The Keynesians and central bankers will have you believe that it’s consumption that drives economic growth.

This is their rationalisation for inflating the currency – which lowers standards of living as prices rise. They say that deflation is dangerous, as with falling prices, people choose to spend less, which will result in an ensuing depression or liquidity trap. They therefore need to inflate to stimulate consumption.

But it’s not consumption, but savings that create economic growth in the form of higher productivity. This can be highlighted with a simple example:

Say you have a lone man on an island. He needs to eat at least 1 fish per day to survive, but prefers to eat two. His production possibilities are as follows:

While the fishing line and fishing net offer higher productivity, he can’t afford to construct them initially, as he has no savings.

He therefore has no choice for the first day but to fish with his bare hands to survive. After a few days of eating his entire catch, he decides to invest in some capital in the form of a fishing line. This way, he will be able to increase his catch.

On the fourth day, he catches two fish and decides to save one – shifting his consumption-savings ratio (proportion of consumption to savings) towards higher savings. This allows him, on the fifth day, to survive on his savings of one fish while he constructs his fishing line.

The fishing line allows him to increase his daily catch to four fish per day. He can now eat two fish per day while still increasing his savings.

The life duration of his capital (fishing line) is four days. At the end of the four days, rather than replace the fishing line, the fisherman realises he has enough savings to live on while constructing a fishing net, which will be even more productive. He therefore, living on savings which allow him to consume two fish per day, takes the next four days (days 10 to 13) to construct a fishing net.

His productivity has now increased yet again, to eight fish per day. Including time taken to maintain and replace capital, his productivity has risen from two fish per day to a maximum average of 5.3 fish per day, simply because he chose to save and invest in capital.

This is an example of what’s called a progressing economy.

Now let’s consider the opposite, that consumption could cause economic growth:

Take the same fisherman, who has worked hard and saved in order to increase his capital and productivity. Say on day 14, that some economist had come along and told the fisherman that he could be very wealthy. All he has to do is increase his consumption!

Hearing this good news, and abandoning his own common sense and good judgement, he decides to party every day and not save at all. He consumes his entire catch every day.

But soon enough,his capital has worn out! He can no longer fish with his fishing net.

Because he has made no savings, he can’t afford to replace it. He has consumed his capital! He is therefore reduced to having to fish primitively with his bare hands again. His productivity has decreased along with his living standards.

This is what’s called a retrogressing economy.

So. Is there any reason that the same principle that applies to one person – that savings create growth – should not apply to many? If not,is it consumption or savings that create economic growth?

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