Savings & Investment: Capital, risk, and currency in the modern economy

This article is an excerpt from the full article 'Economics in One Lesson: An Analysis of Basic Economics' which analyses the work of Henry Hazlitt.

When household savings are deposited in bank accounts, they become available for banks to lend to investors (including other households in form of mortgages) [13]. That’s right, your hard-earned money is used by others to make money, not least the banks that charge interest on it.

Without diving too deep into the murky waters of banking and money creation, banks and other ‘deposit-taking institutions’ hold deposits (which, for them, are liabilities they pay interest on) and grant loans and credit (assets they earn interest from). The Bank of England has this to say about how money is created:

“Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money…The reality of how money is created today differs from the description found in some economics textbooks: Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits; In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”

(https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf)

Essentially, money is created by issuing debt, and destroyed by extinguishing debt (when it is paid back, that is). Monetary policy (adjusting interest rates in the economy) is the key tool policy-makers use to encourage or discourage the demand and supply of money.

In some countries, banks - a term I’ll use to mean deposit taking institutions broadly - have a requirement to maintain a minimum level of liquid assets in ‘reserve’ to safeguard against risks (such as loan defaults, for example) and satisfy various other financial obligations.

“Capital is the cornerstone of the banking system’s safety and stability. It protects depositors during periods of stress, ensures banks can access funding, facilitates payments and helps banks to keep lending to their customers during good times and bad.”

(https://www.apra.gov.au/news-and-publications/apra-finalises-new-bank-capital-framework-designed-to-strengthen-financial)

In Australia, the requirement for statutory reserve deposits was removed in 1988, and banks are now required to hold a certain amount of capital to provide a ‘cushion’ against risk. According to Trading Economics, the Bank Liquid Reserves-to-Bank-Assets Ratio was 16.47% in 2021, an increase on recent years [14].

"From a prudential regulator’s perspective, capital is a measure of the financial cushion available to an institution to absorb any unexpected losses it experiences in running its business. For a bank, such losses might include loans that default and are written off. Insurers might be hit by an unexpectedly high volume of claims in the wake of a major natural disaster.

As financial institutions are in the business of taking on risk, managing capital effectively is a very important function. Ensuring sufficient levels of capital are sustained in good times enables a financial institution to remain resilient during periods of financial adversity, and help to protect their customers in the event that it becomes insolvent (which in practice has been extremely rare in Australia, but has been more common in many other countries)."

(https://www.apra.gov.au/capital-explained)

The concepts of saving and investment at the economy-wide level are a little more complicated, and involve international trade; imports, and exports.

“National saving is the difference between a nation's income and what it spends on the consumption of goods and services, and comprises household, corporate and government saving. The level of national saving has important implications for the economy; it provides a source of funds available for domestic investment, which in turn is a key driver of labour productivity and higher future living standards. In an economy open to trade and capital flows, the difference between the level of investment and saving in the economy is equal to the current account balance.”

(https://www.rba.gov.au/publications/bulletin/2012/mar/2.html)

Talk of a ‘current account deficit’ will be familiar to many in Australia (the current account is the net flow of money from international trade), because Australia has long spent more than it makes from overseas trade. A deficit can indicate greater foreign ownership of domestic capital, though having a current account deficit (as Australia had for forty-for years between 1975 and 2019), is not necessarily a bad thing, and could be interpreted as a country like Australia having many investment opportunities that can’t be satisfied by using its own capital (that is, there is not enough savings available domestically to pay for them).

Historically, Australia’s international trade long prospered on the back of the humble sheep (until the 1960’s, wool was Australia’s largest export at 40% of the total), and more recently from resources - primarily iron ore, coal, and liquefied natural gas (LNG). The country’s largest export partner is China (35%), followed by Japan (16%) [15].

A deficit (the amount owed to trading partners), is ‘balanced’ through the Capital Account, which is the other component of the ‘Balance of Payments’:

Balance of Payments = Current Account + Capital and Financial Account

The Capital and Financial account is how a country like Australia pays other countries for giving it more than it provides through direct trade. It is the ‘other side of the entry’ just like in accounting, where each transaction involves two parts: a debit and a credit. The total balance of payments should be zero [16].

Finally, when talking of trade, it’s useful to remember that transactions can only take place when one party has enough foreign currency to pay the other, so exporting to another country helps a nation pay for imports.

Arguments

Savings and investment are two sides of the same coin; savings is the supply of capital and investment the demand for it. The amount of savings deposited in bank accounts is available to investors, who can use the idle funds in the form of bank loans and credit.

The level of savings and investment are brought into equilibrium by using interest rates (the price of capital), which makes money cheaper when rates are low and costlier when rates are high (and savings or investment therefore more or less attractive).

A high rate of interest is not to be feared, and is a stimulus for greater savings, whereas an artificially low rate can encourage wasteful use of capital on less-productive ventures and allow households to overstretch their finances. Excessive lending can create inflation where banks increase the money supply and are eventually accompanied by a rise in rates as lenders compensate for the decrease in the value of money due to the effects of inflation.

Unproductive savings generally only occur where cash is simply hoarded, or where economic uncertainty that causes banks to tighten their lending and households to hold on to a buffer in their bank accounts.