Famous economist John Meynard Keynes hated savers. Saving your money was not a good idea in his head. A good citizen would spend all their income to stimulate the economy to extreme efficiency.

This is a modern, and twisted, interpretation of the good professor’s ideas on excessive saving. From a personal finance stand-point, we all like to look at spending as the enemy. Wasting money on stuff you don’t need contributes to credit card debt, high mortgage payments, and no money left for retirement. Personal finance blogs preach the virtues of being debt free, having tons of cash for emergencies, and moderately enjoying the nicer things in life if your finances are under control. These are all great ideas, I live by them myself and so should you.

But, a large portion of us do not. Back in 2005 the savings rate in the US dropped to below 1%. That’s sad considering up until the mid 80s we were always above 5% and crested 10% a few times. This is much healthier for us on a personal finance level. During recessions we tend to increase our savings because we cut our spending in anticipation of employment issues. We’re so smart.

Hardly. Our savings rate is currently just under 5% as we emerge from under our desks and realize nuclear war seems to have been averted (duck and cover!). But our mortgages and credit card bills are still holding us back. Though we’re itching to spend, we owe too much money. That’s the 2009 part of me talking. The 2010 Weakonomist knows deep inside that our credit cards are burning holes in our leather wallets and it’s only a matter of time before our consumption addiction returns. I’m doing my part, I bought a TV (a PHILIPS naturally) and a Blu-Ray player recently. Remember I said if your situation is under control you can enjoy life’s little pleasures. But if there was such a thing as a 2006 Weakonomist I’d have a mortgage and a HELOC to pay on, and my purchase wouldn’t be good for me financially. But that doesn’t matter because it’s good for the economy!

70% of our economy relies on consumers. We control the economy. The stimulus programs were designed to get us to spend our money, which would fuel job growth and bring us out of the recession. So buying stuff is good! Or it was good. We bought too much stuff using easy credit. Though Keynes wanted consumption to bolster the economy, we had too much consumption.

In China, they have the opposite problem. We’ll talk about why tomorrow, but for now let’s look at the economic implications of a billion people following the commandments of personal finance. The savings rate in China is something like 30%; and this number has grown in recent years, meaning they are saving more than ever. There are dozens of whiteboard scenarios I could go through and if 2006 Weakonomist had his way I’d have an underwater house with whiteboard paint to do them all. But we’ll just look at a few problems with saving too much:

• Run-up in investment values. Stock prices move up and down due to the balance of buyers and sellers in the market. If there are more buyers than sellers, the price goes up. When there are more sellers than buyers, the price goes down. If everyone is saving their money (assuming they invest some) then you’re going to see a run-up in the prices of the investments most people put their money in. This creates a bubble. As soon as people starting pulling out of the market (either to consume or out of concern for a bubble) a selling frenzy could start. This creates instability in an economy and could spark a recession.
• Deflation. A little bit of inflation really isn’t a bad thing. It’s a healthy side effect of a growing economy; like putting on weight from pumping iron. But deflation is rarely a good thing. If no one is buying anything, then producers must cut prices to incent consumers to buy. This deflation of real prices destroys profits. If companies don’t make profits, they won’t make stuff. This might not be a bad thing when it comes to Coach purses, but if Dole can’t make a profit on bananas, then you won’t get bananas. The economy just winds down into recession/depression.
• No reinvestment. Businesses must reinvest in themselves in order to grow. Reinvestment has given us such things as cancer treatments, the lightbulb, and the iPhone. If businesses just save all their profits, there will be no innovation. No innovation no improvement in the quality of life. Cancer treatment and lightbulbs aside, I might as well be suffering from the plague if I don’t have my iPhone.
• Easy Credit. If we all keep our money in the banks, then the banks have trillions of dollars to lend. To entice you to borrow some money, interest rates will be very low. We all know what happens when interest rates are low for any extended period of time. Though this would be in stark contrast to the scenerio above, it’s just as likely in my opinion. Going from one extreme to another is no better.

So is there a happy medium between saving and consumption? Probably. But the economy is too big and bulky for us to ever isolate that ideal savings rate and hold every other factor equal. Even in the happy medium, innovation and profits would be held back from their potential peaks. If the market is perfectly stable and no one can out innovate to increase profits, you suffer. So true stability may not actually be the happy medium.

I wish I could end this post with something spectacular. The truth is, what’s best for personal finance isn’t what is best for the economy.

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice.

categories: economics, personal finance