Economic Myth Busters

Toby Madden | Regional Economist
Ryan Bathe | Intern

Published May 1, 2009  | May 2009 issue

Untitled Document

If the money the government lays out doesn't get spent—if it just gets added to people's bank accounts or used to pay off debts—the plan will have failed.
—Paul Krugman (New York Times, Jan. 25, 2008)

Upon receiving income, consumers face two choices. They can spend their income, or they can save it. A widespread belief is that consumers must spend income to help the economy and that if people choose to save, the economy suffers. An economy is built on consumption, and too much saving detracts from growth. If people are saving their income, then they are not buying new things or paying for services, which help keep people employed, businesses running and the economy growing. The tax rebate checks sent out in 2008 were intended to help keep the U.S. economy out of a recession. Taxpayers were encouraged to spend the rebate rather than save it, which is right in line with this belief. Saving will not help as much as consumption in an attempt to avoid recession.

The truth is that saving does benefit the economy—consumers themselves are not spending their income, but their savings serve as secondary investments. There are many ways to save, including in a savings account at a bank or as an investment in the stock market, investing in a relative's small business, government bonds or certificates of deposit. Each of these methods is a way for consumers to save, but also allows others to invest saved income.

Saving provides an important source of capital to banks and companies. In particular, banks utilize consumer savings to make loans to individuals or companies, and public companies use consumer investments to build factories, hire new employees, research new products and so on. Saving drives all of the above. If an individual wants to take out a loan to buy a car, the bank can use the savings of consumers to make a loan to that individual. When a bank makes a loan, the person or business receiving the loan will spend the money, which is the secondary spending that takes place to aid economic growth. However, it may take time to make this investment and for the effects of the investment to roll through the economy.

Saving in the present creates stronger spending in the future. When consumers save, they earn interest on their savings and experience appreciation on their investments. When interest is received and profits are made, consumers have more income to spend than they had prior to the investment. When U.S. taxpayers received their tax rebate checks, spending them immediately may have had the greatest effect at the present; however, saving that check would have accrued interest and appreciation, creating greater spending power in the future.

The only form of saving that does not benefit the economy is saving that cannot be used by a secondary institution, such as a bank or public company, or if the secondary institution does not invest the proceeds. An example of this form of unbeneficial saving is storing money under a mattress. In such a case, a consumer's savings are not earning interest, nor can a secondary institution utilize those savings as a secondary investment. Not only are consumers not earning interest on their income, but they are also losing value to inflation. To lessen the effects of inflation, consumers and financial institutions should use funds in such a way that they expect to earn a return on investment.

While saving may not appear to be as helpful to the economy as direct consumer spending, saving does provide a number of benefits. Economies must strike a healthy balance between consumption and saving, and a certain degree of saving is beneficial for every consumer. Consumers must determine their own level of saving based on how much they are willing to give up at the present for future consumption. While immediate consumption may provide the greatest economic benefit at the present, consumers should never avoid saving in fear of stunting economic growth.