Tuesday, November 27, 2012

A broken identity

Savings = Investment

This misleading little identity is one of the foundations in economics and serves as a bulwark in GDP accounting (Consumption + Investment + Government Spending + Net Exports = GDP).

And yet, "Savings" in aggregate, has very little to do with Investment in our modern fractional reserve Banking system with a floating currency.  Rather, "Investment" is driven by much more complicated set of inputs.

Over the weekend I listened to a discussion regarding Keyens's "paradox of thrift".   As a preface, no, this is not my idea of a well-spent weekend.  It happened to que up on the ubiquitous MP3 player while I was on a ladder painting a 14 foot ceiling, and, thus sequestered, I decided to make the best of the situation.   During this gripping conversation, one of the interlocutors stated that the paradox did not exist because more money would be saved, creating larger amounts of Investment...S=I.

However, Investment has nothing to do with the net dollars people and institutions deposit in banks.  Investment is dictated by return characteristics and market powers.  This is because if a bank sees a profitable lending opportunity (risk adjusted through whatever metric you wish to use), it simply creates a deposit in the lendees name and "poof".  INVESTMENT.  There is no "Savings" involved nor are "Savings" some sort of gravity that prevents deposits from shooting currency into orbit.  It is ex nihilo creation of currency.

This is why credit cycles have much more impact on monetary creation than Business cycles.  Attraction, formation, stability, instability, destruction.  Rinse and repeat.

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