How Your Savings Plan Fuels an Arms Race on Wall Street

Finding productive places to invest our money

Share with your friends

More share buttons
Share on Pinterest

By Joanna Masel 

Policy makers are keen to encourage people to save more money for retirement, e.g. via tax incentives. This is great advice for individuals; the more money an individual saves, the more comfortable their retirement. But is it also a good idea for society as a whole? What happens when everybody tries to save money at the same time?

To answer this, we need to understand the distinction between relative and absolute competitions. Think about a running race. An absolute competition pits each runner against the clock. In an evolutionary contest, where anyone who finishes the race in less than a certain time is allowed to have children, those with stumpy legs and flat feet will be replaced by the children of the fast runners. In future generations, the average person runs faster.

In contrast, in a relative competition, where competitors race in pairs against one another instead of against the clock, rules of fair play do not apply. One competitor is super fast. Unfortunately, he gets tackled from behind. In the ensuing brawl, he receives a solid blow to the head and passes out. The slower guy then wins. In each generation, the competition gets tougher, but not necessarily because the new generation runs faster. Strictly speaking, this relative competition does not favor being fast. What it favors is crossing the finish line before your competitor. Running fast is one way of crossing the finish line first. But evolution is a creative process, and there are many different ways of achieving the same goal. It is hard to predict which of the many solutions will triumph, and not all of the solutions are ones that we like.

If saving for retirement is an absolute contest, then policy makers are doing the right thing when they encourage people to save for retirement. But if saving for retirement is a relative contest, the incentives we give for retirement plans may achieve nothing, or even worse, do economic harm.

In the real world, it’s sometimes hard to figure out which competitions are relative and which are absolute. But the mathematics behind the two are different, and so are their outcomes. During my training in evolutionary biology, I learned to use a standard mathematical model in which competition was relative. In contrast, economists learn standard mathematical models that are based on absolute competitions. These default assumptions, built into the curriculum, can shape the way someone approaches a problem for the rest of their career.

As a result, economists are biased towards assuming that competitions increase prosperity. Evolutionary biologists like me are trained to have the opposite bias, instead assuming that competitions are zero-sum. In both cases, the truth is probably somewhere in between, but how we are trained affects which situations we see as “normal” and which as “special”, and which sort of mistakes we are most likely to make.

My recent book argues that saving for retirement has become a relative contest, but that economists dangerously mistake it for an absolute one. If all that is saved is “money”, or more broadly, financial assets, then we have a problem. Financial assets are pieces of paper, or scores kept in a computer. You can’t eat financial assets. If all we save is financial assets, we might as well simply burn money today, and then print it again in the future. Financial assets are only valuable because you can exchange them for useful things like food and shelter, or for desirable things like a luxury holiday. Useful and desirable things are wealth, whether or not you used financial assets to buy them. Saving means forgoing the consumption of goods and services today. Investment means converting this sacrifice into the creation of future wealth. Saving and investment are not the same thing, and investing is the part that matters.

If additional retirement savings are automatically invested in the creation of wealth that will make all of our retirements more comfortable, then saving is the good sort of contest, an absolute one. But if society’s total amount of wealth is less flexible, then savers are in a mostly relative competition, an arms race to stake a claim to a larger percentage share of that fixed amount of wealth.

As Keynes pointed out, “no one can save without acquiring an asset, whether it be cash or a debt or capital-goods[1]. Every time paycheck diversions into a retirement plan are used to buy stock, somebody else sells the stock in exchange for dollars. The retirement plan forces the employee to forgo consumption today in order to buy the stock, but that other person may well cancel out this choice, “dis-saving” by selling the stock to pay for everyday consumption. When the seller is simply rebalancing their portfolio, and uses the cash to buy a different stock instead, then that second stock also has a seller. Somewhere down the line, some seller, not the saver, makes the decision to either spend the money creating new wealth that did not exist before, or to spend it on current consumption.

If you add up all the savings in the world, and subtract the amount of dis-saving, the difference must come out exactly equal to the total amount of true investment. This is why people tend to equate saving with investment. But this equality doesn’t come about because individual decisions to save rather than consume cause someone, somewhere, to decide to invest. Each person and institution decides how to spend their money, whether on consumption or on investment. If they do not spend all their money, they save. If they consume more than they have, they dis-save. The reason that net savings and investments balance out is because all asset transactions have two parties, where each saver/buyer must be paired with either a dis-saver or an investor. Without two parties, the transaction can’t take place. When workers pre-commit a percentage of each paycheck to retirement savings accounts, they are forced to buy bonds or stocks or other assets even at high prices representing low returns, without being able to control whether their savings are ultimately used for consumption or for investment.

If we want to build an economy where there is more investment in the future, the best way to do that is simply to invest more, not to all save more and hope that investment will follow through the magic of efficient capital markets. We bathe in a sea of rhetoric about how we should all be saving more; this advice is misguided. There are plenty of savings in the system already; our problem today is to find good places to invest all that saved money. If we can find enough opportunities for investment, this will convert saving for retirement from a relative arms race to absolute race towards prosperity for all.

Get Evonomics in your inbox

So what investments do provide for the future, and which options are achievable? For example, we certainly can’t store food, nursing and medical care for the baby boomers’ retirement. So as a society, we need to invest in things that will make food and care easier to provide in the future than they are today.

The first step is to finding useful opportunities for investment is to stop thinking about “saving money”, and start thinking about ways to spend money to create wealth. Money is an illusion, with no true value. If I waved a magic wand and doubled everybody’s money, nobody would be any wealthier. They would have more money, but the price of everything might also double. This criticism of money extends to other financial assets such as bonds and stocks.

Money is obviously useful as a means of exchange, and as a unit of account. Money can even store value over short periods of time. But the longer the delay between earning money and spending, the more problematic money becomes as a store of value. This problem could become catastrophic with the retirement of the baby boomers. The baby boomers are all saving at the same time, and later, they will all want to spend at the same time. This affects prices in the stock market, in the housing market, and in markets for all kinds of assets in which baby boomers think they have “invested” their money. Right now, lots of baby boomers, and the pension funds that are supposed to support them, are making a last-ditch attempt to save. This is increasing demand for financial assets such as stocks, and driving their prices up. When the baby boomers need to pay nursing home fees later, they will sell those assets. When many of them do this at the same time, it will steadily, over the course of several retirement decades, drive the price of assets down.

The baby boomers saved money. But they didn’t save food, and they didn’t save medical and nursing care. They saved money, and handed it over to the stock market, and asked the companies there to spend more money investing in the future. But do the baby boomer savings, when they are spent buying stocks, cause companies to invest more in the future?

Most savings are used to buy existing financial assets. By inflating asset prices, this decreases future returns. According to conventional economic reasoning, returns won’t keep dropping forever. Eventually the low cost of borrowing will cause new borrowers will appear. These borrowers will create new return-generating assets, creating somewhere useful for new savings to go. These borrowers have investment plans that only work if they can get financial capital cheaply enough.

But how cheap does financial capital need to be before enough new people venture into the market, borrowing the money in order to spend it on real capital assets that create something of value for the future? The price of capital has been incredibly low for some years. For safe investments, it has been barely above zero, sometimes even negative in inflation-adjusted terms. Why is there so much supply of financial capital willing to settle for very low returns? And why is there so little demand for financial capital even at low interest rates?

On the supply side, baby boomers have been saving money for their retirement. Companies and governments have also been saving money for the baby boomers’ retirement, via their pension plans. China has been saving money and lending it to America. And as societies become less equal, more money ends up in the hands of the rich, who are more likely to save it than are the poor. The oversupply of financial capital is almost a perfect storm. It would be even worse if everybody saved “enough” money for their retirement, the way pundits urge us to. We don’t need more savings: we need more productive places to invest all the money that is already available. Lots of savings would be great if there were lots of good places to invest it. We already have lots of savings, but where should they go?

On the demand side, we do not see businesses full of great expansion ideas, eagerly seeking to borrow the capital to make them a reality, if only that capital were offered to them at a slightly lower interest rate. Instead, many companies today are already sitting on huge sums of cash, profits from their sales, money that they don’t know what to do with. Capital markets are broken; even at rock-bottom interest rates, there are too few people who want to take society’s savings and spend them in a productive way.

If we want to store value for our retirement, or for some other purpose, we can’t just hand money over to a mutual fund and ask its managers to harness “the market” to store it for us. Individually and collectively, we all need to take more responsibility not just for saving, but also for investing. For every lender, there is a borrower. Who do we want to lend money to? Who will make best use of it, and then pay us back? In my book, I present some of my own ideas, but in the end, we all need to stop delegating the job of investing to the magic of capital markets, and instead start taking both individual and collective responsibility for making investment happen. Until that happens, we should challenge the conventional wisdom of urging more retirement savings, and encouraging them with tax incentives; maybe all we are doing is fueling an arms race that benefits only the fees of arms dealers, namely the financial industry.

[1] John Maynard Keynes (1936), The General Theory of Employment, Interest and Money, p.81.

2016 March 10

Donating = Changing Economics. And Changing the World.

Evonomics is free, it’s a labor of love, and it's an expense. We spend hundreds of hours and lots of dollars each month creating, curating, and promoting content that drives the next evolution of economics. If you're like us — if you think there’s a key leverage point here for making the world a better place — please consider donating. We’ll use your donation to deliver even more game-changing content, and to spread the word about that content to influential thinkers far and wide.

 $3 / month
 $7 / month
 $10 / month
 $25 / month

You can also become a one-time patron with a single donation in any amount.

If you liked this article, you'll also like these other Evonomics articles...


We welcome you to take part in the next evolution of economics. Sign up now to be kept in the loop!