. And when Hank does this, the Bank uses that money to loan to businesses. The businesses can employ Hank's savings in a variety of ways: maybe as short-term working capital, maybe to expand production, maybe to invest in new and better equipment, maybe to hire additional workers.
In this way, saving is really just another form of spending. The chief difference is the spending Snuffy engages in can be easily seen with the naked eye, while the result of Hank's investing is harder to grasp because it goes unseen. When people like Hank save, it increases the supply of money capital in the economy, which lowers real interest rates. And when interest rates are lowered, it allows for the production and purchase of capital goods like new houses, factories, office buildings, equipment, and high-tech tools. Businesses are more willing and able to invest because loan payments are cheaper than before. More projects can now be undertaken because interest payments no longer exceed the potential and projected revenues from such projects.
20 years pass. The trust fund becomes exhausted. Snuffy, having spent every dime, is now broke. His former colleagues now think of him as a fool, and he begs his friend Hank for money, who is meanwhile rolling in dough from the interest income he now receives from his investments. And not only has his fiscal prudence secured his own personal financial well-being, but his savings have provided and will continue to provide better, high-paying, and more productive jobs.
In this way, Hank has done far more good for the economy through saving than Snuffy did with his spending. When a company invests in new equipment or better machines, it helps raise living standards by lowering the costs of production. There are two ways in which this happens: (1) workers are provided with higher wages, because they are now able to produce more per hour and thus create more value for their employer, and (2) it allows the business to reduce the price per unit, which translates into more money into consumer's pockets. So not only is Hank's personal income and wealth greater than Snuffy's, but he has added to the economy's productive capacity while Snuffy has not.
This is why a nation's wealth and prosperity depends not on the public's willingness to spend money on consumer goods, but on the amount of accumulated capital the public has at its disposal in its production of such goods. This is why it makes little sense for our government to continue coercing consumers to engage in spendthrift behavior (just so we can get nice, big, fat GDP figures!) instead of allowing the market to adjust and the economy to recapitalize itself. By continuing to inflate the currency and holding down nominal interest rates (now at a ridiculous 0%), people have little, if any, incentive to save their money. Washington is doing everything in its power right now to turn us into a nation of Snuffys, but the road to prosperity lies in having more Hanks.