The Savings Fallacy - why it matters in Labour’s opposition to austerity

The Fallacy

I recently had a conversation with a former civil servant who is a member of my Labour constituency organization about the shadow chancellor’s promise to increase public investment.  He agreed with the need to do so, but challenged me with the question, where will Labour find the money to do this?

The quick answer is, by borrowing.  A country with its own currency never runs out of money, because its government can borrow in financial markets or from its central bank.  The Bank of England, part of the public sector, holds almost 30% of the UK public debt.

However, underlying this simplistic phrasing, how to “find the money”, lies a more fundamental issue.  Investment is by definition expenditure for the future not the present.  Therefore, while it appears as spending in the future, in the present it can be viewed as non-spending, by definition “saving”.  

Since investment represents saving in the current period, is it necessary for private sector business and/or governments to save in order to invest?  Recently at an anti-austerity meeting a speaker maintained that the answer is “yes”.  The argument went as follows.

Image the simple case of an economy with one product, maize.  In order to produce maize in the next growing season, farmers collectively must set aside part of this season’s maize as seed for next season.  To keep production at the same amount each season the same amount of seed must be set aside.  To increase production next season, farmers collectively must set aside an increased amount of seed for planting.  

Thus, it seems that increasing production initially requires that less maize is available to eat during the current period.  The reverse holds – increasing consumption this season means less production and less consumption next season.  To increase consumption increases in the future, consumption must decline in the present.  

This apparent dilemma – more in the future requires less now – is a well-known parable in mainstream economics.  In a commonly used economics text book we read, 

For society to invest more in capital, it must consume less and save more of its current income…[Growth] requires that society sacrifice consumption of goods and services in the present to enjoy higher consumption in the future. [page 141]

When applied to the public sector, this generalization would imply that if governments borrow they should do so to invest, not to consume.  To use the common UK budgetary terminology, our government should cover current expenditure with current revenue.  Borrowing to invest draws saving from the private sector to fund public capital projects.  It is the strict equivalent of setting aside more seed for the next growing season.

Applying the farming parable to government implies that deficits on the current budget undermine economic growth, because the borrowing by the government transforms private sector saving into public sector consumption (private investment into public consumption).  Borrowing for current spending impoverishes;  borrowing to invest enriches.

Where the Fallacy Lies

As reasonable as it may appear, for a market (capitalist) economy this analysis is false.  The conditions for it to be correct do not exist in the real world.  The most obvious requirement for the parable to hold true is that the hypothetical economy operate at full potential (“full employment”).

If all of society’s resources are in use, producing more of one thing requires producing less of others – more investment goods require less consumption goods.  The UK economy is not now and rarely in the past has it been at full capacity (and the same applies to most countries, Weeks chapter 4).

As should be obvious – even to writers of economics textbooks – if resources are idle more consumption goods and more investment goods can be produced simultaneously.  When resources are idle, investment generates saving not vice-versa, one of the principal insights of J M Keynes (perhaps first appearing in a pamphlet written with Hubert Henderson).

Before Keynes, Karl Marx made a very similar argument, ridiculing those who believed that capital accumulation required prior saving by capitalists.  Marx explained that accumulation results from capitalists borrowing to hire idle labour (found in Capital Vol I, “The General Law of Capitalist Production”).

Despite the Chancellor’s claims that the UK recovery is robust, our economy displays all the signs of performing well below potential.  The present unemployment rate of about 5.5% seems good only by comparison to the disastrous years since 2008.  By contrast, over the years 1963-1979, the unemployment rose above 5% in only three (1976-78).  

After 1979 unemployment barely managed to squeeze under 5% in only two years (2004 and 2005, both at 4.8%).   As Ken Livingstone said in his speech to the Labour Against Austerity meeting, in the 1950s and 1960s “full employment” meant unemployment less than 2%.  Data on capacity utilization further undermines the Chancellor’s recovery bravado, since it has fallen for the last three quarters (Figure 2).

Figure 1: UK Employment Rate, 1963-2015 (% of working age population)

Source:  OECD “standardized” unemployment rate

Source:  OECD “standardized” unemployment rate

Figure 2: UK Private Sector Capacity Utilization, 2013Q1-2015Q3

Source: Trading Economics.   

Source: Trading Economics


At this moment, and because policies are unlikely to change for the foreseeable future, the UK economy has the capacity to produce more consumption goods and more investment goods.  This provides the basis for an increase in public investment, which would generate employment, incomes and, therefore, private consumption.

Policy Options for Labour

Were a Labour government in power tomorrow (let me dream), one policy option would be to increase public investment and let the famous “multiplier” process generate jobs, incomes and consumption.  The last of these would reduce idle capacity in the consumption goods industries since the import content of the UK economy and low income consumption is far less than 50%, closer to 30.

However, restricting increases in public expenditure to investment (the “capital” budget) would not solve the chronic problem created by Tory governments since 2010, underfunding of public services.  Currently the National Health Service is desperately under-resourced, with numerous trusts facing financial disaster.  The financial pressure on schools is as bad if less publicized.  Perhaps most scandalous of all has been the devastation of local government services (read David Cameron’s letter to his local council for a bit of black humour).   To these I would add the closure of police stations all over Britain.

Supporting, and in some cases rescuing, public services requires spending on salaries, medicines, school books, janitors, and the list goes on almost without end.  Given the extreme inequality in income and wealth in Britain, no Labour government should prioritize a general increase in private consumption.  However, an increase in public “consumption” expenditure – NHS, education, police, local government – is a clear obligation of the next Labour government.

Public investment represents a priority for the Labour government of the future.  Increasing the consumption part of public expenditure is no less a priority.  With idle resources – and the Tory government is unlikely to bring us to full potential – expenditure on public services and public investment are both possible and sound economic policy.

Because of the Tory commitment to on-going cuts in all things public accompanied by tax reductions for the rich, increases in public spending will require borrowing.  With idle resources a negative balance on the current budget is an outcome of limited policy significance.  As employment expands incomes will rise to generate tax revenue, and deficits will decline.

Cutting public services is the route to an impoverished nation.  Restoring public services through greater current spending, combined with public investment, is the social democratic route to national enrichment.