If anyone gets more after-tax income, he either spends it on consumption or saves it -- there's no other choice. (He could give it in charity, which would then spend it on consumption or -- possibly -- save it themselves.) Savings means "income which is not spent on consumption."
When the right wing was defending Bush's tax cuts for the rich, they claimed that this would vastly increase savings. Indeed, they claimed that when the rich get more after-tax income, they save the 100% that is needed to purchase the treasury bonds to make up for the tax and more to invest in plant and equipment.
Well, right now in the midst of a recession, we need more consumption. We have too much savings. (After the jump, I'll give the conventional explanation of why.) Now, the right wing tells us the way to get that is to lower the taxes on the rich. Specifically, the Republican alternative budget replaces Obama's stimulus plan with a "holiday" on Capital-Gains taxes.
If you want more saving, lower taxes on the rich; if you want more consumption, lower taxes on the rich. Their prescription for any situation.
Okay, why does a recession call for less savings?
The background is that -- at any level of production -- savings = investment in plant, equipment, and inventory. To put it another way, production goes to increase in inventory, new plant and equirpment, and consumption; claims on production are either used for consumption or saved. Somebody gets a claim on production for any production -- it might be profit, taxes, even theft; but somebody gets the claim. So, investment and savings are each the difference between production and consumption.
The half educated make three mistakes about that equivalence. They tend to believe that:
- The equivalence of savings and invesmtnet is somehow magical,
- The equivalence only applies at the macro-economic level; it is true in the entirety, but not for particular transactions,
- The equivalence is between savings and investment in plant and equipment. None of this is true.
Indeed, the equivalence is true for a single transaction. Say that Jones buys a pair of gloves from Smith's store for $10. Jones had paid $6 for the gloves from his wholesaler, and carried on his inventory at that amount. Jones has his savings -- the part he carries in his wallet as cash -- decreased by $10; Smith has his savings increased by $4 -- his profit on the sale -- and his investment in inventory decreased by $6. The total change in savings for that transaction is -$6; the total change in investment for that transaction is -$6.
Now, like this transaction, the immediate result of every sale is a decrease in the investment in inventory. So, when sales are less than expected, the immediate result is that inventory is greater than expected. When retail inventories are greater than expected, retailers order less from wholesalers, who order less from manufacturers, who experience an excess in inventories until they reduce production and lay off workers.
When total savings are greater than planned investment in new plant and equipment and increase in inventory, the level of business decreases. This decrease decreases both savings and planned investment. Sooner or later -- and it can be much later -- the planned investment reduces to the actual rate of savings. In the worst cases, both are negative.
Lord Keynes pointed out decades ago that government can combat this downward spiral by reducing total savings by making their savinggs negative -- that is to say, by borrowing.