Free Lunch (8 page)

What makes people save?

Surely it cannot be patriotic duty that makes people save, or a need to ensure there are sufficient funds for productive investment to take place. It is not hard to find reasons for saving – putting money away in case of unforeseen emergencies, such as loss of income, for the ‘rainy day’ of legend, for school or university fees, or for retirement. Milton Friedman, most famous as the intellectual parent of the monetarism of the 1970s and 1980s, gave us the permanent income hypothesis. This advanced the argument that people have a firm idea of what their permanent or long-run income is, and how much they want to spend out of that income to maintain a certain standard of living. If in one year they receive a large bonus, they are too canny to regard that as part of their permanent income, and so will save a significant proportion of it by buying financial assets. If in another year their pay is cut because times are tough, they may also treat that as temporary, maintaining their spending by drawing down savings. Saving varies according to what people actually earn in relation to their permanent income.

If this sounds a bit too good to be true, Franco Modigliani and Albert Ando offered their life-cycle hypothesis of saving behaviour. At its simplest this is just a story about pensions. People build up savings during periods when they are earning most and run them down when their earnings stop, during retirement. We are spenders rather than savers in childhood, accumulate savings during middle age (or give some of it to our own children to spend) and run down savings in old age, probably leaving some spare at the end to pass on to the next generation. The life-cycle hypothesis fits many people’s experience quite neatly. It can also accommodate variations. Young couples save to buy a house or flat but when the children arrive, and the wife’s earnings may stop for a while, they stop saving, probably for some time.

There is an interesting debate to be had when it comes to housing. Everyday discussion of the economy tends to distinguish between people’s investments in financial assets – stocks, bonds, long-term savings accounts – and in housing. The former is often regarded as saving, the latter as consumption. When share prices soar it is a sign of economic health. When house prices do so, it is a sign of danger, of irresponsible behaviour. This distinction between financial and physical assets is, however, hard to sustain. When people buy a house, they are engaging in the household equivalent of a company investing in new factory or office premises. Buying a home, it could be argued, is the ultimate long-term investment, with monthly mortgage payments being the equivalent of a regular savings plan.

Saving behaviour in aggregate both influences and is influenced by what is happening in the wider economy. High unemployment appears to encourage more saving, because people fear they are going to be next to be made redundant. Low inflation seems to be associated with low levels of saving, ideally because individuals have more confidence that the money they have already put aside will not be eaten away by rising prices. It may also be that savers are affected by what is called the ‘money illusion’. When inflation is low, interest rates are also usually low, making the rates offered on savings accounts look unattractive. It is of course an illusion. An interest rate of 10 percent at a time of 8 percent inflation is lower in real terms (after allowing for inflation) than a 5 percent rate when inflation is 2 percent, but such illusions can be surprisingly powerful.

Many of the basics are now in place. Indeed, we have touched on some fairly sophisticated stuff. We still need to look at what lies behind the behaviour of two other important sets of players – firms and the government – but that will build on what has already been described. First, another entertainment interlude.

6

Classical recipes

When we left Adam Smith, it was with an optimistic view of the world. As long as economic freedom was maintained, prosperity would follow. Our next three speakers, all of whom came after Smith, present a much more mixed vision. The first, Thomas Robert Malthus (1766–1834), known as Robert Malthus, was certainly responsible for giving economics its gloomy reputation. It is not clear whether the writer Thomas Carlyle had only Malthus in mind when describing economics as the ‘dismal science’, but it is a label that survives to this day in spite of the fact that most economists are cheery souls. A rather good American economics website is called www.dismal.com. Also on the bill are two other great economists from the classical era, mainly the nineteenth century, David Ricardo (1772–1823) and John Stuart Mill (1806–73).

Malthusian gloom

Everybody, I suspect, is familiar with the basic ingredients of Malthus’s gloomy vision, although most know little about the man who came up with it. Robert Malthus was born into a well-to-do family in Guildford, Surrey, one of eight children. He was blessed not only with intelligence but with sporting ability. He was also good-looking, making the most of it by wearing his hair in long golden curls tinged with pink, a kind of strawberry blond of his day. The effect was rather spoilt when he ventured to speak, a cleft palate he had inherited from his father giving him a high-pitched, whining voice. Malthus excelled in his studies of mathematics and natural philosophy at Cambridge, becoming a fellow of Jesus College before taking holy orders. He gave up his Anglican priesthood in 1804 in order to marry Harriet Eckersal, ten years his junior, although he used the title Reverend in later life, partly to deflect criticism of his views. A year later he took up the post of professor of modern history and political economy at a college established by the East India Company, making him the world’s first economics professor (Adam Smith held chairs in logic and moral philosophy), and probably the world’s first professional economist.

By then Malthus had already published the first version of the paper that was to make his name. ‘An Essay on the Principle of Population, as It Affects the Future Improvement of Society, with Remarks on the Speculations of Mr Godwin, M. Condorcet and Other Writers’ is a mouthful, and usually shortened to just ‘Essay on Population’. Condorcet, the Marquis de Condorcet (1743–94), was an eighteenth-century French philosopher who had taken Adam Smith’s optimistic view of the future and run with it. He saw a future of strongly rising industrial and agricultural production, in which population and living standards would increase together. William Godwin (1756–1836) was born into a strict Calvinist family, trained as a minister, but became a writer and thinker with unconventional views, including regarding marriage as slavery (although he married twice, the first time to the writer Mary Wollstonecraft, who shared his views on marriage – Mary Shelley was their daughter). Godwin also shared Condorcet’s optimistic vision of the future and if anything was more utopian in his vision. More importantly, Malthus’s father, Daniel, the wealthy Surrey squire, was very taken with Godwin’s vision.

The 50,000-word ‘Essay on Population’ was therefore written by the younger Malthus to settle a family argument, although his father was so impressed he published it at his own expense. The core of Malthus’s pessimistic case is contained in just a few sentences of the Essay. He wrote:

I think I may fairly make two postulata. First, that food is necessary to the existence of man. Secondly, that the passion between the sexes is necessary and will remain nearly in its present state. Assuming, then, my postulata as granted, I say that the power of population is indefinitely greater than the power in the earth to produce subsistence for man. Population, when unchecked, increases in geometrical ratio. Subsistence only increases in an arithmetical ratio. A slight acquaintance with the numbers will show the immensity of the first power in comparison with the second.

The acquaintance with the numbers he was talking about means that food production, he predicted, would increase arithmetically (2, 4, 6, 8, 10, 12, etc.), while population would rise geometrically (2, 4, 8, 16, 32, 64, etc.). If you have ever owned rabbits, you will get the point. Something had to give, and in Malthus’s view the choice was between voluntary restraint on population growth, which he was sceptical about, and something much more nasty, population being controlled by war, pestilence, plague and, perhaps most of all, famine. As for ordinary workers, whom Smith, Condorcet and Godwin had been so optimistic about, Malthus saw their prospects as grim. Workers would not see any rise in living standards; instead they would be stuck at subsistence levels or even below them. Indeed, the sheer grimness of their lives, during periods of which ‘the discouragements to marriage and the difficulty of rearing a family are so great’, would be one way of keeping population down. Dismal indeed.

Was Malthus wrong?

When I first came across Malthus in the early 1970s, it seemed that, while he might have got his timing wrong, his predictions of a world in which population growth would outstrip food supply chimed in with warnings (which are still around today) that this would be the condition, if it were not already, of much of the Third World. In fact, Malthus got two important things wrong. The first was to underestimate the scope for technological advance in the production of food and to misunderstand the biological nature of food production – why should the population of humans rise geometrically but the population of, say, sheep for meat eating, rise only arithmetically? Malthus also got the causes of population growth wrong. Although he wrote on the brink of a huge increase in world population, from under 1 billion in 1800 to more than 6 billion now, this was not due to lusty peasants breeding indiscriminately but to medical advances and rising living standards (including the availability of better and more plentiful food), which both reduced infant mortality and increased average life expectancy. The pattern has been for rising living standards to be associated with smaller, not larger, family size.

Thus, while Third World famine may look like a Malthusian nightmare, his predictions were too pessimistic. The problem in developing countries is not that there is a global shortage of food and they, as the poorest, are missing out. It is that the distribution of the available food between countries is so uneven. There will be more on that vexed question towards the end of the book.

Not just population

While Malthus’s population predictions may have been wrong, his contributions on the subject were invaluable. As well as being the world’s first professional economist, he was probably also its first demographer. Those were not his only claims to fame. Malthus gave us the ‘law of diminishing returns’, again derived from his agricultural observations. There are two ways of looking at this. One is that if ten men work a piece of land they will get a certain amount of produce out of it. Increasing the number of workers to twenty will increase the size of the crop but is unlikely to double it because there is only so much the land can produce. The average output per worker falls because after a certain point the
marginal
product of an additional worker – the amount by which he increases output – is smaller than that of the man who came before him. Another way of looking at the same thing is to take the view that most fertile land is already in use at any given time. Raising output would therefore require bringing into play stony, less fertile land, which would produce less. That was why Malthus was gloomy about food production. He may have been wrong on that but the law of diminishing returns was and is an important piece of economics.

Finally, Malthus took on another Frenchman, Jean-Baptiste Say (1767–1832), with another view that went against the opinion of the time. Say, a follower of Adam Smith, said that not only does the market mechanism ensure that supply and demand meet for individual products but that this was true for the economy as a whole. Say’s Law, sometimes described as ‘supply creates its own demand’, or rather that the act of producing goods – paying the wages of workers and so on – will mean there is ready demand for those products. In the aggregate, too, supply will equal demand. General over-production, or glut, was impossible. Malthus disagreed. He saw little danger of glut for essential products such as food. But he thought that over-production was perfectly possible for other goods. So, by extension, was unemployment. Given that unemployment in Britain may have risen to more than a million after the Napoleonic wars, he appears to have had a point. He also had a remedy, advocating ‘the employment of the poor in roads and public works’. In this he was to anticipate John Maynard Keynes, the most famous economist of the twentieth century, by over a hundred years.

David Ricardo

Ricardo, a contemporary of Malthus, has a biography that reads like that of a character out of Dickens, or perhaps Trollope. One of a large number of children of a wealthy stockbroker, with roughly twenty brothers and sisters (the exact number is not known), he was born in London, a few years after his father, a Dutch Jew, had left Holland for the City. Ricardo junior appears to have had an informal education but one that was sufficient to prepare him for entering the family firm at the age of fourteen. All went well until, at the age of twenty-one, he fell in love and married a Quaker girl, thus outside his Jewish faith, a course of action that was to see him dismissed from the family firm and disinherited. But Ricardo was clever and resourceful, and he established his own firm of stockbrokers and built a highly successful business. He was also a man of culture, reading widely, and in his twenties discovered Smith’s
Wealth of Nations
and began to develop his own approach to economics. By the age of forty-two, having accumulated enough wealth to retire (he ranks as the world’s richest economist, in a profession that throws up relatively few millionaires), he had a string of properties, most notably Gatcombe Park in Gloucestershire, the home of Princess Anne, daughter of the Queen. A few years after retirement he bought himself a seat in Parliament and was regarded, unsurprisingly, as the leading expert on economics in the House of Commons. He did not, however, have much time to develop his political career, dying at the young age of fifty-one.

Ricardo and trade

The bit of Ricardian economics that everybody should know about, and many do, is the law of comparative advantage. Smith argued that the division of labour explained why specialization increased economic output and therefore prosperity. Ricardo developed this, in the setting of international trade, into a fully fledged theory. That countries should specialize in what they are best at seems beyond dispute; it did not need an economist to point this out. But what happens when one country is more efficient than another in everything? Should it produce all those products? And is the other obliged to put up tariff barriers to avoid being swamped with imports from the more efficient country? Ricardo’s answer was ‘no’ on both counts, and he used economic arguments to campaign for free trade in general and the repeal of Britain’s nineteenth-century Corn Laws in particular.

The example he used is by now famous. Suppose two countries, England and Portugal, are trading just two products, wine and cloth. Portugal, with the benefit of sunshine, is obviously good at producing wine – it takes twenty-five workers an average of a day’s work to produce a barrel. England, in contrast, is inefficient at producing wine, 200 workers being required to produce the same amount, even leaving aside questions of whether it would taste as good. Obviously it is best for Portugal to produce wine. But look too at cloth. In Portugal it also takes twenty-five workers a day to produce a roll of cloth. England is more efficient at producing cloth than wine, but still not as good as Portugal – fifty workers are needed to produce a roll. So what should happen? Portugal has
absolute
advantage in both products. Is the game up for England? Ricardo explained that in these circumstances there would be a net gain in output if Portugal switched production from cloth to wine and England did the opposite. Suppose you start in a situation where, with the same number of workers available in each country, Portugal is producing 1,000 units of wine and 1,000 units of cloth each day. Less efficient England is, by contrast, producing only 500 units of cloth and 125 units of wine. If England switches all its wine workers to cloth production, it will make an extra 500 units of cloth, making 1,000 in all, but no wine. Portugal would in such circumstances produce more wine (to satisfy the English market), and a little less cloth. Its total production of both products would remain at 2,000 units, while England’s production would have risen from 625 to 1,000. ‘World’ output would have gone up. The central point was that what matters in trade is
comparative
advantage, not absolute advantage. Ricardo’s law of comparative advantage explains why it is beneficial for countries to trade in every circumstance.

Many people have trouble with this idea. Why should the Portuguese want to buy cloth that is less efficiently produced than their own product? The answer is that the price of English cloth will be determined by ‘world’ levels. English cloth workers, because they are half as efficient, will tend to be paid half as much as Portuguese workers. The Portuguese will thus be able to afford to buy a significant proportion of the increase in world output. There is still a gain for England and its workers, though, from moving from appallingly inefficient wine production to cloth. It is a ‘win–win’ situation.