Economics 216: The Macroeconomics of Development Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.) Kwoh-Ting Li Professor of Economic Development Department of Economics Stanford University Stanford, CA , U.S.A. Spring WebPages:

Lecture 8 Savings and Capital Accumulation Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.) Kwoh-Ting Li Professor of Economic Development Department of Economics Stanford University Stanford, CA , U.S.A. Spring WebPages:

Lawrence J. Lau, Stanford University3 Sources of Savings: Household Savings u Household savings (reflects the trade-off between current and future consumption) u Voluntary u Involuntary--social security contributions, mandatory retirement fund contributions u Quasi-voluntary--contributions matched by governments or employers u Issues--fungibility (Are the various types of savings substitutes for one another, e.g., do social security savings offset voluntary savings dollar for dollar?) u Investment in, appreciation of, and reduction in indebtedness on owner-occupied housing and consumer durables u Other unrealized capital gains and losses u Investment in human capital

Lawrence J. Lau, Stanford University4 Sources of Savings: u Business savings (retained earnings, “intangible” investments) u Government savings (budget surpluses, government capital expenditures (e.g., infrastructure and structures), inflation tax) u Foreign capital (portfolio and direct investments, loans and aid)

Lawrence J. Lau, Stanford University5 Savings and the Stage of Economic Development u The importance of an agricultural surplus as a source of domestic savings in the early stage of economic development u The demographic factor in the emergence of an agricultural surplus; e.g. Japan had almost zero population growth between 1740 and 1840 u The United States had ample undeveloped land for agricultural expansion in the 19th Century u Technical progress and economies of scale, e.g. mechanization of agriculture in 19th Century Japan and the United States

Lawrence J. Lau, Stanford University6 The Role of Foreign Capital: Allowing Domestic Investment to Exceed Savings u Foreign capital can jump-start the early economic development and growth process either as a substitute for or an augmentation domestic savings which is likely to be low at this stage u Australia and the United States in the 19th Century benefited from foreign investment from Great Britain and other European countries u China during its First Five-Year Plan period ( ) received significant assistance from the former Soviet Union in the form of loans for the purchase of capital equipment u Israel, South Korea and Taiwan have been major beneficiaries of U.S. aid in the early postwar period u Singapore had a significant inflow of foreign investment in the early stage of its economic development in the mid to late 1960s

Lawrence J. Lau, Stanford University7 The Evolution of Savings Rates in Chinese Societies

Lawrence J. Lau, Stanford University8 The Savings Rate and Real Output per Capita

Lawrence J. Lau, Stanford University9 The Savings Rate and Real Output per Capita: Chinese Societies

Lawrence J. Lau, Stanford University10 The Savings Rate and Real Output per Capita: East Asian Economies

Lawrence J. Lau, Stanford University11 The Savings Rate and Real Output per Capita: Taiwan

Lawrence J. Lau, Stanford University12 The Savings Rate and Real Output per Capita u Note that the developing countries typically have very low aggregate savings rates at low real GNP per capita u Aggregate savings rates tend to rise rapidly with rising real GNP per capita u After a certain level of real GNP per capita is reached, the savings rates tend to stabilize and remain approximately constant u The slopes of the aggregate savings rate with respect to real GNP per capita during the rapidly rising phase appear to be quite similar

Lawrence J. Lau, Stanford University13 The Relationship between Investment Rates and Savings Rates

Lawrence J. Lau, Stanford University14 Savings and the Rate of Interest u Is the aggregate savings rate sensitive to the real rate of interest? u The rate of interest ultimately reflects the marginal productivity of capital, which in turn depends on the efficiency (or the rate of return) of the investment u Are savings deposits in financial institutions sensitive to the real rate of interest paid by financial institutions? u Are savings deposits in financial institutions sensitive to the security of the depository institutions? u Is deposit insurance, explicit or implicit, desirable? (questions of moral hazard on the part of both the depositors and the owners of the financial institutions)

Lawrence J. Lau, Stanford University15 The Importance of Financial Intermediation u Channeling savings to investments (to highest and best use?) u Asymmetric information u Maturity transformation u Lumpiness of investments u Pooling of risks u Transactions costs u Monitoring costs u Lack of alternative investment instruments for savers u Implicit and explicit deposit insurance u Moral hazard u On the part of the owners of the financial institutions u On the part of the borrowers, large and small u Informal credit markets (the lack of anonymity which limits moral hazard) u Mutual credit associations u Grameen banks

Lawrence J. Lau, Stanford University16 The Impact of Inflation u Chronic inflation discourages savings at financial institutions unless the rate of interest is indexed to inflation u Inflation increases the risks of long-term fixed investment (unpredictability of future relative prices, macroeconomic conditions and demand) u Inflation encourages recklessness (moral hazard) on the part of the borrowers, especially if the rate of interest is fixed in nominal terms u Inflation generally means a higher variability in prices, which in turn causes higher variability in profits (and losses) and hence a higher loan default rate u Inflation may thus discourage lending even though the real rate of return, based on the price index, may be positive

Lawrence J. Lau, Stanford University17 The Possibility of Under- and Over-Investment u Under-Investment u Lumpiness (economies of scale and size of market) u Lack of infrastructure u Lack of coordination u Non-appropriability of the external benefits--spillover effects u Government actions may be needed u Over-Investment u Low or subsidized cost of funds (domestic or foreign) u Non-productive investments u Herd instinct u “Winner-Take-All” type situations

Lawrence J. Lau, Stanford University18 Why Do Savings Rates Differ Across Countries? (1) u Lags in adjustment--the permanent income hypothesis of Milton Friedman, habit formation u Differences in the real rates of return u Differences in the degree of stability of the macroeconomy, e.g., the rates of inflation (inflation discourages financial savings) u Differences in the stability of the financial system and the currency u Differences in the security of the depository institutions u Differences in population characteristics, e.g. the demographic structure (age distribution, dependency ratio), life expectancy, morbidity rate, mortality u Differences in the social welfare system and institutions--pension and retirement, health care, and unemployment u Differences in the availability of insurance—the degree of incompleteness of markets, the need for self- or mutual insurance u Differences in the cost/burden of social services--education, housing, medical care

Lawrence J. Lau, Stanford University19 Why Do Savings Rates Differ Across Countries? (2) u The availability of household credit for consumer goods and for housing (the cash-in-advance constraint) u The availability of consumer goods u The bonus wage system (lumpiness of payment and money illusion) u Differences in preferences and tastes, social norms of consumption and cohort-specific historical experience (e.g., Americans who lived through the Great Depression do not like to borrow; the social expectation for ceremonial expenditures--birthdays, weddings and funerals--in developing economies)

Lawrence J. Lau, Stanford University20 Precautionary Savings as Self-Insurance Given Incompleteness of Markets u Precautionary savings are motivated by the existence of uncertainty and risks (e.g., death, illness, unemployment, bank failure, fire, poor harvest, expropriation, inflation) u Existence of risks does not in itself necessarily imply a higher savings rate to the extent that “actuarially fair” insurance is available as a hedge against the risks u Precautionary savings are necessary because: u Not every risk can be insured u Not every insurable risk can be fully insured (the problem of moral hazard) or fairly insured u Thus the necessity of self-insurance u The more incomplete the markets, the higher the level of precautionary savings, other things being equal u Markets are least complete in developing economies

Lawrence J. Lau, Stanford University21 Savings as a Flow and Savings as a Stock u Savings as a flow is whatever is left over from current real output that is not consumed u Savings as a stock refer generally to the level of financial savings, or even more narrowly savings deposits, at a given point in time—it is the cumulative result of the annual flows of savings (and dis-savings) over time

Lawrence J. Lau, Stanford University22 The Savings Rate and the Distribution of Income u Hypothesis: The savings rate rises with increases in the degree of inequality of income distribution u Typical assumptions of models of economic growth: u capitalists save and workers consume u Profit rates, and hence, business savings, tend to rise with concentration u The initial distribution of capital (human and non-human) and its evolution over time also matter u However, diversions by and leakages from wealthy households are common: u Overseas investments u Imports of luxury consumption goods u Capital (foreign exchange) control, import control, credit rationing and direct government intervention may be necessary

Lawrence J. Lau, Stanford University23 The Savings Rate and the Distribution of Income

Lawrence J. Lau, Stanford University24 The Savings Rate and the Distribution of Income

Lawrence J. Lau, Stanford University25 The Question of Embodiment u Is technical progress embodied in new fixed investment (capital goods)? u Is the hypothesis empirically testable? u What are the implications of embodiment?

Lawrence J. Lau, Stanford University26 The Independence of the Steady-State Rate of Growth from the Savings Rate u R. M. Solow (1956) u The importance of Inada’s second condition--the marginal product of capital approaches zero as the quantity of capital (relative to labor) approaches infinity u If the marginal product of capital has a lower bound, then the steady-state rate of growth may depend on the savings rate (Rebelo (1991))