It seems to be fairly commonly believed that saving money has a deleterious effect on the economy. I was recently told that if everyone in the US saved, the entire economy would come to a complete halt. This is the obvious corrollary to the dumb Krugmanian idea that consumption drives an economy (sure, I realize it’s Keynesian, but Krugman is the diable du jour). I responded thus:

First of all it is not possible that there could ever be a situation wherein everyone in an economy saves. There will always be transactions of some kind, until there is only one person left alive.

Secondly, in the absence of a central bank, savings is what sets interest rates. When savings is high, interest rates come down (supply and demand works on everything). When those interest rates come down, businesses realize that now is the time to embark on investments in the factors of production. In other words: they expand. A steel mill, for example, might build a new furnace.

This is market regulation, without the government. The low interest rate, caused by saving, tells producers two things:

It’s time to expand. It’s financially feasible. The cost of borrowing money is cheap and When our investments in capital come to fruition, the public will have the money to buy the products we are producing.

So, savers, far from being a drag on the economy, are actually the ones who drive the economy.

What I described above, of course, is a laissez-faire economy. What we have today is not the free market. Savers are still important to the economy, but they do not drive the economy as they do in the free market.

In this central bank dominated economy, what is the purpose of savers? The function of savers in this economy is to have a moderating effect on the bust phase of the business cycle. If it so happens that the Fed arbitrarily drives down interest rates artificially, at the same time savings are high, then the inevitable bust won’t be as bad. There won’t be as much malinvestment in the economy to be cleared out, because the consumers will have the money to procure the products that the producers manufactured.

Incidentally, something like the real estate bubble could never happen in a laissez-faire economy, because if the public suddenly started investing absurd amounts of money in a particular commodity, soon enough the savings would start to become depleted. As that happened, the interest rates would climb, and the bubble would be deflated even before it really got going.

But when you have a central bank that can artificially push down the interest rates, that free market check on outrageous, irrational investing is gone.