A note on excess Savings over Investment

Frances Coppola has a very nice post about (among other things) how the German thrift is the main cause behind the imbalances afflicting the Eurozone. Overall I agree with it, but there is an idea, a causality in it, that I have also found in Michael Pettis’ work that I just can’t agree with. The idea, roughly speaking, is that when a country has excess savings over investment it has to invest it abroad, because savings must equal investment. It is true that for the whole world, savings must equal investment (more on that in the end), but the fact that for some country savings exceed investment doesn’t imply in any way that it must invest the excess abroad, in fact, investment might be 0 for the world economy!

Think of the following example. Imagine there are only two countries in the world, A and B, and that in a certain period of time, all transactions were in consumption goods (so no investment) with country A consuming 1000€ and country B 1000€ as well. Of the 1000€ consumption goods country A bought, 100€ of them were sold by country B. 

So we have for country A:

GDP_A=C+I+X-M=1000+0+0-100=900=Y_A

S_A=Y_A-C=900-1000=-100

I_A=0

S_A-I_A=-100

For country B:

GDP_B=C+I+X-M=1000+0+100+0=1100=Y_B

S_B=1100-1000=100

I_B=0

S_B-I_B=100

So country B has excess savings over investment, but that doesn’t mean it has to invest them abroad, it simply means that other country has to have a negative S-I, and investment can even be zero for both countries.

S-I for a given country is simply given by its current account balance by definition:

S-I=Y-C-I=C+I+X-M-C-I=X-M

So, but what does S=I mean?

S=I is a tautology, it’s an accounting convention, it has nothing to do with financing. It merely reflects the real assets we consider important to produce and so we distinguish spending on those kinds of assets from every other spending.

Imagine we considered yellow umbrellas as a real important asset to accumulate, it just made us happy and they had magical powers or whatever. So we defined Investment as spending on yellow umbrellas, consumption as all other spending and savings as income not spent on consumption. So C+I=Y=S+C and S=I which means that savings is simply the yellow umbrellas we produced in that period, the real assets we decided to distinguish from the rest. It says nothing about financing the expenses on yellow umbrellas, it’s a transaction as any other regarding financing issues.